Russia Watch – Growth set to return

by: Peter de Bruin

In this pubication: The economy should turn to growth in coming months… though the recovery will be modest. Inflation should continue to come down, albeit more slowly. Central bank should carefully restart its easing cycle.

160602-Russia-Watch.pdf (154 KB)

Economy shrank by 1.2% in Q1,…

Data are suggesting that the economy will slowly start to grow again in the second half of the year, after a financial crisis at the end of 2014 sent the economy into a deep recession. In the first quarter of this year, the economy shrank by 1.2%, following a 3.8% decline in activity the quarter before. The outcome, which implies that the recession has continued to peter out, was better than the consensus forecast of a 2% drop in economic activity. The improvement can be attributed to two factors. Firstly, since the start of February, oil prices have gradually risen. As energy accounts for roughly 70% of export revenues, a higher oil price creates positive spill-over effects to the rest of the economy. A second reason why the recession has moderated significantly is that inflation has fallen sharply. This is because the effects of the past ruble weakness that significantly drove up import prices at the end of 2014 and in the beginning of last year have fallen out of the annual comparison. As a result, annual inflation fell from almost 17% in March of last year to 7.3% in April. While this is still well above the CBR’s target of 4%, the steep drop in inflation reduces the burden of sharp price gains on the budgets of households, firms, and the government and hence helps their real purchasing power to stabilise. In turn, this has opened the door for higher consumption, investment, and government expenditures.

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Economy should start to grow again in the second half of the year…

In our view, the positive forces that caused the recession to diminish should help the economy to recover further in coming months. Our energy analyst sees Brent oil prices rising to $55 per barrel at the end of the year, and the risks to this forecast are tilted to the upside. This implies that the positive spill-over effects of higher oil prices on the economy will strengthen further. This probably helps to explain why industrial production has shown tentative sign of growth again, with production up by 0.5% yoy in April of this year.

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…but pace of disinflation likely to diminish

However, the pace of disinflation is likely to diminish. Inflation has roughly come down to levels seen before the start of Russia’s financial crisis. Accordingly, it is unlikely to continue to fall at an accelerated pace. Indeed, the consequences of the past ruble weakness have, by and large, dropped out of the annual comparison. As a result, inflation will be more determined by domestic economic forces rather than negative base effects. The ongoing weak economic backdrop, in our view, will continue to keep a lid on price gains. However, this will be partly offset by the fact that there are signs that inflation expectations have become dislodged. For instance, wage growth managed to surpass inflation in February and March, even as the general economy has remained quite weak. Structural constraints are also likely to underpin prices. On balance, we expect inflation to continue to come down, albeit at a much slower pace than over the past months. Against this backdrop, we think that Russia’s central bank will only cautiously ease this year. This mostly reflects that at 11%, the policy rate has remained very high, given the weak stance of the economy. As such, we are forecasting two 50bp rate hikes, which should take the policy rate down to 10%.

Growth should remain modest due to structural deficiencies

Overall, a slightly higher oil price and a modest easing of financial conditions should help the economy to start growing again in the second half of the year. However, the recovery is likely to remain lacklustre, as structural deficiencies will keep a lid on growth. Despite having risen recently, the oil price has remained low from a historical perspective. Russia’s overdependence on oil thus limits the country’s growth rate. In addition, Russia does not have the benefit of a growing population. This also weighs on the country’s capacity to grow. As a result, Russia’s potential growth rate is low, perhaps as low as zero percent. Although we could see some pent up demand after the crisis, we think that the broader picture will remain one of a very modest recovery. Indeed, the economy should start to grow from the third quarter onwards, though negative base effects stemming from 2015 and the beginning of this year imply that average growth, estimated at -1%, will remain negative. Next year, though, growth should average 1.5%.

Government deficit to rise, but fiscal situation remains healthy

Despite the ongoing weakness in the economy, Russia’s fiscal situation remains healthy. Granted, monthly data suggest that government expenditures picked up slightly, while revenues continued to deteriorate. But overall, the rise in the fiscal deficit should remain manageable. We project it to rise from 2.8% in 2015 to around 3.5% this year. Meanwhile, government debt which is projected to increase to 13% of GDP this year remains low. We should bear in mind though, that Russia has started to deplete its Reserve Fund in order to finance any fiscal shortcomings. Indeed, assets under management in the fund fell from $92bn in August 2014 to $39bn in May of this year, a reduction in assets worth around 4% of GDP. Still, the bigger picture remains one of a fiscal situation that has remained manageable by and large.

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FX reserves have continued to rise

The external side of Russia’s economy should also remain healthy. The modest rise in oil prices should underpin exports, though the positive spill-over effects on the real economy from higher energy prices will also support imports somewhat. But the bigger picture should remain that Russia’s current account will remain comfortably in surplus. In addition, following a period of deep falls, Russia’s FX reserves have remained on an upward trend since April of last year. They amounted to $331bn, covering more than 11 months of imports, in April of this year. Finally, while rising, external debt is also relatively low. The fairly sound external side of the economy provides a buffer against external shocks. Still, lower oil prices and/or a sharp rise in geopolitical tensions could risk delaying the moment that the Russian economy will return to growth.