Russia doomed to recession

By bne IntelliNews December 19, 2014

Ben Aris in Moscow -


1.0 Economics


1.1 Economics overview

The mood amongst Russia watchers is as black as it has always been in the midst of one of Russia's major crises. The forecasts for 2015 are almost – but not unanimously – bleak. The crash of the ruble by 10% in a day on December 15 and the subsequent 650-basis-point hike in overnight rates by the Central Bank of Russia (CBR) bring to 17% consigned Russia to a deep recession of a 4.5% contraction, according to the CBR statement following the rate hike. 

What happens next will all depend on where oil prices settle (Brent oil was $60 a barrel at the time of writing) and how much of the CBR's $420bn in hard currency reserves it burns up managing the exchange rate in an effort to stave off a crisis-inducing panic.

Uralsib said in its 2015 outlook that if the ruble continues to tumble, then "Russia would experience economic deterioration on the scale seen in the early 1990s." But this has to be balanced by Russia macro fundamentals, which remain fairly solid, whereas in the 1990s the country was bankrupt.

There is one glimmer of hope for the economy in 2015, largely championed by Evgeny Gavrilenkov, chief economist at Sberbank and an economist of formidable power, who cannot be written off lightly. He is arguing that the problem is the lack of stability in the ruble/oil prices, rather than the level they fall to. If both stabalise quickly, then the devaluation of the ruble will lead to a surge in import substitution investment and give the Russian economy a shot of vitality that will keep growth positive in 2015.

The OECD agrees, saying in November: “Russia would fall into recession if oil prices continue to decline, but sustainable import substitution could provide some boost for the economy."

Gavrilenkov told bne IntelliNews in December that in his trips to the regions, the bank's rich clients there were borrowing and actively investing into import substitution production, and these will get a boost from the increasingly cheap ruble. There was a noticeable upswing in industrial production and manufacturing in the last months of 2014 and agricultural in particular expanded by 16.6% in November, so the idea is not ridiculous. 

Without doubt, the devaluation of the ruble comes with some beneficial effects, as was clearly seen in 1998 (the last time the mood was this black), which led to a surprisingly fast rebound (GDP grew by 10% in 2000, still a record). Really, the debate is over how strong these effects will be – and that comes down to your view on where oil prices will settle and how the political problems Russia is facing will play out.


1.2 Triple whammy crises


Russia was suffering from three simultaneous crises as 2014 came to a close.

The first and most obvious was the military standoff between Russia and the West over Ukraine and the political crisis that led to tit-for-tat sanctions that have wounded Russia's economy. The financial sanctions imposed in the autumn have in effect cut off all Russia's leading banks and corporates from cheap, long-term international funds.

The second was the tanking oil price and associated ruble/dollar exchange rate, which came more-or-less out of the blue. Russia's currency had been losing value all year, but the declines accelerated alarmingly in the last months of year as oil prices dropped below $70 and then $60 in the space of a few weeks. The outlook for oil prices in 2015 remains subdued (see commodities section), but a consensus seems to be that oil will stabilize at about $70, or possibly lower.

The third, and least obvious, but probably the most significant, is a domestic investment crisis; Russian companies are not investing in their production and fixed investment has been flat or negative for several years. Without investment the economy will stagnate and incomes will gradually fall, undoing the sense of prosperity that Russian President Vladimir Putin has been able to deliver in his 14 years in office – both of which were already visible by the end of 2014. The results of this crisis of confidence amongst domestic businessmen are manifest everywhere, including a drum-tight labour market, soggy GDP growth, falling real income levels and cheapening ruble.

Going into 2015 and economists in Russia were almost universally pessimistic, predicting at best stagnation, at worst recession. "Our base case… assumes virtually no economic growth in Russia for the next two years," says Uralsib. "Russia has faced neither stagnation nor stagflation in the post-Soviet period. This presents a serious challenge to corporate capex plans and policies, as well as the overall investment attractiveness of Russian capital markets."



1.2 Chances for resolution to the political crisis


It is pointless writing a detailed analysis of the chances for a resolution to the political crisis, as the situation is far too fluid and the two sides have dug their heels in too deep. Moreover, the fact that both sides – the Ukrainian government and the Russian government – are fighting each other by using military militia (Ukrainian "volunteers" on one side and "holidaying" Russian soldiers or separatist rebels on the other) introduces a wildcard, as was seen by what appears to be the accidental shooting down of the commercial MH17 commercial flight by pro-Russian rebels. Neither side fully control their combatants; they can encourage them to fight easily enough, but they can't order them out of the field with any certainty of being obeyed.

bne IntelliNews' view is that a political compromise will be found, maybe as soon as in the first half of 2015, as both Russia's and Ukraine's economies are in deep trouble and neither can afford a protracted conflict. But sanctions could easily be in place for years. Certainly, the liberals in the Russian government in charge of economic planning assume sanctions are not going anywhere any time soon. Economic Development Minister Alexey Ulyukayev said in an interview that he expects sanctions to remain in place until 2017. Russia’s earlier macroeconomic forecast assumed that the sanctions would be lifted in 2015, Ulyukayev said.

The issue is to find a compromise on the key points: Russia is insisting on a "100% guarantee" that Ukraine won't join Nato, and that its strategic and commercial interests are taking into account in any deal with the EU; Ukraine (and the EU) is insisting Russia withdraw its support for fighters in the eastern Donbass region and Russia stop interfering in Ukraine's internal politics.

The forces pushing the two sides towards a deal include first and foremost this is not an ideological confrontation, the main difference with the Cold War conflict. Russia now shares the capitalist ideology with its opponents and everyone, including the EU, want to go back to doing business and making money.

