18 May 2017

From alleged involvement in US and European elections and military campaigns in the Middle East, Russia is rarely far from the headlines. The recent apparent agreement between Saudi Arabia and Russia to extend previously agreed oil production cuts until the end of 2017 not only may improve sentiment in energy markets, but also has raised expectations the Russian economy will emerge from two years of recession.

Indeed, the worst appears over for the Russian economy; however, the recovery faces numerous headwinds.  In particular, the recent technological advances in global petroleum markets, especially the development of the US shale industry, are likely to keep oil prices well below previous levels for the foreseeable future. In this environment, sustained reforms are needed for Russia to avoid a prolonged period of sub-par growth, and to achieve the goal of reducing the per capita income gap with the world’s advanced economies.

The Worst is Over, But…

To be sure, the Russian economy is emerging from the two-year recession resulting from the collapse of oil prices and the imposition of sanctions following events in the Ukraine and Crimea. However, the tepid 0.5% advance in GDP in Q1 2017 is modest following the earlier 3% contraction. The recovery depends largely upon a revival in consumer spending.  Unlike past adjustments to lower oil prices when unemployment increased significantly, joblessness has remained low, but households have suffered a wrenching 10% decline in real wages. With inflation-adjusted pay now rising again (albeit modestly at 1.5%), will households release pent up demand?  My guess is the consumer will remain wary. And, while household confidence has improved, sentiment remains well below 2014 levels.  Retail sales declined another 2% in Q1 2017 (granted an improvement on 2016’s 5% fall).

Signs of recovery in Russia’s already healthy public sector and international balance sheets reflect improved sentiment.  Public sector debt remains low (near 15% of GDP), despite rising modestly in an effort to cushion the impact of the recent recession. Likewise, for the first time since the imposition of sanctions, Russia returned to international markets last year, raising $3billion.

Likewise, Russia’s international position appears to be stabilising after the rout of recent years.  In order to cushion the impact of the global financial crisis, the Russian corporate sector had borrowed heavily, including from abroad.  The IMF estimates that external corporate indebtedness increased by nearly $200bn between 2008 and 2014.  However, in reaction to the imposition of sanctions in 2014, the Russian corporate sector has experienced a painful deleveraging, which contributed to net private sector capital outflows totalling nearly $250bn between 2014 and 2016.

Fortunately, this situation is stabilising.  Private outflows now have abated dramatically: slowing to $15bn last year after a peak of over $150 in 2014.  As a result, international reserves have been rising during the past 12-18 months, mirroring the nation’s current account surplus of roughly 4% of GDP.  Russian retains a healthy net international investment surplus of roughly $225 billion (15% of GDP).  Total external debt stands at manageable 35% of GDP, short term debt is low, and the debt service costs are easily affordable.

Headwinds:  Living With Lower Oil

The persistence of low oil prices will pose serious challenges.  First of all, the Russia’s public sector relies heavily on oil revenues – accounting for 1/3 of the total.  Indeed, half of the recent deterioration in the government’s budget –swinging from a surplus of 1.5% to a deficit of 4.5% of GDP since 2011 – has resulted from declining energy receipts. In Mexico, equally reliant on oil revenues, recent fiscal reforms have succeeded in boosting non-oil receipts to offset the shortfall from the energy sector.  Russia has yet to do so, but has ample scope to boost non-oil revenues, e.g. income and corporate taxes represent only 25% of government revenues.  Progressive tax reform, however, would face opposition in a nation with one of the world’s most unequal income distributions.

In light of lower oil receipts, the government has announced a multi-year plan to eliminate the budget deficit by 2020, largely by freezing expenditures at 2016 levels.  This would be a formidable headwind for the economy.  With a Presidential election next year, and with spending rising sharply (up 3% of GDP since 2011), these targets are unlikely to be achieved.  With government debt low and demands for additional outlays on health, education, and pensions, a more measured approach is warranted, likely resulting in continued fiscal deficits.

Russia’s external sector, of course, is also highly dependent on oil and gas, accounting for nearly 70% of exports.  However, despite the RUB’s huge devaluation, this reliance has not diminished, as non-energy exports have declined over 20% since 2012. Granted lower metal prices are a factor, but most manufacturing segments have not taken advantage of the currency’s decline. Again, in contrast, Mexican non-energy exports have benefited both from NAFTA and peso weakness.

Russia rode the wave of previously high oil prices.  Between 1998 and 2008, for instance, Russian GDP advanced 7% annually; leading to a significant convergence with the world’s advanced economies (which gained 4% per year).  Russia even compared well with China (10%) and India (7%).  More recently, lower and more volatile energy quotes have revealed Russia’s structural weaknesses.  Indeed, since 2009, Russian growth has slowed to 1.5% annually, well below 8% in China and India.  More importantly, perhaps, Russia has failed to keep pace with the tepid 2% gains in the OECD, and the era of convergence stalled (Russia did outperform the EU’s 1%).

Russian performance reflects a sharp deceleration in the economy’s underlying long term growth potential.  After advancing 6% annually in the 2000’s, the IMF estimates the current trend in Russian labour productivity at just over 1%. Part of the explanation lies in the nation’s low investment rate: at around 20% of GDP compared to roughly 30% in the Baltics and central European countries.  Furthermore, the projected 15% decline in Russia’s population in the next two decades will shrink the labour force, and slow trend GDP growth.

Reform is the key to living with lower oil prices, and unlocking Russia’s enormous potential.  The World Economic Forum Competiveness report ranks Russia 43 out of 193 nations – compared to Germany (5), France (21), and Poland (36).  The WEF does acknowledge that Russia’s rating has improved in recent years (the World Bank’s most recent “Doing Business” report, on the other hand, points to a recent decline).  The WEF also points to Russia’s enormous potential, giving high marks for market size (6), higher education/university research (36), telecom/internet access (28), rails (25), and labour flexibility (40).

On the other hand, Russia scores low on key criteria for establishing/transforming a successful market economy:  market competition (87), property rights (123), judicial independence (95), regulatory burden (103), corruption (85), protecting minority rights (116), non-rail infrastructure (90), financial sector development (108), business sophistication (72), and life expectancy (107).

Market Implications

• Russia’s recovery confronts both cyclical headwinds and a long term structural slowdown. GDP will struggle to advance 1% annually in the coming years, and convergence with the advanced economies will be minimal at best.
• Inflation should approach the CBR’s 4% year-end target. Policy interest rates could decline 150bp this year.
• The RUB will remain a petrol-currency. Indeed, with the CBR now targeting inflation rather than the exchange rate, the RUB’s correlation with oil will remain higher than historically. The RUB is now in line with fundamentals. The CBR would like stability to help reduce inflation.  Without reforms, though, the need for RUB weakness to boost non-oil exports may prevail.
• Reflecting Russia’s healthy current account surplus and external balance sheet, credit spreads may narrow 25 to 50bp. However, assuming oil remains in a $40 to $60 range, spreads will not approach the lows of the mid-2000’s.  Tighter spreads should not be impacted by a modest US Fed tightening.  A dramatic deterioration in relations with the US or tighter sanctions, however, would adversely impact corporate spreads particularly (despite deleveraging, external borrowings remain near $300bn).