bne -

The bad news is that Russia just went through one of its worst quarters since the fall of the Soviet Union. The good news is that the economy looks like it has passed bottom and things will get better from here.

Russia's state statistics agency reported on August 11 that the economy shrank by 10.9% in the second quarter form the year-earlier period, slightly worse than the 10.4% forecast and the worst result in 15 years.

The economy has surprised on the downside every month since the financial firestorm swept the world in September last year. At the start of this year, the optimists were predicting that Russia's economy would be flat this year. As late as February, the president's economic advisor, Arkardy Dvorkovich, was still saying the economy would start to recover in May when all it did was sink further into the mire. One terrible month followed another and the numbers have come out below even the most pessimistic predictions every month since then.

But a slew of good economic results in July suggest that the pendulum has reached its zenith and should start to swing the other way in the second half of the year. There was an unexpected up-tick in electricity consumption in July. Widely used as a proxy for economic activity, the 4.2% increase in power consumption in July suggests that firms are working again as they need power to make things.

Likewise, Russian Railways released its July transportation statistics at the start of August, which is another proxy for economic activity. They show that cargo turnover only dropped 11% on year, its best figure this year. The worst month was January when cargo volumes crashed by a third on month and continued to fall by 20% for four consecutive months afterwards as goods simply disappeared from the market.

Bolstering these proxies was VTB Europe's PMI indicator for July, which showed the total activity index was just below the 50 points mark that represents flat GDP activity. "The 11% drop in cargo turnover implies that industrial production only slowed 7-9% year on year, which would also be the best figure this year," says Aleksandra Evtifyeva, a senior economist at VTB Capital. "Cargo turnover has shown an improving trend for three consecutive months, so we can now definitely say that Russian manufacturing has switched onto the track to recovery: an improvement in transportation figures comes in line with the growing utilisation of energy and raw materials."

Inventories

What underpins both these results is manufacturing. During the collapse in growth, companies stopped producing and sold down what they had in stock instead. What the data suggests is that the storeroom shelves are now empty and companies have to turn their production lines back on again.

The big difference to the 1998 crisis is that this time the payment system effectively collapsed in September. In 1998, there was no payment system at all, as the economy was being run on barter in what was dubbed the "virtual economy" at the time. The devaluation of the ruble on August 17, 1998 was actually a boon, as it made rubles cheap and everyone suddenly demanded payment in cash for the first time. The upshot was that money starting flowing and the economy boomed.

This time round exactly the opposite happened. There was lots of money flowing, but too much of it was borrowed from abroad, so when the squeeze came, triggering margin calls on these debts, everyone was desperate for cash and horded every kopek they could lay their hands on.

What caught the Kremlin off guard were companies' reaction to the collapse of the payment system: they simply stopped producing goods or doing anything that would burn up cash and the economy ran into a brick wall. The related liquidity squeeze in the banking sector only made things worse. The halt in economic activity sent banks' non-performing loans skyrocketing, so they also began hording cash in anticipation of rising levels of bad debt.

The fall in inventories accounted for 80% of the drop in GDP in the first three months of this year, according to the Ministry of Economic Development and Trade. The government has been pouring money into the economy trying to get the wheels of commerce turning again: Russia's stimulus package is equivalent to 14% of GDP - the biggest stimulus package ever, according to the Bank of Finland - but all that happens to this money is it also gets horded.

Happily this can't go on forever and it appears that Russia's companies have sold off most of their inventories and now will have to go back to making things again to meet new orders. Once they start working again they will start spending money again and - hey presto! - the economy starts to recover. "The trends in GDP in July are in line with our expectations, and we reiterate our view that the economy will start growing (though moderately) in the second half of 2009. The revival will be supported by increasing gas exports, restocking and gradually improving crediting. Interestingly, expectations of a recovery in in the second half are becoming the consensus among economists. We forecast a GDP decline of around 5% this year," says Troika's chief economist Evgeny Gavrilenkov.

