Alexei Devyatov of Uralsib -
The recent rally in oil prices has shown that the impact of high oil prices on the Russian economy has been reduced, and the economy has become more sensitive to government policy. The social security tax increase at the start of the year led to a contraction of capital investment and real incomes, which have still not recovered to their former level. The tax increase resulted in a deceleration of GDP and industry growth in 1Q11, which was aggravated by the appreciation of the ruble in real terms and attainment of full capacity utilization after the crisis. Given these factors, we have revised down our previous macroeconomic forecast rather than upgraded it based on a higher oil price outlook. Nonetheless, we maintain our fundamental view that the Russian economy will grow 2-4% over the next several years, which is above the DM average.
Given the oil price rally, we expect a stronger ruble and a smaller budget deficit in 2011. Ruble appreciation has forced the Central Bank to purchase foreign currencies, creating additional short-term inflation risks. However, now it appears that the bank has finally shifted its policy towards lowering inflation. Additional downward pressure on inflation will come from the adoption of a 6% regulated tariff growth cap for all users instead of the currently projected cap of 10-15%. We expect inflation in 2012 to reach 8.4% and in 2013 to come in line with our 6-7% long-term inflation target.
Reduced impact of oil on the economy
After remaining flat at about $75/bbl in 3Q10, oil prices started to climb in 4Q10, fueled by inflationary expectations and large volumes of free liquidity. The unrest in the Middle East and North Africa in 1Q11 pushed oil prices to above $120/bbl, which was followed by a correction to about $110/bbl. Nevertheless, an increase of over 40% in the oil price within a few months appears not to have supported the Russian economy to the extent it had in the past. According to the preliminary Rosstat estimate, 1Q11 GDP growth came to 4.1% YoY after growth of 4.5% YoY in 4Q10. The main reasons for the increasing insensitivity of the Russian economy to rising oil prices are related to ruble appreciation and inflation, which have eroded the purchasing power of oil. In the past, the Russian economy was supported by the volume of crude oil exports doubling between 2000 and 2005 and by a sharp increase in oil prices in 2007-1H08, which caused a temporary spike in both nominal and real oil revenues. However, since 2006, the volume of oil exports has stagnated, largely due to production constraints.
The purchasing power of oil is a combination of the nominal oil price, the nominal exchange rate and inflation. It is more meaningful for the real economy than the nominal price because it shows directly the amount of goods and services oil exporters receive in return for a barrel of oil. Surprisingly, despite its high volatility, the purchasing power of oil has not increased in the last decade. Moreover, in real terms oil at $26- 28/bbl in 2000 was more expensive than it is at $110-120 in 2011. Over the past decade, inflation has eaten away the four-fold increase in the oil price. This is also the reason why in order to both maintain the real value of budget expenditure and to balance the budget, Russia has needed constantly increasing oil prices. Given the stagnant volumes of oil exports and the high inflation, we expect a gradual contraction in the purchasing power of oil, as well as the real revenues from oil exports.
The implications seem to be clear: the impact of high oil prices on the Russian economy will remain moderate, unless prices reach $200/bbl in the next couple of years. Even though the risks of further escalation of civil unrest in the Middle East could lead to such a scenario unfolding, we do not believe this will happen. Consequently, Russia will have to gradually learn to manage without primary dependence on oil and find alternative growth sources. Therefore, it is not surprising to hear calls for the drastic need to improve the investment climate and to attract foreign direct investment, as both state officials and the private sector share the same concerns.
