Russia Watch – A deteriorating outlook

by: Peter de Bruin

Russian-Watch - 09 October 2014 - A deteriorating outlook.pdf ()

Although the truce between Russia and Ukraine seems to be holding, there are still frequent clashes between Kiev’s forces and pro-Russian rebels. Against this background, we doubt that we will see a scaling back of the EU/US sanctions against Russia in the short run. These are leading to an ongoing outflow of capital that is expected to exceed 5% of GDP this year. Together with heightened uncertainty about Russia’s political course this has dented the investment outlook. The capital outflows, a lower oil price, and a wider trading band have led to a steep slide in the ruble. As a result, inflation is on the rise, which is eroding households’ purchasing power, while a tighter monetary policy stance is also leading to a rise in borrowing costs. In turn, these factors are expected to leave their mark on consumer spending. Accordingly, while growth developments in the final quarters of 2013 and the modest growth that we saw in the first half of this year suggest that our growth forecast of this year of 0.5% remains within reach, we have reduced our 2015 GDP growth forecast from 1.5% to 1.0%.

Economy slowing as capital outflows…

Despite some de-escalation of the Ukraine/ Russia conflict, the Russian economy continues to bear the brunt of the consequences of the dispute. EU/US sanctions that have restricted Russian banks’ and companies’ access to Western financial markets have raised borrowing costs. But perhaps more importantly, the conflict and uncertainty surrounding Russia’s political course have led to a constant outflow of capital. According to the Russian central bank, capital outflows amounted to $49.2bn in the first quarter of this year. Subsequently, capital outflows fell to $29.8bn in the second quarter, but – judging by CDS spreads – outflows are expected to have risen a bit again in the third quarter. As a result, the Russian Ministry of Economy expects that the total capital outflows in 2014 will amount to $100bn, or 4.9% of GDP, though we think that actual outflows in 2014 will exceed this amount. All this implies, that this year’s capital outflows will easily exceed the amount of outflows that Russia normally has to cope with due to its adverse investment climate.



…have led to capital control rumours…

While the large amount of capital outflows has led to rumours in financial markets that the central bank wants to impose capital controls, such rumours have been denied by the central bank governor and by President Putin. This is because from a fundamental balance sheet perspective there is no need to impose such a disruptive measure. Indeed, while Russia’s external debt has risen over the past years, at 34.8% of GDP, it is low by international standards. Moreover, Russia holds almost $460bn of international reserves. Although these include Special Drawing Rights and gold holdings, around $400bn remains in principle available for interventions. In addition, due to its energy exports, Russia has a persistent current account surplus, which we estimate will amount to around $75bn, or 3.5% of GDP this year, and will thus cover at least part of the capital outflows.


…and have left their mark on investment…

The large amount of capital outflows are having a significant effect on investment, though. Monthly data suggest that rising corporate borrowing costs and reduced availability of credit in conjunction with ongoing uncertainty about Russia’s political course are weighing heavily on companies investment plans. Indeed, in august, gross fixed capital formation fell by 2.7% in comparison to levels recorded a year ago. This was down from -2% the month before and keeps the series on a firm downward trend, implying that fading investment is increasingly becoming a headwind for the economy.

…while sending the ruble down…

The capital outflows also continue to exert downward pressure on the ruble. Since June of this year, it has fallen by more than 14% versus the dollar, taking its entire decline over the year so far to more than 21%. But other factors are weighing on the currency too. Since June of this year, Brent oil prices have started to decline. Although the relationship between Brent oil and the ruble is not always perfect, energy exports account for 70% of exports, implying that lower oil prices do significantly reduce export revenues. In turn, this means that there will be another negative that weighs on the economic outlook and hence will add downward pressure on the currency. Accordingly, although the Russian central bank over the past days sold $1.8bn of its international FX reserves to support the ruble, it also widened its trading band to allow for more ruble weakness. Given the negative factors that are weighing on the currency, we think that more ruble weakness lies ahead, and see ruble/ dollar at 41 at the end of this year.



….in turn, fuelling inflation

In turn, a weaker ruble is fuelling inflation. In conjunction with food import restrictions, it has caused food inflation to run at double digit rates. Even though the economic backdrop has continued to deteriorate, this has helped headline inflation to rise from 6.1% in the beginning of the year to 8% in September, well above the CBR’s medium term inflation target of 4%. Together with the fact that a rise in the CBR’s one week repo rate would help to stem some of the slide in the Rouble, this has prompted us to pencil in another 50bp rate hike at this month’s CBR meeting. This would add to the 250bp of rate hikes that we have – so far – seen this year, and implies that a tighter monetary policy stance will add to the adverse economic environment.

A softer consumption outlook

Another reason why we are turning more bearish on Russia’s growth outlook is that the rise in inflation is eroding households’ real purchasing power. Indeed, despite the unemployment rate continuing to edge down, nominal wage growth has remained on a downward trend and is only just exceeding inflation. As a result, real wages are barely growing at the moment. Add to this, that the CBR’s tighter policy stance is causing borrowing costs to rise, which in turn explains why household credit – which has always been an important factor to underpin consumption – has continued to slow. The upshot is that consumer spending, which – so far – has remained relatively resilient, is also showing signs of softening. Indeed, in August, real retail sales, which tend to move in tandem with household spending in the national accounts, rose by just 1.4% compared to a year ago. Admittedly, that was up from the 1.2% that was recorded in July, though there is no denying that the series remains on a firm downward trend.

…has prompted us to reduce our 2015 growth forecast

Brining everything together, while Russia’s growth outlook will predominantly be determined by the evolvement of the Ukraine/ Russia conflict, recent developments have made us more cautious. Although we continue to think that a solution to the crisis will ultimately be found in negotiations, a solution will most likely contain a large amount of autonomy for the East of Ukraine, something that will involve a long and painful negotiation process. This means that there is a high likelihood that the Russian economy will continue to suffer from a prolonged period of capital outflows and uncertainty in general. All in all, although growth developments in the final quarters of last year, and the very modest growth in the first half of this year suggest that this year’s growth forecast of 0.5% remains within reach, we have reduced next year’s forecast from 1.5% to 1%, and we continue to think that the risks are tilted to the downside.