15/1/20: Putin's Latest Call Option Buy

"Poekhali!" sad Vlad, refraining Yuri Gagarin's famous phrase. And just like, with a sweep of his hand, Mr. Putin has

1. Removed the entire Russian Cabinet, including his long-serving pal, now ex-Prime Minister Medvedev;
2. Outlined a hefty set of forward-promised reforms; and
3. Added billions of dollars to the Global GDP by creating a tsunami of Russia-related analysis, opinion pieces, reports and updates in the vast Kremlinology Sector bridging journalism, opinnionism, and think-tankerism.

WTF happened in Moscow today?

Putin has been under some sustained pressure in the last couple of years on the domestic economy front. Russian economic growth has been anaemic, to put it mildly. Let's take a brief walk through some headline figures (to-date):

• Despite the 'recovery' from 2015 recession (GDP down 2.3%) and 2016 stagnation (GDP up 0.3%), Russian economic growth peaked at 2.3% in 2018 and slumped to 1.1% in 2019 (based on January-September stats).
• Industrial production is up 2.4% y/y in 2019 (latest data is for January-November) which is worse than 2.9% in 2018, but still miraculous, given the state of Russian Manufacturing PMIs (see: https://trueeconomics.blogspot.com/2020/01/5120-bric-manufacturing-pmis-4q-2019.html).
• Fixed capital investment is in a dire state: in Q1-Q3 2019, investment is up only 0.7%, down from the rate of growth of 4.6% in 2017 and 4.3% in 2018. 
• Retail sales are up 1.6% in 2019 (January-November data), but behind 2.8% growth in 2018. Retail sales rose 1.3% in 2017. None of this enough to recover the sector from a wave of massive contractions in 2015-2016, when retail sales fell 10% and 4.8%, respectively.
• Exports have recovered, but are still running below 2011-2014 period averages.
• Current account surplus is still positive, but way lower than in 2018. 
• Unemployment is a bright side, at 4.6% in H1 2019, down from 4.8% in 2018, currently - the lowest on record.
• After years of growth, population is set to slightly contract in 2019 compared to the post-Soviet peak of 2018. The change is estimated and is not statistically significant, but it indicates one breakaway from the prior trend: inward migration into Russia has slowed down substantially in 2018-2019, in part due to anaemic economy.
• Fiscally, Russia is doing brutally well, however. Government surplus of 2018 - at 2.6% of GDP is likely to be exceeded in 2019: January-November data puts surplus at 3.1% of GDP.
• Central Government Debt is at 13.7% of GDP as of October 2019, a slight uptick on 11.5% in 2018 and hitting the highest level since 2005, but more than benign, given it is entirely offset by the sovereign wealth funds and is being effectively shifted out of foreign currencies and into Rubles. As a reminder, in his first year in the Presidential office, Putin faced Government Debt of 79% of GDP, with External Debt being 67% of GDP. In 2019, external debt is at around 3.9% of GDP.
• Oil reserve funds are up massively in 2019. In 2018, the funds amounted to USD 58.1 billion. At the end of September 2019, this stood at USD 124 billion. Including FOREX and Gold reserves, and other sovereign wealth funds, Russian Government had USD 530.9 billion worth of reserves as of September 2019, almost back to the peak of USD537 billion in 2012.
• Inflation has ticked up in 2019. inflation hit an all time low of 2.9% in 2018 and over January-November 2019 this rose to 4.6%. Inflation has been a major historical point of pain in Russia, so return to above 3% price increases environment is a troubling matter, especially as the economy is barely ticking up any growth.
• Average monthly wages in rubles are growing: up from RB 43,431.3 in 2018 to RB 46,549.0 in 2019 (October data). And wages are up in Euro terms (from EUR587.1 in 2018 to EUR654.1 in 2019). Average wages are also rising in USDollar terms. Which is a point of improvement for the Russians.

All of which brings us back to where Mr. Putin was standing at the end of 2019: he was presiding over an anaemic economy with some marginal signs of improvement and a growing dissatisfaction amongst his electorate with the Government management of the socio-economic conditions. Here is a snapshot of Vladimir Putin's and Dmitry Medvedev's approval ratings as collected by the independent Levada Center: http://www.levada.ru/en/

Notice much? Yep. Traditionally, Russian voters have placed increasing blame for deteriorating socio-economic conditions on the Government, as opposed to the President. Recent years are no exception. The last points on these charts is November-December 2019. Putin's approval ratings have basically stagnated from 3Q 2018 on, while Mr. Medvedev's ratings continued to slip.

