International ratings agency Standard & Poor’s (S&P) upgraded Russia’s sovereign rating to 'BBB-' from 'BB+' with a stable outlook on February 24, returning Russia to the sought after “investment grade” rating category on the back of the end of a two-year long recession and several pleasant surprises that suggest the economy is growing faster than expected.
The S&P upgrade gives Russia a hat trick of investment grade ratings. Rival agency Fitch chose the same day to confirm Russia’s ratings at BBB- with a positive outlook, the agency said in a statement. The third major international ratings agency Moody's Investors Service rates Russia at Ba1, an investment grade, and upgraded the country’s outlook to positive from stable on January 25.
Among the good signs were Russia's solid fiscal performance, real progress in cleaning up the banking sector, surprisingly strong industrial production numbers, another set of strong PMI index results and an unexpected pick up in corporate borrowing. The official forecasts for growth and the federal budget deficit this year is a modest 1.5% and a painful -3.4% GDP respectively, but both those estimates are already looking way too pessimistic; many analysts are predicting at least 2.5% growth in 2018 and even Minister of Economy Maxim Oreshkin said during the Gaidar Forum in Moscow in January there is a good chance the federal budget will be in surplus by December.
“The upgrade reflects the track record of prudent policy responses that as allowed the Russian economy to adjust to lower commodity prices and international sanctions. [The government] demonstrated commitment to fiscal restraint and an enhanced fiscal policy framework have reduced medium-term risks of fiscal slippage. Finally, despite the ongoing clean-up of the banking system, the Central Bank of Russia (CBR) measures have preserved fiscal stability. Credit to the private sector has started to recover, which we view as a sign of improved monetary transmission,” the ratings agency said in a press release.
Investment grade opens doors to new money
Market players expect demand for Russian state bonds to increase as major international funds require two investment grades as a minimum to invest in a country’s financial instruments.
The investment grade status opens Russia up to a new class of investor like US pension funds that are not allowed to invest in junk graded assets. It will also cause an inflow of passive money by index tracking funds that also require investment grade sovereign ratings. However, both these inflows will be muted by the US sanctions on Russia.
Oreshkin welcomed the news, saying: “This opens a path for increased investment lending and expands the possibility of financing the infrastructure debt.” Oreshkin added that the floating exchange rate and careful targeting of inflation “significantly reduced the dependence of the Russian economy on oil prices."
The rerating of Russia represents a catch up with the government’s success in deal with the imposition of international sanctions in 2014 when Russia’s rating was cut to junk status.
Initially investors worried that Russia would not be able to meet its debt obligations – worries that only got worse when Russia was hit by the double whammy of the collapse of oil prices the same year. However, Fitch noted that the general government debt has since fallen to 15.5%,of GDP in 2017, one of the lowest in the BBB category, and that the government can easily meet these debts from the improving tax collections.
The crisis is finally over and two years of economic contraction – the first backwards movement since president Vladimir Putin took office in 2000 – finally ended in 2017 as Russia’s economy returned to growth.
Preliminary figures from Rosstat show that Russia’s economy turned the corner in 2017 and GDP grew by 1.5%, which was slightly less than nearly all forecasters had expected thanks to a “technical recession” in the last part of 2017. Russia is recovering but the recovery remains fragile.
Now the pace already seems to be picking up. One of the pleasant surprises already in was a better than expected performance in industrial production, which expanded by a strong 2.8% in January y/y after contracting in both November and December, Rosstat said on February 16.
This backs up the PMI index results that measures activity in the productive parts of the economy. Business activity growth across the Russian service sector remained strong in January, despite the pace of expansion easing to a three-month low, according to a report by IHS Markit published on February 5. The IHS Markit Russia Services Business Activity Index stood at 55.1 in January, down from 56.8 in December, but still remaining above the no-change mark of 50.0 and indicating "a strong expansion in output among Russian service providers".
"The Russian service sector indicated a solid start to 2018, with strong expansions in output and new business," Markit economist Sian Jones commented., adding that anecdotal evidence of the survey links improved business activity to more favourable economic conditions and greater new order volumes.
Another positive surprise was the all important real disposable incomes – the money left after spending on utilities and food – did not contract for the first time in nearly three years in January. That doesn't mean Russians are feeling rich, but the pressure is off and shoppers are starting to trade up to better quality goods and make big ticket purchases again according to the most recent Sberbank Ivanov index.
Average nominal incomes in dollar terms have made back much of the ground they lost during the Great Recession falling from over $800 a month in the boom years to around $400 in the bowl of the crisis but have recovered to just under $700 a month now.
Breaking the oil addiction
After several years of losing money, Russia’s government went into profit again in January running a RUB190bn ($3.4bn), or 2.8% GDP surplus. The crisis of the last years forced Russia to go cold turkey and has finally broken its addiction to oil.
In the boom years the Russian budget needed oil prices to be more than $115 per barrel to make a profit, but since then cost cutting, a crack down on corruption and an unsung revolutionary reform to the tax system – there has been massive investment into a state-of-the-art tax service IT system that have increased revenues by 40% -- means as bne IntelliNews has reported Russia Inc went into the black in 2017 as the break even price has fallen to $53 a barrel, according to Oleg Kouzmin, chief economist for Russia at Renaissance Capital. The average price for oil in 2017 was $55.44 and so far this year the average price in January was up to $66.23.
