12/8/17: Some growth optimism from the Russian regional data

An interesting note on the latest data updates for the Russian economy via Bofit.

Per Bofit: "Industrial output in Russian regions rises, while consumption gradually recovers." This is important, because regional recovery has been quite spotty and overall economic recovery has been dominated by a handful of regions and bigger urban centres.

"Industrial output growth continued in the first half of this year in all of Russia’s eight federal districts," with production up 1.5–2% y/y in the Northwest, Central and Volga Federal Districts, as well as in the Moscow city and region. St. Petersburg regional output rose 3-4% y/y.

An interesting observation is that during the recent recession, there has been no contraction in manufacturing and industrial output. Per Bofit: "Over the past couple of years, neither industrial output overall nor manufacturing overall has not contracted in any of Russia’s federal districts. Industrial output has even increased briskly in 2015–16 and this year in the Southern Federal
District due to high growth in manufacturing and in the Far East Federal District driven by growth in the mineral extraction industries."

This is striking, until you consider the nature of the 2014-2016 crisis: a negative shock of collapsing oil and raw materials prices was mitigated by rapid devaluation of the ruble. This cushioned domestic production costs and shifted more demand into imports substitutes. While investment drop off was sharp and negative on demand side for industrial equipment and machinery, it was offset by cost mitigation and improved price competitiveness in the domestic and exports markets.

Another aspect of this week's report is that Russian retail sales continue to slowly inch upward. Retail sales have been lagging industrial production during the first 12 months of the recovery. This is a latent factor that still offers significant upside to future growth in the later stages of the recovery, with investment lagging behind consumer demand.

Now, "retail sales have turned to growth, albeit slowly, in six [out of eight] federal districts."

Here is why these news matter. As I noted above, the recovery in Russian economy has three phases (coincident with three key areas of potential economic activity): industrial production, consumption and investment. The first stage - the industrial production growth stage - is on-going at a moderate pace. The 0.4-0.6 percent annual growth rate contribution to GDP from industrial production and manufacturing can be sustained without a major boom in investment. The second stage - delayed due to ruble devaluation taking a bite from the household real incomes - is just starting. This can add 0.5-1 percent in annual growth, implying that second stage of recovery can see growth of around 2 percent per annum. The next stage of recovery will involve investment re-start (and this requires first and foremost Central Bank support). Investment re-start can add another 0.2-0.3 percentage points to industrial production and a whole 1 percent or so to GDP growth on its own. Which means that with a shift toward monetary accommodation and some moderate reforms and incentives, Russian economy's growth potential should be closer to 3.3 percent per annum once the third stage of recovery kicks in and assuming the other two stages continue running at sustainable capacity levels.

However, until that happens, the economy will be stuck at around the rates of growth below 2 percent.

3/8/17: BRIC Composite PMIs: July

Having covered BRIC Manufacturing PMIs in the previous post (http://trueeconomics.blogspot.com/2017/08/3817-bric-manufacturing-pmis-july.html), and Services PMIs (http://trueeconomics.blogspot.com/2017/08/3817-bric-services-pmi-july.html), here is the analysis of the Composite PMIs.

Table below summaries current shorter term (monthly) trends in Composite PMIs:

Brazil has slipped into a new sub-50 Composite PMI trend in 2Q 2017 and, as of July, remains in the slump, although at 49.4, July Composite PMI reading signals much weaker rate of economic activity contraction than the June reading of 48.5. The problem for Latin America’s largest economy is that the hopes for an extremely weak recovery, set in 50.4 readings in April and May are now gone. In fact, 2Q 2017 average Composite PMI for Brazil stood at 49.8, which was stronger than July reading and marked the strongest performance for the economy since 3Q 2014. All in, July marked the start of the 14th consecutive quarter of Composite PMIs signalling economic recession.

Russia Composite PMI at the end of July stood at 53.4, a respectably strong number, signalling good growth prospects for the economy, but down from 54.8 in June and 56.0 in May. In fact, July reading was the lowest in 9 months. Given the economy’s performance in 1Q 2017, set against composite PMIs, the July and 1-2Q readings suggest that Russia is on track to record 1.0-1.5% growth this year, but not quite 2.0% or higher as expected by the Government. We will need to see 3Q and 4Q averages closer to 56-57 range to have a shot at above 1.5% growth.

China posted 2Q 2017 Composite PMI at 51.3, which is below July 51.9 reading. Still, July improvement is yet to be confirmed across the rest of 3Q 2017. China’s Composite PMI slowed from a recent peak of 53.1 in 4Q 2016 to 42.3 in  1Q 2017 and 51.3 in 2Q 2017.

India’s Composite PMI reflected wide-ranging weakening in the economy struck by both botched de-monetisation ‘reform’ and equally bizarre tax reforms. Sinking from appreciably strong 52.2 in 2Q 2017 to 46.0 in July, this fall marked the lowest PMI reading since 1Q 2009 and the second lowest reading on record. India’s economy has been in a weak state since 3Q 2016 when Composite PMI averaged 53.1. The PMI fell to 50.7 and 50.8 in 4Q 2016 and 1Q 2017 before recovering in 2Q 2017. This recovery is now in severe doubt. We will need to see August and September readings to confirm an outright PMI recession, but the signs from July reading are quite poor.

All in, in July, Russia was the only BRIC economy that came close (at 53.4) to Global Composite PMI reading of 53.5. Two BRIC economies posted a sub-50 reading. In 2Q 2017, Global Composite PMI was 53.7, with Russia Composite PMI at 55.4 being the only BRIC economy that supported global economic growth to the upside. In fact, Russia lead Global Composite PMIs in every quarter since  2Q 2016.

3/8/17: BRIC Services PMI: July

Having covered BRIC Manufacturing PMIs in the previous post (http://trueeconomics.blogspot.com/2017/08/3817-bric-manufacturing-pmis-july.html), here is the analysis of the Services Sector PMIs.

Brazil Services PMI continued trending below 50.0 mark for the third month in a row, hitting 48.8 in July, after reaching 47.4 in June. While the rate of contraction in the sector slowed down, it remains statistically significant. This puts an end to the hope for a recovery in the sector, with Brazil Services PMIs now posting only two above-50 (nominal, one statistically) readings since October 2014.

Russian Services PMI also moderated in July, although the reading remains statistically above 50.0. July reading of 52.6 signals slower growth than 55.5 reading in June. The Services sector PMIs are now 18 months above 50.0 marker, continuing to confirm relatively sustained and robust (compared to Manufacturing sector) expansion.

China Services PMI remained in the statistical doldrums, posting 51.5 in July gayer 51.6 in June. The indicator has never reached below 50.0 in nominal terms in its history, so 51.5 reading is statistically not significant, given PMIs volatility and positive skew. Overall, this is second consecutive month of PMIs falling below statical significance marker, implying ongoing weakness in the Services economy in China.

