Russia: In reverse gear Global Economic Outlook, Q2 2015
Russia’s economy is in the midst of difficult times, in part due to low oil prices and Western-imposed sanctions. The central bank and government have been desperately trying to steady the economy.
Russia’s economy is in the midst of difficult times. Low oil prices and the persistence of sanctions imposed by the United States and the European Union have kept the economy under pressure. Net capital outflow in 2014 was $151.5 billion, more than twice the outflow in 2013 and markedly above the $133.6 billion outflow in 2008 at the height of the global financial crisis. The Russian ruble remains weak against the US dollar, and high inflation is eating into Russian households’ real wages. Decreased revenue collection has led to a rise in the fiscal deficit, even though the government has trimmed spending.
The central bank and the government have been making a desperate attempt to steady the economy. However, attempts to prop up the ruble and bail out Russian companies have drawn down Russia’s sizable reserves of foreign exchange and gold.
Russia’s $400 billion 30-year natural gas trade agreement with China in May 2014 is evidence of a significant eastward orientation in economic strategy.
Ruble stays weak, inflation soars, and interest rates fluctuate
The ruble has declined 41 percent against the dollar and 22 percent against the euro since the same period a year ago (March 17, 2014). The ruble’s decline was most dramatic in the first half of December 2014, when the currency shed a quarter of its value against both the dollar and the euro (figure 1). The plunge in the ruble’s value coincides with the equally dramatic plunge in the price of crude oil, which is Russia’s primary source of revenue. In 2013, exports of crude oil, petroleum products, and natural gas accounted for 68 percent of Russia’s total exports, with crude oil and petroleum products contributing four times as much as natural gas.1 Low oil prices mean that Russia’s exporters have fewer dollars to convert into rubles, which in turn means lower demand for the local currency and, therefore, continued weakness.
The weak ruble is driving prices up. Consumer price inflation soared to 16.7 percent in February 2015 from February 2014, up from 15.0 percent in January (figure 2). Food prices in Russia are particularly high, having risen 23.3 percent from a year ago in February. Russia’s embargo on the import of food products (from the United States, European Union, Canada, Australia, and Norway) has been a major contributing factor to high food prices. Import substitution efforts are likely to provide a boost to the domestic agriculture sector, but production is unlikely to meet domestic demand in the near term. In 2013, the total value of currently embargoed imports stood at approximately $25 billion. In 2014, the manufacture of food products grew at an average rate of just 0.4 percent, far below the growth rate required to address the food gap.
Furthermore, rising prices have been eroding the earnings of Russia’s working class. Real disposable income continued to move downward, declining 0.6 percent in February 2015 from February 2014 after dropping 1.0 percent in January and 6.2 percent in December (figure 3). The impact was evident in the retail sector’s performance. January 2015 sales dipped 4.4 percent from the previous January after a temporary expansion of 5.3 percent in December, when Russian consumers rushed to purchase durable goods before they become more expensive.
Russia’s unique combination of problems renders monetary policy difficult and unpredictable. A weak currency, rising prices, and slowing economic growth have made monetary policy decisions a difficult task for the Bank of Russia (BoR). In December, the BoR raised the policy interest rate by 6.5 percentage points—from 10.5 percent to 17.0 percent—in order to arrest the ruble’s free fall. The ruble is now relatively “stable” compared with the sharp dip it experienced in December, but the high cost of borrowing is not helpful to businesses in Russia, especially those looking to refinance debt that is due to mature in the near future. In January, the BoR cut its key interest rate to 15.0 percent, and in March, it reduced the rate further to 14.0 percent, as counteracting a deep economic recession has become the immediate priority. The BoR expects that inflation will peak at the end of the first half of 2015 before easing due to lower real incomes and weak demand.2 If inflation plays out according to the BoR’s expectations, then a further reduction in the key interest rate is likely in order to boost economic growth. Interest rates in the United States are likely to move in the opposite direction at the end of the first half of 2015. The impending rate hike by the US Federal Reserve could accelerate capital outflow and increase the ruble’s volatility, which would further complicate the BoR’s task.