Here is a nice kicker: majority of Russians are increasingly not seeing an alignment between their interests and the objectives of the Government. Again via Levada:

"Probably not" and "Definitely not": 2007 = 62%, 2009 = 65%, 2011 = 68%, 2013 = 67% and ... 2019 = 72%. Other signs of pressure? Position: "The government lives off the people and isn’t concerned about how normal people live" - support = 53% in October 2019 poll.

So Putin has been facing some major dilemmas in recent months. Chief ones are:

1. How to shift economy toward a faster growth path?
2. How to resolve the 2024 exit strategy without triggering an internal 'civil servants war' in the corridors of power? and
3. How to secure an upside to his legacy (remember, recency bias means that people remember more recent actions / legacies of their leaders, as opposed to the more distant ones)?

Step one in dealing with the three dilemmas is: replace the unpopular Cabinet. Step 2 is: announce new reforms that - by historical experience - must include things that haven't failed before (e.g. focus on longer term political reforms as opposed to the shorter term market reforms). Step 3 is: quietly unleash a host of economic development policy changes (these are not reforms per se, but a rather policy tools that cannot be deployed by the current, status quo-anchored, Cabinet).

Unless you are a tin-hat-wearing member of the Putin World-Domination Conspiracy club, so far - rational, right? 

So Putin announced that he will 

• gradually (a good thing, given weak institutional capital in Russia) 
• rebalance the executive power away from the Presidential status quo 
• toward a more co-shared power arrangement with the Duma (Russian Lower House of the Parliament). 
• The only three details Putin mentioned today on the subject are: 

1. Letting Duma elect the Prime Minister; 
2. Giving Duma the power of appointing the entire Cabinet of Ministers and all Deputy Prime Ministers; and
3. The President will have no veto power over the Duma on these appointments.

The whole idea is not new. 

Yeltsin dramatically reduced Parliamentary powers after the 1993 'Constitutional Crisis' - an event that saw the West applauding him for bombing the Parliament. Putin subsequently tightened the Presidential grip on power, motivated, at least at first, by the reality of the post-Yeltsin Russia spiralling into a series of smaller secessionist civil wars. Yeltsin made a deal with the devil in his last election: in exchange for the regions support for his hugely unpopular Presidency run, he gave regions more autonomy. On his timescale, Russian Federation would have been a wedge of Swiss cheese, riddled with newly independent ethnic and religious enclaves, by the mid-2000s. Under Putin, Moscow had consolidated its power, suppressing ethnic strife and nationalist extremism. By 2009, then-President Dmitry Medvedev started talking about the need for development of a functional opposition to the Kremlin-backing party, the United Russia. Chats about devolution of power back to the Parliament were mooted. In the end, Medvedev's reforms program included none of the political reforms to challenge the Kremlin. Worse, Medvedev's Police reform of 2011 was an exercise in federalization of the police force, effectively removing much of the local control over the cops. That said, the same reform significantly curtailed the imbalance between the rights and the duties of the police, giving more rights to the citizens.

Now, the idea of devolution of power is back. Why? Because today's Russia faces three important realities:

1. Reality of a stagnant economy - traceable back to 2011 and post-2014 collapse of oil prices. This stagnation outlived the economic promises of the Medvedev's reforms and the endless statements from Putin about the need for diversification of the Russian economy;
2. Reality of shifting voter preferences away from supporting geopolitical re-entry of Russia into the exclusive club of countries that 'matter' toward domestic agenda; and
3. Reality of the Putin presidency facing the end game of transition of power - something that virtually never has been achieved in the past without a major mess.

One way or the other, the idea of giving Duma a meaningful say in the formation of the Government is a good idea for Russia. And one way or the other, it will provide new incentives for a gradual (over the longer period of time) evolution of the Russian body of politics away from the rubber-stamping 'opposition' to the ruling United Russia (the status quo) and toward genuine competition in policies and ideas. This, too, is a good thing for Russia. In fact, I can't really find anything bad in the Putin's latest idea, without forcing myself to think in conspiracy theory terms.