Industrial production to slow down due to the strong ruble
Even though expensive oil's impact on the real economy seems to have been reduced, high oil prices have led to massive currency inflows, resulting in real ruble appreciation. In turn, the strong ruble has led to a surge in imports, which have substituted domestic goods. After the sharp devaluation of the ruble in early 2009, the Russian manufacturing industry benefitted from import substitution due to a contraction of 34.3% in imports in 2009. In 2010, imports bounced back by 29.7% and have continued to rapidly grow in 2011, which has eroded the import substitution effect and slowed down industrial output growth. The growth of capacity utilization, which has almost reached pre-crisis levels in 1Q11, is another source of industrial deceleration. Operating at almost full capacity requires new capital investment in order to boost production. Installation of new capital is an expensive and time consuming process, which is not allowing industrial production to grow as fast as it expanded in 2010 through increased utilization of existing spare capacity. These factors are responsible for the trend of decelerating industrial output, which emerged in February; after several months of stable industrial growth at 6-7%, in February growth slowed to 5.8% YoY, followed by YoY growth of 5.3% in March and 4.5% in April. We expect that trend to continue, leading to industrial output expanding 4.9% in 2011.
In February, the real ruble-dollar exchange rate reached its pre-crisis high of July 2008 and surpassed it later on. A strong ruble makes imported goods affordable, which in turn boosts imports. Except for the seasonal troughs at the start of each year, statistical data shows a very close correlation between the real exchange rate and the volume of imports. We expect that with oil prices above $100/bbl (which we believe will prevail for most of the year), the ruble should appreciate to the dollar by 13% in real terms. Ruble appreciation will lead to 34.2% growth in imports to $334 bln in 2011 - most of this increase will come from import volumes rather than prices.
On the other hand, high oil prices boost export revenues, whereas export volumes respond only marginally to price changes. Thus, exports are strongly correlated with commodity prices and, in particular, with oil prices. Given our expectations of oil price dynamics, we think that exports will grow 29.6% to $518.7 bln in 2011. Unlike imports, most of this growth is price-based rather than volume-based; we expect export volumes to increase by only 6.4%. Our calculations show that because of the substantial increase in oil prices, in nominal terms, exports will outpace imports in 2011. This will lead to a higher trade balance of $184.7 bln and a current account surplus of $92.5 bln versus $151.4 bln and $71.1 bln, respectively, in 2010. However, due to expected relative stabilization of oil prices towards the end of 2011, imports will grow faster than exports starting from 2012. This will lead to a gradual decline in the trade balance and in the current account surplus in the medium and long term, with the current account balance dropping to zero in 2015.
Tax increase at the start of the year has hurt the economy
2011 started with the social security tax rate rising from 26% to 34% of gross wages and since the social security tax in Russia is paid solely by employers, such a massive increase in the tax burden put businesses under strong financial pressure, with an estimated increase of RUB800-900 bln in companies' tax load in 2011 or roughly 2% of GDP. This resulted in businesses reducing capital investment and in lower real disposable incomes for the population, which have been declining YoY since January. Because the Russian economy has become increasingly detached from commodities, income contraction poses a major threat to domestic demand, which is the key driver of economic growth. A clear sign of weaker consumer demand has been given by the deceleration in retail sales since the start of the year. As a result, Rosstat's estimate of 4.1% YoY GDP growth in 1Q11 has come as a negative surprise for the government, which expected 4.5% YoY growth in 1Q11, and is also slightly below consensus expectations of YoY growth of 4.2%. We think that the weak investment dynamics pose additional downside risks to the economy over the next few months because the lack of capital investment will lead to slower growth in industrial capacity, which in turn will put additional constraints on future economic performance. We therefore expect the Russian economy to grow 4.3% in 2011.
Given the relatively healthy fiscal position of the Russian economy, boosted by high oil revenues, we believe that a tax cut would be the most appropriate fiscal policy response to boost the economy. The monetary policy measures used extensively in 2009 to fight the adverse consequences of the financial crisis have exhausted their potential, which makes fiscal stimulus all the more needed. The government is now considering lowering the social security tax. However, the key issue of the debate is focused on which taxes should be raised to compensate the loss to the budget. Excise taxes, primarily on alcohol and tobacco, are most likely to be raised substantially. Other options include changing the social security tax withholding scheme, increasing the tax on personal income, and using part of the extra oil revenues to finance the deficit. We believe that a reasonably good short-term solution for financing the reduction in the social security tax rate would be to use oil revenues, moderately increase excises on alcohol and tobacco, and increase the efficiency of government spending. A long-term solution requires the long-term sustainability of the Russian pension system, which is currently heavily unbalanced. This would include unpopular measures, such as an increase in the retirement age and nominal pension freezes, to be implemented by the next government.
