- Strong Q2 growth on the back of sharp increase in investments
- We adjusted our 2017 growth forecast upwards to 2%
- Inflation is on target and the easing cycle continues
- We expect a total of 75bp in policy rate cuts in 2018
- New US sanctions will have no impact in 2017; very limited impact in 2018
Exceptionally strong growth on the back of high investments
The Russian economy is leaving the recession behind and has entered a period of growth.
It seems that the policy decisions taken in recent years to manage the recession are finally paying off. While the CBR was under substantial pressure to support the ruble during its depreciation, the Russian central bank continued targeting inflation rather than depleting its already declining FX reserves. Furthermore, the reduction of budget spending has increased fiscal prudence during a period of low oil prices. Healthy government finances and reduced inflation rates are currently helping Russia to maintain a decent growth path.
GDP growth accelerated over the second quarter to 2.5% yoy, which was substantially higher than the consensus expectation (1.7%). In the first quarter and fourth quarter of 2016, the annual growth rate reached 0.5% and 0.3%, respectively. While the recent growth acceleration is partly due to the statistical base effect, it was also helped by higher oil prices and decelerating inflation, which has eased the pressure on household disposable income. On the demand side, the main driver of GDP growth was investment. Rosstat estimates that fixed asset investment grew by 6.3% yoy in the second quarter, up from 2.3% in Q1. Investments increased sharply on the back of large investments in SMEs, commodity extraction and a few major government infrastructural projects (Power of Siberia gas pipeline and construction of the Crimea bridge). Household consumption slowed during the second quarter, but we expect this to be a temporary effect as retail sales turnover is gradually improving.
Leading indicators point to broader-based growth in the second half of 2018
Looking at the leading indicators, we believe that while investments remain strong, growth will also be further supported by consumption. Retail sales increased in August (rising to 1.9% yoy from 1.2% in July), which were supported by higher real wages (up to 3.7% yoy from 3.1% in July). The surge in investments was partly due to a one-off event (SME investment due to changing regulations), but we expect investments in the oil industry to remain strong during Q3. This is because oil prices have edged up since the beginning of July, from a level of 47 to a current price of around 57 (crude oil, Brent bbl/USD). Furthermore, big-ticket investments by the state will continue to add to GDP growth in the remainder of 2017. PMI has been trending around 52 since the beginning of 2017, indicating that the strong growth seen at the beginning of 2017 is likely to last.
Given higher oil prices (57 USD/bbl at year-end) and the slow implementation of the new US sanctions (not expected until 2018, see below), we believe that growth in Q3 and Q4 will be around 2%. This implies we are upgrading our average growth forecast for 2017 from 1% to 2% (rounded). We expect public investment to increase ahead of the presidential elections in March 2018. Also, growth will spill over to next year, and therefore we increase our 2018 forecast from 1.5% to 2%.
The Netherlands profits from increasing demand by Russia
Year to date, exports to Russia from the Netherlands have increase sharply by 35% yoy. In August 2014, Russia implemented sanctions on some agricultural products in reaction to the sanction regimes by the US and the EU. We calculated that around 5% of the exported goods from the Netherlands to Russia are targeted by the counter-sanctions. So while this is troublesome for some agricultural business, it has little impact on the overall export. The Dutch exporters profit from an ongoing recovery of the Russian economy by exporting mostly machineries, transport goods and chemical products. This also explains why exports remained strong, even though the euro appreciated relative to the ruble. Most of these products are rather price inelastic, meaning that companies need them to keep up with production capacity and no substitutes are available. Furthermore, big companies often use FX hedges to eliminate currency volatility risk. Therefore currency volatility does not impact decisions to import products.
