Economic Outlook: Russian investment needs

By Scott Hazelton04 November 2011

Construction growth outlook for Russia

Construction growth outlook for Russia

Russia's economy continues to recover at a moderate pace from its deep recession, due largely to rising oil and gas exports. Even so, the investment environment has deteriorated as corruption has spread and private capital has fled, despite the huge need for investment in infrastructure.

Further complicating factors are inflation, which could become entrenched in the economy, and a strong Ruble which is making imports more affordable but making exports less competitive and causing problems for Russian manufacturers.

The bottom line is that while the Russian economy and construction markets will do better than the global average, and substantially better than those of Western Europe, they will perform poorly compared to the rest of the BRIC (Brazil, Russia, India, China) nations.

The Russian economy is over-dependent on the extraction and export of natural resources, and therefore on movements in global commodity prices. The natural resources sector represents 25% of the Russian economy and exports of fuels and metals account for 75% of total Russian exports.

The problem is that there are significant capacity constraints due to an extended period of insufficient investment following the transition from the Soviet era. Many of the older deposits are in hard-to-reach locations, or in challenging climates, so even more investment is needed for their efficient extraction.

But capital continues to leave Russia on a net basis, and this makes the task of improving the investment environment all the more urgent. It is not just the natural resources sector that needs this, but manufacturing as well to reduce the economy's dependence on commodities.

While the service sector was neglected in the Soviet era, it has been developing rapidly since independence, albeit from a low starting point. As a result growth in services has outstripped growth in industrial production for the past several years.

Russia's aging population is a disadvantage and policymakers are concerned that labour shortages will handicap the economy. Increased immigration of foreign workers - mostly from other CIS countries - could buoy output, but such guest workers tend to be negatively received by ethnic Russians.

Construction

The construction outlook reflects changing patterns across structure types. Investment in infrastructure, particularly energy infrastructure, was strong in 2010 while non-residential structures suffered through to the end of the recession.

The residential market was strong largely due to stimulus spending, but with the withdrawal of stimulus, residential growth collapsed this year, and with a shrinking and aging population, there is no true boom in the offing.

The improving economy should encourage consumer spending on residential repair and maintenance, but nothing spectacular is extpected for the sector.

Spending on non-residential structures will gradually improve over the next few years, driven by the industrial sector. Industrial structures include facilities associated with the processing of raw materials, and modernisation of such plants is the next logical step given investment in energy infrastructure.

Growth rates will remain well below earlier peaks, however, as unemployment remains relatively stubborn and the domestic banking sector continues to insufficiently fulfil its role in financial intermediation. IHS Global Insight expects growth will tail off in the latter part of the forecast as the most readily tapped natural resources are worked-out and the population declines.

Key factors

But the outlook could be better if certain factors play-out. Projects have been announced aimed at increasing the competiveness of Russian manufacturing and relieving infrastructure bottlenecks. Should these initiatives succeed, and should structural and institutional reform accelerate, the environment for investment will improve and Russia could enjoy more robust growth than projected.

On the other hand, given Russia's track record, it is also possible that the government will retain its dominance in key sectors. If this happens, the environment for investors could worsen and the outlook for construction could be weaker than forecast.

The fast growth in Russia's services sector looks set to be an important driver for office and other commercial structures.

Indeed, building has not always kept pace with demand, leading to some of the world's most expensive hotel rates in key cities, due to tight capacity.

Another important driver will be Russia's growing middle class, which will demand better retail facilities.

Respectable growth is expected in institutional structures, but at the lowest rates of the main structure types. Russia needs to improve its healthcare facilities to reflect chronic health issues in its population, but this is mitigated by a reduced emphasis on educational facilities due to its low birth rate.

Institutional structures are typically funded by government spending, and the immediate priority for such funds remains infrastructure development.

Potential

Russia certainly offers strong potential but, there are also risks evident, particularly regarding the availability of capital. The Central Bank of Russia has forecast that net capital inflow will resume in 2012 following the presidential election. Although this will remove some uncertainty, investors' appetite for risk and perhaps more attractive opportunities in other markets will also be decisive.

The future competitiveness of the Russian economy will rely on accelerated investment. While foreign direct investment brings with it know-how as well as capital, domestic investment will be decisive given the huge volumes required to upgrade and expand infrastructure and productive capacity.

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