Secondly, no one can afford a protracted standoff. The pain of the conflict is hurting everyone really badly. Ukraine was on the cusp of collapse in December and desperately needs to start the process of reform. Russia economy is slowing and the financial sanctions imposed in September 2015 have proven to be extremely effective and are really hurting the Russian economy. It can not grow or develop while cut off from the international capital markets irrespective of how much money the Chinese lend the Kremlin. Europe too is sliding back into recession and is still in the middle of the Eurozone crisis, although reporting on this has been pushed into the background in 2014. It is squandering scarce political and financial resources on the dispute that it needs to spend at home to fix its own problems.

Globalisation was the phenomena of the naughties and the showdown has split Europe into blocs again, but this bucks the historical trend for further and deeper global integration. While the politics have become divided, the underlying business relations remain integrated and continue to function: German businesses already in Russia (6,500 companies, ten-times the rest of Europe) are still earning profits and investing into what is already the second biggest consumer market in Europe, which remains their most profitable market in Europe. And as was noted above, Russia can't develop without access to the capital markets in London and New York.

That leads to a mismatch between the political rhetoric and business interests. The politics have mostly been couched in terms of the ideal that countries have an inalienable right to chose their partners, but ignores the realpolitik that small or weak countries have to take the interests of their larger/more powerful neighbours into account. Business doesn’t give a fig for ideology and will go where the markets are rich.


1.3 GDP predictions


Picking through the estimates for Russia's growth in 2015 and bne IntelliNews can't remember when there was less agreement about growth predictions for the upcoming year.

The bne IntelliNews consensus for growth is that Russia will finish 2014 with about 0.5% growth, but there will be a recession in 2015 with -0.2% growth. However, this number went out the window in mid-December by the rate hike, highlighting the unrepdictability of the situation. The CBR is predicting a 4.5% contraction in 2015 and all other predictions have been thrown out of kilter as a result. 

Everything depends on where the oil price settles. At the time of writing, the price for Brent was $60 and the expectation is it will bounce back to at least $70 in 2015, but predicting oil prices is a mug's game. Certainly Russia will fall into a recession in 2015, but if oil prices do recover to $70-$80, the contraction will be less pronounced. Then a mild recovery is possible in 2016.

The other wild card is whether the US and/or the EU impose more sanctions on Russia. Again at the time of writing, the US was proposing a fresh round of sanctions and US President Barack Obama is signaling he will sign them, even though he is clearly under pressure by his European partners to limit sanctions. Likewise, the EU sanctions on Russia are due to automatically expire in May, but it is not clear if the EU will vote to renew them for another year. Everything depends on Russia's willingness to deescalate the fighting in East Ukraine in the meantime – and there were signs that Putin has had enough of the conflict in December. 

"The conflict and associated sanctions have exacerbated a downward trend in GDP growth, the result of years of under-investment in non-energy sectors and diminishing efficiency and increasing costs of oil and gas extraction," Moody's said in a report.

In the meantime, the Eurozone crisis continues and will weigh on Russia regardless of the other factors, plus the global economy is cooling, which will also hold back a strong rally in oil prices. This compares to the OECD's Global GDP growth projection of 3.3% in 2014, before accelerating to 3.7% in 2015 and 3.9% in 2016. This pace is modest compared with the pre-crisis period and somewhat below the long-term average. The euro area growth is far weaker and that will weigh on Russia: the OECD is projecting Europe to grow by 0.8% in 2014, accelerating slightly to 1.1% in 2015 and 1.7% in 2016.

“With the Eurozone outlook weak and vulnerable to further bad news, a stronger policy response is needed, particularly to boost demand,” said OECD's chief economist, Catherine L Mann. “A Europe that is doing poorly is bad news for everyone.”


1.4 Oil price scenarios


The fall of the ruble in the last months of 2014 was down to the fall in the oil price. The ruble lost 50% of its value against the dollar in 2014 (although a lot less against the euro, which is Russia's main trade exchange currency, due partly to the dollar's strong outperformance).

In December, the Economic Development Ministry presented its new macro forecasts for 2015, incorporating a downgrade in oil price expectations from $100 per barrel to $80. "The new oil price of $80-90 per barrel is most likely to stay over the medium or even longer term," Siluanov told Russia's upper house of parliament in November. However, within a week even $80 looked hopelessly optimistic. Oil plunged through the $70 mark and was at $60 at the time of writing. Oil prices have been losing about $10 a month for the last three months, leading some investment banks to introduce a $40 oil scenario in their 2015 outlooks.

The plunging price of oil has made forecasting what will happen to Russia's economy in 2015 impossible, so most banks were issuing scenarios.

While it lies outside our competence, bne IntelliNews finds the argument that there is a floor at $70, as this is a price that will see many marginal US shale producers and fields close, and remove 2mn-4mn barrels a day of production and so stabilise prices. However, we don’t expect this mechanism to kick in until the second half of 2015, so the rest of winter and spring months could be very uncomfortable.

Also it should be noted that December was clearly marked by panic, as the usual rule of thumb linking oil and the ruble had broken down: usually each $10 movement of oil prices down shaves RUB2 off the exchange rate to the dollar. This means that at $70 the ruble should be about RUB42, whereas in the middle of December it was RUB53 and at $60 oil the ruble fell to RUB66 to the dollar at the time of writing, whereas the rule of thumb should put the rate in the late 40s. 

