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Russia and Europe: shared recovery

A recent article about the renewed sense of enthusiasm towards European economies’ ‘recovery’ caught my attention. The piece in the Economist cautions against excessive optimism despite the improvements in several Eurozone countries, and warns that there is still a long way to go before the green shoots of economic growth start to bear fruit. Europe still has several significant challenges ahead, most notably in the case of Greece and a possible ‘Grexit’ from the Eurozone. Yet no mention is made of Russia, whose trade and financial ties with Europe will prove decisive for both parties.

One clear message from the article is that it is important to consider economic troubles as well as the situation in neighbouring countries. For Russia, this means Europe. Russia is an integrated player in international business – in the European region and beyond. Consequently, the fate of its partners will be central to its own recovery, and vice versa. The EU is by far Russia’s largest trading partner, so the progress of both will be closely linked. As the article notes, much recent optimism about the Eurozone has come about because of the boost provided by falling oil prices, and a devalued Euro which has positively driven exports. However, these boosts rely on short term events, and are unlikely to guarantee growth in the long-term.

If we consider the long-term outlook, a number of the risks for sustained growth in the core EU countries and Russia appear remarkably similar. Both economies (for various reasons) will require substantial investment in infrastructure and capital markets within the next decade or two. As the Financial Times prudently noticed the other week, “Beijing has tired of buying up endless volumes of US bonds”, and it is no secret that US capital and current accounts would look vastly different if one were to assume that China will lose its appetite for T-bills.

Effectively, China could become the most formidable source of capital in the international market, with the world’s most important economies seemingly doomed for cut-throat competition in order to finance their escalating deficits. And in this respect, Russia appears to be a step ahead of its largest trading partner. As the Financial Times reports, Russia is the 2nd biggest recipient of Chinese FDI, while out of all the EU countries, only the UK makes it into the top 10. Europe has historically been exceptionally reliant on North American capital to finance its growth, and could perhaps find itself in a difficult position if this source of funds were to dry up.

Courting China is no easy challenge. But as Russia starts to progress along a steep learning curve in building mutually beneficial relations, Europe may find itself falling behind with little chance of catching up, particularly if it continues to shield its industries from the Chinese, and thereby alienate the largest consumer market on the continent. Indeed, Russia has signed economic cooperation deals with China “for up to $25 billion for Russian companies from Chinese banks” in recent days. Furthermore, discussions surrounding HSBC’s potential move out of the UK to Asia have led commentators to note that Asia is actually “an attractive alternative” to the UK with regards to business. This illustrates the importance of ensuring an attractive domestic investment climate and capital market, lest you end up losing business (including jobs and tax revenues) to China.

Naturally, expansion in any market that is a key trading partner will be crucial to Russia’s own recovery, and continuing stagnation in the EU would mean a limit to any benefits enjoyed by Russia.

Yet the Economist’s reference to oil prices demonstrates how Europe and Russia face divergent challenges as they both look towards economic recovery. The same drop in oil prices that bolstered Europe’s economies also served to weaken Russia’s, along with the value of the rouble. A rise in oil prices would stimulate the national economy as well as the value of the rouble, thereby complementing Russia’s current efforts to refocus its economic diversification by prioritising import-substitution, infrastructure investment, and value-added materials processing. All of these measures are aimed at developing an increasingly self-sufficient economy and diversifying and strengthening Russia’s export potential. As a result, Russia will be able to position its economy more advantageously once the overall macro conditions improve.

Both the Russian and European economies remain beset by a number of divergent challenges which are unlikely to be resolved quickly. But just as some are increasingly positive about Europe, I have suggested that there are reasons for optimism in Russia too. Given the symbiosis between the two on an investment level, this should make for a shared recovery further down the line. However any prudent observer should start considering a third significant variable in this equation, the full impact of which remains unknown thus far.

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