- Fiscal and monetary discipline has helped the economy to recover
- Russia emerged from recession with 2% growth in 2017
- We expect 2% and 1.5% growth for 2018/2019
- Inflation has slipped below target (4%) and we only expect a slight increase in 2018 (4.5%)
- Risks stem from problems at private banks and additional US sanctions
Russia has emerged from a recession
After a period of negative growth in 2015 and 2016, economic growth turned positive in Q4 2016. This recovery continued in 2017 and we expect GDP growth to be 2% yoy for the year, driven by higher oil prices, private consumption and investment. Over the course of 2017, the Brent oil price increased over 18% and currently stands at USD70/bbl. Investment growth was led by a surge in public infrastructure investment in the first half of 2017. Meanwhile, households have reduced their savings and are consuming more thanks to the improved credit conditions. However, real disposable income growth continued to decline on the back of tax increases and subsidy cuts. Oil exports were 31% higher yoy in dollar terms, but volumes remained unchanged partly due to voluntary production cuts. Imports increased 15% in dollar terms yoy, benefitting from the ruble appreciation and economic recovery.
Growth expectations remain moderate…
The elections on 18 March 2018 will dominate the headlines over the coming months, but we expect the political situation to remain stable. The incumbent, President Putin, is likely to win as opinion polls show that he will gain around 55% of the votes. The other potential candidates, TV presenter Ksenia Sobchak and opposition leader Alexei Navalny, do not enjoy widespread support. We expect public investment to increase ahead of the presidential elections. Together with higher public wages and pension indexation, private consumption should pick up further in 2018. In addition, the Russian economy will benefit from higher oil prices (we forecast Brent at USD75/bbl end-2018). However, low productivity, a shrinking workforce, a relatively strong ruble and international sanctions weigh on the outlook. All in all, we expect growth to remain around the same level in 2018 as it was in 2017, 2%. Then, as the beneficial effects of the government investments ebb away in 2019, growth we decrease slightly to 1.5%.
Inflation slipped below target
Inflation fell below the inflation target (4%) in May 2017, dipping further in the last months to around 2.5%. However, policymakers have attributed this to one-time factors such as a bumper harvest and the strong ruble. This brings annual inflation to 3.7% in 2017, outperforming the initial expectations of the central bank in the beginning of the year. Going into 2018, we see inflationary pressures rising. Inflation expectations are not well-anchored and remain high. Furthermore, a tighter labour market and higher global commodity prices may also affect inflation via an increase in producer prices. The Central Bank of Russia (CBR) flags these worries as well, and is concerned about wage growth outstripping growth in labour productivity. In light of these factors, we expect inflation to reach 4.5% at end-2018 and 5% end-2019.
High real interest rates leave room for the CBR to ease monetary policy
Since 2015, the CBR has been on an easing trajectory and in 2017 the policy rate was lowered by a total of 225bp, from 10% to 7.75%. While CBR’s guidance this year was hawkish, its actions were generally dovish. In March and April, the CBR surprised the market with deeper rate cuts. The central bank acted again in December, cutting the key rate by 50bp to 7.75%, while a 25bp cut was widely expected. According to the CBR, the latest cut was justified by the extension of the OPEC+ production cut agreement. As oil prices remain high, the ruble will remain strong and result in declining inflationary pressure from the pass-through effect. While some market commentators interpreted this as weakness in communication of the CBR, we believe that the central bank is simply being cautious and very prudent in its policy. After all, inflation figures of 17% were a reality just two years ago and inflation expectations are still high (around 10%). Therefore, CBR guidance is appropriately cautious and will only make further cuts if real inflation figures allow (as they have done in the last few months).
Given our moderate inflation expectations (4.5% at end-2018), we expect the CBR to further relax its monetary policy next year. We forecast a total cut of 100bp to 6.75% by end-2018, just above the nominal equilibrium rate of 6.5% (calculated by the CBR). The easing will most likely take place in the first half of 2018, as elections are scheduled for March 2018 and the appointment of a new cabinet and the subsequent debate over budget policy will be a time for the CBR to pause and see how the new economic policies will impact inflation.