It seems probable that during the panic on the currency markets the pendulum swung too far and the ruble rate to the dollar will recover next year. CBR Governor Elvira Nabiullina said that speculators were to blame for 8 to 10 percentage points of the currency's 49% depreciation since January. She predicted that the Russian currency will rise again in 2015. "The ruble will appreciate significantly next year, given an overshoot effect and a rise in oil prices," she said, referring to official forecasts of the Central Bank.


Oil risk scenarios for Russia in 2015

Oil price (Brent $/barrel)









Real GDP growth YoY









RUB/$, annual average









Inflation, annual average









Budget balance, % GDP









Source: Renaissance Capital estimates 


1.5 Budget


The biggest impact on Russia from the falling ruble is its affect on the budget. Oil tax revenues (and to a much lesser extent, taxes on gas exports) make up well over half of the budget revenues.

Russia's Federation Council approved the federal budget for 2015-2017 on November 25 that assumes deficits for each of the next three years.

In 2015, budget revenue will stand at RUB15.1 trillion and spending at RUB15.5 trillion. However, on December 15 the government announced it would cut the budget spending by 10% because of the economic slowdown, which should leave the budget flat in 2015.

"If approved, this will mean spending of RUB14.0 trillion in 2015, or flat year-on-year, instead of the previously drafted 11% year-on-year increase to RUB15.5 trillion; and this cut would first of all be positive for budget stability: under our base case RUB48/$ exchange rate assumption, the 2015 breakeven [price of oil for the budget] could be as low as $80/bbl. Secondly, it would show much needed support for the CBR in its inflation-targeting efforts, being a long-term positive macro development," says Natalia Orlova, chief economist at Alfa Bank.

It should be noted that while a $100 minimum oil price for the budget to break even is widely quoted, this ignore the appreciatory effect on Russia's dollar-denominated exports a devaluation of the ruble that actaully increases the number of rubles the budget receives. Accounting for this effect, the breakeven price falls with the falling ruble. While depreciation is still painful – largely by pushing up the rate of inflaton – a falling oil is not per se a disaster for the federal budget, as long as the ruble falls in step. Since the ruble was floated in November 2014, the Russian economy has become a lot more flexible and able to absorb these external shocks. 

While details were not available, if the budget spending cuts are made, then it will be the first year-on-year budget spending cut in about a decade; in the boom years, budget spending was increased by about 20% a year, although more recently increases were below the level of inflation.

In 2016, revenue will amount to RUB15.8 trillion and spending to RUB16.3 trillion.

In 2017, revenue will amount to RUB16.55 trillion and spending to RUB17.1 trillion.

GDP is expected at RUB77.50 trillion in 2015, RUB83.21 trillion in 2016, and RUB90.06 trillion in 2017.

Inflation will amount to 5.5% in 2015, 4.5% in 2016, and 4.0% in 2017.

Russia will borrow RUB1.28 trillion on domestically, but the annual $7bn of borrowing on foreign markets in 2015 has already been cancelled. Borrowing of RUB1.09 trillion in 2016, and RUB1.23 trillion in 2017 is planned after that.



1.6 Effect of falling oil prices on the budget


Falling oil prices have made predicting the budget performance very uncertain, but falling oil prices also have much less of an effect on budget revenues than first appears.

As the oil price assumption in the budget is set in dollars, but the spending is set in nominal rubles, if the ruble falls against the dollar, then the amount of rubles created for the budget when the government converts its oil tax dollar revenue actually increases. So as long as the ruble's fall at least tracks the oil price fall, the budget is not badly affected.

And that is what happened in December. Instead of causing a deficit, Russia was expected to end the year with just under 2% of GDP surplus. However, these rubles are worth a lot less and this dynamic also leads to surging inflation and slower growth, which will inevitably affect the state's finances and cause a deficit.

"In the event current levels of the ruble/oil remain in place ($/RUB50.0 and $70/bbl), the budget deficit is likely to increase from 0.6% GDP to 1.3% GDP with the dollar-denominated breakeven oil price reaching the $85/bbl level," Deutsche Bank said in its 2015 outlook. "Overall, the sensitivity of the budget to oil prices remains high. The non-oil deficit increased significantly from 2009 after an abrupt fall of oil prices and subsequent increases in social outlays. Since 2011, the breakeven oil price fluctuated within the range of $100-$115/bbl in 2011-2014. At the same time, in ruble terms, the oil prices remained at the level of RUB3,500/bbl in 2012- 2013."

Deutsche Bank made a sensitivity study that compares combinations of oil prices and ruble exchange rates to product a budget deficit/surplus.

Roughly speaking, any oil price above $85 with a dollar/ruble exchange rate below RUB55/$ will produce a surplus and anything below/above that will lead to increasingly large deficits.



1.7 Oil price scenarios


Taking out the comments from the banks on some oil prices:

$100: In December Putin signed off on a budget that still assumes $100, although the CBR's official position is that oil will average at $95 in 2015 and has $80 as its "pessimistic" scenario. Everyone else has $80 as their optimistic scenario.

$80: This is the price most people were expecting until the December sell off and collapse of oil prices,  and have as their basis or optimistic scenarios. Deutsche Bank says $80 is its "optimistic scenario" that includes full withdrawal of sanctions in 2015 and an increase in energy prices to levels of $85-90 that would lead to a small deficit and even mild growth. However, $80 is also the CBR's official "pessimistic scenario," but would still not do that much damage.

However, others like Uralsib, see even $80 oil as a disaster.

"An average oil price of $80 would lead to a 5% contraction in GDP in 2015 and the ruble failing to recover materially from the current levels," says Uralsib, equating $80 with the sort of pain that Russia suffered in the early 1990s. In addition, a weak ruble depresses investment activity as about 50% of Russia’s imports are machinery and equipment required for capital investment," Uralsib says highlighting Russia's Achilles' heel. "A lot will depend on liquidity provisions by the Central Bank, which may have to spend $50bn-60bn ln next year to support the ruble."

