There are two Russias at the moment. The first is the evil “Putin’s Russia” that kills journalists, bombs civilians and invades other countries. Then there is “bull Russia”, where investors have been making fat profits as Russian assets of pretty much every sort handsomely outperformed the rest of the emerging market (EM) universe in 2016 and remain a top pick for 2017.
It has always been like this. When Putin came to power in 2000 the press corps spent the first six months writing “Who is Putin” stories, as we were not sure if he was an oligarch puppet or a strongman in his own right. That built into “Putin is an evil dictator” (if you were following the second Chechen war story or the jailing of Yukos’ Mikhail Khodorkovsky), and at the same time there was a “Russia is a wonderland of opportunity” story (if you were following the 50% gains the equity market was returning every year and the gold rush of foreign retail companies arriving in Russia to sell to the emerging middle classes).
In those first six months in 2000 I was asked to do an op-ed on Putin and came to the conclusion that there are two Putins: an economic one and a political one. (Appropriately his initials VVP are also the abreviation for GDP in Russian, while French reporters had to incorrectly transliterate his name to avoid calling him “President Prostitute” in their language.) The political Putin had just driven Boris Berezovsky into exile and arrested Vladimir Gusinsky and seized his NTV channel. Today, the political Putin has scaled up considerably and invaded Ukraine and become a warlord in Syria.
But the economic Putin introduced a federal treasury system to stop the stealing and a revolutionary flat tax regime that is still operating and put the federal government into profit – among a very extensive raft of reforms that got little attention at the time. The same thing is happening today: while there has been extensive criticism (including from me) of the government’s failure to put in deep structural reforms that would spur a return to strong growth, the Russian economy is actually doing remarkably well.
It has maintained its massive hard currency reserves (equivalent to a stunning 24 months of import cover and 75% of its external debt), external sovereign debt is risibly small, it continues to have a twin surplus (that used to be a triple surplus), and most have a job that pays okay, even by Western European standards (in PPP terms).
Where Russia is not doing well is in its failure to make broad reforms, which means it is growing by 1%, not the 6-8% it was in the noughties, and can’t grow more than 2.4% in the coming years, according to the Ministry for Economic Development (MED).
Is that a problem? Yes. Kinda. Consumers are being squeeze by the slowdown, but the stunning success of the Central Bank of Russia (CBR) in bringing down interest rates is already easing the pressure. And there are still some reforms going on, with events in banking being nothing short of revolutionary, as rotten lenders get culled by the score. The government is driving a fresh crack-down on corruption (although not yet having much success despite some high-profile arrests – Russia remains near the bottom of Transparency International’s newly released corruption index).
But most importantly, there are plenty of sectors that are just getting on with the job of growing. X5 overtook the investors’ darling Magnit to become Russia’s largest retailer this week. The fight for customers in telecoms is becoming intense. Agriculture is on a roll, and so on. That is why despite the 0.8% GDP contraction of the economy at the macroeconomic level in 2016, the Russian stock market returned over 50% in the same year, because at a micro-economic level there are loads of strong corporate stories where companies are making good profits and using the crisis to grab bigger market shares.
The bottom line is that Russia will always make a residual income from raw material exports irrespective of the price of oil, which puts it in a very strong position compared with its neighbours. It amazes me how commentators on Russia are perennially predicting “Russia will run out of money in a year” or “The revolution that will oust Putin is around the corner”, and it never happens. Thanks to this residual income Russia will keep bumbling along. When oil prices are low – as they are now – then the economy just ratchets down to a slower pace of growth – as it has now.
However, Russia’s sheer size, the volume of tax revenues it generates, the diversity of its economy and extra income it earns from its treasure trove of minerals means that even when it is going slowly, it retains significant geopolitical clout and can maintain a very powerful military without seriously risking popular unrest.
On the outside looking in
All this is very unsettling to the rest of the world, but it is increasingly split into the camps that see an economic Putin or the political one.
This month, the leaders in the US Congress announced they are about to introduce a raft of bills to try to make it impossible for President Donald Trump to lift the sanctions on Russia, while countries across Europe are doing everything to contain what they see as a bellicose bear that could invade them at any moment. German Chancellor Angela Merkel is fully on board with this message and has managed to use her authority in Europe to maintain the sanctions regime despite a growing chorus of complaints by other EU countries.
