Russia’s economy fell off a cliff after the collapse in oil prices, which commenced in the 2nd half of 2014, and the imposition of sanctions by the EU and the U.S. in July 2014. The economy contracted by 3.7% in 2015 and suffered a further decline of 0.2% last year (the decline in 2016 was much less than feared though). The government’s policy response to confront the crisis was swift and largely effective. Bank of Russia (the country’s central bank) quickly realized that defending the currency would be futile and would be a bad use of FX reserves. It abolished the soft dollar/euro currency peg, allowing the rouble to weaken from 35 against the dollar in the middle of 2014 to over 80 in early January 2016, when Brent slumped to its lowest level of USD 27.9 per barrel. Interest rates were hiked to 17% at the end of 2014 to halt capital outflows and to counter rising inflation. Meanwhile, the government used part of its FX reserves to prop up bank balance sheets (VEB will still need some capital though). Russian non-financial companies went into the crisis with relatively low debt levels and were able to repay debt from profits as most of these companies earned dollars from exports but had a significant rouble cost base (thus, becoming more competitive after the depreciation of the rouble). The government also cut its expenditures in real terms, adjusting to the new oil price environment, but could not prevent a fiscal deficit as oil revenues (comprising about 50% of government income) dropped by more. The fiscal deficit reached 3.7% in 2016 (or 4.5% if proceeds from selling a stake in Rosneft are excluded). The budget deficits were funded by taking down the Reserve Fund (established in 2008 as a successor of a stability fund established in 2004 to deal with budget shortfalls in times of low oil prices).

Since January 2016, Russia’s economy is recovering on the back of steadily rising oil prices. The IMF expects activity to pick up this year, forecasting economic growth of +1.1% (most sell-side analysts have penciled in 1.5%-2.0% for 2017). The government has agreed a fiscal plan for 2017-2019 that entails further expenditure cuts (mostly in defence and security), higher dividends from state-owned companies as well as higher tax revenues from oil & gas to reduce the fiscal deficit to 1.2% by the end of the planning period under a conservative oil price of USD 40/bbl (benchmarked against Urals, which trades about USD 2 below Brent). As most market analysts expect oil to trade in the mid 50s, it is likely that the government will run a budget surplus by 2019. Bank balance sheets generally have improved as cost of risk has declined (Sberbank, the largest and strongest bank, expects cost of risk in 2017 to come in at 1.5%-1.7% compared to a net interest margin of 4%-5%). Unemployment is low (<6%) especially given the depth of the crisis; the required adjustment was mainly realized through wage declines in real terms and by outflow of labour migrants.

The last waltz…?

All this is good news but the question is whether the growth surge is sustainable. The problem that Russia faces, is that its economy remains heavily tilted towards commodities, specifically oil & gas. The non-oil fiscal deficit is in excess of 8%, showing the importance of oil revenues for the government. The sanctions have led to slightly more diversification as a result of import substitution. Especially activity in textiles, food processing and agriculture have picked up (helped by an import ban in retaliation to the sanctions). Russian government officials as well as bankers do not expect that sanctions will be lifted or eased anytime soon (i.e. in 2017), irrespective of whether or not more revealing headlines appear in respect of shady Russian dealings by Trump’s entourage. However, import substitution has not yet had a significant impact on economic growth. This is partly due to absence of credit growth as (real) rouble interest rates are prohibitively high. Bank of Russia has kept its key rate at 10% despite a low inflation of now only 4%. This, together with a run-up in oil prices, has resulted in upward pressure on the rouble which is hurting exports whilst reviving imports. The Ministry of Finance and Bank of Russia have agreed, therefore, to intervene in FX markets by purchasing dollars using additional oil revenues when oil prices are in excess of USD 40/bbl (Urals). The size of the intervention is dependent on the exchange rate: purchases will increase if the rouble weakens, which could be self-reinforcing. The idea behind this fiscal rule is to decouple the strength of the currency from the level of the oil price. Bank of Russia is expected to keep monetary conditions tight, apparently believing that the FX purchases could translate in higher inflation. But we think that without easing this system actually provides an attractive carry trade (5% real interest rate with stable currency) which will attract undesirable hot money…

The fiscal rule addresses the budgetary issues that the government is facing and, subject to oil prices, will rebuild the Reserve Fund to counter any weakness in oil prices in the future. However, it doesn’t do anything to make Russia’s economy less hydrocarbon dependent. High real interest rates seem an impediment to capex growth to us, especially for those companies that do not have access to international capital markets. As we also indicated in our blog of January 2016 (“Bear with Us: Russia’s Economic Outlook”), structural reforms are required to get Russia’s economy on a sustainable growth path. Most important elements are: establishment of (independent) rule of law (contract enforcement, property rights), cutting red tape (including intrusive administrative procedures) and increasing productivity (by applying new technology and improving education). Some progress has been made, for example, on easing the start of new businesses and establishing funds to invest in technology ventures. The government also has indicated an increase in spending on education (to be funded by cuts in social spending) but privatizations of inefficient state-companies are not on the agenda for now. We believe a much bigger effort is required. Alexei Kudrin, Vladimir Putin’s trusted advisor on economic growth, made a strong case for economic (and political) reform at the Gaidar Forum earlier this year, trying to link the importance of structural reforms aimed at spurring economic growth to geopolitics (and, implicitly, the survival of Mr. Putin’s leadership). After all, economic stagnation was also one of the important factors leading to the collapse of the USSR. We probably only learn a year from now, after the presidential elections in March 2018, whether Mr. Putin agrees. If not, it may be difficult for him to avoid an economic bear trap…