- Higher oil price is main driver of economic recovery
- Structural growth factors remain weak and investment low
- Ruble appreciation and lower inflation are positive signs
- International political tide is turning in favor of Russia
Oil gets Russia out of the doldrums, but structural factors remain weak
While the Russian economy contracted throughout the first three quarters of 2016, the pace of contraction has slowed. Real GDP declined by an average of 0.7% yoy in the first three quarters of 2016, compared to a contraction of 3.7% in 2015. The downturn has resulted from a combination of declining oil prices and sanctions imposed by the West. However, the recent crisis has not been as severe as the 2009 financial crisis and the authorities’ economic package (flexible exchange rates, banking sector capital and liquidity injection as well as limited fiscal stimulus) cushioned the shock. Even when oil prices were low in the beginning of the 2016, energy companies remained marginally profitable given that their costs are in rubles and that they are among the world’s lowest-cost producers.
Yet the recent crisis also shows the Russian economy’s lack of resilience. Private consumption went down by an astonishing 9.4% and 1.9% in 2015 and 2016 respectively, and investment has slackened. Russia is also burdened by adverse demographics. The corporate sector reflects some weaknesses, with smaller companies in particular showing weaker returns on assets and higher leverage. Still, the tide is turning in favour of Russia. The election of Trump in the US may improve Russia-US relations and, in the best-case scenario, bring an easing of the sanction regime. The recent rise in oil prices are supporting Russian exports and government revenues while leading to an appreciation of the ruble. We expect Russia’s economic recovery to be slow and to remain dependent on movements in the global commodity markets. Our current forecast shows growth returning to positive territory in 2017 (+1%) and 2018 (+1.5%).
A hazy light on the horizon for demand-driven factors
The biggest contributor to GDP is (private) consumption, with a share in total GDP of slightly less than 60%. In 2016, private consumption fell by 1.9% yoy, which is a ‘modest’ downturn compared to the year before (-9.4%). Consumption has been hit relatively hard in the recent crisis; during the financial crisis consumption declined by 5% in 2009. In line with the improving global economic climate and higher oil prices, the decline in consumption has reached a bottom and we expect a small recovery in 2017 (1.3% yoy). Since government tax revenues have been decreasing (due to the lower oil price), government expenditure has been falling as well. In addition, investment declined by 5% in 2016. But Russia has seen worse: this figure was almost triple that amount in 2009. We expect investment to catch up to slightly above zero in 2017, although this depends heavily on whether interest rates are cut and/or (foreign) capital inflow resumes. The sentiment for 2017 is somewhat more positive: consumer confidence has improved since the first quarter of 2016 and the manufacturing PMI reached an all-time high in December (53.7).
The labour market will stay resilient
Unemployment has remained steady, moving in a bandwidth between 5% and 6% over the last three years. The underlying structural cause is a decline in the labour supply due to an ageing and shrinking population. Real earnings have also been flexible in the most recent period, falling roughly in line with output per worker, then slowly climbing again in 2016. Companies have gotten away with price increases without paying higher salaries, thereby sustaining their margins and preventing (major) layoffs. So far, the labour market has been quite flexible in adapting, and since we expect a cooling of inflation and a small pick-up in demand, there will be room for increases in (real) income and hence for stimulating private consumption. The downside risk may be that inflation targets are not met due to higher-than-expected demand.
Inflation surprises on the downside, but will not reach CBR target
Inflation has fallen rapidly in recent months, driven by lower core inflation. We expect that the Central Bank of Russia’s (CBR) relatively tight monetary policy (key rate at 10%) and the appreciation of the ruble will keep annual inflation on a downward path in 2017. During the last CBR meeting on 16 December, the tone was quite hawkish. The CBR has stated it will lower interest rates in mid-2017, based on its oil price expectations. Yet our oil price scenario (65 USD/bbl at year-end) is above the CBR’s conservative base case scenario, so there might be room for an earlier drop in interest rates. We expect the CBR to cut rates by 250 bp and decrease its key rate to around 7.5% at the end of 2017. We do not think inflation will reach the CBR’s 4% target. First of all because of the reasons mentioned above (the rise of real wages and subsequently an increase in private consumption) and secondly because the pass-through effects of the ruble’s fall in previous years have yet to materialise in the import prices. We forecast that inflation will decrease from around 6% at the end of 2016 to 5.4% at the end of 2017 and 4.4% in 2018, therefore remaining slightly above the CBR’s inflation target of 4%.
