Monday, September 29, 2014

29/9/2014: Russian Economy Briefing for IRBA

Earlier today I gave a brief presentation on the topic of the Recent Developments in Russian Economy. Here are my speaking notes:

Economic growth in Russia was running at +0.8% y/y in Q2 2014 versus 0.9% y/y in Q1 2014.

At the same time, GDP shrank 0.2% y/y in July 2014 and 0% y/y in August 2014.

Taken against the consensus forecast for growth at 0.5% for the full year 2014, this suggests geo-political risks-induced slowdown in the economy of some 0.3-0.4% to-date.

Russia's economic outlook for 2014 and 2015-2015 continues to trend down, driven by two core factors:
  1. Geopolitical risks of the Ukrainian conflict, and
  2. Structural weaknesses in the economy.

The first factor is responsible for the expected actual output growth falling below down-trending potential output growth in 2014 and 2015.

The second factor is driving down potential output growth in 2015-2016 and beyond.

How dramatic were the growth forecasts revisions so far?

Take IMF: IMF is about to publish its October World Economic Outlook forecasts revisions.

In October 2013, IMF forecast real GDP growth in Russia to run at 3.0% in 2014, 3.5% in 2015 and 3.5% in 2016. So 3.5% average over 2015-2016.

In April 2014, IMF forecasts were running at 1.33% in 2014, 2.3% in 2015 and 2.5% in 2016, respectively. 2015-2016 average of 2.4% down 1.1 ppt on previous.

We have no forecasts for October, yet, but consider IMF's 'twin' organisation, the World Bank. The WB expect growth of around 0.5% pa on average over 2014-2016, broken down into 0.5% in 2014, 0.3% in 2015 and 0.4% in 2016. Average growth of just 0.35% in 2015-2016 down massive 3.15 ppt on a year ago!

Russian Government official forecasts are for growth of 0.5% in 2014, 1.2% in 2015 and 2% in 2016, so average 2015-2016 growth of 1.6% or 1.25 ppt above World Bank forecasts.

Taken against CIS growth rates, the official sector revisions suggest that about 1/2 of the total downside in growth expectations is down to Ukrainian crisis and the rest are structural.

Based on World Bank forecasts, slowdown in domestic investment and consumption will be the main drag on the structural side of growth.

Private sector analysts forecasts are even worse than those from the IMF and the World Bank. For example, Danske forecast for GDP growth is -0.3% in 2014, -1.9% in 2015 and +0.5% in 2016. These are driven by expected private consumption growth going from 1.2% in 2014 to -2.2% in 2015 and rising to +2.2% in 2016, Fixed investment falling 3.7% in 2014, 3% in 2015 and growing by only 0.3% in 2016.

Morgan Stanley cut its 2014 forecast for Russian economy from +0.8% growth to -1.5% recession earlier this month.

BOFIT forecast estimates growth of 0% in 2014, +0.5% in 2015 and +1.7% in 2016, or an average rate of growth of 1.1% in 2015-2016. These are more in line with official forecasts and are less gloomy than World Bank outlook and Danske outlook. I tend to err on their side, although my expectation is that 2015 growth will be above 0.5% and 2016 will be slightly shy of 1.7%, but the average of 1-1.1% for 2015-2016 looks about right, assuming no major rapid changes to the Ukrainian situation.

All in, there is huge uncertainty as to what we can expect from the Russian economy in 2015-2016.