$70: Alfa Bank is more sanguine and says that even if oil falls to $70, then the GDP decline would be limited to 0.2% with a ruble rate of RUB48/USD1, as the economic theoretical value at this price. This is in keeping with the $10 oil fall produces RUB2 exchange rate movement and so Natalie Orlova, Alfa Bank's esteemed chief economist, is arguing that Russia will return to its previous equilibriums next year and that the pendulum has swing too far at the end of 2014.

"Our expectations that the oil price may recover to $95-100/bbl now look very unlikely, at least if there is no major increase in geopolitical instability in the Middle East and there is no major shift in US monetary policy toward easing," Alfa's Orlova said in her outlook for 2015. "Under a $70/bbl scenario, which we previously considered the worst case (now our base case), we expect GDP to decline 0.2% y/y and the ruble exchange rate to stabilize at ~RUB48/$. The worst case is now $40/bbl, under which GDP should decline ~4%, and the ruble exchange rate could go as low as RUB56/$."

$60: The CBR has explicitly ruled out this scenario, but not so other analysts. Deutsche Bank now takes this to be its pessimistic scenario that would include a significant escalation of sanctions by the West accompanied by further weakness in energy prices. By the end of the year this scenario was looking increasingly likely. 

$40: few bankers believe that oil can fall to $40, but some included it in their outlooks even before December's selloff, as in early 2009 oil did briefly fall below $40. "The worst case is now $40/bbl, under which GDP should decline ~4%, and the ruble exchange rate could go as low as RUB56/$. 12% inflation is done deal for 2015 and could go higher in the event of a dramatic fall in the oil prices," says Orlova.


1.8 First budget spending cuts, non-oil budget


Almost a third of Russia's budget is targeting increased spending on the military. Russia will take defence spending to 3.8% of GDP – well ahead of Nato's obligatory 2% of GDP spending, but still behind the US' 4%-plus spending.

The liberals in the government are not happy with this setup and Alexei Kudrin quit as finance minister over the issue. But Putin has committed himself to a complete revamp of Russia's military and is willing to sacrifice growth and badly needed investment for this end.

A key change to Russia's budget for the last few years is that while spending increased each year by about 20% in the boom years, more recently the increases have slowed to 5%. In 2015, for the first time in a decade the government is looking to cut spending by about 5%. This more than anything has caused the economy to slow and will lead to even more slowing.

Part of those cuts will come in the form of cuts to public sector workers, which make up a quarter of the workforce (more if you include those connected to, but not directly on, the public payroll), who have been enjoying pay rises well above the rate of inflation for most of the last decade. However, pay rises for civil and government worker are now rising below the rate of inflation, which will feed through to lower consumption and retail turnover.

The change can be seen in the non-oil budget deficit – the deficit that Russia would have if you magically made all the oil disappear. The non-oil deficit is a much better way of understanding Russia's spending habits. The government uses oil income to subsidize the rest of the economy, but in the boom years limited this to a non-oil deficit of about 4% (headline surpluses were large and positive).

During the 2008/2009 meltdown the non-oil deficit ballooned out to 13% of GDP and even the headline deficit became negative. The liberals in the government want to return to a 4% non-oil deficit but the military spending is keeping this deficit closer to 10% of GDP.

Putin is pushing the envelope and spending as much as he thinks he can get away with to modernize the military as fast as possible, at the risk of destabilizing the economy. This represents a big change in the way the country is run. Rather than prudentially using the oil revenues to build up reserves, Putin has chosen to treat the headline deficit as the key number, not the non-oil deficit as was the case under Kudrin. Policy is now geared to keeping the headline deficit slightly above zero.



1.9 Debt redemption


Another big worry connected with falling oil prices is whether Russia can meet its debt obligations?

At 13% of GDP Russia's sovereign debt is extremely modest, but corporate debt is higher at about 33% of GDP, or $731bn a of June 2014. Of this three-quarters is denominated in foreign currency (Russia introduced ruble-denominated Eurobonds a few years ago), which become more expensive to service the further the ruble falls.

Debtors have been anticipating the sanctions and have been building up reserves of cash in 2014 so can meet their payments in 2014 and 2015 without much help. Moreover, about half of the debts owed are owed by Rosneft and Gazprom, both of which earn dollars from exports and so can finance their repayments out of their cash flows.

Maturity: However, corporates owe a lot less than they did in 2008 and the average loan maturity has also increased dramatically, with half the outstanding debt having a maturity of two years or more as of December 2014. 

Breakdown by type of debtor: The largest component of debt is attributable to banks and other non-government sectors, which together owe more than $650bn to foreign lenders, 17% of which is short-term, and much of which (46%) is attributable to state-owned banks and enterprises. Banks alone have $192bn external debt (about 10% of GDP), up from $170bn in 2008, and from $18bn in 1998. Companies directly under Western sanctions account for about 60% of the debts due.

Repayment schedule: $35bn of debts are due in December, but another $150bn is due in 2015. However, with the new freely floating ruble and the significant reserves, Russia should have no problem covering its debt in 2015.

More than half of this debt ($90bn) is owned by just two state-owned companies, Rosneft and Gazprom, both of which earn hard currency for their exports and both of which are able to pay their debts out of their cash flow, so this will have no impact on the CBR's reserves. The current account surplus of about $60bn should be enough to cover the rest.