Ruble to continue fluctuating
The sharp increase in oil prices, which started in late 2010, has resulted in substantial ruble appreciation. The nominal ruble-dollar exchange rate has appreciated about 10% between November 2010 and April 2011, while the real ruble-dollar exchange rate appreciated by more than 13% in the same period through an increase of about 40% in the price of Urals oil. The data clearly demonstrates that the primary catalyst behind both the nominal and real exchange rate dynamics is the oil price. The Central Bank's interventions in the forex market have had a limited influence on the nominal exchange rate and almost no impact on the real exchange rate.
We expect oil prices to correct moderately downward over the next few months. The primary factors responsible for the recent price hike are inflationary expectations driven by large volumes of free liquidity due to the soft monetary policies followed by leading industrial countries and the dramatic events in the Middle East. We believe that the situation in the Middle East, especially Libya, will gradually settle down over the next few months. The amount of free liquidity and thereby inflationary expectations should decrease by the summer, when the US will wind down QE2. Liquidity may be additionally decreased by monetary tightening in the US when the Federal Reserve decides to shift its focus on domestic inflation. We therefore expect oil prices to return to the $90-100/bbl corridor in autumn 2011 and remain there for a few months. The quite sharp decline in oil prices in the first half of May 2011 might be the first stage of this oil price correction.
We believe that the long-term oil price dynamics will be shaped primarily by global supply and demand for oil. We expect demand for oil in the US and EU to grow by 1- 2% over the next couple of years, which can be compensated by OPEC spare capacity, which is currently about 4 mln bpd, even after taking into account the shortage of supply from Libya of 0.3-0.5 mln bpd. However, we note that a good deal of OPEC's spare capacity is held by Saudi Arabia, which is unlikely to let oil prices fall below $90/bbl. The main reason behind Saudi's willingness to maintain the "fair" price is increased social spending, which needs to remain high in order to prevent civil unrest in Saudi Arabia. In particular, a report published by the Institute of International Finance in May suggested that Saudi Arabia's budget breakeven oil price rose sharply from $68/bbl in 2010 to $85/bbl in 2011 and would further increase to $110/bbl in 2015. The $90/bbl lower bound of the oil price will also be supported by other OPEC members with high budget-balancing price requirements, such as Iran. Besides OPEC's spare capacity, other potentially very large sources of new supplies are NGLs and Iraq, which aims to raise its production capacity to 12 mln bpd by 2015, which would be almost on par with Saudi Arabia, from its current capacity of 2.5 mln bpd. Although the target seems unrealistically ambitious at first glance, it reflects Iraq's long-term potential, which we believe is large enough to stave off a global supply crisis for five-ten years starting from 2015.
Given the fundamental balance between the supply and demand for oil, we expect that starting 2H12 oil prices will resume moderate growth in line with inflation in industrialized economies. This implies that relative to the dollar, the ruble exchange rate will appreciate by 4-7% in real terms in 2012-13 and by 1-2% starting from 2014. The nominal exchange rate, however, will be more volatile and to a larger extent will track nominal oil prices. Thus, we expect moderate ruble depreciation in 2H11, following the expected decrease in oil prices, to be followed by slight appreciation in 2012 when oil prices begin to rise again. Starting 2013, we expect the ruble to resume gradual depreciation, which will be primarily due to the differential between long-run inflation rates of 6-7% in Russia and 2-3% in the developed countries.