Therefore, to me, the main question that everyone should be asking is not whether or not Putin is proposing these reforms in order to remain in power post-2024, but whether such reforms are feasible today. My gut feeling is that they might be. If the Duma is given real powers, starting with the powers of selecting the Government Cabinet, skin-in-the-game incentives for political parties participation in legislative process beyond today's political posturing will rise. This can, over time, lead to the emergence of a genuine and more effective opposition - the one, driven by policy debates and competing world views. Will it happen? I don't know. Does Putin know? I doubt. 

Frighteningly, not a single journalist I've read on the topic today asked these questions of feasibility of the reforms. Instead, all focused on scaremongering their readers into believing that the announcement is yet another dastardly Putinesque plot to [insert the humanity destroying disaster of your choice here].

CNN produced this utter garbage for analysis:

The CNBC folks decided piped in with this one" 

Neither august outfit of 'world class journalism' has managed to notice the fallacy of their 'damned if he does anything, and damned if he does nothing at all' logic. But enough morons. The real test of Putin's 'reforms' will come post 2024. Until then, watch the proposals for the referendum take shape.

PS: Will we miss Medvedev? Well, he sure beats the tax collector who will replace him. At least in charisma, diplomacy and economic thinking. But not in accountancy. 

13/6/19: Russian International Reserves and Government Debt

Earlier today, an esteemed colleague of mine tweeted out the following concerning Russian foreign reserves:

Which is hardly surprising, as Russia has been beefing up its reserves for some time now, following the crisis of 2014-2016 and in response to the continued pressures of Western sanctions. I wrote about this before here: https://trueeconomics.blogspot.com/2019/04/10419-russian-foreign-exchange-reserves.html.

It is interesting in the light of the above news to look at Russian Government 'net worth' or 'net debt' (note: this is not the total external debt of Russia, nor Government external debt, but the total Russian Government debt comparative). Here is the chart based on the OECD data, with added estimate for Russia for 1Q 2019 based on IMF data and the latest data from CBR:

Based on my estimates and on OECD data itself, Russian Government has the largest positive net worth (lowest net debt) of any country in top 10 countries in the world (measured using nominal GDP adjusted for Purchasing Power Parity), and it is in this position by a wide margin.

The caveat is that India, China and Indonesia are not reported in the OECD data. China's Government net worth is virtually impossible to assess, because the country debt statistics are incomplete and measuring the gross wealth of the Chinese Government is also impossible. India and Indonesia are easier to gauge - both have positive net debt (negative net worth). IMF WEO database shows estimated General Government Net Debt for Indonesia at 25.5 percent of GDP in 2018. India has substantial gross Government debt of ca 70% of GDP (2018 figures), and the Government holds minor level resources, with country's sovereign wealth fund totalling at around 5 billion USD.

Another caveat is where the debt is held (Central Banks holdings of debt are arguably low risk) and whether or not assets held by the Governments are liquid enough to matter in these calculations (for example, Russian gold reserves are liquid, while some of the Russian funds investments in local enterprises are not). These caveats apply to all of the above economies.

On the net, this means that Russian Government is financially in a strongest leveraging position of all major economies in the world.

10/4/19: Russian Foreign Exchange Reserves and External Debt

As recently posted by me on Twitter, here are three charts showing the evolution of Russian foreign reserves and external debt:

Remember the incessant meme in the Western media about Russia eminently in danger of running out of sovereign wealth funds back at the start of the Western sanctions in late 2014? Well, the chart above puts that to rest. It turns out, Russia did not run out of the reserves, and instead quite prudentially used funds available to carefully support some economic adjustments (especially in agriculture and food sector), while simultaneously balancing out its fiscal deficits.

Do note that the reserves above exclude over USD 91 billion worth of Gold that Russia holds and continues to buy at rising clips.

The result of the prudentially balanced management of the reserves and the economy was deleveraging out of debt (a lot of this was done via restructuring of intracompany loans and affiliated enterprises refinancing), with a reduction in the external debt (chart below), without use of sovereign funds:

As of current, Russian foreign exchange reserves ex-gold are more than sufficient to cover the entirety of the country public and private sectors external debts.

If the above chart is not dramatic enough, here is a contrasting experience over the same years for the U.S. economy:

Nothing that CNN and the rest of the Western media pack ever managed to capture.

24/8/18: Moscow's Fiscal Resilience in the Headwinds

Back in September 2017, Fitch (with Russia rating BBB-) estimated that the U.S. sanctions were costing Russia ‘one notch’ in terms of sovereign ratings, with ex-sanctions risk conditions for the Russian sovereign debt at BBB. Last week, Fitch retained long term debt rating for Russia at BBB- with positive outlook, noting the Russian economy’s relative resilience to sanctions.