In any case, Russia's companies and banks have spent 2014 year building up hard currency reserves and according to Moody's are already in a position to meet their obligations. JP Morgan estimates Russian banks have accumulated $292bn in foreign assets as of December 2014.

Moody's drove the point home in a report issued on December 5 entitled "Foreign Exchange Reserves Decreasing but Sufficient to Cover 2015 External Debt Needs."

"According to official data, the Bank of Russia (CBR)'s [foreign currency reserves] (as of 1 December 2014) are at $361bn. This is more than sufficient to cover the country's external debt payment obligations through 2015, which amount to roughly $130bn across government, banks and corporate debt," Moodys concluded. "That assumption holds even when excluding the $150bn of FXRs counted as the central bank reserves that come from the government's two special savings Funds – the National Wealth Fund (NWF) and Reserve Fund (RF). While these two Funds have specific mandates and are therefore unlikely to be used either to intervene in the foreign exchange market or to finance the government's external debt payments, like the CBR's own reserves, the amounts placed in the central bank contain liquid, marketable assets, that can be utilized if required."



1.10 Ruble weakness


The ruble lost about half its value in 2014 and fell in line with the oil prices – as it should. The CBR was intending to free the ruble from the exchange corridor in January 2015, but acted a month earlier after oil prices began falling.

That was because the Kremlin did a gear change in the last two months of 2014. There was an expectation that sanctions might be lifted in November, but it didn’t happen and the Kremlin is now expecting the political problems, and the sanctions in particular, to persist, possibly for years. This has caused a change in thinking at the CBR, which is now much more focused on preserving the crucial hard currency reserves rather than defending the exchange rate or smoothing the trading bumps with large interventions.

This change in tactics has unsettled traders and cause a mild panic on exchange markets, sending the ruble outside its normal the rule of thumb of a RUB2/$1 movement for each $10 change in the oil price. At the time of writing it remained moot if the much deeper devaluation of the ruble than economics fundamentals will persist as a "new normal", but more likely the ruble will appreciate from its RUB55/$1 with oil at $65 in 2015 if stability returns to the oil price. However, a weak ruble, while it has a muted impact on the budget, will hurt the wider economy if low oil prices persist.

"Liquidity shortages would deepen the ruble depreciation, which, contrary to conventional wisdom, would hurt rather than support the economy – as a weaker ruble fuels inflation, hurts real incomes, and depresses consumer demand, which has been the main economic driver recently. In addition, a weak ruble depresses investment activity as about 50% of Russia’s imports are machinery and equipment required for capital investment," says Uralsib.

The minimal intervention on the forex markets by the CBR in December took traders by surprise, but currency traders are facing a CBR with a new modus operandi of random interventions to discourage speculation.


1.11 Capital Flight


Capital flight also remains elevated. It almost doubled in 2014 from 2013 to an estimated $120bn and in December the CBR said it would remain at this level in 2015 as well "in all scenarios."

But drilling into this number and it is not quite so scary. Firstly, Russia is a net exporter of capital, and always has been, as it invests more money overseas than it receives as investment – mostly in the other Commonwealth of Independent States (CIS) countries. This "capital flight" has been running at about $50bn a year for five years to 2013, much of which is invested into companies in other countries in the CIS.

Secondly, a quirk of Russia's accounts mean that the profits earned by these Russian-owned firms abroad that are reinvested in these foreign companies are counted as "capital flight" too – almost no other country does this – and runs at some $20bn a year.

Thirdly, some of this money is foreign banks with subsidiaries in Russia, where the subsidiary is taking money from the cash-rich Russian branch and lending it back to the foreign parent bank – although this has dropped off significantly since 2009.

And finally, after slowing down in the middle of this year, "capital flight" took off again in the third quarter of 2014 to the tune of just under $30bn. But this was exactly the same time as Russia was cut off from the international capital markets by the EU-US financial sanctions. In other words this is not Russian money fleeing a collapsing Russia, but simply companies that are unable to refinance their debts so are paying them off with cash instead, argues Sberbank's Gavrilenkov, thus reducing Russia's vulnerability to shocks even further. The economy already started to deleverage in the third quarter of 2014 as external debt decreased by $53bn to $678bn, which more-or-less accounts for all of the increase from 2013 capital flight level of $63bn.

It should also be noted that even if total "capital flight" this year is $120bn, this is still only 6% of GDP – well down on the approximately 15% Russia was losing a year in the 1990s when capital flight really was capital fleeing the country.


1.12 Incomes and inflation


The main impact from the 2014 currency crisis will be to depress incomes for the first time in nearly a decade, with far-reaching consequences.

In the short term many analysts are expecting a spike in prices in January-February; many retailers have held off increasing prices to off set the soaring inflation and rocketing exchange rate dynamics on imports as they sell off inventory. However, in the New Year they will have to adjust prices to match the new realities and that could mean 10-30% price hikes in both the first two months of 2015. The impact on incomes in 2015 is expected to be significant before recovering in 2016.



The falling ruble will feed inflation, which is the main macroeconomic problem for 2015, together with the lack of investment.

The CBR has had to abandon its mid-2014 target of 5% inflation and was resigned to inflation soaring to at least 12% in 2015, probably more. 

As companies are squeezed, the real wages growth stalled in mid-2014 and turned negative for the first time in almost 14 years at the end of 2014. "Accelerating inflation, the risk of new rate hikes and the lack of aggressive social spending will weaken retail trade growth in 2015," says Alfa's Orlova.

Even during the crisis years after 2008, incomes continue to rise at about 10% a year. However, companies are increasingly being squeezed between the rising cost of borrowing and lower sales. A very tight labour market, with unemployment at historic lows, means they had to continue to increase wages, but this situation is clearly unsustainable.