Patchy recovery

The positive signs are welcome, but the end of a recession is not the same as a recovery. Bringing the economy to a standstill for nearly a year has done a massive amount of damage that will take a long time to undo.

Worst hit were the sectors catering to the booming consumer demand and Russia is unique amongst the BRIC countries (Brazil, Russian, India, China) as the only one to see consumer spending contract.

The booming car market has probably been the hardest hit. Automotive producers are still running start-stop work regimes at their plants, forcing their employees to take as many holidays as they can to save cash. Car sales in the first half of this year were down by half and imports were even worse hit, falling 78%.

However, the news is not entirely bad. Leading Russian mobile phone operator MTS released a solid set of results for the first half of the year, with income of $563m beating consensus forecasts by 4%. According to management, local traffic has stabilized at current levels and is seen as resilient, however the company continues to see weakness in roaming, international and intercity calls, as well as SMS and content.

High unemployment will be a big drag on a faster recovery. After spiking to 10% in the wake of the crisis, the number of unemployed fell to 6.3m, or 8.3% of the workforce, in June, but rehiring those laid off will be a long slow process. For example, Avtovaz, the maker of the Lada and one of the country's biggest employers, said recently it was toying with the idea of laying off 27,000 workers in the near future.

And getting the money flowing again will also take time. Banks reported a 0.1% increase in corporate lending in July on month - the first increase since the crisis began - which suggests the Kremlin's rescue package is starting to get some traction. "The take off of the state guarantees programme, coupled with a continuing decrease in the [central bank's] refinancing rate, is fertile ground for a rebound in credit activity in the banking sector. While at this stage the July result appears rather modest, we expect activity to strengthen over the next couple of months, thereby, finally seeing authorities' efforts to revive lending bear fruit," says VTB Capital's banking analyst Dmitry Dmitriev.

The picture is not as rosy with consumer loans, where the amount of bad debt hit 10% of the total loan portfolio. The local bond market has also come back to life with the number off issues defying gravity: since the end of April, there were more than RUB450bn ($15bn) placed in new bonds. But the anaemic lending activity by banks means bonds are currently the only source of funds in Russia and even this is limited to the top tier of companies.

While the good news is more than welcome, investors are still worried about public financing. The massive spending is bound to get things moving, but some worry that the state is just making new problems for itself. Indeed, the International Monetary Fund warned at the start of August that the Kremlin was spending too much. Budget spending is up by a third over 2008, but revenues are down to a half of previous levels. At this rate the Russian government will use up all its reserve funds by the middle of next year, a de facto bet that the economy will be growing again by then.

The issue is whether Russia can afford the inevitable deficit it will run up. Prime Minister Vladimir Putin has set a target of 7.5% of GDP this year, but investors worry the debt will be larger. However, with more than $400bn in the bank and one of the lowest debt/GDP ratios in the world, there is still wiggle room. Russia is going to return to the international capital markets next year with foreign borrowings the main source of budget-deficit financing in 2010-2012. According to Deputy PM and Finance Minister Alexey Kudrin, sovereign Eurobond issuance will amount to $17.8bn in 2010 (RUB613.6bn), $20.7bn (RUB764.7bn) in 2011 and $20bn (RUB784bn) in 2012, taking Russia's debt/GDP ratio up to about 17% - hardly a lot in comparison to the UK or US, which have ratios in the triple digits.

Taken all together, Russia's economy should progress steadily from here and there is even the hope that the recovery will surprise on the upside. How long will it take? Typically, emerging market crises last an average of 3.5 years and we are two years into this one if you take the beginning of the US sub-prime debacle as the starting point. Kudrin is more pessimistic, predicting it will take four to five years for the economy to return to 2008 levels, but says the government is keeping something in reserve if needed. "We haven't used all the reserves earmarked for this year, that wouldn't be efficient everywhere," says Kudrin. "I think we have a good margin of safety to get through the coming years."

Send comments to The Editor