Budgetary Resilience

Per Fitch, and confirmed by the Russian Finance Ministry analysis, Russia is looking at recording a budgetary surplus in 2018:

Fitch analysis projects the budget surplus to average 0.1% of GDP in 2018 and 0.3% in 2019, from deficits of 1.0% and 0.5%, respectively. This, alongside Russia’s strong performance in monetary policy have been noted by Fitch as core markers of the Russian economy’s resilience to external shocks, including the sanctions acceleration announced back in April 2018.

Looking forward, President Putin's RUB 8.0 trillion (ca USD127 bn) new spending priorities announced back in May will amount to roughly 7.0% of GDP over the next six years. These funds will go to support higher wages and pensions for the recipients of Federal and Local funding, as well as public investment uplift in education and core infrastructure. Per Fitch: “Due to a stronger fiscal position and a robust oil price outlook, the planned measures will not threaten the country's future budget surpluses. The government will also increase available funds by enforcing a tax overhaul and increasing [domestic] borrowing.” (see Chart below)

Policies Resilience

Resilience-inducing policies, when it comes to macroeconomic management of risks arising from sanctions regimes face by Russia include:

• Increase the Value-added Tax (VAT) rate from 18.0% to 20.0% starting in 2019, which will provide (based on Moscow estimates) ca RUB 600bn (USD 9.5bn) per annum. Social and aggregate demand impacts of VAT increases were mitigated by keeping 10% rate on certain foods, children’s goods, printed publications and pharmaceuticals, or roughly 25% of all goods and services. Some transport services will continue benefiting from 0% VAT rate.
• A phased reduction of the export duty on oil and petroleum products from 30.0% to zero and a concurrent increase in the tax on the extraction of minerals by 2024
• The combined tax rate on wages for mandatory social contributions will remain at 22%. 
• The tax on the physical capital of companies (capped at 2%), will no longer apply to moveable assets (the tax will remain for fixed capital, e.g. for buildings).
• Russia will also establish special administrative zones on Russky Island next to Vladivostok and on Oktyabrsky Island, which is part of the Kaliningrad enclave. Both will act as offshore centres where foreign-registered firms owned by Russian nationals can “redomicile” their assets. Tax advantages granted in these zones will cover taxes on profits, dividend income and different types of property.
• A recent increase in the pensionable age (men from 60 to 65, women from 55 to 63) system will lower the burden of an ageing population and a shrinking labour force, “propping up the state Pension Fund's income”

Impact on Debt Markets

Net outrun is that even faced with escalating sanctions, and having unveiled a rather sizeable macro stimulus program, Moscow's finances remain brutally healthy. Fitch research foresees “a contained uptick in government debt levels over the coming years, with the debt burden rising from 17.4% of GDP in 2017 (IMF statistics) to about 18.3% GDP by 2020.” As share of Russian debt held by external funders continues to decline, these forecasts imply increased sustainability of overall debt levels.

In it’s recent assessment of the potential impact of the ‘Super-sanctions’ (The Defending American Security from Kremlin Aggression Act of 2018 (DASKAA)) planned by Washington, the worst case scenario of all U.S.-affiliated investors dumping Russian bonds implies 8-10% decline in foreign holdings of Russian Sovereign debt, which will likely raise yields on long-dated Russian Ruble-denominated debt by 0.5-0.8 percentage points. Based on August 6 analysis from Oxford Economics, Russia will have no trouble replacing exiting Western debt holders with Ruble-denominated debt issuance.

Key Weaknesses Elsewhere

The key weakness for Russia is in structurally lower economic growth that set on around 2010-2011 and is likely to persist into 2022-2023 period (see IMF projections below):

Russian GDP growth rose from 1.3% y/y in the 1Q 2018 to 1.8% in the 2Q, with 1H growth reading 1.6% y/y. The uptick was led by faster industrial output growth (rising almost 4% y/y in 2Q) and manufacturing (up 4.6% y/y in 2Q). These are preliminary estimates, subject to revisions and, based on the recent past revisions, it is quite likely that we will see higher growth rates in final reading. 1H 2018 fixed investment rose 3% y/y. Real wages rose 8% y/y in real terms, but household disposable real income was up only 2% at the end of 2Q 2018 due to slower growth in the 'grey economy' and in non-wage income. Despite the rising household credit uptake (up 19% y/y at the end of 2Q 2018), retail sales were up only 2.5%, broadly in-line with real income growth.