The ruble has recovered, but dollar pressure remains
The ruble appreciated in 2016 due to the higher oil prices and the election of Trump. From its weakest level of 85 USD/RUB in the first quarter of 2016, the currency has strengthened to around 60 currently. Yet this is far from the USD/RUB level seen before the annexation of Crimea in March 2014 (32USD/RUB). Still, we expect the ruble to depreciate only slightly versus the dollar, to around 66 USD/RUB in 2017. This is partly the result of the strong dollar; Fed rate hikes and uncertainty in the financial markets is drawing money to the US. The upward pressure on the ruble from increasing oil prices will also stall as we expect oil prices to increase slightly to 65USD/bbl at the end of 2017.
Fiscal picture looks a bit bleak…
Due to lower receipts from the energy sector and increased spending, the budget deficit rose modestly. The ministry of Finance estimated that the 2016 deficit would run between 3.5–3.7% of GDP. Russia has almost depleted its Reserve Fund (which was set up when oil prices were still high), which fell around 50% in 2016. The well-being fund – set up to support pensions – has not been depleted and has stayed at a steady level in recent years. The depletion of the Reserve Fund will slow in 2017 in light of higher oil prices, less government spending and the privatisation programme (such as the sale of stakes in Rosneft) being pushed through by the government. For the same reasons expect the government balance to improve slightly to -2.9 in 2017. The total debt as % of GDP remains low at 13%.
… but the external picture has improved since the beginning of 2016
The lower oil prices and weaker global demand in 2016 caused the value of goods exports to fall by over 20% last year. Yet imports also weakened (by 8% yoy), due to the sanction restrictions and the subsequent trade barriers set by Russia. As a consequence, the current account surplus halved from 5.2% of GDP in 2015 to 2.7% of GDP in 2016. We expect the current account surplus to increase to 3.7% in 2017 as rising oil prices are driving a faster rebound in exports relative to imports. We expect Russian exports to rise by around 11% yoy in 2017. The current account surplus remains large enough to finance a significant share of external debt payments and most capital outflows over the coming years. Foreign reserves are still high, covering over 12 months of imports, nearly six times the short-term external debt and 70% of total external debt.
The political tide is turning in favour of Russia
The political landscape seems to be improving for Russia. Vladimir Putin’s third presidential term, which began in 2012, has seen a shift towards “illiberal democracy”. Russia’s next presidential election is set for 2018 and Putin looks set to win its fourth term. According to the latest monthly poll by Levada, the President’s approval ratings have risen to 84%. Russia is also finding it has more political partners internationally. For example, both Bulgaria and Moldova elected pro-Russian presidents. Consequently, the Eurasian Economic Union and Collective Security Treaty Organization — Russia’s primary blocs — could become more active in 2017 after languishing over the past two years. Meanwhile, Trump’s nominee for Secretary of State is Rex Tillerson, who has close ties with Putin. Furthermore, many European conservative populists share ideological values with Putin. Russia has re-established its partnership with Turkey after relations were strained in the wake of the downing of a Russian warplane in November 2015. However, we still see this as an alliance of convenience, which is fragile. The alliance survived the recent assassination of Russia’s ambassador to Turkey thanks to mutual gains in the Syrian ceasefire, but may not survive the ongoing conflict in the Caucasus. The main downside risk is that Russia’s politics revolve around one person: Putin. If he disappears from the political arena, there will be a political vacuum and more uncertainty.
Relief of sanctions would have potential upside
We expect financial conditions to improve in 2017. Russian companies are slowly adapting to the sanction regime, which was put in place after the annexation of Crimea in March 2014. The IMF notes that domestic sales of goods and services (in real terms) fell less than domestic demand, suggesting import substitution. Also, in July 2017 the EU’s sanction regime towards Russia may be relieved. EU members may realise that the original goal of the sanctions, to stop Russia from annexing Crimea, is unattainable. The relief of the sanctions would create a significant potential upside for the Russian economy.