India’s Services PMIs followed Manufacturing sector indicator and tanked in July, hitting 45.9 (sharp contraction), having previous posted statistically significant reading for expansion at 53.1 in June. Volatility in India’s Services indicator is striking.

Table and chart below summarise short term movements:

Looking at quarterly comparatives, July was a poor month for Brazil Services sector, with July reading of 48.8 coming in weaker than already poor 49.0 indicator for 2Q 2017. In Brazil’s case, current recession in Services is now reaching into 12th consecutive quarter in nominal terms and into 15ht consecutive quarter in statistical terms. Russia Services PMI also moderated at the start of 3Q 2017 (52.6 in July) having posted average 2Q 2017 PMI of 56.0. Russia Services sector expansion is now into its 6th consecutive quarter (statistically) and seventh consecutive quarter nominally. The same, albeit less pronounced, trend is also evident in China (July PMI at 51.5 against 2Q 2017 PMI of 52.0). India Services PMI was under water in 4Q 2016, followed by weak (zero statistically) growth in 1Q 2017 and somewhat stronger growth in 2Q 2017. The start of 3Q 2017 has been marked by a sharp, statistically significant negative growth signal.

With Global Services PMI hitting 53.7 in July, against 53.8 average for 2Q 2017 and 53.6 average in 1Q 2017, BRIC economies overall are severely underperforming global growth conditions (BRIC Services PMI is now below Global Services PMI in 3 quarters running and this trend is confirmed at the start of 3Q 2017).

3/8/17: BRIC Manufacturing PMIs: July

BRIC PMIs for July 2017 are out, so here are the headline numbers and some analysis. 

Top level summary of monthly readings for BRIC Manufacturing PMIs is provided in the Table below:

Of interest here are:

• Changes in Brazil Manufacturing PMI signalled weakening in the economy in June that was sustained into July. Manufacturing PMI for Brazil has now fallen from 52.0 in May to 50.5 in June and to 50.0 in July. This suggests that any recovery momentum was short lived. 
• Russian Manufacturing PMI, meanwhile, powered up to 52.7 in July from 50.3 in June, rising to the highest level in 6 months. Good news: Russian manufacturing sector has now posted above-50 nominal readings in 12 consecutive months. Less bright news: Russian Manufacturing PMIs have signalled weak rate of recovery in 5 months to July and July reading was not quite as impressive as for the period of November 2016 - January 2017. Nonetheless, if confirmed in August-September, slight acceleration in Manufacturing sector can provide upward support for the economy in 3Q 2017, support that will be critical as to whether the economy will meet Government expectations for ~2% full year economic expansion.
• Chinese manufacturing PMI gained slightly in July (51.1) compared to weak May (49.6) and June (504.), but growth remains weak. Last time Chinese Manufacturing posted PMI statistically above 50.0 (zero growth) marker was January 2013. This flies in the face of official growth figures coming from China.
• India’s Manufacturing PMI fell off the cliff in July (47.9) compered to already weak growth recorded in June (50.9). Over the last 3 months, India’s Manufacturing sector has gone from weak growth, to statistically zero growth to an outright contraction.

Overall, GDP-weighted BRIC Manufacturing PMI stood at extremely weak 50.4 in July 2017, down from equally weak 50.6 in 2Q 2017. In both periods, BRIC Manufacturing sector grossly underperformed Global Manufacturing PMI dynamics (52.7 in July and 52.6 in 2Q 2017). Russia is the only country in the BRIC group with Manufacturing PMI matching Global Manufacturing PMI performance in July. Russian Manufacturing PMI was below Global Manufacturing PMI in 2Q 2017.

Net outrun: BRIC Manufacturing sector currently acts as a drag on global manufacturing growth, with both India and Brazil providing momentum to the downside for the BRIC Manufacturing PMIs.

28/7/17: 1H Marker: Russia on Track to a Weak Recovery in 2017

A quick top level update on the Russian economy from Bofit and Fitch Ratings.

Fitch Ratings today: “The recovery in Russia continues to gain traction. Domestic demand is responding to greater confidence in the economic policy framework, particularly as the inflation-targeting regime becomes entrenched. Activity in Turkey has bounced back rapidly from the coup attempt, with growth hitting 5% yoy in 1Q17. Momentum was supported by government incentives, including temporary fiscal measures and a jump in the Treasury commitment to the fund that backs lending to SMEs.”

Chart from BOFIT confirms the above:

Overall, the recovery is still on track, and remains gradual at best, posing elevated risks of reversals. For example, industrial output, having previously posted gains in January-May 2017, contracted in June 2017 on a quarterly basis. Still, industrial output was up 2% in 1H 2017 y/y.  Despite the U.S. and European sanctions, and generally adverse trends in the commodities sectors, mineral extraction sector expanded 3% y/y in 1H 2017 according to BOFIT. Oil output was up 2% and gas output was up 13%. The above figures imply that higher value added manufacturing posted sub-1% y/y growth in 1H 2017.

Agricultural production was basically flat - due, in part, to poor weather conditions, rising only 0.2% y/y in 1H 2017 and unlikely to post significant growth for FY2017 as crops reports are coming in relatively weak. That said, 2015-2016 saw record crops and very strong growth in agricultural output, so barring a major decline this year, agricultural sector activity will remain robust. Food production sector was the fourth highest growth sector over 2013- 1H 2017 period across the entire Russian economy, rising cumulative 17%  in 1H 2017 compared to 1H 2013 in real (inflation-adjusted) terms.

Construction sector posted a robust 4-5 percent expansion in 1H 2017 compered to 1H 2016, a rather positive sign of improving investment.

Pharmaceuticals (+36%), plastics (+25%), Chemical industry (+22%), paper industry (+19%) were the main sectors of positive growth over 2013-2017 period, according to data compiled by Rossstat.

Really good news is that household demand is now recovering. Retail sales by volume were up ca 1% y/y on a seasonally-adjusted basis and real disposable household income rose from the cycle lows to the levels last seen in May-June 2016. Bad news is that with income growth slower than retail sales and even slower than actual household consumption (which grew faster than domestic retail sales due to accelerating purchases abroad), Russian households are dipping into savings and credit to fund consumption increases.

We shall wait until July 2017 PMI figures come out over the next few days to see more current trends in the Russian economy, but overall all signs point to a moderate 1H and 3Q (ongoing) expansion in the economy, consistent with 1.2-1.3% real growth. The Economy Ministry recently reiterated its view that Russian GDP will expand at more than 2% rate in 2017. Achieving this will clearly require a large and accelerated cut in the Central Bank rate from current 9% to below 8%. Even with this, it is hard to see how above-2% growth can be achieved.

