Tag: Growth

EU Accession and Sustainability Challenges for Ukraine’s Agricultural Sector

Posted on November 18, 2024 | Policy Brief

Combine harvester in a Ukrainian wheat field symbolizing EU accession impacts on agriculture.

Recently the EU opened accession negotiations for Ukraine. Apart from the trade benefits of having access to a large and wealthy EU market, Ukraine’s agricultural producers in particular, will have to comply with and implement a complex and demanding EU acquis in agriculture. Together with the Common Agricultural Policy, this includes regulation of markets and standards in farming practices, animal and plant health, food safety, and environmental and animal welfare. The potential additional compliance costs from EU accession may undercut Ukraine’s agricultural competitiveness and supply growth, crucial for feeding a growing population. However, in this policy brief, we show that these costs are not critical and that there is a potential for agricultural producers to simultaneously increase their output and contract harmful environmental impacts, which in turn can compensate for the additional compliance costs.

Introduction

The European Council granted Ukraine candidate status in June 2022 and eventually opened accession negotiations in December 2023. For the Ukrainian agricultural sector, an EU membership would bring trade benefits from having access to a large and wealthy EU market. At the same time, Ukraine would have to comply with a complex and demanding EU Acquis in agriculture (hereafter called EU agricultural acquis). This, together with the EU Common Agricultural Policy (CAP), includes regulation of markets and standards in the areas of farming practices, animal and plant health, food safety, and environmental and animal welfare (Nivievskyi, 2024).

Complying with these regulations would entail additional costs for agricultural producers, raising concerns about the comparative advantage of Ukrainian agriculture. If these effects are strong enough, it could, in turn, hamper Ukraine’s agricultural supplies growth, crucial for feeding a growing global population.

While the evidence on the expected compliance costs is very scarce (see e.g. EU Commission, 2014), it shows they would be in the range of up to an additional 10 percent of the total costs. This cost increase, however, does not seem to ruin Ukraine’s comparative advantage in agriculture. Moreover, in this policy brief, we demonstrate that producers of grains and oilseeds in Ukraine have the potential to improve their efficiency by increasing their output by almost 20 percent and simultaneously contracting harmful environmental impacts by 16 percent. Such improvements can compensate for additional EU agricultural acquis compliance costs for Ukraine’s agricultural producers.

Relevance

Ukraine’s agricultural sector plays a key role domestically and internationally. It is noticeably dominated by crops, mainly by highly competitive grains and oilseeds. Agriculture alone accounts for about 10 percent of Ukraine’s GDP, but together with upstream (e.g. agricultural machinery) and downstream (e.g. food processing) industries, the entire agri-food sector’s share amounts to roughly 20 percent of GDP. The agri-food sector accounted for 60 percent of Ukraine’s total exports in 2023 with Ukraine’s shares in global corn and wheat trade reaching almost 20 and 10 percent, respectively.

At the same time, agriculture is among the top five sectors of the Ukrainian economy contributing to Nitruos Oxide (N2O) emissions in the country (SSSU, 2018). Since it generates not only desirable outputs but also environmentally undesirable ones (such as GHG emissions, pollution from applied chemical fertilizers and pesticides etc.), the negative outputs should be both considered in the assessment of the sector’s performance.

The existing empirical literature places the main focus on the economic aspects of the agricultural sector’s performance in Ukraine, more specifically on technical efficiency and total factor productivity. A recently published study (Halytsia, Vrachioli, Nivievskyi, Sauer, 2024) we undertake the first attempt to incorporate undesirable outputs of agricultural production in the analysis of Ukrainian agricultural producers’ efficiency and provide empirical evidence on how they perform from a combined economic and environmental perspective. This policy brief summarizes the study’s results.

Data and Methodology

To estimate the environmentally adjusted efficiency of crop producers, we use farm-level accounting data from 2017-2019, collected by the State Statistics Service of Ukraine. The analysis is conducted for cereals (including wheat, barley, maize and others) and sunflower production since they are the major crops in terms of sowing land and output shares and given their importance for Ukrainian agricultural export.

To account for both desirable and undesirable outputs of crop production (environmental bads in our study are N2O emissions originating from the usage of mineral fertilizers and CO2 emissions from fuels’ consumption), the production technology is formalized in the form of a hyperbolic distance function. This gives the maximum linear expansion of a desirable output vector and contraction of an undesirable output vector for a given input vector. Parametric estimation (deploying a so-called stochastic frontier model) of the distance function yielded hyperbolic efficiency estimates that reflect the producers’ ability to expand good outputs and simultaneously contract environmentally undesirable ones to achieve maximum environmentally adjusted economic efficiency.

Empirical Results

The results from the econometric analysis reveal that the average environmentally adjusted economic efficiency estimate for crop producers in Ukraine is 0.84 (efficiency estimates are bounded between 0 and 1). This suggests that, on average, producers of cereals and sunflowers in Ukraine can improve their production results by increasing crop output by 19 percent (1/0.84 = 1.19) while simultaneously contracting undesirable output by 16 percent (1–0.84 = 0.16) in order to be fully efficient, i.e. have their output level on the frontier of the production technology (Figure 1).

The obtained environmentally adjusted economic efficiency level is fairly comparable to the efficiency values estimated in empirical studies for crop producers in other Eastern European countries, more specifically Poland (Gołaś et al, 2020; Stępień et al., 2021).

Figure 1. Graphic synthesis of the study’s findings

Source: Authors’ presentation.

