MACRO ADVISOR: Russia’s recovery faces a reality check

By bne IntelliNews June 22, 2015

Chris Weafer of Macro-Advisory -


After a relatively positive performance for Russia's economy in the first quarter, the second quarter has brought more of a reality check, with sharply lower numbers across many categories reported in April and May. The preliminary GDP estimate for April shows a contraction of 4.2% year on year, after a more modest decline of 2.2% (revised from a first estimate decline of 1.9%) for the first three months of the year. It is already clear from preliminary May data that the decline has worsened. At Macro-Advisory we expect a second-quarter drop of around 5% in GDP. To that extent the economy is not headed into the eye of the storm, which would imply a period of false calm ahead of a further battering, but is actually now in the worst period of the downturn.

But while the downward trend has accelerated, we expect to see a slight improvement in the third quarter and a much better fourth quarter with clear evidence to support the positive, albeit modest, growth expected for 2016. We don’t see any reason to adjust our current year forecast for a decline of 3.5% in GDP and a 0.5% recovery in 2016.  This “worse before it gets better” assumption was also recently echoed by the International Monetary Fund (IMF) and by Russia’s Economy Ministry, both of which have somewhat improved their two-year outlook and are now close to our forecasts.

Consumer blues

The big hit, and the main reason for the headline decline, has come in the consumer sectors, eg. retail sales volume collapsed by 9.8% on year in April as households continue to be squeezed and have little reason for optimism. The May year-on-year decline was a little better at 9.2%. Low nominal wage growth, which is now in the range 5-7% and which led to a real decline of almost 7.5% in May, is certainly one of the main reasons for the headline decline. Aligned with that is the continuing high cost of debt servicing, double-digit inflation and concerns over job security, which many polls show as the main areas of concern and the reasons why consumer activity has fallen so fast.

On the optimistic side of the equation is the fact that inflation appears to have peaked at just under 17% in March and it was below 16% at end-May. The Central Bank cites the expected downward trend in inflation (it expects 12% by year-end) as justification for cutting its benchmark key rate from 17%, at the start of the year, to 11.5% as at mid-June. Based on the CBR’s inflation estimate there is room for at least one, if not two more 100 basis point (bp) rate cuts this year, but most likely they will come in the autumn when the declining inflation trend is confirmed. Although the cost of debt for households and small and medium sized businesses is still relatively high, the significant cut will help ease pressure on both in the second half of this year.

The trend in the ruble, which staged a rapid recovery from over RUB60 against the US dollar at the end of last year to under RUB50 at the start of May, is more of a mixed blessing. On the one had the recovery has greatly reduced the widely held fears of late year that Russia was heading for a more destructive 2015 and has helped stabilize both public and business confidence, albeit both are still at low levels. But the Central Bank of Russia (CBR) and Finance Ministry both expressed concerns that the ruble appreciated too fast and risked undermining some of the positives in the economy. With the ruble trading close to RUB50, or better, against the dollar it is more difficult to keep the budget deficit low and for industry to remain competitive against imports and in the export markets. The clear indication from officials at both agencies is that their preferred rate is around RUB55-56 against the dollar. That is better for export tax revenue and better supports import substitution and export growth, which have emerged as key parts of the government’s long-term recovery strategy.

Compared to the almost chaotic flip-flopping of ruble management in 2013 and 2014, at least the message of where the government would like the ruble to be positioned is becoming clearer even if it also has raised questions over just how much independence the CBR now has. For example, recent comments from the head of the bank, Elvira Nabiullina, suggests that she is not very happy with the rapid interest rate cuts and would have been happier to match the rate cuts with actual inflation reduction. It seems that the Kremlin sided with the Economy Ministry’s view that the high debt cost burden is a major contributor to the current decline and taking the inflation risk is worth it to try and stimulate growth.

The other point which is also now clearer is that the government favours a longer-term weak ruble policy rather than the previous position of trying to defend the currency. That proved to be very expensive in terms of foreign-exchange usage in 2014 and achieved little. The fact that people did not panic over the ruble collapse in late 2014, other than to take cash out and buy durable goods due to inflation and sanctions concerns, also allows this position change. A weak ruble is a key part of the emerging strategy to boost the competitiveness of domestic industries and to expand both the volume and range of exports outside of extractive industries.

At the same time of course we should not expect the ruble to return to the extreme volatility seen late last year. Since the start of this year the CBR has shown itself to be very capable of preventing the sort of extreme volatility which so deeply cut into confidence in November and December.

Hope for reforms

As mentioned the IMF is one agency which recently slightly improved its outlook for this year and next due to the rapid cut in interest rates, the expected decline in inflation and the benefits to the economy from the weaker ruble. But, while more positive than it was late last year, the agency also very clearly highlighted the fragile nature of the economy and the threats which still endanger recovery prospects from sanctions and the unpredictable oil price.

However, while external events are outside of the government’s control over the short to medium term, especially as geopolitical priorities are not expected to be compromised, the most decisive driver of the trend in the economy will be the government’s policy and spending response to the changing environment. There can’t be anybody with an interest in Russia who cannot recite the list of reforms and structural changes the economy needs. These are all long term in nature and will only be able to deliver change on an extended time line. To that extent if the strategies of import substitution, value-added investment in raw materials and export growth promotion actually move from rhetoric to programmes of substance, then this will certainly be one of the most positive outcomes from this crisis period.

More immediately, the government needs to be more consistent with its ruble policy, about which the recent evidence has been much more encouraging. It also needs to make changes to the budget. The Finance Ministry has recently tabled four variants of the budget for 2016-18 with different degrees of savings and tax assumptions. In other words, some tough choices which represent either muddling through and hope for the best or a serious acceptance of the need for real changes starting right now.

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