All of these trends are consistent with what we have been observing in recent years and are indicative of the structurally weaker economic conditions prevailing in the wake of the post-GFC economic recession and the energy prices shocks of 2014-2017.

18/5/18: Euro area current accounts 1980-2017

What happened to the Euro area current accounts since the introduction of the Euro?

Periodically, I update my charts on the Euro effects on the external balances of the EA-12, the original economies of the Euro area. Here are the updates:

Considering first cumulated current account balances over 1980-2017 period, the chart below aggregates the EA12 into two sub-groups:

• The 'periphery' defined as a group composed of Italy, Greece, Spain and Portugal
• The 'core' group composed of the remaining EA12 countries

The chart shows several interesting facts

1. Current account deficits in the 'peripheral' states predate the introduction of the Euro
2. Since the introduction of the Euro through 2013 there was a consistent increase in the current account deficits amongst the 'periphery' states, with acceleration in deficits staring exactly at the point of the introduction of the Euro
3. Current account deficits in the Euro area 'peripheral' states were rapidly accelerating into 2009
4. Since 2014, current account deficits in the 'peripheral' states have been drawn down, at a moderate rate, as consistent with the internal deleveraging of these economies
5. Meanwhile, the introduction of the Euro accelerated accumulation of current account surpluses within the 'core' group of EA12
6. The rate of current account surpluses acceleration increased dramatically around 2004 and then again starting with 2009

In terms of external balances, the creation of the Euro area clearly resulted in compounding pre-Euro era existent structural imbalances in the EA12 economies.

Meanwhile, there is no discernible impact of the Euro on supporting growth in trade within the Euro area (here, we use changing countries composition of the Eurozone):

  As per above chart:

• From 2000 and prior to 2014, Eurozone performance in terms of growth rates in exports of goods and services largely underperformed other advanced economies (ex-G7) and was in line with G7 performance
• Before 2000, Eurozone was broadly in line with both the G7 and other advanced economies in terms of growth rates in exports of goods and services
• Lastly, starting with 2014, the Euro area has been outperforming both the G7 and other advanced economies in terms of growth in exports of goods and services - a development that is more consistent with the fallout from the twin Global Financial Crisis (2007-2009) and the Euro Area Sovereign Debt Crisis (2011-2013), as the process of internal devaluation forced a number of Eurozone countries into more aggressive exporting

On the net, there remains no current account-linked evidence to support an argument that the creation of the Euro has been a net positive for the Eurozone member states in terms of improving their external balances and exports flows. On the other hand, there is little evidence that the Euro has hindered trade flows growth rates, whilst there is strong evidence to claim that the Euro has exacerbated current account imbalances between the 'core' and the 'periphery' states.

12/5/18: U.S. War in Afghanistan: when the patient yields to the compulsion to repeat

On and off, I have written occasionally about the complete lack of value-for-money accounting in the U.S. military spending and its imaginary successes. This is just another one of such occasions.

Here is a summary of the Special Report by the U.S. military watchdog, filed by the neoconservative in it is geopolitical positioning Foreign Policy magazine (the folks who support wars, like the one conducted in the Afghanistan): http://foreignpolicy.com/2018/05/01/the-afghan-war-isnt-being-won-says-new-pentagon-audit/.

I have summed the main findings in a series of tweets reproduced here:

Special Inspector General for Afghanistan reconstruction report of May 1: suicide attacks in Afghanistan up 50% in 2017, opium production +63%. Last GDP growth was recorded in 2012, since then, continued recession +

+ U.S. spent $126bn in relief & investment in Afghanistan over 17 years. The country now ranks 183 in the world to "do business.” < 1/3 of Afghans are connected to power grid. +

+ Number of bombs dropped by the West in Afghanistan in Jan-Feb 2018 was the highest it's been since 2013. Suicide attacks in Afghanistan are up 50% in 2017. Casualties from attacks are steadily rising. Sectarian attacks tripled in 2017. +

+ Only 65% of the Afghan population lives under government control, even though direct US expenditures to Afghan security forces of $78bn > than third largest military budget in the world. +

+ Number of serving Afghan military & police fell sharply in 2017, but U.S. forces presence is rising. "Insider attacks by Afghan soldiers are rising".

