Ben Aris in Moscow -
bne: this report is in three parts. See the end of the page for links to the rest. END
• Economic overview
2013 was an annus horribilis for Russia. Indeed, it was probably the worst year the country has been forced to endure (that was not a crisis year) in the last decade and half.
The economy suffered from a "phantom crisis" that had its roots in the fears of a second global financial crisis which started in Europe in the summer of 2012. The state issued a mass of debt to build up its reserves, which crowded private companies and banks out of the market and created an atmosphere of fear amongst businessmen.
The results were soon to be seen as the economy started to slow in the autumn of 2012 and that slowdown became self-reinforcing. By the summer of 2013 growth had stalled completely and Russia underperformed, missing the 3.5% GDP target most analysts were predicting at the start of the year. At the time of writing in December, Russia looked unlikely to even manage 1.5% for the whole year. "Despite what can be viewed as a high oil price, real GDP growth slowed dramatically to 1.3% in the first nine months of 2013, compared to 4.0% in the first nine months of 2012, as have all major economic indicators," said Aton Capital in its 2014 outlook.
Analysts totally underestimated the impact of the terrible sentiment amongst Russia's businessmen. This climate of fear was only reinforced as the Kremlin ramped up its anti-corruption campaign in 2013, which increasingly is breaking up the old business-politics client system and has exposed all to the possibility of arrest or confiscation of assets.
Perhaps the best illustration of the fears is that companies cut inventories in 2013, leading to a collapse in industrial production in the summer. This is a typical reaction to a crisis, but in 2013 it was being used prophylactically as a way to avoid tying up cash in product and keeping companies' resources liquid.
At the same time Russian President Vladimir Putin introduced a new law that bans Duma deputies and state officials from owning property abroad or holding foreign bank accounts. This is in effect the first capital controls that Russia has used since the 1990s and given the step from Duma deputies to businessmen is short, this measure further unsettled everyone.
And more recently the Central Bank of Russia (CBR) has started a visible campaign to close some of the 800 smaller banks, which has introduced yet another note of uncertainty in the banking sector and the possibility of a domestic financial crisis.
On top of all this have been the poor external conditions and the slower-than-expected recovery in Europe. Access to international capital markets remains muted and the problems have been exacerbated by the bubble forming in developed capital markets due to the endless quantitative easing, which has seriously distorted flows of international capital.
These are some of the superficial reasons for Russia's slowdown in 2013, but at a deeper level Russia's growth model has also run out of steam and the economy will not pick up unless deep structural reforms are put in place. While oil prices held up at over $100 for the year, such high prices no longer deliver growth.
Consumption was the main engine for growth in 2013, but will probably fade in 2014 and was already slowing at the end of 2013. It remains moderately robust with nominal average incomes continuing to rise by an average of 10%, ahead of inflation at about 6.3%. "Personal consumption growth has remained positive, although, with the exception of real disposable income, it has slowed dramatically compared to last year," says Aton.
All these problems have manifested themselves in the collapse of investment, which normally is one of the three big economic drivers (along with consumption and construction).
As bne pointed out in its 2013 Outlook, investment was going to be the key variable in 2013, yet the investment numbers ended up being hugely disappointing, mirrored by the low levels of corporate borrowing, which also contributed to the collapse of industrial production. "Most concerning is fixed investment, down 1.8% year-on-year in the first ten months of 2013, vs a full 9.1% year-on-year growth in the first ten months of 2012. Equally, industrial production growth has disappointed, being flat year-on-year in first ten months of 2013 compared to 2.8% growth in the same period last year," says Aton.
Despite the slowing growth, the continued rise in incomes over inflation means that both companies and banks have been suffering from a sustained squeeze on margins, a problem only made worse by the high cost of borrowing, as the CBR has refused to cut interest rates while it battles stubbornly high inflation.
All this has led to talk of stagnation of the Russian economy. In a much-cited speech on November 7, Economic Minister Alexei Ulyukayev outlined a gloomy economic outlook for Russia, saying that GDP growth could likely average 2.5% per year until 2030, down from the previous estimate of an average of 4%.
This is a very pessimistic call and it is probably partly aimed at the statist elements in the government, to persuade them to allow for more liberal structural reforms. Growth of 2.5% would be below the expected average global growth of 3.5% for the same period. "Ulyukayev's statement should be viewed as a clear acknowledgment by Russia's leadership that the country's economic model needs to be dramatically altered given the country's dependence on oil and other structural and institutional deficiencies," says Aton.
So is the Russian growth story over?