The return of growth has little impact on inflation in Russia
Inflation edged up a bit in June, to 4.4% yoy, as food prices rose on the back of unfavourable weather conditions. Since then, inflation has remained below the CBR target of 4%. The strong ruble (compared to the dollar) has caused imported inflation to fall once again. While we do not expect any overheating of the economy, we do believe that growth will be further supported by consumer spending going forward. Meanwhile, as consumer spending picks up, inflationary pressures arise. Still, we expect this to take place gradually as wage growth is moderate. In addition, contrary to the median forecast, we expect the ruble to continue its rally and strengthen slightly towards the end of 2017 (56 USD/RUB) on the back of dollar weakness and rising oil prices. Therefore, import deflation will continue to add to the deflationary pressures. So far, the output gap has not yet been closed. According to the OECD, it was estimated to be around 0.4% at the end of Q2 and is not expected to close until 2018.
Inflation forecast revised downwards
We have revised our end-2017 CPI inflation forecast to 4% (from 4.5%), slightly under consensus, due to our stronger ruble forecast. This brings the average headline inflation to 4% in 2017. In 2018, we expect inflation to be balanced in light of a stronger ruble and the closing output gap. We have therefore adjusted our end-2018 forecast to 4% (from 4.5%), in line with consensus. That said, inflation remains very much dependent on food prices (one-third of total inflation) and food prices are, in turn, dependent on variations in weather. This makes inflation rather difficult to predict (for economists).
There is further room to ease monetary policy…
On 18 September, the CBR lowered policy rates by 50bp to 8.5% (in line with market expectations). While a rate of 8.5% is still quite high (given that inflation is below 4%), it signalled confidence that lower inflation is here to stay. Inflation is practically on target and the global environment is favourable with respect to oil prices and past US dollar weakness, so there is further room to ease. Moreover, ruble volatility failed to materialize during the last cut, despite geopolitical tensions (new US sanctions, Zapad 2017 military exercise). Therefore, we expect the CBR to catch up with the easing cycle and cut the policy rate by 25bp in December to 8.25% (in line with consensus).
… but we are slightly more hawkish than the market for 2018
We interpreted Governor Elvira Nabiullina’s statements about medium-term developments as hawkish. She does not seem to be in a hurry to lower rates to the neutral level (2.5-3.0% in real terms, i.e. approximately 6.5-7.0% in nominal terms). Underlying these statements is a fear of the unpredictability of the inflationary trend going forward. Inflation substantially surprised to the downside in February, March and August. But in June, the unexpected surge in inflation shocked both the CBR and the market. There may be similar surprises in the future and it is therefore likely that the CBR will remain a comfortable ‘buffer’ above the neutral rate. Furthermore, inflation expectations (currently around 9.50%) are not yet anchored at target. Because expectations are very sensitive to food prices, it will take a long time for them to settle around the central bank’s target, which we do not yet see materializing in 2018. We expect total rate cuts of 75bp in 2018, bringing the key policy rate to 7.50% at year-end. That is above market consensus (7.0%), as we believe that the CBR will maintain a buffer above the 6.5-7% neutral rate.
Is there any bad news?
The economy is growing, inflation remains subdued and the central bank will resume its easing policy over the coming months. While it may look like the sky is perfectly clear, some clouds are gathering. Over the last four weeks, two large private banks were recapitalized with the government’s help. The interventions took place at Otkritie Bank (29 August) and B&N Bank (20 September). Two other banks, Promsvyazbank and Credit Bank of Moscow, are also mentioned as being on the verge of needing a capital injection.
These problems can be traced back to the crisis in 2014, when the CBR gave private lenders access to cheap loans to enable them to take over smaller and struggling rivals. This strategy created opportunities for banks which were not state-owned and hence did not fall under the US and EU sanctions. These banks were still allowed to attract foreign capital and seized the opportunity to expand. However, the assets the banks acquired ultimately proved to be of lower quality than what was anticipated at the time. The subsequent slow economic recovery made it hard for banks to generate earnings and now, with a lag, this has had serious knock-on effects. Over the last three years, the central bank has closed more than one-third (about 300) of Russia’s banks. And even now, S&P estimates that troubled assets represent over 20% of industry loans.