Policy Implications and Recommendations

Performance Improvement

The results from the empirical analysis show that there is room for Ukrainian crop farmers to improve their environmental and economic performance. The following policy interventions can be helpful in facilitating this improvement:

  • establishing clear standards for the quality of chemical fertilizers, promoting organic ones and robust agrochemicals management and monitoring systems
  • promoting the adoption of climate-smart agricultural technologies, such as, for instance, fertigation (which can be especially effective in the steppe agro-climatic zone where most Ukrainian crop production is concentrated and which is noticeably affected by changing climatic conditions)
  • governmental programs for energy saving in agriculture to help reduce the amount of farm CO2 emissions.

Implementation of these measures can contribute to closing the efficiency gap, bring more sustainable agricultural production growth and help farmers compensate for the anticipated costs of EU legislation compliance regarding environment, animal welfare, and food safety.  The latter, in turn, entails not only costs but also a number of benefits. Potential benefits from implementing environmental regulations are, for instance, input savings ( e.g. in fertilizer or pesticide costs), additional revenues (higher prices and increased consumer demand for agricultural products produced sustainably) and extension programs financed through public funds (Mettepenningen et al., 2009).

Data Collection Improvement

Key limitations of this study stem largely from issues related to data availability. More specifically, there is no data available on organic fertilizer application, specification of the types of used pesticides, or details on farm characteristics (such as farm economic size, land type, environmental subsidies, etc.). These data would enable a robust and comprehensive estimation of the environmentally adjusted economic efficiency of agricultural producers, accounting for a broader range of undesirable outputs and incorporating determinants of inefficiency into the analysis.

Currently, the State Statistics Service of Ukraine’s annual statistical survey forms do not contain questions which enable the collection of the above mentioned data. Enhancing farm-level data collection will be necessary to align Ukrainian statistical databases with Eurostat, given Ukraine’s candidate status for EU membership.

The importance of collecting data on farms’ environmental performance is supported by the ongoing transition in the EU from a farm accountancy data network to a farm sustainability data network, which aims to collect rich microeconomic data not only on farms’ income and business activities but also information on their environmental and social sustainability performance.

Conclusion

Over the two decades prior to Russia’s unprovoked full-scale invasion, Ukraine developed into an increasingly important global supplier of staple food.

In this policy brief, we quantify the improvement potential for the performance of crop producers in Ukraine from both economic and environmental perspectives and highlight that potential efficiency improvement could compensate for the additional EU agricultural acquis compliance costs that Ukraine’s agricultural producers are expected to face upon Ukraine becoming a full EU member.

Acknowledgment

This policy brief is based on the academic article Assessing the Environmental Performance of Agricultural Production Using a Parametric Approach: An Application for Crop Producers in Ukraine by Olha Halytsia, Maria Vrachioli, Oleg Nivievskyi and Johannes Sauer, published in Eastern European Economics.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Cognitive Dissonance on Belarus: Recovery and Adaptation or Stalemate?

Posted on January 8, 2024 | Policy Brief

20240107 Cognitive Dissonance on Belarus Image 02

A closer look at the Belarusian economy over the recent year, produces two initially competing narratives. The first one emphasizes that tough sanctions have led to a deadlock for the Belarusian economy. The second one stresses that output losses have turned out to be much lower than expected, and that the economy has displayed a rather high degree of adaptability – securing an early and rapid recovery. This policy brief shows that these narratives are not mutually exclusive but rather elements of the same bigger picture. A short-term focus gives the impression that the current stance is ‘more good than bad’. This reflects the fact that output has recovered and almost reached historically high levels, made possible due to a combination of exports protection mechanisms and compensatory effects on output. However, this does not eliminate the disappointing medium- and long-term prospects for the country. On the flip side of the immediate survival of the Belarusian economy is the country’s economic and political stalemate. This includes the lack of opportunities for future sustainable growth and Belarus’ enormous and continuously growing dependence on Russia. Within this stalemate, stagnation is the best plausible scenario. At the same time, much worse scenarios, both economically and politically, are also highly likely. Ultimately, breaking the deadlock is the only way to a better future for Belarus.

The Belarusian Economy and the Changing Narratives

About 1.5 years ago, Western countries introduced tough sanctions against Belarus, punishing the Lukashenka regime for its role in Russia’s invasion of Ukraine. This gave rise to a huge uncertainty regarding Belarus’ economic prospects. A FREE policy brief published about a year ago (Kruk & Lvovskiy, 2022) presented a model-based estimate of a potential rock-bottom for the Belarusian economy in the new environment, which amounted to 20 percent of output losses. The authors however argued that actual output losses might be significantly lower given Russia’s support and policy responses, which were unaccounted for in the model. At the same time, downside risks and a lack of output consistency seem to have become permanent traits of the Belarusian economy.

Expectations of a large and prolonged recession in Belarus prevailed into mid-2023. International institutions (IMF, World Bank) and rating agencies (S&P, Fitch Ratings) mainly expected a recession in Belarus up to 10 percent 2022-2023.  The reality has however turned out to be quite different with the recession being relatively contained and short-lived. The output losses between the peak (Q2-2021) trough Q3-2022 amounted to 6.8 percent. In Q4-2022 a recovery began, and in Q3-2023 the economy had almost fully recovered, reaching nearly the same levels as in Q2-2021 (see Figure 1). Further, in terms of average real wages and household consumption, the situation appears to be even more positive. The real average wage reached its pre-war level in Q1-2023 and has since displayed record high levels, and household consumption follow a similar trend (see Figure 1).

These dynamics have given rise to a new narrative. As of lately, the Belarusian economic situation is at times treated as ‘more good than bad’. Further, most international financial institutions currently forecast a continued weak recovery growth in the coming years (EBRD, 2023; IMF, 2023; Izvorski et al., 2023).