Several of the factors that have impaired growth in 2013 will drop away in 2014, but the biggest fillip should come simply from an improvement of sentiment amongst Russian businessmen.
The main positive factors for growth in 2014 include:
• Low base effect: the bad numbers in 2013 set a very low bar for 2014 and growth should pick up on a year-on-year measure on the basis of the statistical comparison alone;
• Inflation to fall: the CBR has nailed its inflation-fighting flag to the mast. Confidence in its ability to deliver should bring down inflation, as one of the factors has been the high expectation of inflation amongst the population;
• Food prices to fall: a second factor fuelling inflation was the poor harvest of 2012, which sent the price of food soaring. However, the harvest in 2013 was good and this should reduce inflation towards its core level of 4-5% in 2014;
• Interest rate cuts: falling inflation will allow the CBR to cut rates and reduce the cost of borrowing, which will help spur growth. However, the cuts likely won't begin until the first half of 2014 and take at least six months to have a positive economic impact;
• Structural reforms: the slowdown has forced the Kremlin's hand and it launched what could be argued are the first ever sincere attempts at making deep structural reforms epitomised in, but not limited to, Putin's goal to improve Russia's standing in the World Bank's annual "Doing Business" ranking. Russia has become the best country amongst the BRICs for doing business this year (from 120th to 92nd place) and this process will continue. However, the economic benefits from these changes will take years to have a major economic impact;
• External environment: in the shorter term a general pick-up in the rest of the world increasingly seems to be on the cards and this will immediately benefit Russia, if for no other reason than it will remove fears of an imminent crisis elsewhere.
The bottom line is that recovery is on the way, but a sustained recovery will probably only kick in around the second half of 2014 -and then only if the main growth engine shifts from consumption to investment. For the full year, the consensus is that Russia will grow by about 3% in 2014, with the more pessimistic forecasters like the World Bank predicting 2% of growth and the more optimistic predicting 3.5%.
Putin was clearly becoming frustrated by the lack of progress by December 2013 and has taken a more proactive role in the economy.
In the short term this will only increase nerves. As Russia is not a rule-of-law country but a rules-of-the-game country, when Putin chooses to change those rules businessmen will step back and wait to see how the new rules work before committing to new big investments. This process can take several years before confidence in the new system is achieved.
Still, Putin has taken several positive steps to improve the business climate and made the government more responsive to business needs.
In December he set up a presidential economics advisory team and formally brought former finance minister Alexei Kudrin back into the government as part of this team (notably excluding Prime Minister Dmitry Medvedev.)
Putin has been steadily ratcheting up the pressure of his anti-corruption drive as this has been identified as the main drag on growth. Russia was rewarded for the efforts already been made by going from most corrupt nation in Eastern Europe according to Transparency International annual "Corruption Perceptions Index" to least corrupt - largely by staying at place 127 on the list, while Ukraine and Kazakhstan both dropped down the ranking precipitously. Reducing corruption will reduce the drag on the economy.
And finally in his state of the nation speech in December, Putin cited the 19th century prime minister Pyotr Stolypin as the inspiration for political reforms in 2014. Stolypin is hailed as one of Russia's greatest reformers and personifies a policy of decentralisation. After taking office in 2000, Putin centralised control over all the regions to retake political control of the country. Now it appears he is proposing to farm out responsibility for the local economies to the regional governors again in the hope of emulating the successes of regions like Tatarstan, Leningrad and Kaluga. If he can pull this off, then this reform could be transformational.
Russia remains dependent on the oil price and while a fall would cause a lot of pain, a rise will not deliver the kind of fast growth it used to. That economic model, which has benefited the country in the last decade, has now been exhausted.
Happily, the consensus is for oil prices to remain strong for the foreseeable future. Between 1999 and 2007 the oil price rallied almost 800%, but it has slowed since and by the end of 2007 it is up a mere 19%, with lower growth seen in recent years.
The Bloomberg consensus average oil-price forecast for 2014 is $107.3 a barrel - which means the price will stay flat over the year.
• Other Commodities
The outlook for other commodities is also uninspiring. The year-on-year changes in commodity prices on a quarterly basis for the next year are for most prices to remain where they are or fall from their end-2013 levels.
Bloomberg's consensus estimates for the average 2014 price for oil, steel, gold and copper are actually below the current prices; only for nickel and platinum would there be upside from the current levels if the analyst community is correct, says Aton.
• GDP predictions
Given that 2013 surprised so badly on the downside, analysts are very unsure what 2014 will bring and the spread on predictions is very wide. As the cause of the slowdown is at root psychological and not economic, how the mood will change as the new year wears on is crucial.
