Russia Watch – A near perfect storm

by: Peter de Bruin

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After the Russian Central Bank’s 650bp emergency rate hike and the subsequent ruble panic on the 16th of December, there are tentative signs that the actions of the authorities are leading to some stabilisation. These actions range from de facto capital controls for public companies to the central bank trying to underpin the banking sector and providing FX liquidity to banks and firms in order to help these to meet their foreign liabilities. The recent ruble crisis has come at a huge cost though. Russia’s FX reserves fell by $32bn in December alone and reserves declined by around a fourth in 2014 as a whole. What is more, the steep rise in interest rates will lead to a tightening in financial conditions similar to that seen during the financial crisis. Together with the drop in oil prices, this will provide yet another powerful headwind to the economy. As a result, we have lowered our growth forecast for this year to -4%, down from -1% initially.

Some signs of stabilisation in the financial sector,…

After the Russian Central Bank’s 650bp emergency rate hike and the subsequent ruble panic on the 16th of December – with the USD/RUB reaching an intraday peak of 79 – there are some tentative signs that the authorities actions are leading to some stabilisation. The Central Bank of Russia (CBR) has signalled that it stands ready to recapitalise the banking sector, will provide dollar liquidity to banks, and allows banks to ignore the recent market turmoil when calculating their capital ratios.

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What is more, on 23 December the government ordered five large state owned exporters, including Rosneft and Gasprom, to reduce the level of their foreign currency reserves to early October levels. These de facto capital controls aim to stabilise the ruble. Meanwhile, the CBR has also introduced a new instrument to provide FX liquidity to the market. The central bank will lend euros and dollars to commercial banks who – in turn – are asked to put up foreign currency loans of large exporters as collateral. In essence, this should enable commercial banks to lend foreign FX to companies, allowing

them to meet their foreign liabilities. Finally, on 22 December, the central bank bailed out Trust bank, Russia’s 32nd largest lender by assets. All these measures helped the 3M Mosprime interbank rate, which peaked at almost 30% on the 19th of December, to come down gradually (though recent data are not available due to the holiday season in Russia).

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…though the situation remains fragile

That said, the situation remains very fragile. For a start, CDS spreads have continued to trend upwards and are at levels that do not correspond to Russia’s investment grade rating. Meanwhile, all the actions taken by the authorities helped the ruble to initially strengthen, though lately – in tandem with declining oil prices – it has depreciated again.

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However, the actions of the authorities have come at a huge cost. The central bank’s FX reserves fell by $32bn in December alone, a pace that is roughly similar to the financial crisis, when Russia’s reserves fell by $209bn in a period of six months. Of these $32bn, $11bn was due to FX interventions, but the other $21bn was probably the result of the central bank facilitating capital outflows, or Russia’s reserves being put to use to pay foreign liabilities. Over 2014 as a whole, Russia’s FX reserves fell by more than $120bn, implying that last year, Russia lost about a fourth of its reserves.

Tightening of financial conditions,…

What is more, the authorities’ actions will lead to a steep contraction in activity. Indeed, with the central bank’s main interest rate being raised to 17%, well above the level that we saw during the financial crisis, and interbank rates still above 20%, the tightening of financial conditions will weigh heavily on the economy. This means that there will yet be another powerful headwind on top of the ruble induced sky-high inflation that is eating into households’ and firms’ purchasing power, and uncertainty about the economic outlook in general. As a result, we think that a steep decline in consumption and investment is on the cards this year.

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…and low oil prices suggest the amount of stress is comparable to the financial crisis

Unfortunately, the comparison to the financial crisis does not stop there. Indeed, as in 2008-2009, a low oil price will leave its mark on the economy, with the effects far larger than any of the imposed EU/US sanctions. Oil production accounts for about 70% of Russian exports and half of government revenues. We continue to think that oil prices will rebound later this year, as the current low price negatively affects shale oil production and oil investment, while oil demand is set to rise on the back of a stronger world economy. However, it is clear that there is a risk that oil prices will remain low for longer. At any rate, exports look set to decline in coming months, while the lower oil price will also weigh on government consumption. The upshot therefore is that the Russian economy is currently facing a degree of stress similar to that seen during the financial crisis, when the economy contracted by 7.2% in 2009.

…though starting point of the economy is weaker…

However, there are also differences to the financial crisis. Firstly, the starting point of the economy is weaker. Indeed, we think that the economy grew by just 0.5% in 2014, following a meagre 1.3% expansion in 2013. In comparison, the economy surged by 9.2% in 2007, before slowing down to a still respectable growth rate of 5.5% in 2008. All this suggests that there is probably less room for a deep contraction in output than during the financial crisis.

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…and imports will act as bigger shock absorber

Furthermore, as the graph above shows, the ruble has depreciated much more significantly than during the financial crisis. As a result, imports should fall more steeply as well. Indeed, we expect imports to fall off a cliff in coming months, as a weaker ruble will make foreign goods more expensive, while final domestic demand is expected to collapse. Somewhat paradoxically, the upshot is that imports this time are likely to act as a bigger shock absorber than during the financial crisis, and will therefore somewhat limit the contraction in economic activity.

Economy set to contract by 4% in 2015

Bringing everything together, while the situation remains fragile, and therefore very difficult to predict, we think that the economy will contract by 4% this year, down from our initial forecast of a decline in economic activity of 1%. In quarter-on-quarter terms, we are likely to see the sharpest deterioration in economic activity in the first and second quarter, and the economy should stabilise in the final quarter of this year, before starting to grow modestly in 2016. Still, we have reduced our 2016 average GDP growth forecast from 1.5% to 0.5%.

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