Central government finances in good shape…
With low government debt (12% of GDP) and an average budget deficit around 1.3% in the last 10 years, Russian government finances are in relatively good shape compared to other EMs. In 2016, the budget deficit deteriorated somewhat (to 3.4%) as the government stepped in to stimulate the economy. In 2017, the budget deficit fell to 2% on the back of higher oil prices and government reforms such as cuts in government social security payments and higher taxes on certain items. A draft version of the federal budget was submitted to the Duma in September 2017 (for the coming four years). Conservative forecasts (inflation above 4%, oil prices below USD44/bbl) project that the budget deficit will reach 1.3% in 2018 and around 1% the years thereafter. What’s more, a new budget rule will be implemented in January that directs the Ministry of Finance to use additional oil and gas revenues (arising out of oil prices above USD40/bbl) to buy foreign currency. This effectively means that increased fiscal leeway won’t be used to fund additional government expenditures but will be allocated to the newly created Sovereign Wealth Fund (a merger between the old Reserve Fund and National Wellbeing Fund). As our energy expert expects oil prices to reach USD 75/bbl at the end of 2018, Russia’s new SWF will be boosted throughout the year. The fund currently stands at 5.5% of GDP (USD85bn).
…but local government not so much
The debt stocks of some Russian regions have grown rapidly in recent years relative to their (limited) regional tax base. The regions’ fiscal struggles are primarily due to the increase in public sector salaries, whereby they cover the shortfall through borrowing, including from commercial banks. In recent weeks, several Russian regions have appealed to the federal authorities for emergency support. The indebtedness of local governments poses a risk for fiscal discipline at a central level. Yet, with its low debt level, the government has scope to assist local governments.
Risks stem from the vulnerable banking sector…
In mid-2017, the central bank took over two private banks (Otkritie, B&N Bank), in a move to avoid bankruptcies. Then in mid-December, CBR announced it would nationalise Promsvyazbank. As outlined in our previous Russia Watch: Moving towards stronger growth, the problems at these banks can be traced back to the 2014 crisis, when Russian private banks acquired assets that, with hindsight, were overvalued. Credit Bank of Moscow has also been mentioned as vulnerable. Given that it is a subordinated debt holder of Promsvyazbank (and the government announced that debt will be written off) this bank is likely to be next in line for a capital injection. Others may follow, as overvaluing capital and assets is a systemic issue within private banks.
While the government prevented a domino effect from bankruptcies, there is no clear exit strategy and we suspect that the nationalized banks will remain state-owed for quite some time. Russian policymakers were trying to console the issues in the banking sector by referring to Fitch’s upgrade of the outlooks of 23 banks in September. Yet this was on the back of a sovereign outlook upgrade, and not because of fundamental improvements in the banking sector itself. We expect issues in the banking sector to continue throughout 2018-19, as there are no reforms on the table to address the imbalances in the financial system.
… and additional sanctions
On 2 August, US President Trump signed a new bill (CAATSA) extending the sanctions against Russia. As written in our special on the sanctions, Sanctions against Russia: The New Normal, we do not expect these additional sanctions to have destabilizing effects on the economy as they are targeted at a few specific companies and individuals. Moreover, many Russian companies doing business with European countries have been exempted from the sanctions. For example, Gazprom, which supplies gas to Europe, has been excluded from the sanctions lists as has Nord Stream 2, a second trans-Baltic gas export pipeline to Germany.
Going into 2018, we see two main risks stemming from the bill. First, CAATSA allows for secondary sanctions, meaning that the US can prosecute anyone who has done business with the ‘specially designated nationals’ (SDNs) who are already under sanctions. The SDNs include Kremlin initiates such as Igor Sechin and Gennady Timchenko. Depending on how strictly CAATSA is implemented, this could make some of Putin’s closest allies a target for the US government. In February, the US will release a report including a list of Russian officials with close ties to Putin. Many well-connected Russians are afraid of being included on the list and thus a potential victim of personal sanctions. If the list entails many government officials and CAATSA is implemented strictly, this could have a destabilizing effect on the political system.
A second risk involves additional sanctions from the US that target Russian sovereign debt. A clause has been included in the latest CAATSA that allows the US to sanction Russian bonds. While this will not trigger an immediate sovereign default (as government debt is only 12% and is 70% domestically-financed), it will hamper economic growth as it will significantly increase the costs of debt servicing. Furthermore, such an event would destabilize the ruble. The possibility that US sanctions will target state bonds is the major reason why Fitch has not yet upgraded Russia. The Russian government has responded by considering legal changes to allow for a quick imposition of emergency measures to stabilize the currency if such an event takes place. In our base case scenario, we do not take such a measure into account. However, if a major spat develops between the two countries, the scenario that the US will target Russian sovereign debt cannot be ruled out.