Agricultural and food production are quite significant variable in the growth equation. In 2016, Russia became number one exporter of wheat in the world, with annual production tipping 120 million tons - historical record. Bad weather conditions in 2017 mean that current expected output is estimated at around 17% below 2016 levels. Russia consumes 70 percent of its wheat output internally, so cuts to exports are likely to be on the magnitude of 1/2 or more in 2017. Domestically, food prices inflation is rising this year, threatening overall Central Bank target and putting pressure on CBR to stay out of cutting the key policy rate. Inflation rose in June to 4.4% - moderate by historical standards, but above 4% CBR target.

28/4/17: Russian Economy Update, Part 4: Aggregate Investment

The following is a transcript of my recent briefing on the Russian economy. 

This part (Part 4) covers outlook  for aggregate investment over 2017-2019. Part 1 covered general growth outlook (link here), part 2 covered two sectors of interest (link here) and part 3 concerned with monetary policy and the ruble (link here).

From the point of Russian economic growth, investment has been the weakest part of the overall ex-oil price dynamics in recent years.

Rosstat most recent data suggests that the recovery in seasonally adjusted total fixed investment continued in 1Q 2017, with positive growth in the aggregate now likely for the 2Q 2017:

• 4Q16 investment was down about 1% from 2015
• Total investment rose from 22.12% of GDP in 2015 to 25.63% in 2016, and is expected to moderate to 22.23% in 2017, before stabilsing around 22.9% in 2018-2019
• The investment dynamics are, therefore, still weak going forward for a major recovery to take hold
• However, 2017-2019 investment projections imply greater rate of investment in the economy compared to 2010-2014 average
• However, last year fixed investment was down by 11% from 2014
• This is primarily down to Rosstat revision of figures that deepened the drop in investment in 2015
• About a quarter of total aggregate investment in Russia comes from small firms and the grey economy
• Rosstat data suggests that such investment was roughly unchanged in 2016 compared to 2015
• Other fixed investments, which are mostly investments of large and mid-sized companies, shrank by about 1% in 2016
• This compounds the steep drops recorded in the previous three years (down 10% in 2015 alone), so the level of investment last year remained below that of the 2009 recession
• Investments of large and mid-sized companies within oil & gas production sector rose robustly in 2016
• This marked the third consecutive year of growth in the sector
• Much of the increases was driven by LNG sub-sector investments which is associated (at current energy prices) with lower profit margins 
• On the positive side, investments in LNG facilities helps diversify customer base for Russian gas exporters - a much-needed move, given the tightening of the energy markets in Europe
• In contrast to LNG sub-sector, investment in oil refining continued to shrink, sharply, in 2016 for the second year in a row, 
• Other manufacturing investment also recorded continued sharp declines
• The same happened in the electricity sector
• In contrast, following two years of contraction, investment in machinery and equipment stabilised for the mid- and large-sized corporates
• Construction sector activity was down 4% y/y in 2016, marking third consecutive year of declines
• Exacerbating declines in 2015, commercial and industrial buildings completions fell again in 2016
• Apartments completions also fell y/y marking the first drop in housing completions since 2010

As the chart above illustrates:

• The forecast if for 2017-2019 improvements in investment contribution to growth, with trend forecast to be above 2010-2014 average
• However, historically over 2000-2016 period, investment has relatively weak/zero correlation (0.054) with overall real GDP growth, while investment relative contribution to growth (instrumented via investment/growth ratio) has negative correlation with growth even when we consider only periods of positive growth
• This implies the need for structural rebalancing of investment toward supporting longer-term growth objectives in the economy, away from extraction sectors and building & construction

Going forward:

• Russia's industrial / manufacturing production capacity is nearing full utilisation 
• The economy is running close to full employment
• Leading confidence indicators of business confidence are firming up
• Corporate deleveraging has been pronounced and continues
• Corporate profitability has improved 
• Nonetheless, demand for corporate credit remains weak, primarily due to high cost of credit 
• Most recent CBR signal is for loosening of monetary policy in 2017, with current rates expected to drop to 8.25-8.5 range by the end of 2017, down from 10% at the start of the year
• Irrespective of the levels of interest rates, however, investment demand will continue to be subdued on foot of remaining weaknesses in structural growth and lack of reforms to improve business environment and institutions

Taken together, these factors imply that the recovery in fixed investment over 2017-2019 period is likely to be very slow, with investment recovery to pre-2015 levels only toward the end of forecast period.

Thematically, there is a significant investment gap remaining across a range of sectors with strong returns potential, including:

• Food production, processing and associated SCM;
• Transportation and logistics
• Industrial machinery and equipment, especially in the areas of new technologies, including robotics
• Chemicals
• Pharmaceuticals and health technologies

28/4/17: Russia Cuts Headline Rate by 50bps

Bigger than forecast move by the Russian Central Bank to cut rates (down 50bps against consensus - and my own - forecast of 25bps cut) signals the CBR's comfort with inflationary expectations forward.

As noted in my regular advisory call on the Russian economy earlier this week (transcript here), inflation fell substantial in 1Q 2017, with current FY 2017 forecast sitting at around 4.3 percent. In line with this, CBR started cutting rates at the end of March, moving from 10% to 9.75% for its benchmark one-week auction rate. Today, the CBR lowered the rate to 9.25%.

According to CBR: "“Inflation is moving towards the target, inflation expectations are still declining and economic activity is recovering. Given the moderately tight monetary policy, the 4 percent inflation target will be achieved before the end of 2017 and will be maintained close to this level in 2018-2019.”

Median Bloomberg estimate is for the rate to fall to 8.5% by the end of the year. As I noted in the call: "I expect ...year-end (2017) rate target of around 8.25-8.5% if inflation remains on the path toward 4.3% annual rate, or 8.75-9% range if inflation stays around 4.6% annual rate".

The latest move helps the cause of the Federal budget (championed by the Economic Ministry) that needs to see ruble lose some of its attractiveness as a carry trade currency. In recent months, ruble has been the third best performing currency in the world, resulting in investors willing to borrow in foreign currencies to invest in rubles denominated assets. The net effect of this on the Russian economy is improving demand for imports and deteriorating budget dynamics (as Russian budget operates ruble-based expenditure, funded to a large extent by dollar and other forex revenues from exports of primary materials).

Nabiulina's move today, however, should not be interpreted as the CBR surrender to the Economic Ministry agenda of lowering ruble value. Instead, the rate cut is clearly in line with inflation targeting and also in line with previously stated CBR concerns about investment environment in Russia. Russian aggregate investment has been extremely weak in recent years, and economic recovery needs to involve a dramatic reversal of investment volumes to the upside, especially in areas of technology, R&D, and product and processes innovation. High interest rates tend to significantly reduce investment by making capital expenditure more expensive to fund.

27/4/17: Russian Economy Update, Part 3: Ruble and CBR Rates

The following is a transcript of my recent briefing on the Russian economy. 