The European Bank for Reconstruction and Development (EBRD) released its latest outlook for the CEE/CIS region in November. While the headline says growth is expected for Russia in 2014, it suggests it will be slower than previously thought. However, looking closer, the forecast is even more downbeat.
The report says the EBRD now expects a slight reduction in average GDP growth to 2.8% in 2014. However, the spread of possible outcomes is very wide indeed. The forecast baseline number is actually near the top of the range surrounding the 50th percentile (the spread that has a 50% chance of happening). In other words, there is a 50% chance that average growth will come in around 0.5 percentage point (pp) higher, but by the same token growth could also fall, only much faster. The spread has the regional average dropping to zero in summer 2014.
Going to less likely outcomes: In the best (and most unlikely as it is in the 90th percentile) case scenario, growth could rise as high as some 6% next year. But if things go really wrong, then the region would contract by around 3%. That's a 10pp spread around a prediction of 2.8% baseline growth only six months ahead. Not a very comforting outlook.
However, on balance the outlook for 2014 is better than 2013. A low base effect will boost growth and the good harvest will bring down inflation and allow for rate cuts, but to ensure sustainable growth into the medium term the government needs to get on with deep structural reforms. A start has been made and the effects are beginning to be felt, but it was a late start and the progress will be slow.
• Fixed investment
Like in 2013, what happens to fixed investment in 2014 will determine the course of Russia's economy for the whole year. Given that the low levels of investment seem to be largely due to psychological effects rather than economic ones, the outlook for the first half of 2014 at least is poor and only a mild recovery is likely. "There is not economic reason for the low level of investment," argues Evgeny Gavrilenkov, chief economist at Sberbank CIB.
Fixed investment growth remained negative for most of 2013, down 1.8% year on year over the first ten months of the year and there were no signs of a pick-up as the year came to an end. However, economists say in several ways 2013 was an exception and expect things to improve in 2014. "We expect a mild pick-up in investment in 2014, led by the public sector, where we expect investment, which was disproportionately affected by the squeeze in spending, to recover, and the oil industry, where investment contracted around the time of Rosneft's acquisition of TNK-BP, but should recover, given robust oil prices," says Morgan Stanley.
• Capital flight vs FDI
Private sector capital outflows remained disappointingly high in 2013, and highlight the lack of confidence Russians have in their own economy.
In the first nine months of 2013, a total of $48.1bn (net) moved out of Russia according to CBR data, up from than the $46.4bn that left Russia in the first nine months of 2012.
However, the new money arriving from foreign investors more-or-less matches the money leaving Russia, which is new. The Russians maybe pessimistic about their country, but foreign investors see a place that is growing faster than their own, where incomes are rising and margins remain extremely high.
Direct foreign investment (FDI) tripled in 2013 to $45bn-50bn in 2013, according to the government. And the outlook for 2014 is for FDI to continue at the same level. Russia is still not a "hot" investment destination, but for the investors already in place they are reinvesting every penny in expanding as fast as possible.
The outlook for capital flight is as uncertain as everything else. At the start of 2013 the CBR said that capital flight would fall to $10bn over the course of the year, yet that quite clearly didn't happen. The outlook for 2014 is equally optimistic, but economists are taking a more cautious stance given the last year's experience.
• 2013 budget for austerity
The new "budget rule", which fixes the price of oil used in the budget on the average of the last three years, is making itself felt as it translates into de facto curbs on budget spending.
Analysts have welcomed the introduction of the rule - which perversely has been introduced in the midst of a post-crisis attempt to recover - as it introduces some real fiscal discipline. "The CBR clearly believes cutting rates will not have much impact on growth, which is why it is focusing on alternative stimulus measures, such as the MTRO auctions, to inject liquidity into the system. That said, if the economy continues to struggle and inflation softens then expect a rate cut towards the end of the first quarter of 2014," Aton says.
The effect of this new fiscal rule is to de facto impose spending cuts on the budget year-on-year on the order of 5%, whereas budget spending has been rising on the order of 20% a year for most of Putin's reign. The evapouration of state spending in an economy where more than half of GDP is directly, or indirectly, tied to the budget, is another factor slowing growth. However, because of the rule this will not change and going forward budget spending will be lower and most closely linked to the long-term performance of oil prices, which are due to decline in the next few years.