Figure 1. Real GDP, Average Real Wages, and Real Household Consumption (index, seasonally adjusted, 2018=100).

Source: Author’s estimations based on Belstat data.

Factors Behind the Recent Recovery Growth

The underlying reasons for the recovery growth can be divided into two groups: (i) export protection mechanisms under sanctions and (ii) positive shocks and compensatory effects on output.

Export protection mechanisms under sanctions are twofold. Firstly, the Belarusian regime turned out to be somewhat successful in adjusting to the new sanctions-environment. This partly due to a somewhat geographical U-turn of Belarusian exports, underpinned by new logistics and payment schemes. The best example of this turn is the re-orientation of oil product exports from the EU and Ukraine to Russia (Kharitonchik, 2023). Moreover, some exports to traditional markets, which were challenged by logistics and payment barriers rather than sanctions, were secured by crossing these barriers. The best such example is the recovery of potash fertilizer exports to China, Brazil and India. Since early 2023 these displayed a rapid recovery due to Belarus finding logistic solutions through Russian sea ports instead of EU ports, and by using railway transportation.

Secondly, the practices of sanctions evasion may also have played a significant role. The scope of sanctions evasion is however difficult to assess due to its secretive nature. Moreover, the difference between avoiding and evading sanctions is not always clear.

Export protection mechanisms allowed Belarus to cushion actual export losses, making them transitory (see Figure 2). Actual losses in exports were close to the rock-bottom scenario estimates for only a couple of months. Instead of an expected level shift in exports by roughly 40 percent (from the pre-war level), exports displayed a recovery trajectory. Hence, what was modelled as a permanent shock in Kruk & Lvovskiy (2022), turned out to be transitory.

Figure 2. Physical Volume of Exports (index, seasonally adjusted, 2018=100).

Source: Author’s estimations based on Belstat data.

One important aspect to mention is that part of this recovery is due to oil-product exports taking place already in 2022 (Kharitonchik, 2023). In Kruk & Panasevich (2023) the authors show that the oil-refinery industry is of extreme importance for the entire Belarusian economy. Due to inter-industrial linkages, the oil-refinery industry indirectly accounts for about 11 percent of Belarus’ output, despite its modest direct contribution to the GDP (slightly more than 1 percent). Hence, due to protecting these exports (and the corresponding production of oil products), a large amount of output losses was avoided. A similar situation unfolded also for potash fertilizer exports and the chemical industry producing them (although inter-industrial linkages and effects on output are much weaker for that industry).

Besides export protection mechanisms, the recovery of exports and output stem largely from various positive and compensatory effects on output Some of them arose from Belarus’ and Russia’s respective regimes responses to sanctions, and from Russia’s readiness to support Belarus. Others are classical external positive shocks (to no degree related to sanctions) while some are a combination of both. They include: (i) increasing energy (gas) subsidies from Russia, (ii) a prolonged period of extra-high price competitiveness, especially in the Russian market, (iii) expanded access to the Russian market, (iv) other forms of Russian support (debt restructuring, budget transfers, new loans), (v) favorable trade conditions and export prices (apart from on the Russian market), (vi) a (macro)economic environment that allow for more  room for domestic economic policy interventions.

Taken together, these positive output drivers largely contributed to curbing the recession in 2022 and to the output recovery in 2023. A straightforward decomposition of the actual output growth path is unfeasible (due to the close interconnection of export protection mechanisms and output drivers, and the lack of available statistics). However, approximating the actual path in a model environment results in the following: between Q2-2021 and Q3-2022, about 12 percent of losses due to sanctions (taking into account the export protection mechanisms) and a deprivation of the Ukrainian market, and 5.2 percent of gains due to output shocks, resulted in actual output losses of 6.8 percent. Later in 2023, due to increasing effects from the export protection mechanisms, the sanctions-related output losses shrank to about 6.6 percent, while output shocks expanded output by roughly the same level. This allowed output losses to be zeroed out, i.e. the level of output in Q3-2023 was almost identical to Q3-2021.

An Economic Stalemate

Is the ‘more good than bad’ economic situation sustainable? Does the recent recovery mean that Belarus has overcome the major challenges to the economy? The short answer is no. Even with short-term thinking, there are still numerous downside risks. Sanctions still form a permanently challenging environment for the Belarusian economy, putting exports and output in jeopardy. The export protection mechanisms are not persistent, and they largely depend on Russia’s political will to support them. Moreover, the updated logistics and payment chains may also be vulnerable and sensitive to changes in the sanctions’ environment, and short-term trends in external prices. The aforementioned positive output effects are short-term by their nature and there are indications of them starting to fade already in 2023 (BEROC, 2023). Hence, even short-term projections for 2024 are challenging: the output growth is expected to weaken significantly or even fade away, while inflation spikes and financial destabilization risks are high (BEROC, 2023). Therefore, a return to a stagnant economic environment appears to be the most plausible short-term outlook.

The medium-term outlook seems even worse. According to Kruk (2023), the Belarusian macroeconomic balance (a) is very fragile, (b) is subject to numerous and huge downside risks, and (c) cannot be secured by macroeconomic policies because of the structural weaknesses in their design and the lack of room for maneuver. This means that even the existing weak long-term growth potential cannot be realized in the medium term, while the likelihood of recessions, inflation spikes and financial destabilization is high.