Note: the IMF data does not show decline in Afghanistan's GDP since 2013 in real terms (domestic currency), or in current US dollar terms, or in PPP-adjusted terms. The issue here is that the IMF data shows national accounts that include U.S. and Western Coalition spending and investment in the country and does not account for population growth. In fact: Afghanistan ranked 23rd lowest in the world in income per capita terms (using PPP-adjusted international dollars) in 2012. In 2017 it was ranked 19th lowest. This does mean that the economy got worse in Afghanistan in recent years. In line with this, Reuters reported earlier this year that Afghanistan's poverty rates have risen "sharply" over the last five years (https://www.reuters.com/article/us-afghanistan-economy/afghanistans-poverty-rate-rises-as-economy-suffers-idUSKBN1I818X) from 38% in 2011-2012, to 55% in 2016-2017. "Food insecurity has risen from 30.1 percent to 44.6 percent in five years, meaning many more people are forced to sell their land, take their children out of school to work or depend on food aid".

More details?  In September 2014, Foreign Policy wrote about another report by the same watchdog, headlining their story with a telling tag line: "Watchdog: United States Made Corruption in Afghanistan ‘Pervasive and Entrenched’". It is worth repeating that Foreign Policy is an intellectual bulwark of neoconservative doctrine that saw nothing wrong with any war the U.S. has started in the past.

The U.S. has already spent more on the war in Afghanistan (and related 'investments' there) than the entire country's GDP over the last decade. And it is tied into spending vastly more (https://www.forbes.com/sites/realspin/2016/11/21/war-and-debt-and-fiscal-ramifications-to-2053/#651c540b3d51 and http://trueeconomics.blogspot.com/2017/11/201117-tallying-costs-us-wars-in-iraq.html).

In January this year, to make the valiant efforts by the Western Coalition (read: Washington) in Afghanistan more transparent, Pentagon sought to withhold key information about the campaign from the public (https://www.reuters.com/article/us-afghanistan-usa-oversight/pentagon-blocks-release-of-key-data-on-afghan-war-watchdog-idUSKBN1FJ0GZ).

Yet, despite the U.S. larger-than-reported presence in the country, January report by SIGAR noted that  "43 percent of Afghanistan’s districts were either under Taliban control or being contested". This was after more than 16 years of war waged against the Taliban and other extremist groups by the largest, the mightiest and the best-equipped military force in the world. "Last year [2017], U.S. forces in Afghanistan restricted the amount of data it provided on the ANDSF, including casualties, personnel strength and attrition rates - data that has now been completely withheld." (See https://www.cbsnews.com/news/pentagon-fails-to-disclose-troop-numbers-in-syria-iraq-afghanistan/ for more details).

In 2011, ten years into the campaign that promised to bring democracy and human rights to Afghanistan, the U.S. State Department stopped listing human rights as an objective for the U.S. Afghanistan policies. Not because these rights have been fully restored (or rather instituted), but because it became too embarrassing to keep them in policy documents as a reminder of the U.S. failures.

Seventeenth year into what amounts to a small war for the enormous military machine of the Fourth Rome, and the 'most brilliant', 'highly decorated', grossly overpaid and deeply revered in the popular media culture U.S. generals and politicos are clueless as to why the exceptionalist U.S. of A. has failed to control a dispersed gang of resistance fighters that, unlike the Vietnamese of the 1970s and the North Koreans of the 1950s, do not even have a superpower standing directly behind them. The reason, of course, is in the very ethos of the American power, the notions of exceptionalism and self-appointed mandate, both of which imply zero capacity to think based on historical and rational premises. As one of the authors on the topic quipped, quoting from Freud's 1914 paper Recollecting, Repeating, and Working Through,  "...the patient yields to the compulsion to repeat, which now replaces the impulsion to remember... The greater the resistance, the more extensively will acting out repetition replace remembering."

The Freud's quote (part of it) appears in this article from 2017 on the depressing comprehensiveness of the American war failure. It is worth a read: https://www.thenation.com/article/what-the-us-military-still-doesnt-understand-about-afghanistan/ for it narrates in some detail the process of the repeated denial of reality by, at this stage, the third presidential administration in Washington engaged in an imperial dance of victory amidst the defeat.

