Perestroika Again: Why rapid investment growth is another deceptive signal from the Russian economy

The growth of investment in Russia by the end of 2023 will be at its highest level for the past 12 years; during the peace years, the economy could only dream of this. However, like the unexpectedly high economic growth rates in the midst of war and sanctions, investment growth does not signal economic development. Investment growth in January-September 2023 was 10% of the previous year's level — a record 20 trillion rubles. At the same time, the main sources of investment were enterprises' own funds and cash injections from the budget, while the share of 'market' funds decreased. A sectoral analysis of the economy’s investment structure shows that the investment boom in 2023 serves not so much the economy's growth as it does its structural reorganisation: replacing falling imports, expanding the military-industrial sector and creating a parallel transport and logistics infrastructure, as well as shifting the focus from some industries to other, often less profitable ones. The situation will change as the share of companies with high profit margins shrinks and the economy quite feels the effects of the Central Bank rate hike. As a result, the economic growth associated with the structural manoeuvre is likely to run out of steam unless it receives additional investment doping from the budget. But such a development is fraught with weakening macroeconomic stability and new price growth.

Military-Sanctions Boom

In January-September 2023, investments in fixed capital in Russia grew by 10%, and within the circle of large and medium-sized companies, it grew by almost 11% compared to the same period last year, according to Rosstat data. During this period, the dynamics were nearly flat in the first quarter (0.7%), with an increase of 12.6% in the second quarter and 13.3% in the third quarter. Even the Russian authorities did not expect such a sharp growth: in September 2023, the Ministry of Economic Development revised its annual forecast from 0.5% to 6%. It is now clear that this is a too conservative estimate, and experts anticipate an investment growth of around 10% by the end of the year, setting a record for the past 12 years.

However, the quarterly dynamics of investments can be largely explained by the base effect: in the first quarter of 2022, investments were still 'pre-war' (+13.8% year-on-year), and therefore their growth in the first quarter of 2023 was less than 1%; after the start of the war, in the second and third quarters of 2022, they sharply contracted (+3.3 and +2.3%, respectively) and the results of the second and third quarters of 2023 play off the effect of this contraction.

Dynamics of investments in fixed assets, 2010-2023, % year-on-year

Against the backdrop of the ongoing war in Ukraine and broad sanctions, the main drivers of investment activity were the 'steady growth' in domestic demand for Russian products, resulting from the departure of foreign companies from Russia and, consequently, the implementation of import substitution projects, according to the authors of the investment review included as part of the Central Bank's regular report title 'Regional Economy'. At the same time, government support measures, which were aimed at import substitution, as well as the expansion of production in the military-industrial complex (in 2023, budget expenditures on national defence amounted to 6.4 trillion rubles, up from 4.68 trillion rubles in 2022), played an important role. It was these factors that, above all, made it possible to surpass the investment effect of the 2021 post-Covid recovery and achieve a level of investment activity that the economy could only dream of in the previous decade.

Where the money comes from

At the same time, the structure of investments by their sources of financing has noticeably changed compared to ‘peacetime'. The share of companies' own funds increased to 57.5%, although the average for 2017-2019 (before the anomalous Covid and war years) was 53%. In addition, the Central Bank experts specify that the share of budgetary funds increased significantly, while the share of credit funds decreased from 11.4% to 9.2%. This structural reorganisation was facilitated, firstly, by the growth of corporate profits. In the first nine months of 2023, the net profit (profit minus loss) of large and medium-sized enterprises increased by 24.3% to 26.07 trillion rubles, according to Rosstat. This dynamic is evidently linked to the low base of the previous year and the sharp depreciation of the ruble.

On the other hand, the share of bank loans in total investment decreased primarily due to a sharp drop in borrowings from foreign banks, declining by a factor of six, from 2.5 to 0.4%. The reduction in the share of borrowed funds was also influenced by the increase in the cost of loans starting in the third quarter, after the Central Bank raised the key interest rate. This, as noted in the investment review of the Central Bank, has already affected those sectors where profitability is not very high, in particular, in agriculture. The share of investments from the budget even slightly decreased in nominal terms compared to the three quarters of 2022 (from 17.8 to 17.3%). However, the level of loans from other companies, among which state-owned enterprises play a significant role, increased by almost one and a half times, from 5.4% to 7.7%. According to Rosstat's data on investor ownership for 2022, state-owned companies contributed to the growth of state investment roughly on par with the federal budget. In the 'peace' years of 2017-2019, the share of budget funds in total investment was 15.9%, while the share of other organisations (private and state-owned) was 4.8%. In total, they accounted for just over 20%, whereas now it's 25%.

Thus, the military-sanctions investment boom is driven by the growth of government spending and investment of enterprises’ own funds, including that of state-owned companies, while the share of 'market' credit funds in investments is shrinking.