Re-shifting focus to a long-term and international perspective makes the viewpoint ‘more good than bad’ appear inconsistent. First, the long-term growth potential for Belarus, which was very weak even before the sanctions, keeps on worsening. This as adverse supply shocks and a deterioration of the productivity determinants continue eroding it (Kruk & Lvovskiy, 2022). Estimations of the growth potential (that rely on historical time series) are mainly within the range of 0-1 percent per annum. However, even such disappointing estimates might be optimistic bearing in mind the current political and sanctions-related risks and uncertainty (absent in the historical data). This makes stagnation the best possible long-term outlook, although it cannot be guaranteed.

Second, despite the milder recession and rapid recovery, the well-being gap between Belarus and its EU neighbors keeps on expanding (see Figure 3).

Figure 3. Well-being in Belarus vs the average among its EU neighbors (Latvia, Lithuania, Poland), 1990-2022, in percent.

Note: The GDP per capita PPP in 2017 constant international dollars is considered as well-being. The average well-being for EU Neighbors is the simple average in GDP in Latvia, Lithuania, and Poland.
Source: Author’s estimations based on World Bank data.

The average well-being in Belarus (measured in GDP per capita in constant international dollars) vs. that among its EU neighbors reached an (almost) historically low level in 2022. After attaining a level of well-being of roughly 75 percent of the average in Latvia, Lithuania, and Poland in the early 2010s, the well-being in Belarus has fall to about 52.5 percent, almost as low as in the mid-1990s. Given the economic stagnation as the most likely outlook, this means that the country will, in relative terms, keep on getting poorer in comparison to its EU neighbors.

A Political Stalemate

The hypothetical way out of the economic stalemate is more or less obvious. For instance, there is somewhat of a consensus among Belarusian economists about strengthening the long-term growth and securing macroeconomic stability (see Daneyko & Kruk, 2021; Kruk, 2023, for an overview of a collective view from a group of Belarusian economists). This vision, however, clashes with the views of the Lukashenka regime, which has inhibited its implementation throughout decades. Hence, democratic transition, or at least deprival of power of the Lukashenka regime has long appeared to be a highly likely precondition for moving away from the stalemate.

This, however, has changed in the last couple of years. The Belarusian economy’s dependence on Russia has moved from large to absolute. Prior to 2022, Russia was an important market for Belarusian exports (about 40 percent), the single energy supplier, and de facto the lender of last resort. To date, Russia’s role has expanded dramatically. The share of exports to Russia has increased up to about 65 percent. Moreover, the majority of the remaining 35 percent is exported with the assistance of or through Russia, using Russian infrastructure. Therefore, it would be fair to argue that Russia in some form “controls” roughly 90 percent of Belarusian exports. Further, being Belarus’ sole energy supplier, Russia has increased its significance for Belarus through expanded energy subsidies. The size of the energy subsidies reached a historical high in 2022, and the mechanism of the energy subsidies has become a cornerstone for macroeconomic stability in Belarus. Furthermore, Russia has turned out to be the only effective creditor for Belarus. Overall, Russia has accumulated a significant number of tools to undermine Belarus at any given moment.

A democratic transition or at least deprival of power of the Lukashenka regime might therefore not be sufficient preconditions for breaking the economic deadlock. Even if domestic political will to do so should emerge, the risk that Russia will successfully suppress it using the above outlined economic tools is very high. Hence, apart from a democratic transition, the way out of the economic stalemate requires a way out of the political stalemate. This seems to only be possible through either a politically weakened Russia, and/or an external political force, allied to the Belarusian democratic forces, and strong enough to suppress Russia.

Conclusions

Recently, the narrative on the Belarusian economy has changed. The prevailing expectations of a large and prolonged recession has been substituted by expectations of a gradual recovery. The narrative ‘the jig is up’ has somehow been crowded out by the ‘more good than bad’ viewpoint on the Belarusian economy. However, these narratives are not mutually exclusive. Behind the current ‘more good than bad’ viewpoint on the Belarusian economy, a severe economic and political deadlock prevails. Moreover, future economic and political deadlocks are the actual price being paid for the recent survival and recovery of the Belarusian economy.

From a positive perspective, the economic and political deadlock means that the country is likely to, at least, be bogged down in stagnation. Belarus’ total dependency on Russia makes the country hostage to Russia’s political preferences and country-specific risks. Should Russia decide to exert further economic and/or political influence over Belarus, it is likely to succeed. Consequently, any economic downturn faced by Russia would automatically impact Belarus.

From a normative perspective, breaking the economic and political deadlock might be the only solution, and for this, the order might matter. Prior to 2020 there was a widespread opinion that breaking the economic deadlock must be prioritized, and that it could – in turn – break the political deadlock. As of now, the tables have turned. The current order postulates the political deadlock comes first, as it seems to be the only way of breaking the economic stalemate. However, breaking the political deadlock appears to require external political will.

With these conclusions in mind, the recent Belarusian democratic forces’ manifest regarding Belarus’ EU membership aspiration, deserves attention (BDF, 2023). At first, such aspiration might appear schizophrenic given the actual political situation inside of the country. However, taking a Belarusian EU membership serious (within the EU and among Belarusians) might be the answer to Belarus’ political and economic deadlock. From this perspective, the task for the Belarusian society is thus to convince EU counterparts that this is not madness, but rather a feasible solution. It is rather evident why this solution is both desirable and feasible for the Belarusian society. The main question to be answered is therefore whether, and why it would be desirable and feasible for the EU.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Russia’s Real Cost of Crimean Uncertainty

Posted on June 10, 2019 | Policy Brief

Blue sky with fighter jets flying across the sky representing Russias Real Cost of Crimean Uncertainty

The annexation of Crimea has real costs to the Russian economy beyond what is measured by some items in the armed forces’ budget; social spending in the occupied territories; or the cost of building a rather extreme bridge to solve logistics issues. Russia’s real cost of the annexation of Crimea is also associated with the permanent loss of income that the entire Russian population is experiencing due to increased uncertainty, reduced capital flows and investment, and thus a growth rate that is significantly lower than it would have been otherwise. Since the years of lost growth are extremely hard to make up for in later years, there will be a permanent loss of income in Russia that is a significant part of the real cost of annexing Crimea and continuing the fighting in Eastern Ukraine. It is time to stop not only the human bleeding associated with Ukraine, but also the economic.