The staggering cost of the Washington's adventurism in Afghanistan (and Iraq, and Libya, and next up - Syria, as well as in other parts of the world) has now cost the U.S. one of its historically closest proxies/allies, Pakistan (https://www.reuters.com/article/us-usa-trump-pakistan-idUSKCN1B3125).  This is a major, strategic defeat, given Pakistan's role in the region and the potential for the strengthening of the Pakistan-India-China-Iran cluster of power contests that will undoubtedly shape the entire region into the future. In simple terms, the U.S. has lost not just the war in Afghanistan, but it is losing dominance over the large swath of land that constitutes the largest cluster of world's population and has strategically central importance to the global economy and resources.

These failures are not surprising, once one takes a more rational look at the U.S. military machine and the religious devotion to it exhibited by Washington and American press. Quoting at length from Forbes (https://www.forbes.com/sites/realspin/2016/11/21/war-and-debt-and-fiscal-ramifications-to-2053/#370435f3d51a):

"As it happens, the Pentagon is unique among federal agencies in having never undergone a full audit, an oversight with serious national security consequences. ...The good news is Congress has finally mandated an audit be completed by September of 2017, a deadline reached after the Department of Defense managed to skirt a government-wide audit requirement for more than two decades. The bad news is likely the audit results themselves. After all, a recent audit of the Army General Fund found bookkeepers somehow screwed up their accounting by $6.5 trillion in 2015. That number is particularly remarkable given that it is 13 times the size of the entire Pentagon budget for that year. “How could the Army misplace, fudge, misappropriate or otherwise lose $6.5 trillion?” asked an incredulous Matthew Gault reporting on the Army audit for War Is Boring. “It’s simple. Years of no oversight, bad accounting practices and crappy computer systems created this problem. And remember, this is just the Army and just its general fund.” If that’s the sort of rot we find in a single branch of the military, imagine the fiscal horrors yet to be uncovered throughout."

Note: the Defense Department delayed the audit start until December 2017 and is now promising a report from the auditors by November 2018. Worse, the audit is conducted by internal teams, in other words, the lunatics who run the asylum are now counting plates and pills in the place too. To put some veneer on this exercise, the Inspector General has hired 'external audit firms' to help analyse data collected by Pentagon's teams. The same 'audit firms' are some of the largest military and security consulting contractors, of course.

Meanwhile, the idiotic parroting of the past and failed narratives remains the leitmotif of the Washington's policy. Best exemplified by the amnesia-ridden, Ivy League-trained army of status quo dependent 'experts' and the headlines in the U.S. media echoing them: https://www.usnews.com/news/politics/articles/2017-11-27/victory-or-failure-in-afghanistan-2018-will-be-the-deciding-year. "Armed with a new strategy and renewed support from old allies, the Trump administration now believes it has everything it needs to win the war in Afghanistan." This, pretty much, sums up the best that the American-trained 'intellectual class' of the West Point-graduated generals and Harvard-trained 'analysts' can produce in place of a strategy.

The logical denouement of the U.S. failure to learn from Afghanistan adventure is the loss of the U.S. position in the region to China, followed by Iran, Pakistan, India and Russia - in that exact order. Afghanistan is likely to be the next - much larger than Syria - theatre of confrontation between Iran and Saudi-U.S. coalition, with Israel at a play too, and the American liabilities in such a conflict will be well beyond anything experienced in Iraq and Afghanistan combined. A proxy war between Iran and the U.S. via Afghanistan can risk spilling into an outright war between the two countries, which the U.S. will lose more decisively than Afghanistan, although the toll on Iran will be huge as well.

What Afghanistan has been exposing over the last 16 years, plus, is that the Pax Americana lacks not fire power, but vision, and that the lack of vision is what loses wars, and ends empires. Sail on, my thought-lacking friends from the Western Academia, military colleges, Washington's circles of Byzantine power-brokering expertise, and 'influential media'. Keep those aircraft carriers busy circling the globe. Keep awarding your military ranks free parking spaces at Walmarts and rent subsidies in the Paradise.

5/3/18: S&P upgrade and Russian markets reaction

Belatedly, on the S&P upgrade for Russian Sovereign Debt, here is a good primer from Bloomberg: https://www.bloomberg.com/gadfly/articles/2018-02-23/russia-bonds-are-poised-to-come-off-the-junk-heap.

Markets repricing was quick on the news, when S&P did upgrade country bonds from BB+ to BBB: Russian dollar- and euro-denominated bonds rose across the maturity curve. Russia’s 2043 eurobond was up 1.4 cents to 115 cents in the dollar the day after the upgrade, while 2026 issue was up 0.69 cents to 105 cents, and the 2027 issue was up 0.72 cents to 101 cents. 5 year CDS fell 5 bps to 103 bps.