This part (Part 3) covers outlook  for ruble and monetary policy for Russia over 2017-2019. Part 1 covered general growth outlook (link here) and part 2 covered two sectors of interest (link here).

Outlook for the ruble and CB rates

The ruble has appreciated this year about 6.6% against the US dollar, from 61.15 at the start of 2017 to just above 57.10 so far, and 3% against the euro from 64.0 to 62.06, compared to the start of 2016, ruble is up on the dollar ca 21.3% and on the euro some 22.4%

• The ruble has been supported by the strengthening in the trade surplus in late 2016 into early 2017, and by improved foreign investment inflows
• The ruble has been on an upward trend after hitting the bottom at the start of 2016
• However, rate of appreciation has fallen in recent months, while volatility has risen
• March real effective (trade-weighted) exchange rate (RER) was up nearly 30% y/y, as reported by BOFIT (see chart below)
• As noted by some researchers (e.g. BOFIT), “in Russia, exchange rate shifts tend to pass through relatively quickly and strongly to consumer prices, so ruble strengthening tends to curb inflation” which, in turn, increases private and fiscal purchasing power
• Another effect of the ruble appreciation is that it lowers government ruble-denominated tax revenue through direct link between energy exporting taxes (oil and gas) and oil prices, which are denominated in dollars 

For domestic businesses, a stronger ruble:

• Reduces their price competitiveness with respect to imports, but also 
• Lowers the cost of imported capital, technology and intermediates
• Majority of Russian manufacturers are relatively highly dependent on such imports and have very limited non-ruble exports

• Stronger ruble has very limited effect on the volume of Russian exports, primarily due to heavy bias in exports in favour of dollar-denominated energy and other primary materials
• Ruble appreciation reduces the costs of foreign debt service for firms (a positive for larger firms and banks) and can lead, over time, to lower borrowing costs within Russian credit markets (a positive for all firms)

In line with the export-import effects discussed above:

• Volume of Russian exports grew by over 2 % last year (primarily driven by oil and gas prices recovery and continued elevated volumes of Russian production of primary materials), plus by another (second consecutive) year of grain harvests 
• In 2017, export growth should slow as both harvest and energy prices effects dissipate
• Volume of exports of goods and services fell 1.87% in 2014, 0.41% in 2015 and 0.68% in 2016. Current forecasts suggest that the volume of exports will rise 4.5-4.6% in 2017
• Volume of imports was much harder hit by the crisis
• Volume of imports of goods and services fell 7.6% in 2014, followed by 25.0 drop in 2015 and 4.0% decline in 2016
• Current forecasts suggest strong, but only partial recovery in demand for imports, with volumes expected to rise 7.0-7.2% in 2017
• Key driver for imports growth will be the recovery in aggregate demand, plus appreciation of the ruble
• Key downward pressure on imports will continue to come (as in 2016) from trade sanctions and from ongoing reforms of public and SOEs procurement rules and systems (more on this later)
• Russia’s current account surplus contracted last year to less than 2% of GDP, printing at USD 22.2 billion, down from USD69 billion in 2015
• 2017 projections of the current account surplus range widely, although no analyst / forecaster projects a negative print, despite expected increase in imports
• IMF’s most current (April 2017) projection is for 2017 CA surplus of USD51.5 billion
• This level of CA surpluses would stand above the 2014-2016 average (USD 49.6 billion), but below 2010-2013 average (USD67.4 billion) and lower than 2000-2007 average (USD 55.7 billion)
• If IMF projection comes through, CA surplus will be supportive of significantly tighter fiscal deficit than currently projected by Moscow
• As a percentage of GDP, CA surplus is expected to come in at 3.30% in 2017, slightly above 2014-2016 average of 3.19% and slightly below the 2010-2013 average of 3.42% of GDP

Inflation

• With Russian inflation falling and current account surplus strengthening, 2017 will witness further pressures on the ruble to appreciate vis-à-vis the dollar and the euro
• Russia’s annual inflation fell below 5% in 1Q 2017
• The CB of Russia has kept a relatively tight monetary stance, holding the key rate at nearly 10% through most of 1Q, as consistent with the CBR strict targeting of the inflation rate (4% inflation target set by the end of 2017)
• CBR dropped rate to 9.75% at the end of March, noting a faster-than-expected drop in inflation and a slight decline in inflation expectations 
• Inflation fell from 4.6% in February to 4.5% in March and 4.1% as of mid-April
• 12-month forecast now at 4.3%
• CBR governor Nabiullina said the central bank does not share the finance ministry's view of a overvalued ruble, which is consistent with her projecting continued cautious stance on inflation
• Finance Minister, Anton Siluanov, recently stated that the ruble is overvalued by 10–12%
• Consistent with this, I expect a 25 bps cut at April 28th meeting of CBR Council and year-end (2017) rate target of around 8.25-8.5% if inflation remains on the path toward 4.3% annual rate, or 8.75-9% range if inflation stays around 4.6% annual rate

27/4/17: Russian Economy Update, Part 2: Two Key Sectors

Two key sectors to watch

Now, looking at some sectors across the Russian economy

Manufacturing:

• In 2015, total volume of manufacturing output dropped 5.4% and in 2016 it was basically unchanged on foot of robust growth in the chemical sector (+5.6% growth) and food sector (ca 2% growth)
• Other positive growth sectors were Pulp & Paper and Rubber & plastics, Wood products and Machinery and Equipment. The latter sector has been in a free-fall since 2012
• Negative growth continued in Transport vehicles (negative growth since 2014), Metals and products (also in decline since 2014)
• Production of oil products fell, ending years of growth starting even before 2007
• Construction materials experienced their second year of declining output
• Electrical machinery & equipment continued to contract for the fourth year in a row

• Corporate Leverage:
• Overall, economy continued to deleverage out of debt, especially external debt. CBR data shows that by the end of 2016, private sector external debt stood at USD470 billion, of which more than ¾ was held by non-financial corporates and ¼ held by the banks.
• The external debt/GDP ratio was stable and benign at 36%
• Corporate debt is largely - 80% - non-ruble denominated, while the same number for the banks was around 87%
• Corporate deleveraging slowed down substantially in 2016 as debt rollovers fell and debt renegotiations/restructurings declined
• Changes in ruble valuations had positive effect on debt burden in the oil and gas sector (forex earnings) and negative effect on debt burden in domestic producers
• If in 2014-2015, companies used receipts of funds from parent holding enterprises to roll over maturing debt, in 2016 these funds were increasingly used to pay down debt. In effect this means that the first part of the deleveraging cycle has swapped external debt for internal debt, while current phase of the cycle is witnessing overall debt levels reductions.