Federal budget surplus
The sharp increase in oil prices boosted federal budget revenues, resulting in a federal budget surplus of RUB134 bln, or 0.9% of GDP, in January-April 2011. Revenues amounted to RUB3.34 tln (38% of the annual projection) and expenditures came to RUB3.21 tln (30% of the annual forecast). According to the budget amendments submitted to the State Duma, the 2011 federal budget deficit forecast has been reduced to 1.3% of GDP (RUB 719 bln) assuming an average Urals price of $105/bbl compared to the previously projected deficit of 3.6% of GDP (RUB 1.8 tln), based on an average Urals price of $75/bbl. Given the high revenues from oil, the government raised expected budget expenditures by RUB418 bln, pushing the budget-balancing Urals price to $119/bbl (based on rough estimates, an increase of 1$/bbl adds about $1.8 bln to the budget, conditional on annual oil production of 500 mln tons). Given our average Urals price forecast of $110.6/bbl in 2011, we estimate the federal budget deficit at RUB450 bln or roughly 0.9% of GDP, which is slightly less than the revised government projection.
The high oil revenues have revived the government's intention to replenish the Reserve Fund, which was heavily depleted during the crisis, with its value declining from $140 bln in September 2008 to $25 bln in January 2011. Since then, cash withdrawals from the fund have stopped and its value was estimated at $27 bln in May 2011. The government's current plan is to increase the size of the Reserve Fund to about $50 bln towards the end of the year. Given the projected federal budget deficit of 1.3% of GDP, implementation of that plan requires a commeasurable increase in government borrowing, which is consistent with the government's intention to diversify the sources of financing the deficit. In addition, such diversification allows the Finance Ministry to effectively target government bond yields. Given Russia' relatively strong fiscal standing, the ministry has decided to practically cease borrowing abroad, which implies that the total amount of borrowing in domestic markets in 2011 may amount to RUB1.4 tln.
Inflation risks remain high
Inflation started to rise sharply in mid-2010, driven by a dramatic hike in food prices following the devastating drought and contraction in agricultural output. The Central Bank's soft monetary policy, aimed at preventing excessive ruble appreciation after its sharp depreciation in early 2009, and a 10-15% increase in regulated tariffs in January 2011 also contributed to the rise in inflation. As a result, inflation almost doubled from 5.5% YoY in July 2010 to 9.7% YoY in January 2011. Since then, inflation has stabilized and even slightly decreased on a YoY basis to 9.5% YoY in March and to 9.6% in April 2011. April was also the first month since the summer of 2010 when food was not the primary inflation driver, as the prices of non-food items and services rose at a faster pace. The relative price stabilization in 1Q11 was assisted by the government's efforts to contain fuel prices, which were growing in response to surging oil prices. However, despite the relative stabilization of inflation, we think that inflation risks remain high and expect inflation to increase in the summer to double-digit values, driven by the Central Bank's soft monetary policy and a rebound in fuel prices, which the government is clearly unable to control.
Given the high oil prices, the primary objective of the Central Bank's monetary policy was a weaker ruble in order to support domestic producers. Even though the bank has consistently talked about its intention to change its monetary policy objective towards inflation targeting since 2005, if not earlier, it had not taken any significant steps in this direction. However, in late 2010 and early 2011, the bank finally took measures aimed at the gradual transition to inflation targeting; including the abolishment of a fixed corridor for the ruble, widening the inner flexible corridor, and lowering the amount of interventions to defend the flexible corridor. A more important policy change was related to the substantial decrease in the volume of CBR interventions in December 2010 and January 2011, which allowed much greater flexibility for the ruble. These measures have been accompanied by the introduction of a series of reserve requirements and rate increases to further tighten monetary policy. However, faced with the dramatic increase in oil prices following the escalation of civil unrest in the Middle East, the Central Bank, resorted to currency interventions in order to limit a sharp appreciation of the ruble. In particular, the Central Bank purchased $3.5 bln in February, $4.5 bln in March, and $3.2 bln in April. Nonetheless, we believe that the Central Bank's priority is to maintain low inflation, so it is likely to substantially limit future forex interventions and raise interest rates and reserve requirements several more times this year. Although we maintain our fundamental view of inflation at 6-7% over the long-term, the bank's change in attitude towards prioritizing the importance of low inflation has implications for our medium-term inflation forecast, which we have lowered to 8.4% in 2012, 6.8% in 2013, and 6.9% in 2014 - still above the official inflation targets.