• Revenues & spending
The budget of the central government is expected to run a deficit of 0.6% of GDP in 2013. Standard & Poor's thinks that earnings from the raw materials sector of the economy will decrease slightly following a drop in oil prices to $95 per barrel by 2015. As a result, the budget balance is expected to decrease step by step to a deficit of 1.5% of GDP by 2016, which is equivalent to average annual changes in total debt at the rate of 1.5% of GDP over the years 2013-2016.
S&P expects that the government's total liabilities will exceed total assets slightly beginning with 2015. A low level of the gross debt provides for a low level of the central government's expenditures for the debt service - about 2% of revenue.
"[Russia's] stable outlook reflects S&P's opinion that risks are balanced from the perspective of their impact on the ratings. The budget and the economy are still dependent on changes in prices for chief items of export, including oil in the first place. However, these negative factors are partly compensated by a relatively low level of the public debt and a relatively strong external position of the country," the rating agency said in a note in December.
Consumption was the main economic driver in 2013, but is likely to fade in 2014 and give way to investment. The problem is nominal wages have continued to rise, while company profits have not. This squeeze on margins will have to come to an end and either companies will cut wages or they will start sacking people in 2014. That would lead to a rise in unemployment from current 20-year historical lows that would also slow income growth.
The economic slowdown was starting to weigh on the consumer by the end of 2013 anyway. With consumer borrowing rising by some 40% a year for the last two years, repayments of loans started to eat into household budgets. Indeed, borrowing continued in 2013 in double digits, but Alfa Bank economist Natalia Orlova argued that increasingly consumers were taking out fresh loans to pay off old ones.
The upshot was that despite the robust growth in consumer borrowing, there was little impact on retail sales, which started to fade in the second half of 2013.
This is a very worrying trend, as consumption has become Russia's main economic engine. Ultimately consumption is linked to the general malaise hanging over the whole country and will recover if the rest of the economy recovers. The main point is that consumption alone no longer has the power to lift economic growth on its own.
• Inflation & overnight rates
Despite a decent harvest in 2013, as the year closed food prices were continuing to rise, keeping inflation at 6.5%, well above the 2013 target range of 5-6%.
The CBR, which is now governed by Elvira Nabiullina, a close ally of President Vladimir Putin, has unexpectedly persisted with its inflation focus and hence has not caved to pressure to cut interest rates. On her appointment Nabiullina was expected to be more dovish, but has turned out to be as much of a hawk as her predecessor.
The fight against inflation has been disappointing, with inflation remaining high in 2013 at about 6.3%, although core inflation is through to have declined to about 5%.
The inflation outlook for 2014 is much better. Morgan Stanley is predicting the rate will fall to 5.2% - close to the CBR target.
Sharply rising food prices have been the main factor in driving up inflation in 2013 (that and expectations for higher inflation). But Russia brought in a good harvest of about 95m tonnes of grain in 2013 and this alone should be responsible for bringing down inflation closer to the government target of about 5% in 2014, as well as adding about 0.4% to GDP growth.
In addition, the government has ordered regulated tariffs to be held below the level of inflation for 2014 - a very 1990s solution to high inflation - which will also bring rates down.
Progress in the fight against inflation will free the CBR to cut rates and this too should have a positive impact and support faster growth. "With a better harvest, monetary easing and some investment recovery, we think that Russian growth troughed in 3Q13 and will now recover gradually. Falling inflation opens the way for easier monetary policy. Still, we think that new Governor Nabiullina will err on the side of caution. In light of recent inflation persistence and the increased CBR focus on inflation expectations, we now pencil in a first 25bp cut in 2Q14 and 50bp in total in 2014," says Jacob Nell, chief economist at Morgan Stanley.
In the meantime, the CBR has continuously widened the trading corridor in which the ruble can move, and the plan is to make it a freely floating currency by 2015.
• Balance of Payments & imports
Russia's inability to export anything other than oil is finally coming back to bite it and the country is headed towards twin current account and federal budget deficits. This alone is a big goad for the state to finally tackle its structural reform issues.
"Despite weak growth, a ruble which has been flat in real terms [in 2013], exports supported by a strong oil price and subdued trade imports, Russia's current account surplus is set to halve from 3.6% of GDP in 2012 to, we expect, 1.8% in 2013, driven in particular by rising service, income and transfer deficits. As a result, we now see the current account in deficit in 2015, and see a weaker ruble, at RUB35 to the dollar by end-2014," says Morgan Stanley.
Read Russian OUTLOOK 2014 Part 1: Russia's growth model runs out of steam
Read Russian OUTLOOK 2014 Part 2: Turning more bullish on Russia markets
Read Russian OUTLOOK 2014 Part 3: Change afoot in Russian business and banking
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