Estimating the real cost of Russia’s annexation of Crimea and the continued involvement in Eastern Ukraine is complicated since there are many other things going on in the Russian economy at the same time. In particular, oil prices fell from over $100/barrel in late 2013 to $30/barrel in 2016 (Figure 1). Becker (2016) has shown that 60-80 percent of the variation in GDP growth can be explained by changes in oil prices, so this makes it hard to just look at actual data on growth to assess the impact of Crimea and subsequent sanctions and counter sanctions.

Figure 1. Russian GDP and oil price

Source: Becker (2019)

The approach here is instead to focus on one channel that is likely to be important for growth in these circumstances, which is uncertainty and its impact on capital flows and investment.

From uncertainty to growth

The analysis presented here is based on several steps that link uncertainty to GDP growth. All the details of the steps in this analysis are explained at some length in Becker (2019). Although this brief will focus on the main assumptions and estimates that are needed to arrive at the real cost of Crimea, a short description of the steps is as follows.

First of all, in line with basic models of capital flows, investors that can move their money across different markets (here countries) will look at relative returns and volatility between different markets. When relative uncertainty goes up in one market, capital will leave that market.

The next step is that international capital flows affect investment in the domestic market. If capital leaves a country, less money will be available for fixed capital investments.

The final step is that domestic investments is important for growth. Mechanically, in a static, national accounts setting, if investments go down, so does GDP. More long term and dynamically, investments have a supply side effect on growth, and if investments are low, this will affect potential as well as actual growth negatively.

These steps are rather straightforward and saying that uncertainty created by the annexation of Crimea leads to lower growth is trivial. What is not trivial is to provide an actual number on how much growth may have been affected. This requires estimates of a number of coefficients that is the empirical counterparts to the theoretical steps outlined here.

Estimates to link uncertainty to growth

In short, we need three coefficients that link: domestic investments to growth; capital flows to domestic investments; and uncertainty to capital flows.

There are many studies that look at the determinants of growth, so there are plenty of estimates on the first of these coefficients. Here we will use the estimate of Levine and Renelt (1992), that focus on finding robust determinants of growth from a large set of potential explanatory variables. In their preferred specification, growth is explained well by four variables, initial income, population growth, secondary education and the investments to GDP ratio. The coefficient on the latter is 17.5, which means that when the investment to GDP ratio increases by 10 percentage points, GDP grows an extra 1.75 percentage points per year. Becker and Olofsgård (2018) have shown that this model explains the growth experience of 25 transition countries including Russia since 2000 very well, which makes this estimate relevant for the current calculation.

The next coefficient links capital flows to domestic investments. This is also a subject that has been studied in many empirical papers. Recent estimates for transition countries and Russia in Mileva (2008) and Becker (2019) find an effect of FDI on domestic investments that is larger than one, i.e., there are positive spillovers from FDI inflows to domestic investments. Here we will use the estimate from Becker (2019) that finds that 10 extra dollars of FDI inflows are associated with an increase of domestic investments of 15 dollars.

Finally, we need an estimate linking uncertainty with capital flows. There are many studies looking at risk, return and investment in general, and also several studies focusing on international capital flows and uncertainty.  Julio and Yook (2016) look at how political uncertainty around elections affect FDI of US firms and find that FDI to countries with high institutional quality is less affected by electoral uncertainty than others. Becker (2019) estimates how volatility in the Russian stock market index RTS relative to the volatility in the US market’s S&P 500 is associated with net private capital outflows. The estimate suggests that when volatility in the RTS goes up by one standard deviation, this is associated with net private capital outflows of $30 billion.

These estimates now only need one more thing to allow us to estimate how much Crimean uncertainty has impacted growth and this is a measure of the volatility that was created by the annexation of Crimea.

Measuring Crimean uncertainty

In Becker (2019), the measure of volatility that is used in the regression with net capital outflows is the 60-day volatility of the RTS index. Since we now want to isolate the uncertainty created by Crimea related events, we need to take out the volatility that can be explained by other factors in order to arrive at a volatility measure that captures Crimean induced uncertainty. In Becker (2019) this is done by running a regression of RTS volatility on the volatility of international oil prices and the US stock market as represented by the S&P 500. The residual that remains after this regression is the excess volatility of the RTS that cannot be explained by these two external factors. The excess volatility of the RTS index is shown in figure 2.

It is clear that the major peaks in excess volatility are linked to Crimea related events, and in particular to the sanctions introduced at various points in time. From March 2014 to March 2015, there is an average excess volatility of 0.73 standard deviations with a peak of almost 4 when the EU and the USA ban trade with Crimea. This excess volatility is our measure of the uncertainty created by the annexation of Crimea.

Figure 2. RTS excess volatility

Source: Becker (2019)

From Crimean uncertainty to growth

The final step is simply to use our measure of Crimean induced uncertainty together with the estimates that link uncertainty in general to growth.