Banking sector:

• In contrast to 2014-2015, the ruble valuations acted largely to reduce debt burdens in the banks, as ruble appreciation in 2016 supported the forex valuation of the foreign debt 
• Banks deleveraging continued in 2016, at a pace that is roughly ½ the rate of 2015 and 2014 
• Data from the CBR show total banking sector assets fell last year by 3.5% in nominal terms
• Controlling for FX effects (ruble appreciation), total assets were up ca 2% at the end of 2016, compared to the end of 2015
• Stock of loans outstanding to the corporate sector was down roughly 4%, while stock of loans to households rose by more than 1%
• However, overall household credit contracted 7% in 2015, making 2016 recovery weak 
• Non-performing loans (NPLs) are declining as a share of the assets base, with decline accelerating in recent months
• NPL ratio for corporate loans still exceeded 6%
• Household credit NPL ratio was about 8%
• Aggregate banking sector 2016 profits rose five-fold to $15 billion y/y
• Three large SOE banks (Sberbank, VTB and Gazprombank) accounted for over half of the banking sector profits
• The CBR has continued to weed-out poorly run and non-performing banks using tools ranging from full shut down to forced mergers 
• At the start of 2017 there were 623 active credit institutions in Russia, of which 205 institutions had general banking licenses
• At the same time in 2016 there were 733 active credit institutions

26/4/17: Russian Economy Update, Part 1: Growth Outlook

The following is a transcript of my recent briefing on the Russian economy. This part (Part 1) covers general economic outlook for Russia over 2017-2019. 

Growth outlook and recovery analysis

Russia's Composite PMI = 56.7 in 1Q 2017, the strongest growth performance since 4Q 2006

• In both Manufacturing and Services sectors, Russian economy has outperformed in 1Q 2017 global economic growth momentum

• Russia is currently the strongest BRIC economy for the fourth consecutive quarter

• Russian Manufacturing PMIs averaged 53.2 in 1Q 2017, unchanged on 4Q 2016 and up on 49.1 average for 1Q 2016  

• 3rd consecutive quarterly PMI reading for Manufacturing that sits above 50.0 marker

• Russia Services PMI for 1Q 2017 came in at a blistering pace of 56.8, up on already significant growth in 4Q 2016 at 54.6 and significantly above 1Q 2016 reading of 50

• All in, this was the fourth consecutive quarter of Services PMIs above 50.0

• Energy and commodities prices

• Lack of structural reforms within Russia

• Key support was higher output in natural gas and the broader extractive sector (+ more than 1% y/y in 1Q 2017)

• Seasonally adjusted manufacturing output recovered in March, but still down almost 1 % y/y.

• Growth will be led by private domestic demand which also stimulates imports; and

• Firmer oil prices.

• The latest forecasts of the CBR and Econ Ministry expect GDP increasing by 1–2% pa over 2017–2020

• The forecasts assume the annual price of Urals crude to average USD40–50 a barrel

• Key drivers for growth assumed to be household consumption and fixed investment (both expected to rise 2–3 % pa)

• In contrast, imports are expected to outpace in growth terms exports, with current account surplus falling, although remaining in the ‘black’ at USD6-8 billion range

• The financial account deficit (excluding currency reserves) is expected to be within the range of USD6–10 billion annually

• GDP growth will be expected to fall to around 1% if Urals price falls to USD35 a barrel and zero growth will kick in at the USD25 per barrel. This astonishingly low level for zero growth oil price is a testament to aggressive deleveraging of fiscal and private sector balancesheets during the 2014-2016 recession

• Approaching presidential elections of 2018 may put pressures on Moscow to increase public spending. While this would be running contrary to current budgetary plans, it will provide a short run boost to growth. However, such a boost would come at the expense of reducing Russian fiscal policy resilience in the longer term

• Continued tensions in Syria can spillover into a [limited] conflict involving Russia and either Turkey or the U.S.-led coalition or even the U.S. forces. Such an event would trigger massive spike in geopolitical uncertainties and will undoubtedly severely disrupt markets and investment flows, as well as global trade flows

• Emerging tensions (with growing Russian involvement) around North Korea, where Russian traditional role of being a distant secondary guarantor to China is gradually moving up the scale, just as China appears to be more accommodative of he Western demands

• Currently stable, but nonetheless risky and ambiguous outlook in Eastern Ukraine, with continued risk spillovers (albeit much more subdued) to Easter European politics

• Still evolving (and for now benign) re-alignment of powers in Central Asia that can spiral out of control 

• Emerging and occasionally visible (albeit relatively benign) policy confrontations with Belarus

• Potential for re-igniting of the Nagorno-Karabakh conflict

• Internal protests focusing on lack of meaningful anti-corruption reforms, especially set against the backdrop of continued, but abating, internal power struggles, involving some close past allies of the Kremlin – struggles that occasionally involve accusations of corruption and graft

• Internal issues relating to human rights abuses, especially and most recently, highly visible and robust accusations of suppression of LGBT minorities in Chechnya

Another factor is import recovery: 

• Imports recovery can run stronger than forecast, hitting largely modest in scale, although rather successful in the short run in some sectors, policies aimed at import substitution

• This stability suits both the West and Russia, where the sanctions are supporting domestic producer

• Given these dynamics, there is no pressure for Russia to abandon its current trade sanctions stance, despite the public statements by the Government to the contrary

• This is exemplified by the lack of changes in trade relations with Turkey post-normalisation of relations, and especially by March 2017 changes to Turkish tariffs on Russian exports of grains (corn and wheat)

• In mid-March this year, Turkey imposed 130% import tariff on imports of certain food items from Russia, including wheat and corn imports

• Although Turkey is one of the largest export markets for wheat and corn for Russian producers (Russian exports last year valued at roughly USD550 million), Russia did not attempt to trade food tariffs for its own import bans on Turkish products, including fruit and vegetables

• A year-old ban is beneficial to both Turkey and Russia from geopolitical perspective, even though it fuels higher inflation in Russia so much so that instead of relaxing its own prohibitions, Russia expanded the imports ban for Turkish goods to a wider range of plant materials

Overall, in the long run, achieving faster sustainable and resilient growth will require deeper structural reforms. These include: improving the business environment and institutional structures, accelerating modernization of the capital base and adoption of new technologies, raising R&D and technological capital investments, accelerating modernization of management systems, and significantly reducing the state share of the economy, including the extent of the State Owned Enterprises (SOEs) dominance across a range of sectors

• Implementation of such reforms will support private investment and raise productivity growth rates for both TFP and labour productivity

• Structural reforms would also reduce economy’s dependence on extraction industries and, if targeted toward processing sectors, can significantly improve value added component of these sectors, helping to de-link economic growth from energy prices and commodities prices in general

• While the Economic Ministry is now tasked with drafting a set of economic policy reforms to cover the period through 2035, to-date, we have no indications which reforms are being considered. We are unlikely to see any official drafts prior to the onset of the 2018 Presidential election campaigns, and the impact of any such reforms is unlikely to materialise before 2020.

