Russia: Not Rushin’ to Buy!

15 April 2021

The Russian ruble (RUB) — traditionally a petro-currency — has not benefited from the recent rise in oil prices. Indeed, during the recent bout of Emerging Market currency volatility — provoked by a combination of rising US bond yields and problems in Turkey — the Russian central bank (CBR) raised interest rates 25bp to curb inflationary pressures. Since the beginning of 2021, Russian bond yields have risen 125bp (to 7.25%), and the RUB appears undervalued (Chart below). Is it time to buy?

In addition to oil prices, global geo-politics are a key driver for Russian markets: note the RUB’s decline since the imposition of US sanctions in response to developments in Ukraine in 2014. Typically after American elections, diplomatic chatter turns to the prospect of a “reset” of frosty US-Russian relations. Such discussions are conspicuous by there absence now, e.g., witness the recent ratching up of US sanctions. From the American perspective, President Biden appears more willing than his predecessor to hold Russian to account for alleged cyber-attacks, election meddling, poisoning of dissidents at home and abroad, etc. More broadly, the new Administration has renewed American support for the liberal international order, and aims to build support amongst democratic nations to strengthen existing multilateral institutions.

In Russia, meanwhile, constitutional changes will allow President Putin to remain in office until 2036. If he serves the full term, the then 84 year-old President will be Russia’s longest serving leader since Peter the Great. But, unlike his illustrious predecessor who admired Western modernity, President Putin views America and western coalitions amongst Russia’s powerful rivals with suspicion. Amongst other strategic tactics (often heavy-handed), Russia appears intent to pursue its security by building new alliances, reflecting what it refers to as the reality of a new “multi-polar world”. Most noteably, China has become Russia’s largest trading partner, having doubled its share of Russian exports since 2010 (overall, the European Union remains by far the largest market for Russian goods). Unfortunately, this complicated, and potentially dangerous “cold peace”, is likely to prevail for the foreseeable future.

At the same time, the Russian economy faces formidable headwinds: not least is the challenge posed by climate change to a nation so heavily reliant on fossil fuels. Despite prevailing bilateral tensions, collaberation between the USA and Russia on this issue (and several others) would be in the interest of both countries. For now, I’m not rushin’ to buy!

Strong External Finances Limit Global Risks

Rising US bond yields — in part the result of the Biden Andministration’s enormous fiscal expansion — pose uncertainties for all Emerging Market currencies. However, the greatest risks lie in countries with large external financing requirements; reflecting sizeable short-term foreign debt or current account deficits. Russia, fortunately, enjoys a very healthy external balance sheet. The Chart above illustrates Russia’s central bank reserves are high, and the current account is in surplus of 2% of GDP. Meanwhile, external government debt is a mere 4% of GDP. Likewise, the private sector has reduced it’s foreign borrowing considerably since the bout of RUB weakness in 2014 (next Chart). Consequently, Russia enjoys a sizeable buffer if the international market environment turns volatile.

Post-Covid Recovery: Plenty of Fiscal Ammunition Remains

Russia has endured the 5th highest number of Coronavirus cases, and suffered the 7th largest number of deaths during the pandemic. If the numbers are accurate (reasons for scepticism), however, the mortality rate as a percent of the population is much lower than the USA, European Union, and Latin America, although much higher than Asian nations (next Chart). Unfortunatley, it’s premature to suggest Russia is out of the woods, as its vaccination performance has been very poor: 10% of residents have been immunised compared to 60% in the UK and USA.

Mirroring its health outcomes, the pandemic’s impact on the Russian economy ranks in the middle: less severe than the European Union, but worse than the Asian economies that successfully contained the virus’ spread (next Chart).

Several factors keep me optimistic Russia’s economy will recover by 3% this year, before slowing again in 2022 (more in the next section). Unlike previous episodes of declining petroleum prices, Russia sharply cut oil production as demand slumped during the world-wide lockdown (next Chart). As the global economy recovers, Russia’s oil production will quickly bounce back. Indeed, as I expect higher output in Saudi Arabia, USA, and possibly even Iran as well, I am not as optimistic about oil prices as other pundits.

In addition, compared to other nations, Russia’s Covid-related fiscal stimulus has been a modest 4% of GDP. And, as the 2021 budget deficit is projected to be only 3% of GDP and the government debt/GDP ratio is an enviably low 20%, Russia enjoys considerate fiscal space to support its economic recovery if needed.