Where the money is going

The key contribution to the growth of investments in January-September 2023 came from the manufacturing industry, transportation and storage, including significant projects with government participation, as well as the extraction of minerals, as outlined in the Central Bank's review. Indeed, almost 20% of all investments by Russia's medium and large enterprises (3.1 out of 15.6 trillion rubles) are still concentrated in the extractive sector, with oil and gas extraction accounting for 12% of all funds. A year ago, the extractive industry accounted for 20.4% of the economy's investment spending, with nearly 13% specifically for oil and gas. However, over the nine months, investment in oil extraction increased by 15%, while investment in gas extraction, on the contrary, decreased by 20%, according to the Central Bank. Thus, the contraction in the gas sector due to the loss of export markets was offset by intensive investments in the oil sector, as well as in the extraction of metallic ores, where investment growth exceeded 25%.

Investments in the development of transport infrastructure and storage (warehouses and logistics) equaled those of the extractive sector, crossing the 3 trillion ruble mark (+10.1% by the first nine months of 2022). The sector's investment share totalled 19.6% of total investment, compared to 17% in the 'base' years 2017-2019. This jump is due to the need to provide transport and logistics infrastructure for the so-called turn of the economy to the East. However, it is worth noting that these investments can only be loosely termed productive. For the most part, they are aimed not at creating additional capacities, but at replacing the previous ones: the volumes of exports and transport of goods have not changed significantly compared to the pre-war period, and these investments only ensure the implementation of non-market, political decisions. Moreover, large-scale investments in transport are inevitably transferred to costs and, consequently, lead to higher prices or lower profits. Thus, freight rail tariffs increased by 8% at the beginning of 2023 (after an increase of 17% in 2022), and from 1 December 2023 by another 10.75% (including a 2% surcharge for infrastructure overhaul).

In third place are investments in the manufacturing industry (2.75 trillion rubles; +12.2%). Their share in the total volume, compared to the "baseline" years of 2017-2019, increased from 14% to 17.6%, and more than half of them are concentrated in the production of petroleum products, chemical industry, and metallurgy. Here, we find the main areas of abnormal investment growth in industries related to defence needs: the production of finished metal products (+73%), electrical equipment (+59%), machinery and equipment (+44%), and vehicles (+41%). In addition, investments in government administration, ensuring military security, and social support grew by 61% over nine months compared to the previous year, reaching almost 300 billion rubles, according to Rosstat.

Thus, the investment boom of 2023 serves not so much the growth of the economy as it does its structural reorganisation: replacing falling imports, expanding the military-industrial sector and creating a parallel transport and logistics infrastructure. It also involves shifting the focus from some industries to other, sometimes less profitable ones, as is the case with the shift of investment from gas production to iron ore mining. From this perspective, investments in import substitution should also be assessed: investments in domestic production replacing imported goods are likely less profitable than alternative uses of these funds. In any case, being in a state of pre-war and more market-oriented equilibrium, the economy preferred to buy these goods from imports, directing investment resources into other areas.

What's next

Meanwhile, the growth of investment activity in 2023 has been concentrated in the major sectors listed above, while others — retail trade, consumer services, agriculture and construction — on the contrary, have seen a decline. For example, investments in wholesale and retail trade of motor vehicles, which suffered significantly due to the departure of Western brands from the Russian market, fell by 17%. In agriculture and construction, investments decreased by 4% compared to the same period last year. The main deterrent to investment activity in these sectors is the lack of own funds in the face of rising credit costs. For January-September 2023, the net financial result of companies in retail trade decreased by 5%, and in agriculture, it decreased by 16%. Against this backdrop, companies and industries point to factors limiting investment activity, such as a shortage of personnel and difficulties in replacing imports of equipment and components. In sectors with a good financial result, these constraints are felt to a lesser extent.

These circumstances clearly indicate the problems that may seriously affect the dynamics of investment activity in the future. As shown above, companies compensate for the reduced availability of borrowed funds with their own funds or cash from the budget. However, the rise in interest rates on loans due to an increase in the key rate will lead to further contraction of the market borrowing share, and only companies with high profits or access to budgetary funds will be able to compensate for it. Meanwhile, further expansion of budgetary stimuli is unlikely, and the share of profitable companies is likely to decrease.

As the Central Bank's surveys indicate, businesses have already lowered their assessments of investment activity at the end of this year. The proportion of companies intending to increase investment activity is 3 percentage points higher than those intending to decrease it; in the second quarter, the difference was 11 points. 9% of companies (and that is still a small number) say they have reduced their investment programmes for 2024. 'These are mainly companies financing investments with borrowed funds’, the authors of the Central Bank's investment review note.

Meanwhile, according to estimates by Rosstat and expert centres, industrial production in Russia has been stagnating since July amid maximum capacity utilisation of production (in the second quarter of 2023, the indicator reached a historic high of 80.9%), as noted in a report from Raiffeisen Bank. 'To revive industrial growth, further activation of investments is necessary, which is currently observed only in several major industries,' they add. Economic growth associated with structural manoeuvre is highly likely to run out of steam unless it receives additional investment support from the budget. However, such a development is fraught with weakening macroeconomic stability and a new rise in prices.