And the government can't help; social payments in 2015 will only be increased 5.5% year-on-year, less than inflation, which will undermine retail trade growth and depress consumption.



"Real wage growth has been much faster than productivity growth since the early 2000s, which has reduced the competitiveness and profitability of Russian firms. But this cannot continue indefinitely and wage growth will have to re-adjust to a much weaker pace of productivity growth," says London-based consultants Capital Economics.

The mismatch between wage growth and slow growth in productivity has finally caught up with Russia and kicking in now. Moreover this comes just as Russian households' ability to borrow has been constrained. A consumer credit boom that came to an end at the start of 2014 and now households are deleveraging as they borrowed too much. "Households’ balance sheets are starting to look stretched and, at the same time, structurally high inflation and persistent capital outflows will keep domestic monetary conditions tight," says Capital Economics.

To make matters worse for the average Russian, unemployment has started to rise slowly, albeit from very low levels, although Russia will not see European levels of joblessness. Unemployment has been at a record low of about 4.9% and is expected to rise to around 5.5% in 2015.



1.13 Russian slowdown in consumer spending is here to stay


Consumer spending has been the backbone for Russia's economic growth for much of the last decade and the only thing propping up the otherwise terrible macroeconomic story in the last few years, which has culminated in the current undeclared triple-dip crisis.

Capital Economics is even more pessimistic and thinks not only will consumption fall further, but it will remain weak for years to come. "Consumption growth has been the key driver of the Russian economy over the past ten years. And even though overall GDP growth has been slowing for the best part of the past two years, for most of this time, consumer spending has remained relatively robust. However, this has now started to change. It looks like consumption is on course to grow by just 1.5% in 2014. This compares to annual growth rates of 5-6% in recent years," the company said in a paper at the end of November. The outlook for 2015 is more of the same or worse.


1.14 Capital investment contracting


The real crisis in Russia is the lack of investment, which has been absent for several years now due to the uncertainties of Putin's politics.

Externally the conflict with the West and the prospects of a war have made domestic business nervous, but internally the de facto renationalization of Bashneft, a privately owned oil company that the state took over in December, has undermined confidence in property rights and also acted as a deterrent to investment.

Capital investment has been negative almost all year. It contracted 2.9% year-on-year and has been shrinking all year, bar one month in the summer. Uralsib predict a 3% contraction in capital investment in 2014 and an even deeper contraction in 2015 due to massive capital outflows, the high level of uncertainty surrounding the Russian economy and ruble weakness.



1.15 Interest rates


The CBR was under a lot of pressure in the first half of 2014 to cut rates to promote growth, but as the currency crisis got worse it ended up hiking them five times, raising the overnight rate from 5.5% at the start of the year to 17% by the end.

The last two large back-to-back rate hikes in December had no affect on the ruble/dollar exchange rate, as traders thought the CBR had done too little too late. But the fundamental problem was the ruble was tracking the oil price down so rates have little relevance. The upshot is the CBR has made an already difficult situation for business worse by raising the cost of capital further without stemming the devaluation.

Some economists are hoping that the ruble will readjust in the first quarter, bringing down inflation and allowing the CBR to cut interest rates. Previous tightening of the monetary policy did not influence inflationary dynamics, the CBR said in December, and the regulator is committed to cutting rates as soon as the turmoil is passed and the oil and exchange rates stabilize.

CBR Governor Nabiullina hopes the easing can start in the second half of 2015, "as soon as inflation and inflation expectations show they are slowing… once the temporary effects are played out."

Nabiullina unleashed another ‘dove’, saying that the central bank "will not fight inflation at the expense of the economy." This shows its clear understanding that permanently tightening monetary policy in Russia would not prevent accelerating inflation, but mostly slash economic growth. But this remains an optimistic scenario. 


1.16 Gross international reserves


At the end of 2014 there was a spate of articles suggesting that Russia was running out of money and could go into default in 2015. The Economist ran a cover story claiming that, "Russia is closer to crisis than the West or Vladimir Putin realize," because it was running out of money. This was followed by Professor Anders Aslund of the Peterson Institute for International Economics, who said in a blog that nearly $200bn of Russia's $420bn of hard currency reserves at the start of December 2014 somehow "don’t count" and that it doesn’t have enough money to meet its debts.

However, these pieces are pure scaremongering. Of the $420bn, $45bn are gold reserves, and another $172bn are held in the two reserve funds under the control of the Ministry of Finance and not the CBR, but actually held on the CBR accounts. Although this money is not quite as liquid as the cash that the CBR holds, it is still available to help shore up the economy if needed, said Moody's in a report.

"According to official data, the Bank of Russia (CBR)'s [foreign currency reserves] (as of 1 December 2014) are at $361bn. This is more than sufficient to cover the country's external debt payment obligations through 2015, which amount to roughly $130bn across government, banks and corporate debt. That assumption holds even when excluding the $150bn of FXRs counted as the central bank reserves that come from the government's two special savings Funds – the National Wealth Fund (NWF) and Reserve Fund (RF). While these two Funds have specific mandates and are therefore unlikely to be used either to intervene in the foreign exchange market or to finance the government's external debt payments, like the CBR's own reserves, the amounts placed in the central bank contain liquid, marketable assets, that can be utilized if required," Moody's said.


1.17 Capital controls


The CBR burnt through approximately $100bn in 2014 trying to keep the ruble in the exchange rate corridor before finally abandoning it in November.

