Chris Weafer of Macro-Advisory -
It is axiomatic that every major sporting event has a distinctive theme tune and every financial crisis has at least one unique descriptive slogan or buzzword. In Russia today the competition for that catchphrase is between “localisation” and “the new norm”. A great deal has already been written about localisation, aka “import substitution”, but what exactly does “new norm” mean and how may it affect businesses and investment returns in the future?
The one point we can be sure of is that it will not involve a return to the old macro or growth model. Between 2000 and 2012 the Russian growth model was founded on an almost unprecedented consumer boom, which was fuelled by $3 trillion of trickle down oil and gas tax revenues and the start of the credit industry. That led to a dozen years of strong double-digit growth in the retail and other consumer sectors which, in turn, was the main driver of headline GDP growth.
That phase is now over and while the consumer and retail sectors are still capable of growing at rates above those of developed economies, the sector has matured relative to the end of the nineties and is no longer capable of driving strong headline growth alone. Russia needs a new growth driver and that has to be based on a big and sustainable increase in investment spending.
This is something that President Putin acknowledged publicly for the first time in his annual Federal Assembly Address in December 2013. Recall that growth in 2013 slipped to only 1.3%, from almost 4.5% two years earlier, and that despite oil averaging $110 per barrel and against a backdrop of global recovery. The message about the need for change could not have been clearer.
So, if we know that Russia cannot return to the old macro model, what new conditions can be created which will constitute the new norm?
It is fair to say that this is work in progress and while some revised policy priorities have become clear, there is still a lot more which is still unclear. Russia is at a crossroads and must decide on which road to take. This is unlike the 2009 recession when it was okay to simply sit it out and wait for the oil price to recover. This is one of those times when it really is different.
Of course the Kremlin could make the conscious decision to try to pursue a muddle-through strategy, i.e. a sort of cross your fingers, hope for the best and keep telling people that it will be fine tomorrow. That’s a sort of Brezhnev option and would more likely lead to borderline stagnation and poor investment returns. Eventually a long period of poor economic performance could create conditions for a colour revolution. It seems that many in the Kremlin are aware of this, and fear it, so that a do nothing option is most unlikely.
Those with a Russia phobia warn of a turn towards increased nationalism and isolationism, i.e. a sort of blame the West option as a possible distraction strategy. There is zero evidence that this is a plausible option being considered. On the contrary, there is plenty of evidence from the past 18 months which shows that despite the tough geopolitical rhetoric and threats, in the end the Kremlin has been careful not to push away Western companies and has been trying to limit the damage to longer-term recovery prospects. In any event a colour revolution would surely come much sooner down that particular road.
Instead the evidence suggests that Putin’s government is more interested in changing the model and creating conditions that can lead to a higher level of growth over the longer-term. Certainly for now the priority is maintaining stability and riding out the financial storm and almost all of the resources available to the government are being set aside to ensure that remains the case. Only when banks and industrial companies are again able to access international debt markets may we see a clear shift from planning and optimistic government rhetoric to specific actions.
But one part of the long-term recovery strategy has already been put into effect and that is the 180-degree change in the ruble policy. Ever since the 1998 default and ruble collapse the government has prioritised a strong and stable ruble policy.
There were several good reasons for that. The first being that the country was performing very nicely on the back of rising hydrocarbon wealth and had little need to create diversification or to boost such sectors as manufacturing. Russia could afford to import what it needed and people were very happy to spend the strong ruble on foreign holidays.
The second reason was because of the legacy of the 1990s during which there were several currency and bank crises. To some extent the ruble had become the bellwether of overall wellbeing in the country and so long as the ruble was stable and the state banks expanding there was no reason to worry about much else.
The third reason, which was especially evident in 2008 and 2009, was because so many of Russia’s industrial companies and banks had borrowed so much in low interest bearing foreign currencies on the assumption that there was no exchange rate risk. The 2008 oil price collapse forced the Central Bank to burn through around $200bn of its reserves to try to defend the ruble while Russian companies scrambled to convert their external loans into ruble debt. That situation has also changed completely and the risk mis-match is much less dangerous today.
Over the past six months the policy started to change. First there was no public panic when the ruble collapsed in December. For sure there were queues at ATMs but only to extract cash in order to buy durable goods that could have become scarce or more expensive in the months ahead. People no longer equated a ruble collapse with a broader economic threat in the same way they used to a decade or more earlier.
The key message that a weaker ruble is better than a strong ruble started to be better understood when the first quarter macro report showed a significant gain in some parts of domestic manufacturing as a result of the competitiveness boost from the ruble weakness in late 2014. Suddenly people were looking for cheaper domestic alternatives. We also now hear government officials linking the more “competitive” currency with the import-substitution strategy. The same can be said for the plan to try to boost exports in sectors outside of extractive industries. “Competitive Russia” may also become one of those slogans to be associated with this crisis.
The other epiphany we hear, and have seen in action, is the understanding that it actually matters much less where the oil price trades so long as the ruble is allowed to be flexible to compensate. This is one of the reasons cited by the finance minister for his concern about the strong ruble recovery in the three months to early May. He can more easily balance the budget with a weaker or flexible ruble.
It is early days yet and we should not expect any major new initiatives from the government until there is more confidence about financial sector sanctions ending and, perhaps, until the election process is completed. But what we do know with certainty is that the economy has survived the crisis and will pull out of recession in Q4 this year or early in 2016.
But just surviving is not good enough beyond the short term and, thankfully, it seems those with the power to make changes seem to understand that. There needs to be many changes in the years ahead, not least of which is the need to improve the business climate and boost competitiveness. But the shift in the ruble policy shows there is an underlying pragmatism. For businesses and investors looking past the current crisis that alone should offer a reason for optimism.
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