Russia Watch – A deepening recession

by: Peter de Bruin

  • April data suggest that Russia’s recession is deepening
  • As a sharp deterioration of the economy was expected, financial markets have kept their nerves,…
  • …even though the CBR is now pursuing a policy of replenishing its foreign FX reserves
  • Jury is still out on whether the stabilisation in Russia’s FX reserves will last


April data suggesting that recession is deepening

April’s round of data revealed that Russia’s recession is deepening. Due to the past ruble weakness, consumer prices rose by 16.4% compared to a year ago in April. As a result, households are seeing their purchasing power being eroded. Real wages fell by more than 13% in April compared to the same month last year. This led to a plunge in real retail sales of almost 10% yoy. Meanwhile, the uncertain economic backdrop has prompted firms to continue to shelve their investment plans. Accordingly, investment remained about 5% lower than levels seen a year ago. The reduced economic activity is clearly leaving its mark on industrial production. It decreased by 4.5% yoy in April, following a 0.6% drop in March, while May’s manufacturing PMI fell from 48.9 to 47.6. All in all, April’s and May’s round of data clearly implies that Russia’s recession has taken a turn for the worse.

GDP tracker in line with contraction of around 5 – 6%

Indeed, according to our GDP tracking estimate, the economy is set to contract by around 5 – 6% in the second quarter. This would be considerable worse than the relatively modest 1.9% decline in economic activity that we saw in the first quarter of this year, which had prompted some commentators to argue that the end of Russia’s economic malaise was in sight. Looking further down the road, we think that the third quarter will mark another quarter of sharp contraction, but the deepness of the recession should abate thereafter. This reflects that inflation is expected to fall sharply as the boost from higher import prices due to the past ruble weakness drops out of the annual comparison. In turn, this should help to limit the erosion of households’ purchasing power, moderating falls in consumer spending. With consumption showing signs of stabilising, companies should slowly start to invest again. In addition, lower inflation should enable the central bank to continue to bring down its policy rate. And, looser financial conditions should also help the economy to find some ground towards the end of year, before returning to modest growth in 2016. All in all, we think that the economy will contract by 4% this year, following an 0.5% expansion in 2016.

However, financial markets have kept their nerves

The worsening of the economy has come against a backdrop of relative stability in financial markets though. Admittedly, over the past days, we have seen some renewed ruble weakness, but this mostly reflects the recent softness in oil prices. Indeed, since the end of January, when USD/RUB peaked above 70, the ruble has strengthened by around 25%. What is more, while remaining at levels higher than countries with more or less comparable sovereign credit ratings, CDS spreads have remained on a downward trend, with spreads having come in to around 300bps. Finally, despite recently giving up some of its gains, the Russian MICEX equity index is up by around 15% since the beginning of this year.

CBR has started to replenish its FX reserves…

The relative calmness in financial markets has prompted Russia’s central bank to start replenishing its FX reserves. In its statement on the 14th of May, the central bank mentioned that it intends to purchase $100-200 million worth of foreign currency per trading day. Since the 14th of April, the average amount of purchases has averaged $212 million, slightly more than the CBR has indicated.

…risking its credibility,…

While the decision of the CBR came as a surprise to us, and the market, it did not lead to sharp movements in the ruble. Still, it begs the question why the CBR has resorted to a policy of buying FX reserves. After all, it was just in November that the central bank moved to a free floating currency, only to see it selling large amounts of FX reserves to try to halt the steep slide in the ruble in December of last year when Russia’s economy was in the midst of a severe banking crisis. So, at the very least, the decision seems to be at odds with the central bank’s long-term strategy, and some may argue that the bank’s credibility could even be at stake.

…but helping its external position to stabilise,…

That said there is some merit in the decision as well. Buying $100 – $200 million of foreign currencies on a daily basis would directly boost the stock of Russia’s foreign FX reserves by $25bn – $50bn per year. Although the most important driver of the ruble will remain the development in the oil price, FX purchases will also weigh on the currency somewhat. This will make imports more expensive and hence support the country’s current account surplus, leading to a larger inflow of foreign currencies. While difficult to precisely estimate, the total effect of the central bank’s changed policy on Russia’s FX reserves is therefore likely to be somewhat larger.

…and further underpinning market sentiment

The central bank’s decision could also help to bolster market sentiment. In particular, if financial market participants were to believe that the economy has moved through the eye of the storm, though as we mentioned earlier, incoming data are clearly suggesting this is not yet the case. Improved optimism would probably limit capital outflows somewhat, implying that there would be less of an outflow of foreign currency.

Effects will be small compared to total loss

Still, the size of the amount of foreign FX reserves that the CBR will be able to accumulate is likely to remain small compared to the total outflow that we have seen over the past one and a half years. Indeed, since the beginning of last year, almost $150bn of FX reserves have seeped out of the country, though at $360bn, Russia’s pool of reserves is still sizeable.

But oil price developments remain key

The CBR’s move notwithstanding, the bigger influencer in terms of Russia’s reserves will be developments in the oil price. Indeed, it was the plunge in oil prices that ignited the ruble crisis last year, as it laid bare the overdependence of the economy on energy. Working in the opposite direction, we do not think that it is a coincidence that there are some tentative signs that Russia’s FX reserves have started to stabilise roughly around the same time that the oil price seems to have found some footing. With 70% of Russia’s exports consisting of energy, movements in oil price are the key determinant for the amount of hard currency that flows into the country and for the health of the economy more generally.

Too soon to give the all-clear signal

In this respect, it is encouraging to note that, despite the recent renewed softness in oil prices, our energy analyst continues to see Brent oil bouncing back to $65 per barrel at the end of this year. Still, we think it is too soon to raise the all clear sign for Russia’s reserves. While the central bank’s changed FX policy will help to bolster the tentative stabilisation in Russia’s FX reserves, there remains a risk of ongoing capital flight, in particular now that the recession is deepening. As such, we are sceptical whether the stabilisation in Russia’s FX reserves will last.