The Russian embargo was imposed as a reaction on the sanctions introduced by the EU and the US after Russia invaded Ukrainian Crimea. At that time Russia strongly depended on food imports, as the internal agriculture production covered about 40 per cent of the domestic fruit consumption, approx. 80 per cent of the meat and meat products consumption, fish and seafood, milk and dairy products, and approx. 90 per cent of vegetable consumption.
The embargo was imposed on the largest global food exporters (including the European Union, United States, Australia and Canada), which significantly limited the possibility of a geographical reorientation of Russian imports. The strong depreciation of the RUB, associated with a significant drop in oil prices and the economic crisis in Russia, also were not conducive to purchases of foreign food.
As a result, after the introduction of sanctions, there was a strong increase in food prices in Russia. In the first year of the embargo (i.e. from August 2014 to July 2015), the average annual inflation in the “food and non-alcoholic beverages” category amounted to 18.1 per cent y/y. In the second and third year food price inflation also remained at a relatively high level and amounted 11 per cent and 4.7 per cent, respectively. A relative stabilization of prices was only recorded at the end of 2017, when their annual increase amounted less than 1 per cent.
Rising food prices amid the isolation of the Russian market from Western competitors had a positive effect on the profit margins of companies from the Russian agricultural and food industry. This, in turn, encouraged entrepreneurs to invest in the expansion of their production capacities in order to increase sales. This process was additionally supported by numerous government programs aimed at ensuring that Russia achieves the greatest possible self-sufficiency in the food production.
People who invested in the shares of leading Russian companies associated with the agricultural and food industry during the imposition of the embargo should have no reason to complain today. Since then, the share prices of the largest Russian meat producer Cherkizovo Group, and the key producer of fertilizers PhosAgro, have doubled.
Meanwhile, the share prices of the leading Russian confectionery producer Red October and those of the fish processor Russian Sea Group have tripled. During that time the main index of the Moscow stock exchange increased by approx. 60 percent. This indicates that after the imposition of the embargo the largest companies associated with the Russian agricultural and food industry generally performed better than other companies listed on the Moscow stock exchange.
Growth under government protection
In terms of individual sectors, one of the greatest beneficiaries of the Russian embargo has been the pork production. According to the estimates of USDA (the United States Department of Agriculture) in the years 2013-2017 it increased by 23 per cent. At the same time, the consumption of pork has already returned to pre-embargo levels after a significant drop in 2014 due to the sharp price increase. Currently, Russia covers over 91 per cent of its demand for pork domestically, while back in 2013 this coverage reached only 73 per cent. The high consolidation of the sector is conducive to the strong growth in pork production in Russia. Thanks to the economies of scale, companies are able to invest in increasing their production capacity quicker and fill the market void left by Western pork exporters. The high concentration also enables more efficient cooperation with the government in the co-financing of investment projects, as large companies are a better partner for talks than small, dispersed enterprises. Assuming that the high rate of growth in pork production observed over the past three years will continue, Russia may soon reach a production surplus.
The Russian poultry sector also achieved success due to the embargo. According to estimates of the USDA, in the years 2013-2017 its production increased by 29 per cent. An important factor influencing the development of this industry was the strong internal demand for poultry following the imposition of the embargo. After the significant increase in food prices poultry remained the cheapest type of meat. As in the case of the pork, the development of the poultry industry was also supported by its high consolidation. As a consequence, according to USDA data, Russia now covers almost 98 per cent of its poultry demand domestically. If the Russian poultry industry wants to maintain the current rate of growth in production, it will face the necessity of entering export markets in the coming years.
The Russian fishing industry has also been increasingly successful amid the embargo, which eliminated exports of Norwegian food to Russia. The development of mariculture (breeding of marine organisms) accelerated after the crisis of 2015, when the largest companies incurred significant losses due to fish epidemics. The sector is currently experiencing a strong investment push, which is supported by government subsidies. However, the shortage of modern equipment, production technologies and specialist feeds are inhibiting production growth. One solution to this problem are acquisitions, as evidenced by the recent purchase of the Norwegian producer of salmon smolt Olden Oppdrettsanlegg by the largest Russian fish company Russian Sea Group.
Embargo does not guarantee success
However, recent years have provided numerous examples proving that even the absence of Western competition is no guarantee of success. One of them is the Russian dairy industry. According to USDA data, in the years 2013-2017 the production of milk in Russia increased by only 0.2 per cent – a growth rate too small to even dream of approaching the distant goal of self-sufficiency. This is due to the very high fragmentation of milk production in Russia. Small farms are often unable to finance long-term investments involving the purchase of high-yield cattle breeds, modern equipment or veterinary solutions. The high interest rates and the low exchange rate of the RUB are also not helping, especially since most modern production factors must be imported due to the low level of development of the Russian dairy industry.
