“Constantly choosing the lesser of two evils is still choosing evil.” Gerry Garcia. Lead vocalist of the Grateful Dead  

Positive trend in GDP. Over the past month, two developments have stood out. One was expected and the other was not. The first is a strong bounce in the economy evident in the latest statistics. All major parameters have shown significant spikes in year-on-year terms – from GDP to industry, construction, retail sales and personal incomes. That was a widely expected shift driven by the base factor.

Ruble moves to the RUB80-90/$ band. The other development is a surprise: the ruble lost RUB10/$. As a result, the ruble’s trading corridor moved from RUB70- 80/$ to RUB80-90/$. This now appears to be the new reality for the struggling domestic FX market. Ruble devaluation will increase financial instability and is certain to strengthen the already rising inflationary risk in the coming months.

Budget support is now the top priority. The traditional key topic on the government’s mid-summer economic agenda is the budget-planning process. However, this year the budget discussions are being held in secret. The news that is filtering through shows that the main concern is to bring federal finances into balance without spending much of the accumulated reserves.

Implications for taxes and spending. The discussion is about budget consolidation. This implies the use of all available means to boost revenues, such as additional taxes (all areas) and a search for politically “safe” ways to cut spending.

Strong consumer sector recovery. Another important development is the quick recovery in domestic consumer demand. The expansion of public spending on salaries, pensions and funding for the military was a prime driver behind the reversal in the real wage growth trend. This trend is also supported by long-term structural shifts in the economy, such as the tightening of the labour market on the back of poor demographics and declining migrant inflows.

Inflationary risks are increasing. The growth in consumer lending has also boosted the recovery in demand. While these developments are met positively by the government, which sees them as key drivers for the new economy, they also trigger growing inflationary concerns among monetary authorities.

Forecast changes. The shifts in the macro dynamic led us to review our forecasts:

• Growth upgraded – the faster recovery warrants an upgrade to our estimates of GDP growth, industrial output, retail sales and real incomes. The tighter labour market means that low unemployment will last longer.
• Ruble downgraded – the recent devaluation, and the reason for it, prompts us to downgrade our 2023 average and YE23 forecasts.
• Inflation is unchanged – we retain our previous estimates for inflation and the key rate in 2023.
• Budget deficit grows – the approach of a new election cycle means that social spending from the budget will remain high and could grow further. That will support local demand but will also lead to a higher budget deficit.
• External accounts deterioration – the recovery in domestic demand has already translated into y/y growth in imports while export volumes continue to shrink in y/y terms. This resulted in a significant contraction of the trade and current account surpluses and led us to downgrade our estimates of external accounts.

Budget consolidation takes priority.

Currency stability was on top of the government’s economic agenda … In previous reports, we wrote that the Russian monetary authorities will probably make efforts aimed at stabilising the ruble exchange rate in the RUB70-80/$ range. We therefore chose to retain our FX rate forecast at a level of an average of RUB75.7/$ in 2023. We reasoned that for the Kremlin, the government and the CBR, the top priority of their monetary and FX policies will be to protect stability – that should include the economy as well as the financial market, inflation and the currency rate. Since any significant weakness in the currency always triggers – usually after a 1-2-month delay – a spike in retail prices for imported goods and services, we thought that the authorities would be hesitant to see a weaker ruble, as this could ultimately undermine their efforts aimed at controlling inflation and at ensuring continued macro and financial stability in the country.

… but that is not the case any longer. The events of recent weeks have shown clearly that the top priority of the Kremlin and the government has now changed. While it is still about stability, the notion of stability seems to be now centred around maintaining a fiscal balance and protecting the government’s FX reserves. According to data from MinFin, in June the government’s National Welfare Fund saw a monthly drop of $9.2bn, while the fund’s liquid assets fell by $4.1bn. From this perspective, any fluctuations in the FX exchange rate and even the inflation trend become secondary. But it would be incorrect to say that control over inflation has been completely taken off the policy agenda. That is not the case, but in the new reality such a goal is now left sole at the Central Bank’s discretion. At the same time, the government for its part seems to be prioritising the budget execution.

Budget consolidation has now become the main policy priority. The task of budget consolidation has been voiced recently by many government officials. Over the past 6-8 months their views have significantly evolved. Back in October-November 2022, government speakers were shrugging off any possible negative implications that the Western oil embargo and export oil price caps might have on state finances. Their view was supported by budget statistics which showed that in October-November the Russian federal budget was still running a hefty monthly surplus. Then in December 2022 Russia suddenly recorded a massive deficit of almost RUB4 trillion, which was again presented as no cause for concern and interpreted as a one-off due to a forward dispatch of federal funds from next year’s budget with the aim to ensure a more balanced approach to spending throughout 2023. Budget deficits were again reported in January-February 2023 but speakers from Russia’s Finance Ministry kept a brave face, arguing in their public communications that the budgetary situation should improve dramatically as the year proceeds.