The surplus was helped by higher oil prices, but the crisis has lead to a huge shake up of the tax system, which is working more efficiently and expanded its sources of revenues.
Consolidated budget revenues (federal, regional and municipal, plus social funds) increased by over 13% y/y. Higher oil prices helped increase revenues via oil & gas tax income (up 23%) whose share rose to close to a fifth of total budget revenues, but this is still way down on the 50% it used to be.
“The tax system reforms have lead to other budget revenues to rise by 10%, which is rapid even if the data was adjusted for inflation. Revenues from corporate profit taxes and goods excise taxes rose especially fast,” Bank of Finland Institute for Economies in Transition (BOFIT) says.
Budget spending also grew but at a more modest pace, up by 6% in January y/y. Most of this went into social security spending, which rose to over 10% and the share increased to over 36% of total budget spending. But serious savings were made by cutting back on military spending, which has skewed the budget for most of the last few years towards a deficit.
However, the biggest change to the budget has been the re-introduction of the so-called budget rule since the start of January. This dictates that any revenue earned from oil exports when the price of oil is over $40 must be squirreled away in the sovereign reserve fund. The practical impact of this rule is the link between the ruble exchange rate and oil prices gets broken as oil can’t rise above $40 as far as the currency is concerned.
It also means Russia will start accumulating gross international reserves (GIR) again: reserves were already up to $450bn in January from a April 2015 low of $356bn. However, as far as the Ministry of Finance is concerned the real benefit is the budget rule will put a floor under the wild swings the Russian economy has always been prone to; Russian Finance Minister Anton Siluanov says he wants to build a “second Norway.”
“We have got stability now,” Siluanov said at during the Gaidar forum in January. “But we have to go beyond that. The growth and the fall of the deficit is welcome but what it brings is not just stability, but predictability. That is the point of the budget rule; its not there to accumulate reserves. Its there to increase the predictability of the economy for business and for investors.”
Russian banks back in business
Russia’s banking sector is recovering from two nightmare years in 2015 and 2016 and 2017 saw the sector’s aggregate income up y/y even counting in the collapse of three of the country’s biggest commercial banks (Financial Corporation Otkritie, Binbank (aka B&N bank) and Promsvyazbank) last autumn.
The banking sector ended 2017 with a total profit of RUB790, which was less than the CBR was hoping for (the regulator was targeting RUB1 trillion) and would have been more than the RUB930bn the sector earned in 2016 had not banks lost RUB322bn in September alone following the crumpling of Promsyvazbank that month.
Bankers fervently hope the problems with the so-called Garden Ring banks last autumn was a one off and that the sector will do better this year. Indeed, state-owned retail bank giant Sberbank says it hopes to reach RUB1 trillion of profits by 2020 on its own.
Maybe the most encouraging sign that the economy is coming back to list is the pick up in January in corporate loans. After slumping during the “silent crisis” of 2015-2016 retail lending start to recover at the start of 2017 and is now growing fast – so fast that the CBR is starting to get worried about another bubble forming. However, corporate leading has been falling for two years and without investment by companies Russia cannot hope to sustain its growth.
That changed in January when corporate loans surprised economists after the portfolio of loans issued by banks to Russian companies increased in annual terms for the first time since mid-201, up by 1.8% with the exception of currency revaluation, according to the CBR.
The reason for this is not clear, but there is a interconnected web of motives that go into corporate borrowing decisions: demand (incomes were falling but now are rising), the cost of capital (CBR rate cuts have made borrowing cheaper and cheaper), and confidence (many businessmen have held off until the uncertainty of the March elections are passed and there is more clarity on the mooted new US sanctions).
And the borrowing conditions will only improve this year. The regulator cut rates in January to 7.5% and since then has said it expects rates to fall further to 6-7% this year, sooner than its earlier than the 2019-2020 it suggested previously.
“This represents a change in thinking by the CBR. It is transitioning from worrying about containing inflation, which has fallen beyond expectations, to thinking about boosting growth with lower rates,” says Kouzmin.
For most of the last four years companies have spent any extra money they have paying down their debt and that process of deleveraging continues. But it has left companies debt free and their ability to borrow abroad as renewed sanction fears receded has also depressed taking credits at home as for those companies with access to the international capital market it remains cheaper to borrow longer for less by issuing bonds than it does to take a credit from a Russian bank – until now. Russia’s companies have begun to replace their bonds with loans.
“Companies are becoming more active on the market: their debt on bonds last year has been steadily growing,” according to BOFIT. “So the smooth recovery of corporate lending was expected.”
But the switch from bonds to loans is a work in progress. The Russian central bank said that in the fourth quarter, corporate obligations on bonds, including single large placements, increased by RUB733bn ($13bn) while the portfolio of loans taken was up only RUB139bn. And only a limited number of Russian blue chips have access to the international capital markets in the first place.