In April, Prime Minister Vladimir Putin ordered the government to investigate the possibility of reducing regulated tariffs for all users to levels in line with projected inflation, which, according to government officials, will be 5-6% in 2012. The order was issued in reaction to a series of annual regulated tariff increases, which outpaced consumer inflation by 5-10% and therefore are one of the key inflation drivers. These annual tariff increases have pushed most regulated tariffs close to tariffs prevalent in developed markets. Government officials are claiming that high tariffs are hurting the Russian economy and must be contained. The final decision, however, is unlikely to come earlier than late summer and, if passed, will impact both inflationary expectations and future inflation. We are, however, skeptical that tariff reduction would come into effect at levels of 5-6% for 2012. There are many factors supporting our stance, aside from the fact that our own estimates show that the announced inflation target is not realistic, ranging from high capital investment demands, existing obligations in investment contracts with long-term strategic investors, the strong lobbying power of the key natural monopolies, and the historically poor track record of the government in opposing their demands. Nevertheless, a tariff growth cap of 5-6% would lower consumer inflation by 1.2-1.5% in 2012 and by 0.4-0.8% in the following years, bringing our long-term inflation projection close to 6% per annum, in line with the proposed tariff cap.
Heavy capital outflows from Russia
After a period of modest capital outflow in 1H10, capital started to fly out of Russia at an astonishing pace in 2H10, resulting in total capital outflows of $35.3 bln in 2010, of which $21.5 bln exited in 4Q10. In 4M11, capital outflow amounted to $28.1 bln, which now appears to be forming a new trend. We also note an almost perfect correlation between the trade balance surplus and capital outflows, which emerged in August 2010 at the peak of the devastating drought. This implies that oil revenue does not remain in the country: it enters Russia via the current account and exits via the financial account, being invested in foreign assets. The Central Bank refers to these outflows as a "search for quality". On the other hand, in the past few months, Russia has benefitted from substantial inflows of short-term speculative capital, driven by investor presumptions that high oil prices are good for the Russian economy. Although this has apparently led to an increase in the capitalization of Russian public companies, it is primarily invested in blue chips, which would allow investors to withdraw capital quickly should market conditions change. That, in turn, has increased market volatility and investment risks.
We note that the trade balance and capital flows had apparently decoupled in 1H10, implying that there was a shift in investor attitude towards Russia in 2H10. This was triggered primarily by the following factors: (1) the severe drought last summer, which increased the uncertainty about the prospects of the Russian economy and thereby investor concerns; (2) the projected increase in the social security tax at the start of 2011, which increased negative investor sentiment; (3) long-standing Russian problems such as bureaucracy and corruption; (4) increasing political uncertainty as investors have become increasingly worried about the upcoming elections and the possibility of disagreements within the ruling tandem. The drought resulted in an economic slowdown in 3Q10, and its adverse effects were not confined to the agricultural sector but were felt in all sectors of the economy. The tax increase reinforced expectations of the possibility of additional tax hikes to finance increased social spending during the upcoming election. In addition, many investors think that faced with modest tax revenue growth and increased spending, the government will increasingly resort to predatory behavior with respect to businesses. As a result, in 2010, foreign direct investment fell to $13.8 bln from $15.9 bln during the crisis in 2009 and $27.8 bln before the crisis in 2007. In 1Q11, foreign direct investment, driven by oil prices, grew 48.3% YoY; nonetheless, we expect Russia to receive $21.8 bln through FDI in 2011, which is in line with the projected FDI in Kazakhstan in 2011 - a country which is a tenth of the size of Russia.