Despite some robust numbers, the economy remains relatively exposed to the downside risks, including

Somewhat deflating the leading indicators, Rosstat reported that seasonally and workday-adjusted industrial output recovered in March on a relatively weaker February

After a two years-long recession, real GDP growth should be + 1.3-1.6% this year (mid-point 1.4-1.5%)

Continued sluggish performance in 2017-2019 is due to the economy already running near full capacity and lacking deeper structural reforms to boost long term growth potential. Thus, my expectation is for real GDP growth to remain around 1.4-1.5% mark over 2017-2019

Risks:

Biggest short-term risk (upside and downside): the price of oil

A second risk factor involves geopolitical and political triggers that could hit Russian growth outlook hard, either directly or indirectly via increased political instability and adverse investors’ and entrepreneurs’ perceptions

Relating to both, imports substitution drive and the issue of geopolitical risks, the current sanctions regime (for both Russian sanctions vis-a-vis Western producers and Western sanctions vis-a-vis Russian economy) appears to be stable

Stay tuned for more transcripts

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6/1/17: Russian markets briefing transcript: November 2016

This is a transcript of my advisory 4Q 2016 conference call on Russian economy from November for Western institutional investors and advisory companies.


GEOPOLITICAL REBALANCING

US Election

• Uncertain outcome of the election implies that outlook for 
• Highly volatile environment remains
• Short term pause in September-November signaled lack of understanding / lack of certainty, not expectation of rapid de-escalation and are likely to be followed by re-amplification of tensions
• European dimension is now at play, yet and unlikely to become such, especially if economic conditions in the Euro area improve
• Key markers to watch:
• France – 23 April 2017 Presidential election
• Germany – remains a key driver for strong stance against Russia – Federal Election in 2017 (latest date possible is end of October)
• Holland – Dutch General Election, March 2017
• Italy Referendum and post-Referendum political fight
• Eastern European position of influence in NATO is weakening, so we can expect more amplification of pressure at the EU level
• British position in the EU is weakened by Brexit that also deflects UK attention away from Russia

Outside the US-Russia and Russia-West planes of confrontation are:

• Turkey - fragile rapprochement with Moscow and some re-alignment of objectives ex-Syria
• China - rebalancing in Asia Pacific, but caution on Trump
• Ukraine - sliding into internal problems and losing US and European catalysts
• Syria (and broader to Egypt and North Africa) - a very narrow window of opportunity to achieve some stabilisation
• Uzbekistan and Central Asia - the unknown unknown is now a known unknown
• Armenia-Azerbaijan - a frozen conflict that impacts peripheral issues in Turkey-Russia and Russia-Central Asia areas.

How likely are we to see short term rebalancing in the Russia-West relations?

• Not likely as new Washington-Moscow dynamics will require some serious re-thinking and the incoming U.S. Administration will take time to weed-out – assuming the weeding-out happens at all – the remnants of ‘permanent government’ established during neo-conservative foreign policy of Bush-Obama years. Short term prospects are also at risk from the existent leadership in the Congress.

How likely any rebalancing is sustainable over time?

• Not likely, as the two countries remain at loggerheads in geopolitical arena and the pressure points will remain, whilst trust and cooperation will be in short supply no matter what levels of positive rhetoric are attained today.
• It will take a major re-structuring of international agreements, and long term strategies, including across the Former Soviet Union (ex-Baltics) to provide a base for trust-intensive relations.
• Neither party currently has such capacity in place.

The real issues to watch are internal political games being played in Russia:

1. Recent cabinet changes and Presidential Administration changes signal gradual renewal of the power vertical inside the Kremlin.
2. Recent corruption scandals and response to these – Ulyukaev’s case is the most visible one – signal renewed push for change. This deflects public opinion away from increasingly harder to achieve wins in geopolitical strategy, and gives some breathing room for improving relations with the West. The gesture is yet to be reciprocated by the West, however, as political leadership in Europe and the U.S. is too pre-occupied with shoring up status quo distribution of power, instead of pursuing constructive normalisation of geopolitical relations.
3. Recent Presidential statements – especially, notably, the focus of economic reforms into post-2018 election period relate to two factors
1. This suggests that until 2018, Kremlin is likely to push for more focus on social / political measures, e.g. accelerating corruption clearing at the top and reshuffling the elites; and
2. It also implies that until 2018 the current course (moderating the adverse impact of budgetary adjustments) will remain the main objective of policymaking.

On balance, political risks are better balanced today than they were three months ago, but catastrophic risks (major destabilization risks) still remain in place.

• Syria is still a tough and a very dangerous game, with key players becoming more and more restless in the current stalemate:
• Russia-Syria-Iran axis is countered by U.S.-Saudis axis that recently also gained Egypt into its ranks. Which gives the former a greater impetus to achieve some cease fire and political dialogue than before (a positive for risks), but also creates added pressure point in the already volatile environment (a negative for risks).
• Meanwhile, Turkey is pursuing own game in Syria that serves both internal political dynamics and, potentially, threatens a destabilising momentum in Armenia-Azerbaijan conflict.
• All of these dynamics are extremely volatile and dangerous.

MONETARY POLICY

As of the end of October, inflation is running at 6.1 percent (averaging over 2016), down from 12.9 percent in 2015 and 11.4 percent in 2014. So far this year, inflation is running at the levels of 2011, tied for the lowest rate of price increases for the last 10 years. This clearly supports CBR moving down in terms of key rates.

M2 is up 12 percent y/y (end of 3Q 2016 data), strongest growth in 3 years, but below 2011 rate of increase (22.3 percent). Overall, M2 is highly volatile, so it is not exactly a signal for policy move, but on the trend, money supply aggregates support the view that CBR can move lower on rates.

Both, retail lending and deposit rates have come down in 2016 (again, data through 3Q 2016). Lending rate is down to 12.1 percent from 18.3 percent in 2014 and from 13.8 percent in 2015. Lending rates are still running above 9.3 percent average of 2010-2013. Meanwhile, deposit rates are at 6 percent, which translates into healthiest lending margins since 2008. Again, this suggests that CBR is gaining momentum on a rate cut.

What is holding CBR back from cutting from its current rate of 10 percent - reaffirmed on October 28th? 

• CBR did not have any currency markets interventions since July 2015.  And the Ruble is trading in the comfort zone from the budgetary perspective: average through October at 62.6 against USD and 69.0 against Euro. CBR would like to keep it in this range: above 60 to USD and above 65 to Euro.
• Uncertainty about US rates and the pace of ECB policy suggests that CBR will stay cautious, especially if there are no major blowouts on the real economy side. Lift up in US rates will be a negative for the Ruble due to oil price tie-in, and any firming up in the Euro will be a positive due to gas prices tie-in. So CBR has plenty of moving parts in the Forex equation to keep its policy balanced around 9.25-10 percent range.
• Oil prices firming up – especially post-OPEC meeting last week – will require confirmation over time, so that is not a catalyst, yet, for moving on the rates.
• Meanwhile, wages inflation is heating up: average wages in USD terms stood at 578 per month in 10 months through October 2016, up on 2015 average of USD553. Revised September-October figures show growth in real wages of 1.9 percent and 2.0 percent, respectively.

