January’s and February’s data clearly showed that the Russian economy has slid into recession. This could, for instance, be seen by the deep fall in retail sales and investment. Meanwhile, against a backdrop of economic uncertainty, Russia’s FX reserves have continued to fall due to ongoing capital outflows. However, there is a silver lining. Russia’s central bank has cut its key policy rate earlier and sharper than expected. It clearly intends to look through the temporary surge of inflation on the back of past ruble weakness. While a shift in focus to the weakening economy is one reason why the central bank has started to lower rates, a stabilisation in the ruble, due to the slight rebound in oil prices, is another reason why monetary policy can afford to become less tight. We are likely to see a further deterioration in the economic data in coming months, but a gradual easing of inflationary pressures, a slight gain in oil prices, a stabilising ruble and an easing of financial conditions should all help to slowly brighten the economic outlook in the second half of the year.
The recession has arrived,…
January data clearly showed that the long-expected recession has arrived in Russia. After holding up in December of last year, as consumers rushed to the shops to buy goods before companies would raise their prices, retail sales collapsed in January. Sales fell by 4.4% in yoy terms, following a 5.3% rise the month before. This reflects that sky-high inflation is eroding households’ purchasing power. Indeed, real wages contracted by a staggering 8% yoy in January. Meanwhile, a tightening in financial conditions and uncertainty prompted companies to shelve their investment plans. As a result, investment fell by 6.3% yoy in January, down from 2.4% the month before.
On the supply side of the economy data is also deteriorating. Industrial production growth slowed to 0.9% yoy in January, down from 3.9% the month before, keeping the series moving sideways at low levels. Against this background, the rise in the manufacturing PMI from 47.6 to 49.7 in February was somewhat surprising. We suspect that the gain was mainly driven by Russian firms being forced to do business with other local firms due to limited external finance and high import prices on the back of the weakening of the ruble. Given the developments in final domestic demand, we think that the manufacturing PMI will weaken again in coming months. Weak domestic demand was also behind the sharp drop in Russia’s service sector PMI, which plummeted to 41.3 in February, down from 43.9 the month before, taking the index to the lowest level since the financial crisis. All in all, after a contraction of 0.2% yoy in the final quarter of last year, it is clear that we will see a very sharp fall in economic activity in Q1, possibly as large as 4-5% yoy.
…while FX reserves have continued to fall
The weak economic backdrop in conjunction with ongoing uncertainty also continues to weigh on Russia’s FX reserves. These fell by around $25bn in the first two months of the year to $360bn, covering around 7.7 months of imports. This brings the total drop in FX reserves since the beginning of last year to almost $150bn, a monthly decline of slightly more than $10bn a month. Given ongoing capital outflows, we expect FX reserves to remain under downward pressure going forward. However, we expect the downward pace to moderate slightly later in the year when the deepest part of the recession is behind us and oil prices should have picked up a bit more.
But CBR has started to loosen policy,…
While the deterioration in the economic data is playing out broadly as we expected, there are also a number of positive surprises. For a start, the monetary authorities were earlier with bringing down policy rates than we had expected, and have done so more aggressively. Indeed, after being forced to hike its policy rate to 17% to defend the ruble, Russia’s central bank cut its interest rate to 15% in January. Although inflation rose to 16.7% in February of this year, the month-on-month gains eased slightly. We think that the passthrough of the ruble depreciation will continue to drive inflation higher in the next couple of months. However, it should start to gradually come down later in the year, as the impact of the ruble weakness fades, and economic slack puts downward pressure on inflation.
Although this risks somewhat more ruble weakness, we think that the central bank will look through the temporary surge in inflation and will continue to shift its focus to the weakening economy. As a result, we expect to see another 100bp cut at this Friday’s policy meeting. Moreover, we think that the central bank will continue to gradually bring down its policy rate in the course of the year.
…helped by a stabilising ruble and higher oil prices
While the weakening economy is one reason why the central bank has started to loosen its policy, a stabilisation in the ruble is another reason why monetary policy can afford to become less tight. Since the end of January, the ruble has gradually strengthened against the dollar. This reflects that oil prices have rebounded somewhat. As almost three quarters of Russia’s exports account for energy exports, a higher oil price tends to have a profound effect on Russia’s economy that far outweigh the impact of EU/US sanctions, for instance. As such, rising oil prices tend to lift the ruble, as can be seen in the graph on the right.
As our energy analyst sees Brent oil prices rising to $65 per barrel at the end of the year, the risks to our year-end forecast of USD/RUB 60.00 are slightly tilted to the downside. That said, geopolitical risks, risks of a new round of sanctions, and ongoing easing by the central bank make us cautious in adjusting our forecast.
Recession to deepen, before easing gradually
All in all, we think that the economic data will continue to worsen in the next couple of months. But a gradual easing of inflationary pressures, a slight gain in oil prices, a stabilising ruble, and an easing of financial conditions should slowly help to brighten the economic outlook in the second half of the year. As such, we continue to look for a 4% contraction in economic activity in 2015, followed by a modest recovery in 2016.