Monday, January 12, 2015

12/1/2015: Euro area and Russian Economic Outlooks: 2015

My comments to the Portuguese Expresso, covering forecasts for 2015 for Russia and the Euro area:

- Russia

Despite the end-of-2014 abatement of the currency crisis, Russian economy will continue to face severe headwinds in 2015. The core drivers for the crisis of 2014 are still present and will be hard to address in the short term.

Geopolitical crisis relating to Eastern Ukraine is now much broader, encompassing the direct juxtaposition of the Russian strategy aimed at securing its regional power base and the Western, especially Nato, interest in the region. This juxtaposition means that risks arising from escalated tensions over the Baltic sea and Eastern and Central Europe are likely to remain in place over the first half of 2015 and will not begin to ease until H2 2015 in the earliest. With them, the prospect of tougher sanctions on Russian economy is unlikely to go away.

While capital outflows are likely to diminish in 2015, Russia is still at a risk of increased pressures on the Ruble due to continued debt redemptions calls on Russian companies and banks. In H1 2015, Russian companies and banks will be required to repay ca USD46 billion in maturing debt, with roughly three quarters of this due to direct and intermediated lenders not affiliated with the borrowers. These redemptions will constitute a direct cash call of around USD25 billion, allowing for some debt raising in dim sum markets and across other markets not impacted by the Western sanctions. USD36.3 billion of debt will mature in H2 2015, which implies a direct demand for some USD17-20 billion in cash on top of H1 demand. The peak of 2015 debt maturity will take place in Q1 2015, which represents another potential flash point for the Ruble, especially as the Ruble supports from sales of corporate foreign exchange holdings requested by the Government taper off around February.

Inflation is currently already running above 10 percent and this is likely to be the lower-end support line for 2015 annual rate forecast. Again, I expect spiking up in inflation in H1 2015, reaching 13-14 percent, with some stabilisation in H2 2015 at around 11 percent.

Economic growth is likely to fall off significantly compared to the already testing 2014.

Assuming oil prices average at around USD80 per barrel (an assumption consistent with December 2014 market consensus forecast), we can expect GDP to contract by around 2.2-2.5 percent in 2015, depending on inflation trends and capital outflows dynamics.

Lower oil prices will lead to lower growth, so at USD60 per barrel, my expectation is for the economy to shrink by roughly 4-5 percent in 2015. Crucially, decline in economic activity will be broadly based. I expect dramatic contraction in domestic demand, driven by twin collapse in consumer spending and private investment. In line with these forces, demand for imports will decline by around 15 percent in 2015, possibly as much as 20 percent, with most of this impact being felt by European exporters. Public investment will lag and fiscal tightening on expenditure side will mean added negative drag on growth.

About the only positive side of the Russian economy will be imports substitution in food and drink sectors, and a knock on effect from this on food processing, transportation and distribution sectors.

To the adverse side of the above forecasts, if interest rates remain at current levels, we can see a broad and significant weakening in the banks balance sheets and cash flows arising from growth in non-performing loans, and corporate and household defaults, as well as huge pressure on banks margins and operating profits. This can trigger a banking crisis, and will certainly cut deeper into corporate and household credit supply.

On the downside of my forecast, a combination of lower oil prices (average annual price at around USD50-60 per barrel) and monetary tightening, together with fiscal consolidation can result in economic can result in a recession of around 7 percent in 2015, with inflation running at around 13 percent over the full year 2015.

Even under the most benign assumptions, Russian economy is facing a very tough 2015. Crucially, from the socio-economic point of view, 2015 will see two adverse shocks to the system: the requirement to rebalance public spending on social benefits in order to compensate for inflation and Ruble devaluation pressures, and the rising demand on social services from rising unemployment. Volatility will be high through H1 2015, with crisis re-igniting from time to time, causing big calls on CBR to use forex reserves and prompting escalating rhetoric about political instability. We can also expect Government reshuffle and rising pressure on fiscal policy side. The risk of capital controls will remain in place, but. most likely, we will have to wait until after the end of Q1 2015 to see this threat re-surfacing.

