Can Russia Avoid a Hard Landing?

Featured Blog Comments

“ Thank you for very sober outlook without bringing politics in the context. I appreciate that your analysis is based purely on economics. Let me add... more ”
By Anonymous 11-26-2008

“ In this "global crisis" potencial win-countries have to be less debt-burdened, with unsatisfied domestic market, strong export and ability to by food,... more ”
By Guest 11-26-2008

“ Russia is much more integrated to global financial system than it thinks. No money in the world can save it from capital flight and risk perception... more ”
By Guest 11-25-2008

“ good summary, but the author fails to highlight many "leakages" that are taking, and will take place, by transmitting state funds through the VEB Bank... more ”
By Guest 11-25-2008

See all blog comments

Perhaps not, now that growth estimates are being rapidly revised down for 2008 as the oil price keeps slipping, but Russian government responses could go a long way towards cushioning the population.  However, in addition to more spending, Clarity and transparency about Russia's fiscal response is needed. For some time now, since the oil price starting slipping sharply, many factors seemed to suggest major downside risks for Russia, but data from October suggest give a hint of what is ahead.   Industrial production growth was near zero, the unemployment rate jumped to 6.1%, Manufacturing PMI suggest contraction and with the going price of Ural oil at $45/b, Russia’s current account will likely be in deficit as early as this quarter. Meanwhile even consumption, the largest driver of growth is faltering. While retail sales are still growing at double digits in real terms,  the desire from consumers to get rid of depreciating roubles might be contributing to a last gasp from consumers as consumption on goods like appliances may be propping up double digit retail spending growth.

This note surveys the macro outlook for Russia, the proposed policy responses and obstacles policymakers will face in implementation in the face of a worsening crisis of confidence. It builds on previous notes on Russia’s capital injections and the run on Russian assets that began earlier this year

If oil remains at current levels, 2009 could be very difficult for Russia, despite the fact that the government has already had a quick and relatively coordinated response. The semi-annual Russia Economic report released by the World Bank’s Moscow office released last week and worth reading in its entirety suggests Russian GDP growth might halve in 2009, falling from 6% in 2008 to 3% in 2009. And the EBRD Transition report is pretty much in line. It also suggests that the CIS as a whole might see its growth halve. 3% sounds like a hard landing for Russia – it would be the slowest pace of growth in a decade, and 5ppts lower than in 2007 real GDP growth and 2.5ppts lower what the IMF predicted only 2 months ago. Note that with Russia, much depends on the oil price -  the IMF prediction assumed the oil price would average $100 a barrel, which seems even less likely now than it did in early October.  Although as yet no economists are suggesting that Russian growth would actually contract as it did in most of 1998 and 1999, clearly the macroeconomic signs are starting to flash red.

The government has been quite active though, taking fiscal and monetary responses to try to sustain growth and avoid bank runs. However at times some of the policies have seemed inconsistent.

Yet, the recent decisions to speed up the depreciation of the rouble and to take significant fiscal spending may provide a cushion for Russia. Last week Prime Minister Putin announced another series of policy measures including corporate and personal income tax cuts to try to arrest the economic crisis. Russia is trying to ensure that a sudden stop in capital inflows based on a falling price of oil, and reversal of capital flows to emerging markets does not turn into a sudden stop on the economy.  The measures (detailed below, along with their likely costs) add to previous plans to reduce oil export taxes, to encourage energy sector investment.

Yet, clarity  of policies and transparency of implementation is needed to make sure the public funds have the desired effect. Already the liquidity injections and recapitalizations of banks and backstopping the hefty external debt of Russian corporates likely had a bill of at least $200 billion. The government desire to avoid a hard landing of the rouble could actually prolong the pain. This week, the Central bank again widened the rouble’s band against the basket by about 1% or 30 kopecks, and the rouble subsequently fell to 30.87 as it did just over a week ago. In fact on Nov 27, Russian Authorities again widened the band, the third such time it has done so in 2 weeks. The Russian government clearly wants a gradual depreciation of the rouble – some analysts suggest it will now allow 1% devaluation a week.   Yet such policies may be exacerbating the outflow from the  banking system (outflows were about 5-7% in October) even as it erodes Russia’s cushion of foreign exchange reserves..

The lower oil price and current account deficit suggests a cheaper rouble is ahead. Russia's interventions in the fx market have left the rouble, not much cheaper than it was at the peak, meaning that it is now overvalued compared to most commodity currencies. The Australian and Canadian dollars as well as the Norwegian Krone have fallen sharply, but the Russian rouble has not. This relative stability has come at a cost - in the depletion of Russia's foreign exchange reserves which have lost a quarter of their value. Although Russia still has a lot of savings its reserves are eroding quickly and are now about the same level as those of Russia's net external debt. Furthermore, the rouble's strength also has the net result of implicit tightening. Like in the GCC, whose currencies have appreciated along with the US dollar against the Euro, fx has accentuated domestic and global liquidity shortages. Related RGE Content: CBR Tries Gradual Rouble Depreciation: Adding to Uncertainty?