The estimated excess volatility associated with Crimea is conservatively estimated at 0.7 standard deviations. Using this with the estimate that increasing volatility by one standard deviation is associated with $30 billion in capital outflows, we get that the Crimean uncertainty would lead to $21 billions of capital outflows in one quarter or $84 billions in one year. If this is in the form of reduced FDI flows, we have estimated that this means that domestic investments would fall by a factor of 1.5 or $126 billions.

In this period, Russia had a GDP of $1849bn and fixed capital investments of $392bn. This means that $126 billions in reduced investments correspond to a reduction in the investments to GDP ratio of 7 percentage points (or that the investments to GDP ratio goes from around 21 percent to 14 percent).

Finally, using the estimate of 17.5 from Levine and Renelt, this implies that GDP growth would have been 1.2 percentage points higher without the estimated decline in investments to GDP.

In other words, the Crimean induced uncertainty is estimated to have led to a significant loss of growth that has to be added to all the other costs of the annexation of Crimea and continued fighting in Eastern Ukraine. Note that recent growth in Russia has been just barely above 1 percent per year, so this means that growth has been cut in half by this self-generated uncertainty.

Of course, the 1.2 percentage point estimate of lost growth is based on many model assumptions, but it provides a more sensible estimate of the cost of Crimea than we can get by looking at actual data that is a mix of many other factors that have impacted capital flows, investments and growth over this period.

Policy conclusions

The annexation of Crimea and continued fighting in Eastern Ukraine carry great costs in terms of human suffering. In addition, they also carry real costs to the Russian economy. Not least to people in Russia that see that their incomes are not growing in line with other countries in the world while the value of their rubles has been cut in half. Some of this is due to falling oil prices and other global factors that require reforms that will reorient the economy from natural resource extraction to a more diversified base of income generation. This process will take time even in the best of worlds.

However, one “reform” that can be implemented over night is to stop the fighting in Eastern Ukraine and work with Ukraine and other parties to get out of the current situation of sanctions and counter-sanctions. This would provide a much-needed boost to foreign and domestic investments required to generate high, sustainable growth to the benefit of many Russians as well as neighboring countries looking for a strong economy to do trade and business with.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Economic Growth and Putin’s Approval Ratings —The Return of the Fridge

Posted on February 25, 2019 | Policy Brief

20190225 Economic Growth and Putin Approval Image 01

This brief discusses how the approval ratings of president Putin covaries with economic growth. In most years the relationship between approval ratings for Putin and growth looks like approval ratings for politicians in most countries so that when growth is higher, the president is more popular. Or to use an American expression “it’s the economy stupid”. The caveat in Russia is that external events at times overshadow the importance of growth to the extent that the president’s ratings stay high and can even go up despite a faltering economy. In a time of low Russian growth, this is not good news for geopolitics unless Putin can be convinced to focus on policies that generate high, sustainable growth instead of international turbulence. That said, it is clear that poor economic growth carries a political cost also in Russia. The only sustainable way of maintaining high approval ratings for the president is by fostering economic growth since in the contest between “the TV and the fridge”, the fridge will eventually win.

Russia is a complex country and culture. Instead of the simple American saying “it’s the economy stupid”, Russians talk about “the TV vs the fridge”. This translates into that concerns about the economic situation can be made irrelevant by propaganda so that voters turn their eyes away from the half-empty fridge to follow how Russia’s armed forces fight the enemy in foreign countries.

The propaganda messages have of course varied over the years, but it seems that external enemies that threaten the nation are at the heart of many of the messages. This theme in propaganda is of course not unique to Russia, but it seems to carry more weight in Russia than in other countries.

The observation that propaganda is used and that it seems to work to a relatively large extent at times can lead to the conclusion that “it’s not the economy stupid” when it comes to approval ratings of the Russian leadership.

This observation is tempting as another piece of evidence on how Russia is different and unique, but this brief will show that in most times, it is indeed “the economy stupid” also in Russia.

Putin’s ratings and growth

The idea that Russia is different in that growth would not be important for the president’s approval rating can be justified empirically when we look at the full series of approval ratings of Putin as measured by the Levada center and corresponding quarterly growth rates going back to 1999 (Figure 1).

Instead of showing a strong positive correlation as we would expect, the correlation is negative 0.3. However, a more careful look at the observations in the scatter plot suggests that there are a few clusters of observations that create this negative correlation. In the figure, three distinct clusters are marked; first there is the period when Russia rebounded strongly from the 1998 crisis in 1999-2000, with growth rates that have not been seen before or after that time in Russia. The growth was an artefact of the previous massive decline in income in combination with a large devaluation, and later followed by oil price increases. This happened in Putin’s initial time in the highest offices when he was prime minister, interim president and then elected president. Although Putin enjoyed high ratings as a consequence, it was not in line with the extreme growth rates that were the result of events preceding his tenure and can thus be regarded as outliers.

The second cluster is related to the global financial crisis in 2008/09 when Russian growth took a major hit as oil prices collapsed and the exchange rate was not allowed to appreciate correspondingly. However, this crisis was blamed (as in many other countries) on the US and the West and did not cost Putin in terms of approval ratings.

The final cluster is related to the annexation of Crimea and ongoing involvement in the conflict in Eastern Ukraine. This period also coincides with a sharp drop in oil prices that taken together led to negative growth that then remained low for a prolonged period. We should note that before the annexation of Crimea, growth rates in 2013 were very low at 1-2 percent with approval ratings going down to 63 percent, which was an all-time low since Putin’s first year in office.

