How Russia can manufacture a leading economy

How Russia can manufacture a leading economy

Oil and gas is not just Russia’s core business, but also its core opportunity. And mobilizing for large-scale undertakings is one of Russia’s proven core competencies.

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How Russia can manufacture a leading economy

This article originally appeared in Russian in Vedomosti (subscription required)

Russia’s truly massive oil and gas industries help to make it the eighth-largest economy on earth. With revenues from distribution, they account for two-thirds of Russia’s export volume and 35% of GDP. Russia is now the world’s top producer. Yet this is still a very thin reed for supporting the nation’s quest to become a leading economic competitor.

Why? Because measured against this mammoth commodity-based sector is a value-added manufacturing capability that is seriously out of balance. The latter has been hovering at a paltry 17% of GDP for the past decade. Today, value-added manufacturing amounts to just 7% of exports.

Russia needs to reverse those ratios, and soon. Not just because of the inevitable decline of oil and gas reserves. Rather, because the planned expansion of value-added manufacturing has been the proven method for achieving sustained global ascendancy by such countries as Germany in the 1950s, Japan in the ‘60s and China in the ‘90s.

Historically, these countries have achieved not only a high percentage of GDP from manufacturing. They have also prospered because of specific government policies supporting manufacturing and creating incentives for private investments.

China, for example, achieved 10% GDP growth during the 90’s when 33% of GDP came from value-added manufacturing and investment was an average 39% of GDP. Compare this to Russia’s 4% GDP growth over past decade, with investment representing only an average 22% of GDP.

Yet in almost every category where the Russian government can support manufacturing, Russia falls below countries it competes against – such as China and India – in key industrial measures: In a 2012 IMD world competitiveness study of 59 countries, for instance, Russia ranked number 53 in productivity and efficiency, and 34th in technological infrastructure. It was 57th in business legislation and 58th in the freedom to set efficient market-driven prices. Overall, Russia ranked 48th.

Given its disproportionately small manufacturing base, how should Russia think about global expansion? At Bain & Company, we have long observed that the timeless principle for building market power is to find a strong core and expand into adjacencies. Our studies over decades show that wrongly diversifying away from a core into new areas in an attempt to find growth usually spells disaster.

Fortunately, Russia’s doesn’t have to look too far to find its strongest core. Indeed, it should surround its oil and gas (and other strong commodities) assets with world-class value-added manufacturing, equipment and services sectors. Today, Russia sources nearly half of such services and gear from foreign contractors.

The good news is that Russia already knows how to do this. It virtually defined this pattern in its defense-industry and nuclear power sectors. And in both, government policies and investments were essential. The “why” and “how” are instructive.

Defense has always been linked to Russia’s self-image – and to its exports and aid to other countries. The government therefore has continually financed stable levels of defense-related R&D and, through scale, ensured low costs to enable low prices. It also consolidated exports through one agency.

As a result, Russia’s defense shipments last year totaled $15 billion, making it the 2nd-largest exporter after the U.S. and more than four times bigger than the next rival, China. In nuclear power, Russia is already a global leader.

Russia’s nuclear efforts began at scale more than 50 years ago. The reason: authorities wanted to quickly find a cheap source of power, while reducing logistical and infrastructure needs around shipping coal, across a vast country.

As a result, Russia has the third-largest nuclear-generation capacity in the world, after the US and France, and is the world leader in constructing nuclear plants, with more than 35% of the global market.

Again, the government played a key role. It made nuclear power R&D and education a priority. It grew these investments over the last five years at a significant rate.

Another outcome: Russia is close to operating (and exporting) plants that run on nuclear waste – a truly next-generation technology that promises less expensive and far safer nuclear power.

The question remains, though, can Russia summon the will to duplicate these feats around oil and gas? Other countries have: In Norway, annual value-added oil and gas services are growing nearly four times faster than in its oil and gas production.

The Norwegian government orchestrated this stunning growth by giving preferences to local producers, by requiring multinational petrochemical firms to spend 50% of their R&D dollars with Norwegian institutions, and by only allowing foreign access only in exchange for technology transfer rights.

Brazil is doing something similar: The Brazilian government mandates that its oil and gas value-added operators have between roughly 40% to 85% local content.

Simply put, Russia can and should place similar bets. Oil and gas is not just Russia’s core business. It is also its core opportunity. And mobilizing for large-scale undertakings is one of Russia’s proven core competencies.

But Russia’s leadership must act quickly – and with the right incentives – before the country’s inherent natural advantages slip away.

Orit Gadiesh is chairman of Bain & Company. This article was written on the occasion of the St. Petersburg International Economic Forum.

This article originally appeared in Russian in Vedomosti (subscription required)


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