Chris Weafer in Moscow -
If you left Russia for the last New Year holiday and did not return until the recent May holidays, and did not follow the news from or about Russia in the meantime, you would certainly be scratching your head and wondering what on earth happened? Late last year there were predictions that the war in Ukraine would escalate and sanctions toughened against Russia. People scrambled to get out of rubles because they believed that it would soon be at the RUB100 level against the dollar. The general assumption was also of a big unemployment spike and a recession at least as bad at that of 2009. In short, widespread doom and gloom about Russia’s near-term and medium-term future.
Instead, the first-quarter performance of the economy and the very strong ruble rally has given rise to a great deal of optimism, especially within the government, that the peak of the crisis has passed. There is now no longer talk of tougher sanctions but, against a backdrop of what is looking more like an extended frozen conflict in eastern Ukraine, the discussion now is about which sanctions may not be renewed at the July 31 expiry. The Central Bank of Russia is optimistic enough about the trends that it has already cut its benchmark rate from 17% to 12.5%, a negative real rate of 4%, which of itself also adds to the reasons for optimism given the impact on household disposable incomes. Investors also buy into at least part of that optimism, and have pushed the dollar-based equity indices, such as the RDXUSD, up by more that 40% since the start of the year.
However, while there are some very clear trends to cheer, to make such the assumption that the worst is over for the economy and that financial pressures will continue to ease is decidedly premature. The country’s economy has had a good start to the year, but now is more likely to slide lower for the next two quarters as the legacy of last year’s events start to bite the more important parts of the economy and especially those focused on the consumer and small and medium sized enterprises. But the operative word is “slide” and not “collapse”.
Overall, the economy contracted by just under 2% year on year through January and February, but dropped by almost 3.5% in March. That trend confirms my view that the positive start to the year will not be sustainable in the current or next quarters. But while expecting to see a deterioration, all fears of a major collapse or problems with external servicing etc. – all of which were widely discussed and predicted late last year – have been dispelled. Russia’s economy is already in recession, but the contraction for this year will be in the range 3-4% of GDP and the economy should see a small but positive growth next year, ie. all else being equal with regard to sanctions.
That said, the headline number for GDP is somewhat misleading or does not show the broader picture. The manufacturing and agriculture sectors continued to benefit from the competitive boost they received as a result of the fourth quarter ruble collapse as consumers switched heavily to cheaper domestic produced alternatives. The much vaunted import-substitution shift allowed the agriculture sector to report growth of 3.5% on year for the quarter and the decline in industrial production to stay low at 0.4%.
But beyond that, some sectors are being beaten up badly. The construction sector reported a 5% drop in output, investment spending fell 6% and retail sales, the biggest segment of the economy, dropped 6.7% year on year. At the expensive end of durable goods sales, vehicle sales declined by 36% year on year in the quarter and that despite the government’s subsidy programme remaining in place. Small business is publicly calling for an easing of access to new bank credits and warning of a faster pace of closures and job losses if they continue to be squeezed by the banks.
Another reason why the economy fared relatively well – ie. at the headline rather than broader level – in the first quarter is because of accelerated budget spending. The deficit at the end of February was at 10.5% of GDP, albeit that fell back to 4.9% of GDP by the end of March. Still, that is well in excess of the full-year target and implies that spending will be much slower in the second half of the year. A lot of the extra spending took place in the defence procurement area – which totalled 40% of the full-year allocation in the quarter – and while that does impact the headline growth numbers it does little for the broader economy.
A big factor supporting the mood of optimism amongst officials and investors has been the strong performance of the ruble since early February. Here again the reasons are clear enough and either cannot be sustained or would be difficult/expensive to. But as with the outlook for the economy, few are now looking at a major ruble collapse as had been widely assumed late last year. A gradual weakness from the current ruble-dollar rate of 50 to around the 55 level is expected rather than anything more dramatic over the summer months. Where oil trades will determine which side of that exchange rate the ruble trades.
Through February to end April both the central bank and Finance Ministry carried out co-ordinated actions to boost the ruble. Chief amongst them was the provision of almost $40bn in forex loans to the corporate sector to cover external debt repayment obligations. It means that those companies did not have to go into the open market to try to buy forex, thus removing that demand pressure. At the same time the Finance Ministry converted up to $15bn of its Reserve Fund from foreign currencies into rubles to cover the budget deficit. That created forex supply and ruble demand. Also pushing the ruble higher was the reversal of at least some of the ruble withdrawals by individuals and companies made in November and December. As the ruble rallied it created a positive reverse momentum.
But the ruble rally has been too much and now endangers the demand for cheaper domestic goods as imports, in ruble prices, start to again become less expensive. We have already heard from various government ministers and central bank officials that they prefer to see some weakening of the ruble so as to sustain that positive driver in the economy. Whether that happens, and to what extent, now depends more on the oil price than domestic factors over the medium term.
The price of Brent crude has rallied by over 25% since the start of the year and is again trading over $65 per barrel. When one looks at the reasons for that rally you come up with the same conclusion as for the Russian economy – the positive drivers are not sustainable, but previous expectations of a price collapse to 2009 levels are now almost unrealistic. The oil price rally has been chiefly driven by three factors: 1) expectations that either US shale supply will soon start to decline or Opec ministers will be forced to agree a production cut; 2) traders built up the largest ever long position (500mn barrels); and 3) the US dollar declined as expectations of a Federal Reserve rate rise are again delayed.
The fact is that there is no evidence that US oil output is about to fall, albeit forecasts for supply growth have been scaled back. Within Opec, the Saudis appear ever more determined to defend market share and are now pumping at a record of over 10.5mn barrels per day. Comments from the Saudi oil minister, always influential in terms of price sentiment, should also dent any optimism that the current price can hold. An unwinding of the speculative long oil position would also create more downside pressure and volatility.
So, when you factor in all the price drivers for oil, including the increasing likelihood of sanctions against Iran being lifted (the EU is looking at Tehran as a meaningful alternative to Russian oil and gas for reasons known only to bureaucrats) the conclusion is that the oil price rally is about done. But using the principle of “once bitten, twice shy”, it is unlikely that too many traders will be keen to sell too far down. A slide back to the mid to low $50s per barrel is more realistic than either a push to $80 or a collapse to $40, albeit history tells us that it is foolish to dismiss either as impossible.
The picture that is emerging, therefore, is one where sentiment and politics pushed expectations to extremes by last New Year but where the actual reality, caused by a great deal of pragmatism and common sense, has been a whole lot better. Those efforts and the sentiment shift has resulted in a better than sustainable ruble and oil price rally. But neither is facing much more than a modest slide through the summer. I still expect the ruble to weaken coming into the year-end as those forex repo loans have to be repaid and because December is also the peak month for foreign debt repayments. But that’s only a provisional number for now and it, along with the broader macro forecasts for 2016 and 2017, will be adjusted in the autumn. By then we should have a better understanding of where oil is headed and a decision, one way or another, about sanctions will have been made.
Chris Weafer is Senior Partner at Macro Advisory, which offers bespoke Russia-CIS consulting
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