Figure 1. Ratings and growth

Source: Becker (2019)

If we purge the data from the three exceptional episodes that we have identified above, we get Figure 2. Note that the scale has not been changed from Figure 1. Now there are no observations of negative growth rates, but the distribution of growth rates is still rather spread out, going from around 1 to 9 percent growth. The spread of the growth distribution is important since it allows us to identify the relationship between growth and approval ratings more clearly.

The relationship between approval ratings and growth in Figure 2 is strongly positive with a correlation coefficient of 0.7, and in line with what we would expect in other countries. This is a quite remarkable shift from the negative correlation in Figure 1. Note that if approval ratings in 2014 had been behaving as in “normal” years, the regression line would have put them around 60 percent instead of the actual approval rating that peaked at 86 percent after the annexation of Crimea. Such is the strength of the TV.

Figure 2. Ratings and growth

Source: Becker (2019)

This is very clear evidence that Russia is a “normal” country in “normal” times, but that there are also times when other forces overshadow this normalcy.

Policy conclusions

Are there any policy conclusions that can be drawn from the stark contrast between figures 1 and 2? The answer is a very clear “yes”, both for the Russian leadership but also for the rest of the world that has economic interests and security concerns with Russia.

For the Russian president, the message is that it pays in terms of high approval ratings to generate growth and “keeping the fridge well stocked”. It is also clear that the high popularity rating that was seen after the annexation of Crimea has been followed by several years of poor growth. A forthcoming brief discusses how the increased uncertainty created by this event has led to lower capital inflows, lower domestic investments and lower growth.

Not surprisingly, the sustained low growth has started to show in terms of falling approval ratings. The polls at the end of 2018 and early 2019 (for when there is not yet data on growth rates) indicate a significant decline in approval ratings, down to 64 percent from over 80 percent at the end of 2017. This is linked to protests over pension reforms, but they in turn are a result of lower government revenues in an economy that lacks growth.

In other words, if growth does not return before the propaganda loses its appeal, this will eventually result in falling approval ratings for the president, which is what we are seeing now.

There are potentially also some policy conclusions for Russia’s foreign investors, trading partners and neighbors. When growth in Russia is low and no credible reform programs are on the horizon, expect external actions that take the attention away from poor economic performance while increasing the level of uncertainty both in Russia and abroad.

For the more pro-active external actors, finding ways to support Russia’s return to growth through dialogue on real economic reforms could perhaps be both politically feasible and of mutual interest to Russia and the West. There are clearly some geopolitical issues that may interfere with this process, but it should still remain high on the wish list of regular people in Russia and elsewhere. Let the fridge rule!

References

  • Becker, T., 2019. “Russia’s macroeconomy—a closer look at growth, investment, and uncertainty”, forthcoming SITE Working Paper.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Revisiting Growth Patterns in Emerging Markets

Posted on October 15, 2018 | Policy Brief

20181014 Revisiting Growth Patterns Image 01

Recent studies document that emerging markets are rather similar in their growth patterns despite profound differences in starting conditions and productivity fundamentals. This challenges the common view on productivity as the main growth engine. The crucial role of the external environment for emerging markets emphasized by numerous studies adds to this doubt. I argue that productivity fundamentals still matter and remain the core driver of sustainable growth. However, external factors are crucial for understanding deviations from the trajectory of sustainable growth, i.e. episodes of growth accelerations/decelerations.

Challenges for Understanding Growth in Emerging Markets

As we enter the 4th decade of economic transition in Central and Eastern Europe (CEE), the causes and directions of causality of long-term growth in emerging markets might need to be reconsidered. Some recent studies emphasize that growth trajectories in emerging markets are pretty similar, i.e. average growth rates do not differ too much, while jumps and drops in growth rates are synchronous for the bulk of emerging economies (e.g. Fayad and Perelli, 2014). For instance, a decade ago the level of GDP per capita (in 2011 international $) in Macedonia was roughly 45% of that in the Slovak Republic, which likely reflected the productivity (measured through the Global Competitiveness Index) gap  between them. During the last decade, Macedonia has roughly closed this productivity gap. Growth theory would postulate that this should have transformed into faster output growth in Macedonia vs. Slovak Republic closing well-being gap. However, the two countries’ had throughout the decade roughly equal average output growth and the well-being gap today is still the same as it was ten years ago.

Such observations seem to conflict with existing theoretical views. First, this is a challenge to the well-being convergence concept that results from growth theory. Moreover, if we measure growth in terms of the speed of closing the well-being gap with respect to the frontier (the US economy), one may argue even for divergence. For instance, Figure 1 presents a scatter-plot for a sample of emerging markets relating the initial conditions – well-being level in 1995 (GDP per capita  relative to one of the US economy) – and the average speed of well-being gap (vs. the US economy) closing throughout 1996-2017  (measured in p.p. of corresponding gap ).

Second, the evidence that productivity gains do not automatically trigger output growth challenges a common view that productivity is the major driver for sustainable growth.

Figure 1.Starting Conditions and Well-Being Gains

Source: Own computations based on data from World Development Indicators database (World Bank).

What are possible explanations for the observed similarity in growth rates of emerging markets?

A study by the IMF (2017) suggests a response: growth in emerging markets is similar and synchronous due to the external environment. This study emphasizes the crucial dependence of medium-term growth in developing countries on the following factors: growth of external demand in trade partners, financial conditions, and trade conditions. Moreover, it states that these factors are dominant in explaining the episodes of growth strengthening/weakening.

Does this explanation change the growth nexus for emerging markets? Can one state, that while external factors are crucial for growth and growth in developing countries is rather homogenous, the productivity gains are not so important anymore?