As a result, Russian farms are not able to provide high-quality raw material. Such an assessment is supported by USDA data, according to which only about 67 per cent of the milk produced in Russia makes its way to the dairies, while the EU average is around 89 per cent. The lack of high-quality raw material is a barrier to the development of milk processing. The scale of the problem is demonstrated by Danone’s latest investment. In the face of the shortage of high-quality raw material that company decided to transport 5,000 cows to Siberia and start producing milk on its own. This is an unprecedented situation, since Danone’s core activity is milk processing, and not its production.
Beef producers are struggling with the same problems as the dairy industry. The production of beef in Russia is mainly a “by-product” of the dairy industry, which is the source of as much as 85 per cent of supply of this type of meat. As a consequence, according to USDA data, in the years 2013-2017 beef production in Russia decreased by approx. 3 per cent. Along with the deterioration of the population’s economic situation there was a strong decline in the demand for beef, whose consumption decreased by 24 per cent in the years 2013-2017. Nevertheless, Russia still covers only 72 per cent of its demand for this type of meat domestically.
The Russian fruit and vegetable industry is also facing difficulties. High interest rates are not conducive to investment in a situation where one has to pay interest for many years and wait for the new orchards to produce the first fruits. According to USDA estimates, approximately 64 per cent of Russian supply of fruits and 70 per cent of the supply of vegetables comes from small farms. An additional strong barrier is the insufficient infrastructure for the storage and transport of fruits and vegetables, which results in oversupply during the harvest season and shortages after the season.
However, in the Russian agricultural and food industry we will also find sectors that are doing exceptionally well despite the fact that they are not protected by the embargo. One of them is the grain sector. According to USDA, in the 2017/2018 season the production of grains in Russia amounted to approx. 127 million tons and was approx. 26 per cent higher than in the season in which the embargo was imposed. At the same time, it has reached the highest levels at least since the collapse of the Soviet Union.
As a result, in the last season Russia became the world’s largest exporter of wheat, leaving behind previous leaders such as the European Union and the United States. This success exceeded the logistics capabilities of Russia, whose infrastructure proved insufficient to handle such large volumes of exports. The production of cereals in Russia is primarily supported by the very favorable geographical factors, such as the large resources of high-quality soils and the territorial potential. At the same time the industry is profiting from the economies of scale due to the dominance of very large farms, which makes investment significantly easier. In the export markets Russia is also gaining advantage thanks to its access to the Black Sea, which significantly reduces the costs of transporting cereals to the countries of North Africa, which are their largest importers. In recent years, the low exchange rate of the RUB has also been a factor favorable for the Russian cereal exporters, significantly increasing their price competitiveness.
The Russian sugar production has also recorded impressive growth in recent years without the help of the embargo. According to USDA data, in the years 2013-2016 Russian sugar production increased by 40 per cent, to 6.2 million tons in the 2016/2017 season, thereby reaching the highest levels at least since the collapse of the Soviet Union. As in the case of cereals, geographical factors play an important role here. Nevertheless, in recent years, there has also been a clear improvement in the industry’s production efficiency, which is due to previous investments. As a result, Russia now produces slightly more sugar than it consumes, while just three years ago its production covered less than 80 per cent of domestic demand.
There is no efficiency without competition
The examples of individual sectors of the Russian food industry show that the embargo is not a prerequisite for success, and that it does not guarantee success in itself. What is more, in the long term it creates a significant risk for the competitiveness of Russian food producers protected by the embargo. This is due to the following mechanism. Before the imposition of the embargo, Russian companies were losing market share to Western food exporters, which suggests that they were less competitive. The imposition of the embargo, which resulted in a shortage of food products on the Russian market and an increase in prices, is primarily a factor encouraging Russian companies to increase their production volumes. In the absence of Western competition, the motivation to increase efficiency is limited, as they compete within their own circle, where the level of competitiveness is lower than among Western food exporters.
Many sectors of the Russian agricultural and food sector protected by the embargo will soon generate surpluses and will be forced to enter export markets. Meanwhile, the West is both a significant producer of food and its affluent consumer. As a result, it is a very attractive market for exporters.
It is highly likely that the West will not allow significant imports of Russian food, as long as the Russian market remains closed to Western food. Russia will therefore face the necessity of lifting the embargo should the problem of low competitiveness of some sectors of the Russian agricultural and food industry remain unresolved. A very likely scenario is that many of the protected sectors and companies will not survive the competition and their market share will return to the levels recorded before the embargo.
Russia undoubtedly has very strong natural competitive advantages in the area of food production which are related to geographical factors such as the large amount of high-quality soils over vast territories. At the same time, the progressing global warming will be increasing these advantages. In the opinion of the International Monetary Fund of October 2017 (report entitled “Seeking Sustainable Growth – Short-Term Recovery, Long-Term Challenges”), Russia is included in the group of countries that benefit the most from global warming.
With the right economic policies based on market principles, the Russian agricultural and food industry could achieve success. However, building one’s advantages on the isolation of domestic producers from Western competition may turn out to be a short-sighted solution which will slow this process down.