Measuring Government’s Interest 2

15-11-2017
Economists Alexey Krivoshapko and Mattias Westman talk about the Government of Russia’s current role in the economy and how privatization can influence it
 
November 14
Alexey Krivoshapko, Mattias Westman
/ For Vedomosti
The level of the government’s involvement in the Russian economy was estimated at 70% at the 2017 Gaidar Forum. In our view, this figure which reverberated through the media has nothing to do with reality resulting from the plain arithmetic addition of the public sector’s relative share in the GDP production and the ratio of consolidated budget expenditure to the GDP, which is a blatant error (going by this logic, if you earn $1,000 per month and spend $800 per month, your total purchasing power is $1,800 per month). Such speculations play into the hands of those who believe that the Government has full control over the Russian economy and that investments in Russia are therefore not worth the trouble.
Estimating the Government’s real share in the economy is not a piece of cake. The most common approach is looking at the ratio of consolidated expenses attributable to budgets of all levels to the GDP. Given the wide availability of this information, comparing different countries and appraising the situation over time is fairly easy (although some essential details should be taken into account). In particular, the share of consolidated government spending in Russia increased from 30% of GDP in 2000 to 33% in 2007, to 36% in 2016. For reference, the ratio of consolidated budget spending to GDP in 2015 was only 29% in China, 44% in Germany and 50% in Brazil, which puts Russia in the middle of the value range. For a fairer comparison though, one should know that pensions and other social payments from the budget accounted for 13% out of that 36% share in the Russian GDP, while there are virtually no such payments in China.
According to the System of National Accounts, government spending on ultimate consumption accounted for 19% of GDP in 2016. Besides, the budget, obviously, was one of the sources of capital expenditure in the economy (which reached 28% of GDP in 2016). Assuming that one-quarter of the investment was funded from the budget, the public sector’s total spending on consumption can be easily estimated at no more than 25-26% of GDP.
We also analyzed the Russian Federal State Statistics Service’s employment data broken down by sectors on the federal, regional and municipal levels, as well as employment data for the 25 largest state-owned Russian companies. The summary data (see the table) show that state-funded organizations and major state-owned enterprises employ about 30% of the total labor force in the economy. There are certainly smaller state-owned companies, but their share in total employment is not very high, in our view.
On the production side, we analyzed the 600 largest companies in terms of revenues (based on the RBC / Forbes rankings) adjusted for the double-entry accounting of holding companies’ revenues. State-owned enterprises accounted for 41% of the 600 largest companies’ total revenues in 2016. The total revenue earned by these 600 companies is $1.1 trillion, which is approximately 45% of Russia’s total economic output in 2016. The obviously higher relative weight of state-owned companies in the segment of large businesses shifts the overall picture upwards.
To get a clearer picture, we analyzed the Federal State Statistics Service’s GDP production data for 56 separate industries (the Federal State Statistics Service provides annual statistics on production and added value in separate economic sectors). One should certainly know what the output of specific economic sectors consists of, as classified by the statistics service (for example, the added value of Gazprom’s gas business in the System of National Accounts is distributed among gas production, transmission and wholesale trade); fortunately, these data are easy to obtain from public companies’ financial statements or the SPARK system containing reports from more than 10 million Russian legal entities. This work is quite labor-intensive as one should be aware of the ownership structure in the economy and make allowance for how profits are distributed among different sectors. For lack of details, our analysis was based, inter alia, on the assumption that different companies within the same sector have similar profitability, so that the relative weight in revenues can be reasonably assumed to be equal to the share in added value. To summarize, we analyzed the economy broken down by industries and companies and calculated the share of state-owned companies in revenues earned in each sector; then we likened their share in added value to their share in revenues, then we added together all state-owned companies to calculate their total share in the output. We discussed this method with financial institutions keeping records of international statistics, and secured their approval.
One-third or two-thirds?
As follows from our aggregate calculation broken down by sectors, the overall relative share of the public sector in the produced GDP was 33% in 2003. According to our estimates, the economic growth and higher diversification reduced this percentage to 31% of the produced GDP in 2007. The expansion of state-owned companies (acquisition of Sibneft by Gazprom, acquisition of Yukos, TNK-BP and Bashneft by Rosneft) added 1.7% to this relative share in GDP by 2016, with another per cent added by the growth of the financial sector in the economy and a huge role of state-owned banks.
According to these different estimates, the share of the public sector in the economy should actually range from 26% to 41% of GDP – which is quite different from the level of 70% which different analysts refer to.
In our view, opinion, there is nothing generally wrong with the Government owning production assets in the economy provided that these assets are managed properly (including the management team’s responsibility, the focus on the economic effect in investment decisions, a transparent financial and dividend policy). Moreover, there are cases of perfectly managed state-owned companies, some of them (such as Sberbank, Aeroflot) are apples of portfolio investors’ eyes.
Less is more
At the same time, there are quite obvious examples of industries where the Government’s non-involvement and free competition resulted in a serious decline in prices of end products.
For instance, in the 100% privately-owned mobile industry where the Government only sold or distributed frequency resources, competition among mobile operators, coupled with the technology development , reduced the average mobile subscriber bill from 3,500 rubles per month in 2003 to 350 rubles per month in 2016, while mobile penetration increased to 100% (hereinafter the authors’ calculations are based on data received from companies).
Another example is the wholly privately-owned food retail sector where competition has brought down margins on socially important products from 30-40% to 5-10% in the last decade.
As a result of the reform in the electricity generation market, prices on the competitive market have seen an 8% price increase on average every year in the last decade, while pipeline rates have grown by 11% every year in the same period.
The reform of the railcar component market in the total freight rate of Russian Railways  and the subsequent privatization of the rolling stock reduced lease rates for gondola cars in the wake of excess production from 1,600 rubles per car per day in 2007 to 1,100 rubles in 2016.
It should also be noted that in most cases, sectors where the competitive market plays a higher role have contributed most substantially to the overall GDP growth, employment and economic prosperity, a trend detected in most of the world’s economies. Even the super-effective oil and gas industry has grown by a mere 1.6% per year since it underwent substantial nationalization, while the average annual economic growth rate in Russia has been 2.6% in the last decade.
 