This led to the speculation that Russia was going to reintroduce capital controls. Bloomberg wrote a speculative piece suggesting this was the case at the end of September. The CBR virulently denied it was the case within an hour and has repeatedly said it will not introduce capital controls. The Daily Telegraph ran a similar piece in November also suggesting capital controls were on the way.

Capital controls are an instrument of last resort used by countries just before they run out of money. As Russia still has 1.7 years of import cover as reserves versus the three months' worth most economist believe is the minimum necessary to ensure the stability of a currency, Russia remains a very long way away from the need to impose capital controls.

Russia nixed the last 10% mandatory conversion of 10% of hard currency earnings in May 2006 after the country's reserves had risen from $180bn at the start of the year on the way to $300bn at the end of 2006.



1.18 Trade and current account balance


The brightest spot in the Russian economy at the end of 2014 was that the devaluation has further improved its trade balance and the country was running a triple trade/current account/federal budget surplus – pretty much the only major economy in the world to do so.

The devaluation of the ruble killed off imports while exports remained strong. Russia's current account doubled in size in the second half of 2014 and was expected to be $60bn by the end of 2014, or 3% of GDP. The trade surplus was also supercharged by the falling ruble and expected to be up year-on-year to some $200bn.

"Currency weakness is likely to prompt the population to spend less on imports; thus, we expect a significant reduction in imports of goods and services next year. We expect the CA balance to improve to 5.5% GDP in 2015E gradually declining to 4.9% GDP in 2017E," Deutsche Bank said in its outlook.


1.19 How much has devaluation cost?


Trade is another place where the devaluation comes with pluses as well as minuses. One article suggested that the devaluation of the ruble had reduced the dollar value of the Russian economy from $2.1 trillion at the start of 2014 to $1.4bn at the end, knocking down from 8th largest economy in the world to 13th, or on a par with Spain. This is equivalent to a 34.6% contraction.

However, this was simply recalculating the value using the exchange rates at the start and end of the year and is shoddy economics ($2.1 trillion times RUB32/$1 in January 2014 to give a ruble value, then dividing by RUB53/$1 rate in December to convert back to dollars = $1.4 trillion, or a $700bn worth of value destruction.)

This sort of calculation fails to take into account the fact that Russia exports annually some $500bn worth of goods (mostly oil and gas), where the devaluation calculation above works in reverse and increases the value of exports to $700bn. It also ignores the fact that the state debt of RUB1 trillion also becomes cheaper thanks to devaluation, but as Russia has only $50bn of external debt the $15bn increase in the cost of this debt due to devaluation is negligible. Adding in this factor and Russia's economy contracted, in dollar terms, to $1.88bn, or only 4.5%.

Finally, in reality most of Russia's trade is actually with Europe and denominated in euros, not dollars. Part of the ruble's rapid fall against the dollar has been due to the rapid rise of the dollar against all world currencies. If the change in the economy's value over 2014 is recalculated in euro terms (RUB49.2/€1 in January vs RUB62.6/€1 in December), then Russia's economy has only lost 3.1% of its value due to the currency crisis and is still the eight largest economy in the world.



2.0 Banking and Finance


2.1 Banking overview


Banks have been in the front line in 2014. Firstly, the Central Bank of Russia (CBR) killed off their most profitable business, consumer lending, at the start of the year to pop a ballooning consumer credit bubble.

As of the end of 2014, about one in five Russian banks were making a loss and few retail orientated banks were making money. The number of profit-making credit institutions (including those whose profit is zero) decreased 18.6% to 646, according to the Bank of Russia's statistics as of November 1, 2014 year-on-year – and the same is expected in 2015.

However, the fall in the profits of banks fell at a slower pace, which suggests the banking business is becoming more concentrated in the top banks. Total net profit of state banks was RUB416.7bn for three quarters of 2014 versus RUB394.7bn for the same period in 2013. In particular, net interest and commission income of state banks increased 21.3%. This increase together with profits from operations with foreign currency allowed the state banks not only to make up for nearly double growth of net expenses for provisions, but also to cover losses from operations with securities.

The financial sanctions on a handful of state-owned banks made the entire Russian banking sector toxic, cutting it all off from the international capital markets. Banks were left to fund their business the traditional way – by raising deposits.

The upshot is that while asset growth continues and were up by 22% in 2014 to RUB70 trillion, profits have fallen to an estimated RUB750bn for 2014, or down by a quarter year-on-year. At the same time the lack of funding means banks have been dipping into their own capital to fund operations and the sector's capital adequacy rate has fallen from about 20% in the boom years to 12.4% by the end of 2014, but still above the mandatory minimum of 10%.

Non performing loans (NPLs) are ticking up, especially in retail loans, but are still on the order of 5% of total loans and well within the manageable range.

The banks remain well capitalised, the state has offered significant support and no one is expecting a financial crisis in 2014. But the banking sector is doing little more than treading water and cannot contribute to economic growth until its funding problems are solved.

Lending and deposits growth for the sector should remain around 10% in ruble terms in 2015, as Russian companies will need to refinance through the domestic banking system as long as the international wholesale markets remain closed.

The CBR published benchmark rates for capping unsecured consumer loans for commercial banks in Q1/15, under a law that was passed in the end of 2013 over increased concerns about overheating in unsecured crediting sector.

The CBR has been worried about a possible consumer credit boom and so capped the main interest rates banks can charge. It calculated that rates on POS-loans will not be allowed to exceed 55%, credit card loans 35%, and new car lease rate 20%. Before the outbreak of the Ukrainian crisis, the International Monetary Fund (IMF) mission to Russia listed rapid growth (30-40%) of the unsecured retail credit sector as one of the main risks to the short-to-mid-term outlook.