As well as widening the rouble's trading band, the government also raised interest rates to try to discourage outflows. As Danske Bank notes, these interest rate hikes (the second this month) may have the positive effect of taking Russia's interest rates closer to positive territory, but may have limited effect on fx policies given the scale of the depreciation likely to come. Moreover, they warn against policies trying to stop corporates from hedging their exposure.  So expect further depreciation perhaps at the current pace. Given how far the rouble may have to fall (20-30% or more), faster depreciation may be preferable especially before investors and consumers get locked into a depreciation expectations.

And the uncertain certainty of the exchange rate policy may actually limit the effectiveness of other policies, such as the raft of proposed fiscal measures. Similarly the uncertainty about where the money is going, who will receive the funds and the timing may undermine the effectiveness of the interventions.  Some of the capital provided to the banks seems to have vanished, perhaps to the fx markets. And the allocation of funds by VEB seems already to be serving to consolidate control of key sectors in government hands.

The fiscal policies proposed focus on transfers to individuals and trying to support small businesses through tax cuts. It is noticeable that Russia has not made infrastructure spending a priority, nor have there been major statements that its previously planned investment spree would continue. Proposed policies (and the estimated costs) include

·         A cut in the profit tax rate from 24% to 20% - cost RUB400bn

·         Regions will be able to cut small business taxation rates further, by up to 10ppt -> RUB 20b

·         30% hike in the unemployment benefit - RUB 20bn

·         Pensions will be increased by 50% during the course of 2009 and 2010;

·         RUB 50bn ($1.8bn) on defence in2008–09 in order to avoid bankruptcies (so Russian military spending expansion may continue

·         Construction projects and major infrastructure projects be financed by VEB, the state development bank and the government will guarantee infrastructure bonds issued by companies

·         increasing tax deductions for property purchases

·         ability to expedite amortization/depreciation of fixed assets- 100bRUB

The government will also speed VAT refunds to improve liquidity, but are budget neutral)

All in all, Citigroup suggests that the price tag for existing and planned monetary and fiscal measures may be as high as $400 billion or 25% of Russia’s GDP. Now while much of that reflects monetary measures, the fiscal portion is significant if it can get where it needs to go, ie avoiding a bust of some of these overheated markets.  But it will mean a much higher expenditure for 2008 and 2009.

Finance minister Kudrin suggests the new spending might reach $30 billion and contribute to a fiscal deficit of 0.5-1% of GDP. But macro analysts are more pessimistic, with some suggesting 2009's deficit might range from 1.5-3% of GDP in 2009. Quite a reversal from the accumulated surpluses of recent years.

However, given the negative outlook for corporate profits, it is possible that the corporate tax rebates might not give as much of a boost as one might hope. If lower oil prices persist, and export tax cuts come into effect, revenues could slow sharply at the same time that expenditures increase at a fast pace. This will likely mean Russia's savings will fall further. Of course, Russia would be much worse off if it had no savings on which to draw.

For more details see Russian Fiscal Stimulus: How Will It Be Financed And Will It Help Cushion The Russian Economy?

Russia's sovereign wealth funds in particular now seem to be focused on their stabilization not savings purposes. While doing so is one of their intended goals, it may make longer term challenges harder to achieve. Furthermore, Russia, like other countries has seen the liability side of its balance sheet balloon as the government is taking on many of the private sector debts, at least for the next few years. As such its explicit liabilities are rising and it may need more liquidity.

Russia’s reserve stock is now lower than it was at the beginning of January meaning the outflow of reserves erases most years oil and foreign investment windfall. More accurately it reflects the reversal of non oil investment flows (FDI and portfolio investment). But with the oil savings about to be used to finance a range of spending, Russia’s oil funds will also begin to shrink from their current level of over $192 billion.  Transfers of funds from the reserve and national wealth fund to the VEB may be as large as $5 billion a week. As a result, ING suggests that the reserve fund may fall to 3% of GDP from the 6.8% of GDP today.

Adjusting for the valuation losses on euro and pound assets, the Russian government has lost at least $90 billion in its attempt to support the rouble. Its attempts to limit fx trading have also put pressure on the domestic liquidity.