- Eurozone

2014 was characterised by continued decoupling of the euro area from other advanced economies in terms of growth. Stagnation of the euro area economy, arising primarily from the legacy of the balances sheet crisis that started in 2007-2008 will remain the main feature of the regional economy in 2015. Despite numerous monetary policy innovations and the never-ending talk from the ECB, the European Commission and Council on the need for action, euro area's core problems remain unaddressed. These are: public and private debt overhangs, excessive levels of taxation suppressing innovation and entrepreneurship, a set of substantial demographic challenges and the lack of structural drivers for productivity growth.

My expectation is for the euro area economy to expand by around 0.8-1 percent in 2015 in real terms, with inflation staying at very low levels, running at an annual rate of around 0.6-0.7 percent. Inflation forecast is sensitive to energy prices and is less sensitive to monetary policy, but it is relatively clear that consumer demand is unlikely to rebound sufficiently enough to lift inflation off its current near-zero plateau. Corporate investment will also remain stagnant, with exception of potential acceleration in M&A activities in Europe, driven primarily by the build up in retained corporate earnings on the balance sheets of the North American and Asian companies.

Barring adverse shocks, growth will remain more robust in some of the hardest-hit 'peripheral' economies, namely Ireland, Spain and Portugal. This dynamic is warranted by the magnitude of the crisis that impacted these economies prior to 2013. Thus, the three 'peripherals' will likely out-perform core European states in terms of growth. Italy, however, will remain the key economic pressure point for the euro area, and Greece will remain volatile in political terms. Within core economies, recovery in Germany will be subdued, but sufficient enough to put pressure on ECB and the European Commission to withdraw support for more aggressive monetary and fiscal measures. France will see little rebound from current stagnation, but this rebound will be relatively weak and primarily technical in nature.

Crucially, the ECB will be able to meet its balance sheet expansion targets only partially in 2015. Frankfurt's asset base expansion is likely to be closer to EUR300-400 billion instead of EUR500 billion-plus expected by the policymakers. The reason for this will be lack of demand for new funding by the banks which are still facing pressures of deleveraging and will continue experiencing elevated levels of non-performing loans. In return, weaker than expected monetary expansion will mean a shift in policymakers rhetoric toward the thesis that fiscal policies will have to take up the slack in supporting growth. We can expect, therefore, lack of progress in terms of fiscal consolidations, especially in France and Italy, but also Spain. All three countries will likely fail to meet their fiscal targets for 2015-2016. Thus, across the euro area, government debt levels will not post significant improvement in 2015, carrying over the pain of public sector deleveraging into 2016.

As the result of fiscal consolidation slack, growth will be more reliant on public spending. While notionally this will support GDP expansion, on the ground there will be little real change - European economies are already saturated with public spending and any further expansion is unlikely to drive up real, ROI-positive, activity.

Overall, euro area will, despite all the policy measures being put forward, remain a major drag on global growth in 2015, with the regional economy further decoupling from the North American and Asia-Pacific regions. The core causes of European growth slump are not cyclical and cannot be addressed by continuing to prime the tax-and-spend pump of traditional European politics. Further problem to European growth revival thesis is presented by the political cycle. In the presence of rising force of marginal and extremist populism, traditional parties and incumbent Governments will be unable to deploy any serious reforms. Neither austerity-centric deleveraging approach currently adopted by Europe, nor growth-focused reforms of taxation and subsidies mechanisms will be feasible. Which simply means that status quo of weak growth and severe debt overhangs will remain in place.

The above outlook is based on a number of assumptions that are contestable. One key assumption is that of no disruption in the current sovereign bonds markets. If the pick up in the global economy is more robust, however, we can see the beginning of deflation in the Government bonds markets, leading to sharper rise in 'peripheral' and other European yields, higher call on funding costs and lower ability to issue new debt. In this case, all bets on fiscal policy supporting modest growth will be off and we will see even greater reliance in the euro area on ECB stance.

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