Funding costs are expected to continue to grow, but these costs should to some extent be passed on to clients in the form of higher rates on loans (further slowing the economy), which was already happening at the end of 2015.

The banks have proven to be resilient in the current environment and 2015 will see them grind out more, albeit modest, growth. Their return on average equity (ROAE) will be depressed and organic capital generation will be subdued, making recapitalization a necessity for some banks. The CBR, for its part continues to close smaller and iffy banks at a pace of about 50 a year -- a process that has gone smoothly – and will continue to whittle way at the deadwood banks in 2015. "Even if our pessimistic scenario of low oil prices and a weakening economy and ruble fails to materialize, we could see certain banks fail to meet capital requirements, thus raising the general level of uncertainty and apprehension in the sector," says Andrew Keeley, a banking analyst with Sberbank.

In a desperate move to stop the ruble sliding, the CBR hiked interest rates by a surprise 150 basis points in late October. The move didn't work and the ruble continued to slide, but one of the knock-on effects is that analysts are expecting bank deposits to rise in 2015 as a result of the higher interest rates on offer.

Corporate deposits continued to grow twice as fast as retail deposits (24% year-on-year in nominal terms in October compared to 10% year-on-year for retail), and the share of funding from the CBR rose to 9.2%, a new post-2009 high in 2014.


2.2 Russia's savings dilemma


Savings are the natural funding base of investment. The rate of savings in the Russian economy has been on a continuous decline since 2012. Based on desired long-term economic growth of 3-4% per annum, bankers estimate that the Russian economy was underfunded in 2014 by about 5% of GDP, or RUB3.8 trillion.

CBR is currently the only sources of longish term money for the economy. But the cost and term of the money is determined in the market where households offer their savings and entrepreneurs place demand on them. When the central bank offers its own money (it can easily print) to finance investment projects (as the CBR is planning to), this leads to a distortion of economic incentives and creation of moral hazard.

Domestic savings are now the only source of funding for investment projects within Russia. So the question is how much savings Russia needs to ensure sustainable development?

2011 resembles Russia's long-term norm. Periods of active savings accumulation generally correspond to periods of rapid economic growth. This was true before the crisis in 2008 and has remained true since then. In 2011, after the trough of 2008-09, Russia's GDP growth stabilized at 4.3%, with the ratio of savings to GDP at 32.9%, slightly below the levels of 2006-07 (which were among the most economically successful years in Russia's history).

The Russian economy underfunded by 5.2% of GDP, or RUB3.8 trillion in 2014, Uralsib estimates. The calculation is straightforward: the difference between the savings rates in 2011 and 2014 multiplied by nominal GDP in 2014. According to the same formula, the savings deficit last year was 4.4% of GDP, or RUB2.96 trillion. To rebalance the situation the government has to persuade the population to voluntarily shift an amount equal to 5% of GDP from consumption into savings.




3.0 Capital Markets


3.1 Equity


The outlook for Russian equities in 2015 is at best unpredictable and at worst dire. The outcome will depend heavily on the outlook for oil. Given the uncertainties over where oil prices are headed, it is already clear the previous highs set pre-crisis in May 2008 of 2487 for the RTS and post-crisis record of just over 2000 will not be obtained in 2015.

The Russia story of consumer-led fast growth, high margins and increasing penetration has got lost in the Katyusha barrage of bad news. The economy and political news have become the main drivers for stock prices. "The Russian financial markets have become increasingly driven by domestic news flow rather than global sentiment," Uralsib said in a report.

Politics was written large over the stock market's performance in 2014. The market tumbled hard following Russian President Vladimir Putin's decision to annex Ukraine's Crimea in March, but then rallied through to September 5 when a summit in Minsk agreed a ceasefire. However, the failure for real peace to take hold subsequently meant the RTS Index remains bound in a range of approximately 1,100-1,400 and is unlikely to break out unless there is significant progress in the international diplomatic situation.

Bad news at home is also pulling prices down. Russian stocks have always traded on a price/ earnings (P/E) multiple in the single digits, whereas the other leading emerging markets have re-rated and trade on multiples in the teens. However, Russia's stocks have generally outperformed their emerging market peers on the basis of strong earnings growth, thanks to Russia's large and increasingly affluent consumer market.

That won't happen in 2015, as poor economic growth is putting pressure on earnings. Real incomes turned negative for the first time in a decade at the end of 2014, poor economic growth, high inflation and an absence of domestic investment are all going to push consumption down and so will drag stock prices down with them.

Finally the Russian market has almost totally decoupled with the rest of the world's stock market performances and become a special case in the minds of most investors, pushing valuations down, as the news has been unremittingly bad.

According to Uralsib, the 52-week rolling correlation of the RTS with the MSCI World has dropped below 0.3, while the correlation with emerging markets remains just above 0.5, while the domestic story is being ignored. "The main factors that investors are reacting to these days are on the economic front. These factors include the ruble dynamics, oil prices, capital outflows and indicators of the level of stress in the financial system," says Uralsib. "Political news with the potential to trigger new economic sanctions has become the second most important factor. The last time the Russian markets were correlated this weakly with the global markets was in 2002-04, when Russia was barely on the radar screens of international investors."

A clean outcome to the Ukraine conflict will be the big driver for the Russian stock market performance and is the only chance for an outperformance for stocks. If east and west can settle their differences in an amicable way, then Russian stocks should rally strongly by at least 20%-30% just to get back to where they have always been.

Some funds were venturing back into the market at the end of 2014 simply because the stocks were so cheap that the downside risks seemed minimal, but the upside possibilities so large as to be tempting.




3.2 Equities and oil

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