Then into this toxic atmosphere you have a bank like Societe Generale release its quarterly strategy report on Russia on January 19 entitled: “Focus Russia: investigating the Russia bull-case”.
“In two years, Russia has gone from being a feared and largely avoided jurisdiction (end-2014) to an all-time favourite (end-2016). The country is benefiting from a combination of improving macro fundamentals, credible monetary and financial authorities, and what is perceived as manageable political risks, making it the sweet spot in the EM universe. This already has been largely reflected in the valuations of Russian assets with the ruble acting as one of the best EM FX performers both in 2016 and early 2017, while the Russian local debt yields are breaching the 3-year lows under pressure from international buyers,” the report said in its introduction.
That report has just been followed by an upbeat report from Renaissance Capital’s Charlie Robinson, entitled “Moscow Calling: Russia’s rehabilitation rally reviewed”. The report was picked up by US investment newspaper Barron’s in a piece titled “12 Russians stocks to buy”. Russian equity and bond investors are expecting the rally to continue in 2017, albeit at a slower pace. The brokerage Aton Capital issued a 2017 equity strategy report in January – the first time the bank has bothered to issue this report in at least two years – predicting the RTS index will rise from its current value of about 1,000 to at least 1,330 this year, a 15% upside, or even 1,400 if the reset promised by Trump’s presidency appears.
SocGen says the driving force behind the rally is foreign investors, who have increased their share in Russia bonds from 26.7% at the start of last year to over 45% by the end. Europe’s investors are literally financing Europe’s biggest political and military threat. And this year’s Russian budget calls for a doubling of sovereign bond issues at home and abroad.
What to make of this dichotomy? And which part is the more significant: the business or the politics? Should investors even be investing in Russia in the face of its aggressive foreign policy and alleged hacking of the US elections? Give the volume of money that has flowed into Russia assets, it is pretty clear that investors don’t care much about moral questions. They take the line that the business of business is business and will go wherever they think they can make a buck.
The position of the politicians is more difficult, as they are caught in a dilemma between principle and pragmatism. In Europe, Merkel won’t budge on her insistence that the Minsk II agreements on ending the conflict in East Ukraine is the only way to end the impasse. But against this, in just the last week former EU boss Romano Prodi called for an end to sanctions on the grounds that they “don't work”. Likewise, the Belgian parliament’s commission for external affairs is about to have a second attempt at pushing through a resolution to revoke the EU sanctions against Russia.
The principled politics of the US and Germany have held sway until now, but newly inaugurated US President Trump is probably a pragmatist – certainly he likes to boast that he is above all a “dealmaker”.
There are many pragmatists in Europe who would like to see the dispute settled so everyone can go back to work. Russia remains by far the largest consumer market in Europe and until 2008 was ticking off a lengthening list of “biggest market in Europe for X”. While the Russian market is not the biggest export or investment destination for European businesses, it is still one of the most profitable, according to research by Aton. The German business lobby has been trying to pressure Merkel to kiss and make up with the Kremlin, while countries like France and Italy have openly said they want to find a way to drop sanctions. The motive here is that the business of politicians is to ultimately to manage the economy, as well as performing their social and civic duties. And our democracies are becoming ever more corporatised as relations between government and companies grow tighter – first and foremost in the US.
Of course, the situation is not black and white. Russian assets are performing well, as they are coming off a low base from the shock of the events in 2014. The stock market’s expected 15-20% gain this year will be less than half the gains of last year. And the amount of money flowing into Russian assets is still well below the levels that will make a noticeable difference to its economy. Foreign direct investment (FDI) into Russia in 2016 was $25bn, and almost all of that was money reinvested by foreign companies already in Russia, verses the peak FDI of $75bn in 2008, almost all of which was new money coming in from the outside.
And principles still count for something. Trump might want to withdraw the US from European affairs, but Congress will not. Merkel is up for re-election this year and has been badly wounded by a miscalculation with her “open door” policy to refugees. But as the opposition Social Democratic Party (SDP) doesn’t have a strong challenger, Merkel has a good chance of being re-elected.