The slowdown in investment is driven by a number of factors, such as:
  1. Capital outflows and high interest rates (in part related to the Ukrainian crisis, but also linked to stubbornly high inflation and the Central Bank move to free floating ruble). Policy interest rates currently stand at 8% and are expected to rise to 8.5% by the end of 2014-beginning of 2015. Currently, EUR/RUB exchange rate is at 50.22 and 12month forward contracts imply the rate of 53.65, while USD/Ruble rate is at 38.8 currently and 12 months forward markets pricing implies the rate of 41.18. Much of this is down to the expected revaluation of the dollar and the strong euro vis-a-vis majority of the emerging markets currencies. But some is down to expected structural weaknesses in the Russian economy. Weaker ruble implying higher cost of imported capital goods and technology.
  2. Weaknesses in the banking sector (exacerbated by the impact on the banks' access to global funding markets arising from Western sanctions) relate to continued sector consolidations (Central Bank has shut down more banks in 2014 so far than in 2010-2011 combined) and sector deleveraging (with credit supply growth falling dramatically over the last 12 months).
  3. Tight fiscal policy: Russia's draft federal budget approved by the cabinet on September 18, upholds the budget rule adopted in 2012 that says the deficit may not exceed 1% of GDP. Spending composition changed to allow higher allocations to defence and national security, as well as to boost certain sectors of the economy. Much of the spending in the latter will go to building new production or expand existing capacity to substitute for imports, especially in the defence and agriculture sectors. The measures are part of Russia’s new emphasis on economic self-sufficiency. New funding was allocated also to Crimea and the Far East region development, and to large infrastructure projects such as Moscow’s new ring road. Per BOFIT: “The government sees giant state-funded infrastructure projects as a way to revive economic growth”. But big infrastructure investments are not identical in terms of their future productive capacity as business investment in new technology and capital goods. As Brazil example shows, infrastructure uplifts based on public funding are virtually one-shot game when it comes to funding growth.

On the budgetary policy side:
  • The Government refrained from new tax hikes and shelved the proposal for sales-tax. VAT remained unchanged at 18%. This is a major net positive for domestic demand.
  • Another positive on domestic demand side, but presenting new risks on long term macroeconomic sustainability front, the new budget includes decision to raise revenue by transferring federal budget pensions contributions for 2015 into general budget, same as in 2014. Under 2002 pensions reform, Russian pension system moved from pure pay-as-you-go system to partially funded system. Under the 2002 reformed system, a share of pensions contributions collected by the federal authorities went to fund current pensions obligations, while the balance was invested in long-term instruments to help fund future pensions provisions. Since 2014 and now into 2015, the second part of contributions will be diverted to general budget.

As mentioned above, Russia is moving toward a greater degree of economic self-sufficiency in two key areas: defense industry and agriculture. While the former is likely to be a drag on general investment, the latter presents opportunities for Irish exporters and is likely to lead to some economic grains in Russia.

Russian agriculture is in a desperate need of investment. I wrote about this on my blog on September 8th - a post that I shared with you on the IRBA Linkedin page. To summarise my findings, modernisation of Russian agriculture and food sectors will require annual investments in the region of USD10.7-11.7 billion per annum. Agriculture Ministry requested a 50% increase in annual farm subsidies from EUR4.2 billion in 2014 to EUR6.3 billion in 2015.

These investments will have to cover:
  • -       Agricultural production, especially in dairy, fisheries, beef and fruit and vegetables sectors, including staples, like potatoes;
  • Supply Chain Management and Logistics, especially in storage and transportation relating to fruit and vegetables sectors;
  • Food processing sectors, especially relating to dairy and fishing sub-sectors.

Increasing Russia’s agricultural output will take significant time, somewhere across 2-6 years, depending on a sector (

We can expect significant uplift in investment support schemes in beef and poultry sectors, as well as in pork production. So far, draft 2015 Budget provides only 20% of the funds requested for this purpose. The hope is that the bumper crop of cereals this year is going to provide off-setting breathing space for investment: Russia expects grains harvest in 2014 to hit 104-106 million tons, just shy of the all-time record of 108 million tons achieved in 2008 and well above the 84 million tons average for the last 10 years.

Overall, most acute risks to the Russian economy are geopolitical, with sanctions escalation on September 12-18th resulting in more severe pressures on the banks for funding, as well as increased pressure on oil producers. So far, the sanctions war has been escalating despite the ceasefire in Ukraine holding and this suggests that we cannot expect lifting of the sanctions before the end of 2014 even under the most optimistic scenarios.

Credit supply from euro and dollar funding has fallen to zero for all Russian companies in July 2014.