Failure to Reform Keeps Russia in the Slow Lane

Meanwhile, Russia confronts structural macro-economic challenges on several fronts. Faced with an aging population, trend GDP growth will remain weak without aggressive reforms to improve Russian productivity. Unfortunately, that’s not happening. During President Putin’s first decade, which coincided with soaring energy prices, the labour efficiency gap between Russia and the USA and Europe narrowed (Chart above). However, as a result of the failure to implement meaningful reforms in the past decade, Russian efficiency remains low, and has ceased converging towards levels in more advanced economies. As a result, Russian GDP growth will remain in the global slow lane — lagging (and diverging) from other EM regions, the USA, and European nations (especially new EU members). The long-term GDP growth potential may be as low as 1% (Chart below).

Moreover, despite the aim to reduce the nation’s dependence on oil production, the lack of needed reforms have not promoted a sustained expansion in the manufacturing sector. The following Chart illustrates that fuels still account for nearly 60% of exports (metal and food commodities represent another 15%). In addition, Russia’s public finances are also heavily reliant on oil, which accounts for one-third of government revenues. Indeed, Russia’s non-oil budget deficit totals 11% of GDP. Russia’s lack of economic diversity, including it trade and financial reliance on fossil fuels, will become increasingly consequential in the coming era of climate change.

Climate Change: No Progress, None Planned

Russia is the world’s 4th largest emitter of Green House Gases, and 6th on a per capita basis (amongst major countries). And, the Chart above illustrates that while GHGs in advanced economies are declining, Russia’s level continues to rise. The problem for Russia and the world is the lack of intention to change direction. In the Paris Climate Accord, for example, Russia committed to a 30% GHG reduction. However, Russia chose 1990 as its benchmark, prior to the economic collapse following the demise of the Soviet Union. As a result, emissions targets set for 2050 allow for further GHG increases during the next 30 years.

Russia’s energy mix is a key driver its high emissions. The Chart above illustrates fossil fuels still account for nearly two-thirds of Russian electricity generation, compared to 38% in the European Union. Meanwhile, solar and wind represent 25% of Europe’s power generation versus virtually none in Russia! In its recent Energy 2035 Strategy document, Russia continued to emphasise fossil fuels development. The lack of focus on renewable energy has limited progress in lowering the nation’s carbon intensity (e.g., the amount of carbon per unit of energy consumed), especially relative to European neighbours — next Chart.

Likewise, Russian energy efficiency — the amount of energy used per unit of GDP — ranks the worst amongst major countries; when you have lots of fuel, you get wasteful. And, while US and European efficiency has improved 25-35% in recent decades, Russia’s has gotten only marginally better (next Chart).

Russia is also the world’s second largest emitter of highly-damaging methane (next Chart). The nation’s large agriculture sector contributes signficantly, but the major culprit is flaring in the production of oil and gas. Russia ranks #1 in the world in flaring — a status it is likely to maintain given the continued focus on fossil fuel production. Most ominous, however, is the possible rise in methane levels resulting from a potential thawing of Russia’s vast permafrost (accounting for 65% of the nation’s land mass). On a positive note, Russia’s enormous forests create a considerable “carbon sink”: offsetting 27% of annual CO2 emissions (compared to 16% in the USA). However, aging woodlands and forest fires are projected to reduce this sink in the future.

The Climate Action Tracker projects current climate policies will lift Russian temperatures 3-4%, e.g., twice the Paris Accord target. Likewise, Russia’s Audit Office (very) conservatively projects climate change will reduce GDP 3% during the next decade. Likewise, public finances will be impacted adversely. And, as other nations, especially Europe, shift away from fossil fuels, Russian exports will become more limited. Moreover, if the EU implements its proposed “border tax” on imports from heavily-polluting nations, Russian exports could begin to suffer in the near term. Increasingly, Russian will look to China, where the demand for natural gas is expected to be enormous.

Strategic Considerations

  • RUB could decline 5-10% over the next 12 months.
  • While I do not anticipate an inflation problem, the CBR is likely to tighten monetary policy up to another 100bp this year to ward off FX weakness.
  • I am less optimistic than many commentators regarding oil prices. Major oil producers are likely to increase production, as the global recovery in demand takes place.
  • In the 1980s, western nations transitioned towards technology and information-driven economies. Russia’s inability to adapt and compete had enormous domestic political consequences. Arguably, climate change — and efforts to mitigate its impact — involves a similarly significant shift in the global economy. Russia’s challenge is to recognise and repond to these trends. Russia has the scientific prowess to adjust and contribute significantly. Hopefully, the political commitment will emerge. Collaberation with the West would be in the interest of all. For now, however, I’m not ” rushin’ ” in!