Russia's Reserves Plunged to $454b As the Rouble Sinks Russia’s external balances are being eroded. Danske Bank predicts a C/A deficit of 4-5% of GDP in 2009 and a public budget deficit could be 3-4% of GDP in 2009 if current $45/b Ural oil prices persist. Russia's imports have been growing at a 40% y/y pace in recent years, funded in part by the extension of credit to Russians. With credit contracting, and the rouble falling, so might imports, which may limit the deterioration of Russia's external balances. With Russia likely to run current account and fiscal deficits next year, reserves and its sovereign funds shrinking, a sovereign rating downgrade is likely on the way  - despite the fact that Russia is unlikely to default on its actual sovereign debt which remains small. However, the Russian government has taken on responsibility for much of the private and quasi-private corporate debt of state banks and SOEs. And technical defaults of corporate bonds have been on the rise for some time. Although Russia’s government was quite conservative with its oil proceeds (at least until 2008, that is), its corporations and banks were not. So instead of oil revenues flowing in directly through government spending, banks and companies implicitly borrowed against the oil wealth – and now the bill is coming due. A recent ranking of Russia's largest multinationals from Columbia and the Russian Management School Skolkovo notes that 11 of the top 25 Russia multinationals have shares listed on stock exchanges outside the country and another 6 are only listed in Russia. And many borrowed heavily abroad and are now turning to domestic sources Foreign borrowing helped finance credit growth that outstripped deposit growth and fuelled asset bubbles and large amounts of imports. Russia’s imports have been climbing 40% year on year for about the last two years. The lack of credit and depreciation of the rouble will of course erode imports. But Russia may have difficulty sourcing some of the goods at home as productivity in most sectors remains weak.

The government’s plans may be effective in supporting key sectors like construction by offsetting the withdrawal of private capital. Russia’s policy challenge is to deter speculation and property flipping while still adding to housing supply and keeping it affordable. Prices have risen dramatically in urban centers, fuelled in part by negative real interest rates. The withdrawal of foreign credit and tightening of domestic money markets were particularly difficult for Russian property developers. Construction output was already slowing sharply as supply constraints contributed to high inflation and credit shortages further delayed projects. Government support to property developers may unfreeze some projects, partially avoiding a bust.

Property price growth is slowing – which may be a necessary response to an overheated market in Moscow. And adjusting for inflation, the slowing housing price appreciation might be more pronounced. A whole range of macro indicators seem to show worrisome trends ahead

Industrial production barely grew in October, the second sub-1% reading this year – and on a three month average basis has returned to levels last seen in 2006.  And tougher times may be ahead.

VTB’s manufacturing PMI reported the second monthly sub 50 reading, indicating a contraction in the sector.

Source VTB

Meanwhile manufacturing companies are paring jobs – perhaps because as yet wage rates remain high, even for less skilled workers. Unemployment rose to 6.1% in October from a year before (up from 5.3% in September). Nominal and Real wages do continue to show double digit growth, despite faltering from peaks reached earlier this year. Meanwhile real disposable income is also slowing.

And supporting private consumption may become harder in the near-term. Retail sales are on a downward path. Adjusting for inflation, retail sales have returned to mid 2006 levels. High inflation, loss of wealth, difficulty accessing credit may all account for slowing retail sales growth. But evidence suggest further slowing is to come, despite the fiscal stimulus.

Furthermore, while only a small number of Russians invested in the equity markets, they account for a high share of consumption so the negative wealth effect of falling asset markets might be significant even if it is much lower than in developed economies. But overall, it is the decline in the rouble and perceived future loss of purchasing power, and that might have the most significant effect on consumer confidence. So far, Russians are still consuming.

Russian Consumption: Retail Sector Faltering?

Slowing consumption in Russian is bad for its suppliers, whether they be German or Chinese. Amplified by borrowing, Russian import growth has averaged about 40% for the last two years, with consumers and corporations importing key products. This rate of growth may now slow, weakening the outlook for European exporters like Germany. After China, Russia is Germany’s largest non-EU export market.

Foreign investment flows have clearly reversed – In 2008, Russia has now had net outflows of investment in contrast to the inflows experienced in recent years.

One good thing – very elevated inflation is starting to slow, though both consumer and producer inflation remains quite elevated – and the depreciation of the rouble could create inflationary pressures, though these may be counterbalanced by competing deflationary pressures as output shrinks.

It is these macro trends – especially concerns about any fall in consumption – and outflows from the banking system that have likely contributed the governments call to action, just as major outflows and  runs on the banking sector prompted them to inject more money in the banks.

In Russia, like many oil exporters, the outlook depends heavily on the outlook for commodity prices, which still account for much of government revenue and with which all of Russia's asset markets are highly correlated. Russia's savings garnered over the last few years do give it some firepower, but it must use them wisely to support long-term productive growth.

However, with Russia having underspent many emerging markets in the past bust and boom cycle, it is particularly vulnerable to a decline in fixed investment that may be coming. It also needs to make some long-term investments in infrastructure (a big planned investment agenda might now be scaled back). Counteracting the rather low productivity in several sectors and in improving the predictability of its investment climate will be necessary for Russia to  attract capital when risk appetites return