The second immediate risk is that of declines in oil prices. Russian economy is more sensitive to changes in oil prices than to gas prices and the fact that oil is currently down some 16% on its June 2014 highs and is trading closer to USD95-96/bbl presents a major threat to the economy. Should oil prices fall below USD90/bbl, federal budget will require major tightening to keep the Government within targeted 1% deficit rule.

The third risk is to the investment side from the monetary policy: stubbornly rising and high CPI - currently running at around 7.9% against CBR and Government targets of 5.5-6%, and devaluation of the ruble, plus rapid outflows of capital from Russia - all are implying future potential tightening of interest rates policy. This, if it were to pass, will push even further down the already poor investment performance.

On the positive side, even with sanctions tightening, we are seeing some recovery in producer and consumer confidence, as signaled by PMIs and consumer surveys. But the recovery is fragile and uncertain in terms of future prospects. We need to see confirmation of the stronger PMIs trend in September figures, due to be released this week.

If we are to look at the demand side for exporters into Russian markets, things are tough. Russian imports have already fallen in 2014, driven by depreciation of the ruble more than by anything else. Imports declines contributed +6.5% to Russian GDP growth in 2009, but rebounded relatively strongly in 2010 and 2011, erasing the 2009 contraction. Imports shrinkage is likely to contribute some 1% to GDP growth in 2014, 0% to 2015 growth and -0.3% in 2015, so expected rebound to the current imports drop is likely to be less swift and longer-drawn out.

Surprisingly, imports slowdown and sanctions did not hurt, to-date, bilateral trade in goods between Russia and Ireland. In the first seven months of 2014, compared to the same period of 2013, Irish exports to Russia rose from EUR397 million to EUR509 million - an uplift of 28% y/y. Our trade balance in goods with Russia improved from a surplus of EUR301 million in January-July 2013 to a surplus of EUR353 million in January-July 2014. If in 2013 exports to Russia accounted for 3.67% of our goods exports ex-EU and USA, in 2014 so far it is accounting for 4.31% of our goods exports ex-EU and USA.

Keep in mind: in national accounts, net trade (trade balance) is what counts as additive to national income and GDP. In these terms, for the first 7 months of 2014, our surplus vis-a-vis Russia (at EUR353 million) is much more to our GDP and GNP than our trade deficit with China of EUR478 million.

While we do not have detailed breakdown of July trade flows, comparing H1 2014 against H1 2013, noticeable increases in Irish exports to Russia were recorded in:
  • Coffee, tea, cocoa, spices and manufactures thereof
  • Miscellaneous edible products and preparations
  • Essential oils; perfume materials; toilet and cleansing preps
  • Chemical materials and products nes
  • Photographic apparatus; optical goods; watches and clocks
  • Miscellaneous manufactured articles 

Noticeable decreases were recorded in:
  • Live animals
  • Meat and meat preparations
  • Metalliferous ores and metal scrap
  • Organic chemicals
  • Medical and pharmaceutical products
  • Office machines and automatic data processing machines

Opportunity space for Irish exporters in Russia remains wide open in areas not impacted by sanctions, e.g. outside immediate supply of some food and agricultural products. And new opportunities should open up in the areas relating to agricultural production, food processing, storage and transportation. In addition, there is renewed scope for investment in Russia in the above areas and in areas relating to technological innovation and modernisation in a wide range of sectors.

However, to facilitate this, it would be positive if Russian authorities were to accelerate policy efforts directed at attracting foreign investors into the country, especially in areas linked to investor protection and regulatory and tax facilitation. There is also a need for assuring investors that ruble valuations are going to become less erratic and the global rates divergence is not going to precipitate dramatic further drops in currency values. Key here is Euro/Ruble pair, rather than Dollar/Ruble one. Access to trade finance and insurance are also a major bottleneck.

While over the next 1-2 years we can expect more uncertainty and risks to materialise, including the risk of significant further devaluation of the ruble valuation, taking a longer-term horizon of 5-10 years, these factors are likely to be replaced by more positive growth momentum and improved returns on foreign investment.

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