Net result:

Central Bank Chief Elvira Nabiullina said recently that she does not expect any rate cuts this year, and that the economy is in a stable condition. "We assume that there will be no sharp changes in the economic structure as it needs time. The growth rates will be positive, but unfortunately will remain at low levels".

Latest PMI reading for Manufacturing shows that manufacturing is gaining pace and is now running at best performance reading since 1Q 2011. Services PMI gained new momentum. Composite PMI is at its highest reading since March 2011. So indicators are good, but headline growth catalysts remain absent, especially on policy side (actually for the full range of policies: from monetary and fiscal, to structural).

A day before Nabiullina speech, Russian President Vladimir Putin requested in his state-of-the-nation address to the Federal Assembly an ambitious plan to get the economy to growth rates above than 3 percent. The timeline for the plan implementation is after the 2018 Presidential contest.

According to the Central Bank, Russia’s GDP stopped falling in the third quarter of this year as it slowed down to 0.4 percent from 0.6 percent in the second quarter. Russia’s GDP contraction will amount to 0.5-0.7 percent by the end of the year, the regulator said. Nabiullina called on the government not to put up with the "ceiling" of the Russian economy growth at 1.5-2 percent.

Overall, the Central Bank has been the best performing Russian institution during the current crisis. It has managed extremely well both the monetary policy and the ruble flotation, while resisting pressures from the Government and various Ministries (Finance and Economic Development) for more accommodative monetary stance. The CBR also managed well the process of weeding out weaker Russian banks and shutting down banks closely tied to industrial conglomerates.

Catalysts for change:

Key catalyst for rate policy changes in 2017 will be: inflation, budgetary dynamics and Urals oil price. The CBR is also well aware of the crisis in fixed investment and the adverse impact this is having on the economic growth. Key external catalysts will be the U.S. Fed policy changes (pace and timing of tightening), and Euro area growth dynamics (external demand driver).


BUDGETARY AND FISCAL DYNAMICS

Despite the concerns at the start of 2016, Russian budgetary dynamics have been returning pretty strong figures, when set against the backdrop of the economy which is second year into a recession and have not seen substantial economic growth since the start of 2013.

Looking at the headline numbers, all data through October 2016, Government revenues are running at 15.3 percent of GDP, below 2015 levels of 18.5 percent and marking the lowest over the last 10 years. Government expenditures are running at 17.6 percent of GDP, also down on 21.2 percent in 2015 and also marking the lowest reading since 2007.

On the expenditure side, however, setting aside any arguments relating to fiscal investment stimulus (which is not happening, not surprisingly), 2007-2008 expenditures were averaging around 18.2 percent of GDP, which is relatively comfortable in comparison to current rate of expenditures. In other words, 17.6 percent rate of fiscal spending is not a tragic example of austerity, but against the backdrop of continued contraction in GDP and lack of investment in the economy, fiscal conservativism is not helping.

General Government balance is actually quite healthy, again compared to conditions in the economy. Current deficit is at 2.3 percent of GDP and this is an improvement on 2015 levels of 2.6 percent of GDP. The deficit remains much better than the average of 4.7 percent of GDP deficit in the recession of 2009-2010.

More problematic, however, is the longer term trend: Russian Federal Budget has now run deficits in seven of the last ten years.

Central Government debt ticked up in 2015 to 13.6 percent of GDP, and is currently (based on 3Q figures) running at around 13 percent of GDP, so there is no fiscal re-leveraging. Current debt levels are sitting comfortably below 2014-2015 levels. External debt is at 2.9 percent of GDP – hardly a serious matter when it comes to sovereign debt risks. Total quantum of external debt is currently at USD36 billion – well below 2012-2014 levels, but somewhat higher than USD30.6 billion at the end of 2015.

Oil funds and forex reserves depletion continues, but at a much slower pace.  The combination of the Reserve Fund and the National Welfare Fund – the so-called Oil Funds – currently amounts to USD103.9 billion (data through end of October 2016) down from USD121.7 billion at the end of 2015, and down from the pre-crisis peak of USD176 billion in 2013.

Forex reserves, including gold, are standing at USD390.7 billion as of the end of October 2016, and this is actually up on USD368.4 billion in Forex reserves at the end of 2015. Still, forex reserves are down from the pre-crisis peak of USD537.6 billion at the end of 2012. The uplift on 2015 came from stronger currency reserves (up ca USD12 billion y/y) and expanded gold allocations (up roughly USD14 billion y/y).

Key concerns forward are: to what extent can the fiscal policy continue constraining economic growth and how politically imports will a return to more robust (above 1.5 percent pa) growth will be in a year before the Presidential Elections?

My view is that government fiscal policy will continue to act as a drag on the economic recovery in 2017. Assuming average annual oil prices around USD53-55 per barrel range, and given the GDP forecast for a very mild expansion in 2017, government budget revenues will rise only slightly faster than inflation in 2017–2018.

The consolidated government deficit in 2015 amounted to about 3.5 percent of GDP. My expectation is that it will finish 2016 at around 3.1-3.3 percent of GDP mark. For 2017, the Government is aiming to reduce the deficit by 1 percentage point – a measure that is hard to put into place given forthcoming 2018 Presidential election.

To finance the deficit, the government can withdraw money from the Reserve Fund, and if needed, the National Welfare Fund. The combined liquid assets of the two funds stand below 7 percent of GDP.

It is, however, unlikely that Moscow will pursue more aggressive depletion of reserves in 1H 2017, as it needs to retain a safety cushion for 2018 Presidential Election year. Thereafter, with March Presidential poll looming closer on the horizon, in 3Q 2017 and especially 4Q 2017, we can expect much stronger efforts to support some growth in the economy on demand side (social spending, pensions, health and education), as well as stronger economic reforms rhetoric.


2016 GROWTH PERFORMANCE

Improving conditions in the services and manufacturing sectors over 2H 2016 – as indicated by the industrial production and headline GDP figures, as well as by PMIs – suggest that the economy has indeed returned to growth. Industrial output contraction in October was just 0.2 percent y/y and there was growth of 5.8 percent m/m. However, the rate of economic expansion remains weak and growth is fragile, and subject to significant potential shocks.

The drop in economic output over the entire recession was mild once we take into the account that oil prices are currently some 60 percent down on 1H 2014. Recent rebound (or rather firming up) in oil prices is helping to bring economic growth around. However, on the negative side, the rebound in oil prices remains weak and unconvincing – as evidenced by the bounce up, followed by swift reversal in oil prices in the wake of the most recent OPEC meeting.