Fiscal deficit, corporate debt, and dwindling reserves
On the fiscal front, Russia’s deficit grew to 10.5 percent of GDP in February, up from 4.2 percent in January. The spurt in fiscal deficit is due to reduced revenue collection that outweighs the reduction in budgetary expenditure. Half of Russia’s budget revenue in 2013 came from taxes and duties on oil and natural gas. The current low energy prices mean that the government’s revenue from the energy sector is lower than in previous years. Furthermore, taxes collected from non-energy sectors have also declined due to weak economic activity. Non-oil and gas revenue dropped from approximately $13.25 billion in January to $7.06 billion in February. Russia’s budget for 2015 was initially drawn on the assumption that oil would average $100 per barrel; however, the budget is currently being redrawn to fit the current scenario (figure 4). A 10 percent cut in most expenses is expected, although a $35 billion anticrisis plan has been announced in order to support social spending, agriculture, and defense.3 It is interesting to note that Russia’s military budget is set to increase in 2015 despite the pressure on the economy.
Another problem at the core of Russia’s economy is the high level of outstanding foreign corporate debt. Russia’s companies hold a total foreign debt of $550 billion, of which $109 billion is up for repayment in 2015. Though some of this debt might be rescheduled for payment later, the issue is that sanctions are preventing Russian companies from raising money from Western financial markets, therefore making state assistance a necessity. Some of Russia’s large companies hold sizable reserves of foreign exchange; however, the possibility of protracted sanctions and the ruble’s weakness make spending these reserves an imprudent decision. Support for Russian companies is likely to come from the National Wealth Fund, which was worth approximately $75 billion as of March 2015. However, a quarter of this fund is illiquid, and the demand for assistance exceeds the remainder of the fund.4 While Russia’s total foreign exchange and gold reserves are still large at $356.7 billion (as of early March 2015), these reserves are being depleted at an alarming rate, having dropped by $130 billion in just one year (figure 5). Additionally, the portion of Russia’s reserves available for short-term use, while a matter of debate, is definitely lower than the overall figure.
Depletion of foreign exchange reserves, an erosion of fiscal position, and the central bank’s reduced ability to carry out an effective monetary policy have led all three of the world’s largest rating agencies to downgrade Russia’s credit rating in 2015. Russian debt is now rated below investment grade by two of the three agencies, and at the lowest investment grade level by the third. The rating downgrade increases Russia’s external cost of borrowing. Additionally, a rating below investment grade could bring early-redemption clauses into effect, therefore increasing the corporate debt due in the coming months.
Russia’s pivot to China will not address immediate economic concerns
With the country now at loggerheads with the West, the Russian administration has been striving to reduce its dependence on Western markets. Russia’s $400 billion 30-year natural gas trade agreement with China in May 2014 is evidence of a significant eastward orientation in economic strategy. Ties with China were further strengthened by a follow-up natural gas deal in November of last year. Under these agreements, Russia will supply almost a fifth of China’s natural gas needs by 2020.5 Furthermore, the volume of trade between Russia and China is expected to touch $100 billion in 2015.6 While this is a significant development, it is unlikely to make a substantial contribution to the economy in the near term. Increased trade with China is unlikely to alter Russia’s dependence on the West, particularly on Europe. In 2013, the total trade turnover between the European Union and Russia stood at approximately $440 billion, more than four times the expected volume of trade with China in 2015.Additionally, investors in the European Union account for 75 percent of all foreign direct investment in Russia. This is exponentially more than China’s direct investment in Russia, which has totaled less than $2 billion in five years (2008–2013). Particularly within the energy sector, Russia also depends on Western technology, which China cannot provide. Moreover, China’s economy has slowed down to its slowest growth rate in 24 years. Given the combination of these factors, it is unlikely that Russia’s orientation towards China will ease the former’s immediate economic burdens.
Russia urgently needs to reengage with the West and take measures to diversify its economy away from a crippling dependence on the energy sector. However, if the current status quo holds, then sanctions will persist, and cheap oil will sink Russia’s economy into a painful recession in 2015.