I would say no. First, for better understanding of growth patterns we must clearly compare the relative importance of productivity gains vs. external factors in affecting the growth schedule. Second, we must separate relatively short-term fluctuations in GDP growth from sustainable growth.

Detecting Relative Importance of Growth Drivers

To answer the question about the relative importance of productivity fundamentals and growth factors, I study a panel of 34 emerging market economies (EBRD sample netted from 3 countries for which the data is not available) for 11 years (2007-2017).

To evaluate the relative importance of productivity and external factors, I use a standard approach of running panel growth regressions with fixed effects. At the same time, I make a number of novelties in the research design.

First, for measures of productivity, I engage a unique database – Global Competitiveness Indicators by World Economic Forum (WEF). Although this database provides an insightful perspective on productivity fundamentals at the country level, it is rather seldom a ‘guest’ in economic research. From this database, I extract a number of individual indicators in order to detect which ones among them that have the strongest growth-enhancing effect. For an alternative specification, I use principal components of 9 individual indicators from this database as proxies for productivity gains.

Second, for external factors, I use an approach similar to the IMF (2017) and calculate variables representing external demand growth, trade conditions, and financial conditions (such as a measure of capital inflows) for each country. Moreover, in respect to external demand growth, I use different competing measures (based on either imports of GDP growth of trade partners) and choose the best one in each individual equation. By doing so, I allow this dimension of the external environment to be represented in each model to the largest possible extent.

Third, I depart from using output growth as the only measure of economic growth and response variable in growth regressions. I argue that for international comparison purposes it is worthwhile to consider also the speed of closing the gap towards the frontier (the US economy). On the one hand, this measure is strongly correlated with the traditional output growth rate. On the other hand, this measure, in a sense, nets out the growth rate of a country from global growth, thus capturing something more unique and peculiar just to individual countries’ gains in well-being. Furthermore, I argue that in the discussion about the factors behind growth, one should distinguish between relatively short and long term growth. Annual growth rates, especially at relatively short time horizon, are too dependent on fluctuations, which may be interpreted in terms of growth rate strengthening/weakening. However, to emphasize the property of growth sustainability, we should get rid of ‘unnecessary noise’. For this purpose, I also introduce a trend growth rate measured in a most simple way as the 5 year moving average (following the discussion in Coibion et al. (2017), show that the bulk of measures of ‘potential’ growth are not good enough to get rid of demand shocks and these measures are pretty close to simple moving average measures).

I apply this definition of trend growth both to ‘standard’ GDP growth rate and to the speed of closing the gap towards frontier. So, finally I have 4 response variables: ‘standard’ growth rate, the speed of closing the gap to frontier, and two corresponding measures of trend growth.

Sustainable Growth Mainly Depends on Productivity

Having short-term (annual) growth rate as response variable (either ‘standard’ or the one in terms of closing the gap) provides results close to those in IMF (2017). It may be interpreted in a way that the external environment is more important than productivity factors. If dividing all regressors into two broad groups of factors – external and productivity – the former is responsible for up to 70% of the growth effect, while the latter for about 30%. Among external environment factors, the most important one is financial conditions. Its relative importance is roughly 50% of the group of external factors’ total.

Among productivity fundamentals, an important contributor to short-term growth is the quality of the macroeconomic environment. According to the methodology of WEF (2017), this indicator encompasses the fiscal stance, savings-investment balance, the external position, inflation path, debt issues, etc.

When refocusing from short-term growth to the growth trend as a response variable, the relative importance of the factors behind growth changes. Productivity fundamentals in this case drive up to 80% of growth effect, while external factors are responsible for the remaining 20%. It is worth noting here that the proportion in favor of productivity factors is higher for the concept of closing the gap to frontier rather than for ‘standard’ trend growth rate. This evidence may be interpreted as additional justification for treating this measure of growth as ‘good’ at reflecting individual properties of a country in a global landscape.

Furthermore, the role of individual variables also changes. Among external factors, the most important role in driving sustainable growth belongs to trade conditions and external demand growth, while the role of financial conditions is either miserable or insignificant at most. Among productivity factors as drivers of trend growth, the quality of the macroeconomic environment seems to play a special role, as well as the efficiency of the goods market and the financial system.

Conclusions

The evidence showing rather similar and synchronous growth in emerging markets and recent evidence on the crucial importance of external factors for emerging markets should not lead us to incorrectly believe that productivity fundamentals do not matter anymore. Productivity fundamentals are still the core driver of sustainable growth. At the same time, we should keep in mind the important role of the external environment for emerging markets. However, changes in the external environment are more likely to generate relatively short-term growth rate fluctuations, while having a modest impact on the sustainable growth trajectory. Hence, a country aiming to secure sustainable growth should still first of all think about productivity fundamentals.

References

  • Coibion, O., Gorodnichenko, Y, Ulate, M. (2017). The Cyclical Sensitivity in Estimates of Potential Output, National Bureau of Economic Research, Working Paper No. 23580.
  • EBRD (2017). Transition Report 2017-2018, European Bank for Reconstruction and Development, London, UK.
  • Fayad, G., and Perelli, R. (2014). Growth Surprises and Synchronized Slowdown in Emerging Markets—An Empirical Investigation, IMF Working Paper, WP/14/173.
  • IMF (2017). Roads Less Traveled: Growth in Emerging Markets and Developing Economies in a Complicated External Environment, in IMF World Economic Outlook, April, 2017, pp. 65-120.
  • World Economic Forum (2017). The Global Competitiveness Report 2017-2018, Geneva: World Economic Forum.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.