- Growth will remain below long-term trend at 1.5% in 2019/2020
- Strong fiscal and external positions support resilience to shocks
- Inflation expected to peak at 6% in first half of 2019
- Monetary policy will remain tight and we expect one rate cut end-2019
- Sanctions on sovereign debt and/or energy sector remain biggest risk
In 2014, when a drop in oil prices coincided with the imposition of US sanctions, Russia fell into a recession. The subsequent recovery has been sluggish. With growth running at 1.5% in 2017 and around 2% in 2018, Russia’s growth trend is still below its long-term average of around 3.5% over the last 20 years. While higher oil prices have mitigated the adverse impact of new sanctions over the last year, weak domestic factors such as a poor investment climate and longstanding structural inefficiencies are curbing economic growth. That said, while growth may be unimpressive going forward, stability has largely returned. Inflation, while expected to remain above target in the beginning of 2019, is being addressed head-on by the Russian central bank, which increased rates unexpectedly twice last year. Moreover, the government maintains a fiscal framework anchored in a medium-term primary balance target and is adding to its fiscal reserves when the oil price exceeds USD 40/bbl. In 2018, the government balance was in surplus (0.3% of GDP) and is expected to remain in surplus for the coming two years. Moreover, the Russian rouble was dealt a blow amidst heightened risk aversion due to less favourable global conditions in 2018 and rising interest rates in the US. Still, the impact was not as severe compared to some other emerging markets.
Unimpressive performance is forecast to continue in 2019
We expect investment growth to remain subdued. The frail investment climate in Russia, resulting from weak property rights, a large state footprint in the economy and low competition, is not expected to improve soon. Following President Putin’s inauguration, he signed a list of national goals – the so-called 2018 May Decrees – which foresee an ambitious development plan. However, the programme fails to target much-needed structural reforms. Nevertheless, it may bring some short-term stimulus to the economy. Despite the uptick in salaries, real disposable income growth has remained sluggish in 2018, reflecting growing wealth inequality and an increase in indebtedness and servicing costs. We expect no sharp rise in consumption for 2019, as higher inflation, partly due to a VAT rise, will leave households with less purchasing power. Despite slightly less favourable global economic conditions (see Global Outlook 2019: Slower, but continued growth), we still expect a modest recovery in oil prices to USD 70/bbl for Brent, which will be positive for investment and consumption. On balance, we expect Russia to remain on course for expansion, but at a slow pace. We expect growth of 1.5% per year in 2019/20. The main uncertainty for this outlook is further sanctions (see last paragraph).
Inflation breaking through target despite tight monetary policy
While inflation was still below 2.5% in the first half of 2018, it has accelerated since September. In December, inflation reached 4.2%, breaching the 4% target of the Central Bank of Russia (CBR). Base effects have pushed inflation higher, but there is also evidence of broader price pressures. The main drivers behind these price pressures are rising fuel costs as well as the pass-through effect of the weaker ruble. After a long easing trajectory that started back in 2015, the CBR unexpectedly decided to hike interest rates by 25bp twice this year, in September and December.
Inflation will peak in first half of 2019, monetary policy remains tight
Going forward, several tax changes and increased government expenditure will push prices higher. The VAT hike (from 18% to 20%) at the start of this year, is applicable to one-third of the consumption basket. Furthermore, the pass-through effect of the weaker ruble will continue to put pressure on prices. On the back of stronger price pressures, inflation is on course to overshoot the inflation target in 2019. We forecast headline inflation to reach a peak of 6% in the first of half of 2019, before easing to 4.5% end-2019. Despite this uptick in inflation, we don’t expect the CBR to hike rates further in 2019 as the 25bp hike in December already incorporated the surge of inflation in the first half of 2019 into its base scenario. Our base case scenario is an unchanged rate at 7.75%, at least until the fourth quarter of 2019, and we may see a 25bp cut in the last quarter. This will bring the benchmark rate to 7.50% at the end of 2019. That said, risks are tilted towards further tightening. Even though the Russian Central Bank has taken decisive action in order to keep inflation low, inflation expectations are still not well-anchored, and the risk remains that inflation will get out of hand. If inflationary pressures increase the CBR’s 6% expectation in March-April 2019 or if a new set of sanctions materialize, we expect the bank to react by raising rates further.
Strong external position mitigates risks…
The US took a tougher approach to Russia in 2018. While sanctions in 2014 were initially put into place because of the illegal annexation of Crimea, there are now several issues on the table such as the ongoing Mueller investigation, the Skripal poisoning in the UK, Russian support for the Assad regime and cybercrime allegations (see: Russia Watch – Sanctions looming). But while the imposition of new sanctions last April and August sent the ruble lower and triggered capital outflows, it did not cause a breakdown as Russia’s external position is fairly strong.
For years, Russia has seen a surplus on its current account, amounting to 4% of GDP last year. Gross external debt has fallen from USD 668bn in December 2013 to a current level of USD 536bn, largely due to sanctions preventing Russian from borrowing on international capital markets in combination with domestic policies to improve borrowing conditions. External debt-to-GDP stands at 33%, which is relatively low by emerging market standards. FX reserves cover almost 10 months of imports and are expected to grow further because of the fiscal rule that channels oil revenues into the reserves. Russia has strategically focussed on import substitution, more protectionism and trade reorientation towards the East. Meanwhile, Russia’s central bank has divested most of its US Treasury holdings, while accumulating more gold, suggesting they are preparing for the worst-case scenario. We expect the ruble to gain against the dollar (USD/RUB 60 end-2019) on the back of a cheaper dollar, rising oil prices and the country’s high real interest rates. From a nominal effective exchange rate perspective, the ruble is considered to be cheap and hence attractive from a risk/reward perspective. In light of the strong external position and de-dollarization of the economy, the medium-term effects of new punitive sanctions seem to be manageable.
… but sanctions remain one of the biggest risks
The unpredictability of further US sanctions against Russia continues to dampen investor confidence. Currently, markets expect a mild second phase of penalties, such as further restrictions on specific individuals and companies. However, more severe sanctions, such as cutting off trade or targeting sovereign debt and Russian state banks, could bring a major shock. The extent and harshness of new sanctions in 2019/2020 will largely depend on US domestic policy developments and the position of President Trump. If the draft legislation entitled Defending American Security from Kremlin Aggression Act (DASKAA) is pushed through in its current form and sanctions on Russian sovereign debt become a real option, this will pose a severe risk for Russia’s ambitious borrowing programme, which foresees raising USD 13bn on international markets. The second main risk to Russia’s growth forecast is a sharp drop in oil prices. Although unlikely, such a scenario could be triggered by a strong disappointment in oil demand growth. An unexpected fast rebound in Venezuelan crude production or Libyan oil exports, or a further loosening of sanctions against Iran could potentially also cap any upside in oil prices.