We expect no spill-overs to the banking sector
The immediate reaction by the market to the bail-out of Otkritie was subdued: The Russian 5Y CDS sovereign spread barely reacted at all. However, as the news emerged about the troubles at B&N Bank, 5YSovereign CDS spreads jumped approximately 15bp during the day. This was mainly due to worries about a ‘domino effect’ and the confirmation that two out of four of the list of vulnerable banks needed support (and the other two would likely follow in the future). Still, we are not concerned that all this will initiate a full-blown banking crisis. First of all, the CBR’s swift reaction to the crisis at B&N signals that the situation is being closely watched and that the CBR is committed to prevent any contagion to the rest of the financial sector. In fact, the central bank interventions prevented a complete bank run. Secondly, the particular problems at Otkritie and B&N Bank are concentrated in a small part of the banking sector. Otkritie was Russia’s largest private bank, but only represented 3.5% of the total banking sector. This is also confirmed by the fact that we have not seen irregular movements on the one-week interbank rates. Banks are still confident about lending to each other because the biggest (state-owned) banks are not impacted. Thirdly, the government has enough room to support the banking sector as its foreign reserves increased by USD 31 bn this year (totalling USD 348 bn in 2017). This means the CBR should be able to help banks repay (foreign currency) debts and still have room for a capital injection.
In sum, the bail-out of Otkritie and B&N Bank is not a tropical storm but a few clouds blocking the sun. Still, the interventions by the CBR do imply a greater role for the government in the banking sector, without any clear exit strategy. The state already owns around 60% of the banking sector and this will now only increase.
And the new US sanctions are just a veil of clouds
On 2 August, US President Trump signed the new bill extending the sanctions against Russia. The most important changes compared to the sanctions already in place are:
1. They limit financing opportunities by shortening the finance period for energy companies (from 90 days to 60 days) and the banking sector (from 30 days to 14 days).
2. They prohibit the provision of technology, services, investment or any support valued at 1 million USD or more to Russian export pipeline projects (or investment and services cumulatively valued at 5 million USD).
3. They prohibit US investment in new Arctic, deep-water and shale oil projects in which Russian sanctioned firms hold a stake of 33% or more.
4. They include a provision that, if further pursued, could lead to a ban on investing in Russian sovereign debt.
5. They limit the US President’s ability to lift sanctions in future, as relief must be approved by Congress.
While the sanctions have been approved, they have not yet been enacted. President Trump and the Secretary of State have been critical of the new sanctions and Trump has been reluctant to sign the bill. Therefore, risks of a tough near-term implementation are limited.
Overall, we expect the new sanctions to have a limited impact on Russia this year, in line with our previous thoughts on sanctions against Russia (see our previous report: Macro Focus: Sanctions against Russia the New Normal). The Russian CDS premium continues to ignore the latest round of US Russia sanctions. Indeed, the 5y sovereign CDS spread tightened when the sanctions were announced at the end of July. The limited duration of energy and banking sector finance will have little impact given that much of the foreign debt has already been repaid since the implementation of the first round of sanctions in March 2014. The investment cap of 1 million USD does create some uncertainty concerning a few existing projects, such as the Baltic LNG project (Shell/Gazprom) and the CPC pipeline (Shell/Eni/Rosneft). However, the big Nordstream 2 and Turkish stream projects will continue for the time being as the threshold for Russian participation in an energy project subject to sanctions was raised from 10% to 33%, due to EU efforts. We believe it is unlikely that the sanctions will be extended to the sovereign bond market as long as there are no major developments in Russia’s border areas. So far, it seems that Russian retaliation is largely of a political nature and we do not expect any further counter-sanctions. However, while the sanctions will likely have little impact on the economic outlook, it is very unlikely we will see any easing of sanctions in the coming years. The new bill limits the president’s ability to suspend or terminate the sanctions without Congressional approval. Trump was seen as moderately favourable towards Russia, but most members of Congress take a rather more conservative stance. Unless Russia makes major concessions, Congress will not soften the sanctions bill.