Cabinet debates taxes and other means to increase the revenue flow. Around April-May 2023 the bullish mood started to gradually change when, following the start of the budget-planning process for 2024, as Russian government officials started to talk more frequently about the need for budget consolidation including a review of current and planned expenditures. That was accompanied by discussion of the need for new or a revision of existing taxes – the “windfall tax”, a hike in the oil price used for taxation purposes (via cutting the set gap between the Brent and Urals blends), re-introduction of personal tax on interest paid on bank deposits, and a new wave of discussion of a higher progressive personal tax rate, etc.

Spending cuts back on the Cabinet agenda. Attempts to boost the government’s revenue flows are also accompanied by a stronger push toward slashing some, less critical, fiscal expenditures. The efficiency of the way the Cabinet spends its money on many budget items has been recently questioned by a number of officials from Cabinet ministers to auditors of the Audit Chamber and a range of Duma deputies. The last such move came from Finance Minister Anton Siluanov who, according to media reports, on June 29 at a government meeting on the new budget draft suggested that all ministries should cut spending on their “non-protected” items by 10% y/y. While he did not specify what such items include, most probably the larger of these items could be expenditures on investment, road construction, economy, public administration and ecology. At the same time, “protected” items clearly will include social programmes, defence, education, healthcare, regional transfers and debt payments. We believe that this year’s budget process will be a difficult one, as the government is facing the major task to balance its finances in a situation where it no longer can rely on large inflows of oil and gas revenues or easy and almost unlimited access to the credit markets. Under these circumstances, fiscal tightening will come as unwelcome news for the economy, which in 2022-23 grossly benefited from a huge expansion in budget spending: MinFin data shows that in 5M23 nominal federal budget expenditures were 25% higher than in 5M22 and 49% above the levels seen in 5M21.

Ruble on a losing streak since December 2022. All these changes in attitudes coincided with some notable shifts in the dynamic of the ruble exchange rate. The ruble has been steadily losing ground since early December 2022, when Western oil price caps were put in place. There were two instances when this weakening trend was interrupted. The first occurred in late December 2022-early January 2023, which came as a timely act of support to Russian tourists who traditionally travel abroad en masse during the Christmas holiday season. The second period when the ruble’s weakness was briefly reversed during early May – again, that coincided with another traditional period of mass holiday travel from Russia.

Belousov announces a new RUB80-90/$ corridor for the ruble. Since mid-May the ruble’s weakening trend has continued without interruption. On June 15, during the St. Petersburg Economic Forum (SPIEF), First Deputy Prime Minister Andrei Belousov announced new trading parameters for the ruble – he said that in his view a trading range that is comfortable “for the Russian economy” lies in the RUB80-90/$ corridor. That confirmed what was already seen as a new reality by the market. However, still some hope remained that by late June, once the bulk of monthly and quarterly tax payments to the budget was complete, the ruble might bounce back to the levels around RUB80/$ or below. However, that did not happen once the main tax payments were completed on June 29; instead, the weakening of the Russian currency accelerated, and the ruble hit lows of RUB91/$ and RUB99/€ not seen since the end of March 2022.

Russian currency lost 50% of its value to a bi-currency basket in seven months. The best way to analyse the dynamics of the ruble exchange rate is by looking at its value to the $-€ basket. Such an approach helps to neutralise fluctuations in the $-€ currency pair. Our analysis shows that since early December 2022, the Russian currency has lost 50% of its nominal value to the bi-currency basket: if in late November-early December 2022, the ruble rate to the basket was in a RUB60-61/basket range, by early July 2023 the rate had dropped to RUB90-91/basket. The last attempt to reverse this trend took place in late April-early May 2023, when the basket value moved from RUB85/basket to RUB80/basket, but this happened only for a brief period.

Weak ruble benefits exporters and the budget … It is quite obvious that a lower ruble rate is quite beneficial for Russian exporters and the budget (the latter receives payments of export duties in nominal rubles, although such duties are set in dollars). A weaker currency helps the government to compensate for losses to the budget that are caused by lower prices and shrinking volumes of exports and trade earnings. Together with other initiatives – such as the introduction of higher (or one-off) taxes – the government attempts to significantly improve its fiscal situation. That, in turn, should allow it to skip using its National Welfare Fund as the main source for funding the budget deficit.

… but also leads to an increase in inflationary pressures. Such a policy does come with an important side-effect: it leads to a material rise in inflationary pressures. But that is a problem that the government and Kremlin have left for the Central Bank to resolve. In other words, the forthcoming July hike in the CBR’s official rate – if it materialises, as we expect – will also come as a logical result of the steps undertaken by the Cabinet and aimed at protecting the budget and state FX reserves.

Russia sees a growing deficit of fully convertible currencies. One other important factor that has added to the weakness in the ruble derives from the transformed structure of the Russian domestic FX market. The collapse in Russia’s energy and commodity trade with the West and the introduction of Western sanctions against Russia’s banking sector has effectively cut off Russia from a major part of financial flows in $ and EUR. Instead, Russia has switched to payments in alternative currencies, mostly the Chinese yuan and Indian rupee. However, as these currencies have limited convertibility, access to export earnings in these currencies is often limited. As a result, there has been a dramatic decline in volumes of FX traded on the domestic market – and this could not but increase negative pressures on the dynamic of the ruble’s exchange rate.