Another growth support factor during the recession (and throughout 2016) is the contraction in imports. Over 2014–2016, decline in imports has been steeper compared to the drop of the GDP. Imports in 1H 2016 were down by close to 10 percent y/y and cumulative decline was running at around 40 percent compared to 1H13. Much of the decline is driven by weaker ruble (down about 6 percent y/y and nearly 30 percent on the 1Q 2013 levels), but some was also arising from sanctions and counter-sanctions. While consumption goods imports drop is a short-term positive for the economy that is actively seeking breathing room for diversification (mostly via imports substitution at this stage), a drop in imports of capital equipment and technologies, as well as associated services, is a net negative for the economy.

Russian fixed capital formation (investments) – having started falling back in 2014 – continued decline in 2016. Investment is down in 1H 2016 some 4 percent y/y and some 10 percent on 1H 2014. Over the first nine months of 2016, fixed investment was down 6.6 percent y/y – slower rate of contraction than 8.4 drop recorded in 2015, but second fastest since 2009.

With ruble back at the levels last seen in 2005, private consumption slumped over the course of the recession, and is continuing contracting through 2016, with retail sales down roughly 6 percent y/y and 14 percent on the same period of 2014. October figures show return of the downward trend, with retail sales down 4.4 percent y/y. On foot of devaluations, Russian household income also contracted significantly. In addition, underemployment (reduced paid hours of work and extended unpaid leaves – practices that help sustain lower overall headline unemployment figures) also took a significant chunk out of Russian purchasing power and household investment capacity. In August, Russia recorded the steepest drop in real household incomes since 2009, the decline that started in 2014 and continued through 3Q 2016. August rate of decline was 9.3 percent y/y.

On a positive side, however, recent months saw a return of international investors to Russia. The Government announced sale of a 19.5 percent stake in Rosneft to Quatar and Glencore for some USD 11.3 billion. Outside oil sector, retailers Ikea and Leroy Merlin SA are putting more money on the ground in Russia with plans to open new stores, logistics facilities and assembly plants. Ikea is investing USD1.6 billion in new stores over the next 5 years, and Leroy Merlin plans to plough USD 2 billion in new retail locations. Pfizer is in the process of building a new factory, PepsiCo is investing USD50 million in a new factory, and Mars Inc is expanding two plants. In H1 2014, foreign direct investment in Russia was running at around USD 20 billion. This fell to USD2 billion in H1 2015 and stood at approximately USD 6.1 billion in 1H 2016. In January-September 2016, FDI was up at USD8.3 billion, against FY 2015 FDI of just USD 5.9 billion.

Despite the severe headwinds, Russia is managing the macroeconomic and fiscal positions relatively well. Amidst falling growth rates in global trade and operating under sanctions, the economy is still generating current account (and balance of payments) surpluses. In May this year, the State issued USD1.75 billion worth of 10-year Eurobonds at an effective yield of 4.75 percent – the first foray into international lending markets since 2013. This comes on foot of continued declines in oil revenues. In the first eight months of 2016, oil export revenues were down 27 percent.

Public sector wages freeze and limited increases in pensions help reduce fiscal deficit, even if they impose a drag on economic growth. Still, the deficit is a significant risk factor with some projections putting FY 2016 deficit at 3.7 percent, well above the 3 percent target that Kremlin was setting in its 2014-2015 programs published in response to the Western sanctions.

The early official figures for 3Q 2016 GDP imply a contraction of 0.4 percent y/y in real terms for the full year, with 1Q-3Q 2016 decline of 0.7 percent.


GOING FORWARD: 2017 OUTLOOK AND BEYOND

Coming out of the recession, Russian economy has low growth potential with expected long-term growth rates of 1-1.5 percent per annum. The reduced potential for growth comes from adverse demographics, shrinking labor force, decline in capital investment and weak human capital investments. Low productivity growth also suppressing potential rate of economic expansion. In the short run, these factors coincide with uncertain business environment. Structural reforms are still severely lagging and corruption remains a major problem, especially when it comes to the efforts to diversify economic base. Delay in structuring and implementing significant institutional reforms, set to start after 2018 Presidential election, as well as uncertainty as to the nature of these reforms (with plans likely to start emerging in 2017) also create an unfavourable backdrop to growth scenarios.

Under my longer term outlook, Russia is unlikely to recover to pre-recession levels of GDP until 2020-2021.

In the short run (2017) we are likely to see slower contraction in investment, with 2H 2017 seeing return to positive domestic investment growth, while 1H 2017 likely to witness accelerated inflows of FDI, barring any adverse shocks. Imports will pick up in 2017, with growth of some 4-5 percent y/y. Nonetheless, current account will remain in surplus through 2017. I expect inflation to moderate from roughly 7 percent in 2016 (FY) to 5-6 percent in 2017. Still, real income are going to remain significantly depressed through 2017, as even moderate inflation will be running against extremely weak labor productivity growth. With recent increases in unemployment, as well as elevated levels of underemployment (latest figures showed an uptick in unemployment to 5.4 percent in October 2016 from 5.2 percent in September), 2017 will see some labor force slack being absorbed into new jobs creation.  This will provide some upside to household incomes.

The above scenario assumes no significant public spending or investment uplift in later part of 2017 as the Government shifts toward elections mode. The pressure on this side will come from pensions: under the new law, working pensioners (accounting for just over 1/3rd  of all pensioners) will receive zero inflation adjustment to their pensions and other pensioners are set to receive pay increases of ca 3 percent, below the inflation rate. This is likely to prompt some declines in the approval ratings for President Putin and the Government as well as some localized protests, both putting pressure on the Government to react by awarding larger pensions increases.

I expect GDP growth to come in at just above 1 percent in 2017, before rising to 1.5-1.7 percent in 2018.

Positive contributions to GDP growth in 2017 will come from:

• Exports, moderated by the negative contribution from rising imports (in 2016, imports contributed positively to growth, while exports contributed negatively)
• Private consumption (in 2016, private consumption was a net drag on growth)
• Fixed investment is likely to provide zero meaningful support for growth in 2017.

The same drivers will operate in 2018, with exception for fixed investment that is expected to generate small positive contribution to growth in 2018.

On the negative side:

• Public consumption will contribute negatively to growth in 2017 (same as in 2016) – the effect that will likely dissipate in 2018;

My outlook for the Russian economy is less optimistic than that of the World Bank which projects growth on 1.7 percent in 2017 and 2018, and more in line with the Ministry of Economic Development, which forecasts 2017 growth at 0.6 percent and 2018 growth at 1.7 percent.

All forecasts – mine, World Bank’s and Ministry of Economic Development – are based on average oil price of USD55-55.5 per barrel in 2017, rising to USD59-60 in 2018.