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 What assets can the Government dispose of?
We believe that in some economic sectors, a higher percentage of private ownership and stronger competition would yield clear benefits for the Russian economy, as exemplified by financial intermediation services. The share of state-owned banks in the banking sector’s total assets was 65% even before the recent nationalization of Otkritie Bank and B&N Bank. In our view, a full and transparent privatization of VTB (not in favor of the management and at the Bank’s expense) would improve governance, step up competition against Sberbank and reduce interest rates for businesses and private borrowers.
Another case suggesting itself is gas production. Nothing except for export obligations which Gazprom’s management team refers to actually prevents the monopolist from being split into production subsidiaries which could be granted the right of export along with other Russian gas producers (Rosneft, NOVATEK, LUKOIL, Surgutneftegas). The continuing gas transmission earnings can be used as a source of financing for new pipelines. Such a reform would lower domestic gas prices and electricity rates in the economy, boost investments in extraction, refining and energy-intensive production facilities. The Government even does not need to reduce its interest in the separated companies to below what it currently holds: competition will spur efficiency.
In addition to a huge portion of petroleum companies’ taxes absorbed by the Russian budget, an increase in the relative weight of private companies in the sector could step up competition for reserves resulting in higher payments for subsurface resources (although we believe that the spin-off of Gazprom Neft from Gazprom followed by the privatization of this subsidiary company would make the market more balanced).
Privatization of companies in the electric power sector is also far from the finish line. Companies such as Inter RAO UES, RusHydro, Gazprom energoholding, regional interregional distribution grid companies should be separated from the parent entities (that often have a quite complicated structure) and privatized, so as to increase management efficiency, reduce prices for consumers and generally improve the quality of service.
Transport costs are also crucial for the competitiveness and profitability of Russian businesses, especially in steelmaking, production of fertilizers and agriculture. Russia has a huge natural potential for diverse exports in these sectors. In the rail industry, the use of private locomotives by Russian Railways and the final rolling stock privatization should result in higher efficiency and lower prices for consumers, entailing an increase in investments, production, exports and taxes.
According to our estimates, simply the sale of control in companies of no strategic importance to the Government (VTB, Gazpromneft, Gazprom energoholding, Inter RAO UES, RusHydro, interregional distribution grid companies) would reduce the relative weight of the public sector from 33% to 31% of GDP in Russia. The potential positive effect of splitting Gazprom, liberalizing domestic gas production and the locomotive traction function at Russian Railways is hard to access precisely, but the indirect effect may obviously add a couple of percent to the annual GDP growth rate.
We believe that a methodologically correct calculation of the public sector’s relative weight in the economy is essential for long-term economic decisions and may serve as a useful national policy instrument for building a more effective and diversified economy.
 
 By: Prosperity Capital Management partners
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