The downward trend in foreign direct investment has forced President Dmitry Medvedev to announce a set of policy measures aimed at improving the investment climate. The most important of these measures are a cutback in the recently raised social security tax, a 15% decrease in the expenditure of the state procurement system, the creation of a state direct investment fund to co-finance investment projects, and the creation of an investment ombudsman institute. The reduction in the tax load on businesses should increase their profitability and improve negative investor sentiment. The government is also debating potential sources for financing the proposed tax cut. One such source should be a reduction in government spending, in particular, in the state procurement system, which is both corrupt and inefficient. The state's direct investment fund should both reassure investors that the government is serious about protecting their investment and create the necessary motivation for the state to protect investors from the opportunistic behavior of local bureaucrats. As regards investor protection, an investment ombudsman can play a very important role in mitigating the conflicts between investors and local officials. Later, when the Russian legal system becomes fully mature, the investment ombudsman can transfer its powers for resolving conflicts to the general courts.
There is an ongoing debate both in the government and the private sector on the sources of revenues needed to compensate the loss to the budget from the proposed tax cut. However, little attention has been paid to federal budget expenditure, which accounts for over 20% of GDP. Since the beginning of the 2000s, price growth in the state sector has been consistently higher than price growth in the private sector. Part of the dramatic increase in the government expenditure can be explained by a sequence of indexations of state employee wages, which outpace inflation. However, at the same time, there is ample evidence that the government spends inefficiently, in particular through the state procurement system. A few months ago, President Medvedev announced that about RUB1 tln out of the RUB5 tln which Russia spends on state procurement is stolen. This is a huge loss to the budget which clearly shows that Russia needs to dramatically improve the efficiency of its budget expenditure.
Budget efficiency can be improved by the adoption of performance budgeting where most of the budget expenditure is allocated to specific state programs, which jointly cover most of the government's functions. The key aspect of performance budgeting is preliminary, interim, and final program efficiency evaluation based on cost-benefit analysis. The central questions of the analysis are (1) whether the benefits to society from the implementation of the government's program exceed the costs and (2) whether it is possible to increase the benefits given the costs. Performance budgeting is currently central to budget planning and execution in developed countries. The adoption of performance budgeting requires enormous methodological efforts because of the need to develop an explicit system for measuring both effectiveness and efficiency in diverse areas of state activity, such as health care, education, and infrastructure. The preliminary steps to adopt performance budgeting in Russia have been taken; however, this will probability result in a mere reshuffle of budget items. The creation of an independent institution to evaluate efficiency will be crucial for success. Given that people who evaluate government programs in developed countries are often subject to pressure from state officials, it is important to provide them with immunity at the same level as federal judges.
Russia needs strong institutions for long-term growth
We expect the Russian economy to grow about 4% on average in 2011-13 and starting from 2014, at 2-4%. Russia is an extremely interesting case. On the one hand, it has huge human capital and abundant natural resources. On the other hand, there is a lack of opportunities for transforming that potential into strong economic growth and prosperity. The main obstacles are an uncompetitive economy, an addiction to oil; poor demographics; weak institutions; and as a consequence, a poor investment climate. Administrative barriers make it more difficult for entrepreneurs to enter the market, which reduces competition and results in higher prices. The businesses suffer from pervasive corruption, which has effectively turned into unofficial tax burden in Russia.
To attain rapid economic growth and prosperity, Russia needs to drastically improve its institutions, which means removing an entire class of corrupt officials. Unfortunately, over the last ten years, little has changed in terms of the quality of institutions, not least because those interested in maintaining the status quo have sufficient power to effectively block the reforms. Still we see the potential for gradual institutional changes as the government intensifies its efforts to fight corruption, to improve investment climate, and to modernize the economy.
However, Russia is only in the beginning of a long and winding road towards its new institutions. That makes us look with caution into the distant future, so that our long-term outlook is for growth of 2-4% rather than 5-7%, which could occur under fully developed institutions. We recall the words of Russian envoys sent to the Varangians some 1,150 years ago: "Our land is vast and abundant, but there is no order in it." It still seems to be true today; it will hopefully change in the coming years.
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