This was not a watershed, however, as Russian bonds been rallying (with some volatility) for quite some time prior, shaking off completely end of January extension of the U.S. sanctions.

A neat chart via BOFIT shows the improvement in the state of Russian fiscal position:

Russia spent 3 years in 'junk rating' lock up, much of it down to the U.S. and EU sanctions, rather than to any adverse dynamic in Russian sovereign default risks.

As BOFIT noted, "S&P Global Ratings noted that Russia’s macroeconomic policy has allowed the economy to adjust to lower commodity prices and international sanctions. The outlook for the Russian economy is stable. S&P’s rating for Russian sovereign foreign bonds now matches that
of Fitch, while Moody’s continues to apply a junk rating (Ba1). ... The Russian government currently faces no compelling need to borrow from abroad as the current fiscal outlook is rather good thanks to the rise of oil prices and fiscal discipline."

In 2017, Russia witnessed an 18 percent rise in Federal revenues, and an 8 percent increase in allocations to the Social Reserve Funds (spending from the funds rose 6 percent).

Russia retains the position, rather rare for any country, to be able to pay off its entire external Government debt from its sovereign reserves.

20/11/17: Russian economic growth slides. Structural issues loom large

An interesting view of the Russian economy (as usual) from Leonid Bershidsky: https://www.bloomberg.com/view/articles/2017-11-14/russia-s-economy-is-growing-with-borrowed-money

Credit, is not a sustainable source for growth in Russia, especially as the Russian households’ leverage capacity (underpinned by expected future wages) is not exactly in rude health. A recent study from the Russian government's own Analytical Center found that roughly 17% of the working population, or about 12.1 million Russians, can be classified as the working poor - those earning less than enough to cover the minimum purchases required to sustain a family. The study also found that majority of the working poor in Russia rely on microcredit, short term payday loans and/or traditional bank or credit card borrowing to meet daily necessary expenditure.

Low wages, rising credit

Rosstat data confirms the findings. Roughly 7% of all wage-earners are paid wages below the monthly subsistence minimum. Over 17% of people working in the education sector or various municipal services earn below-subsistence wages.

Moscow has set a target of 2019 for raising wages to the legally required subsistence minimum level, with minimum wages hiked in 2016 and mid-2017. Current minimum wage is set at Rub 7,000 per month (roughly EUR115) which is only about 60% of the average subsistence minimum levels and close to 20% of the average monthly wage, according to BOFIT report. This is about half the level (of 40%) ratio of the minimum wage to the average wage across the OECD countries.

Accumulation of household debt, therefore, is hardly the good news for the economy in the long run, as debt affordability is only sustained today by the falling interest rates (cost of carry), and is not consistent with the wages dynamics, and wages levels, especially at the lower end of earnings.

Meanwhile, the latest data on economic growth came in at a disappointing print. Russian GDP growth fell from 2.5% y/y in 2Q 2017 to 1.8% in 3Q 2016, driven down by slower expansion in both exports and domestic investment. Over the period from January through September, Russian economy grew by roughly 1.6% y/y - well below the official forecasts and analysts consensus expectations. Oil output fell, despite the rise in global oil prices, as Russia continued to implement OPEC-agreed production cuts.

On external trade, exports of oil and related products were up in 3Q 2017 in line with oil prices, rising 26% y/y. Exports of metals and other primary materials were down sharply. In January-September, exports of goods were also up 26% y/y with the share of oil and gas in total goods exports up sharply to 60%.

Notably, the value of exports of goods and services (at USD250 billion) over the first nine months of 2017 has robustly exceeded the value of imports (at USD 170 billion).

Structural Problems

Russian growth slowdown is structural, as I wrote on numerous occasions before. The structural nature of the slowdown is reflected in subdued private investment growth and lack of dynamism in all private enterprise-led sectors, with exception, perhaps of the cyclical agriculture. Even food production sector - which should have benefited from record crops (over 2014-2017) and trade sanctions (import substitution) is lagging. Capital deepening and technological innovation are far behind where these should have been after roughly 19 years of post-default recovery in the economy.

The structural decline in the private sectors activities is contrasted by expansion of the state sector.

According to the Rosstat figures, over recent years some 11-12% of total earnings in the Russian economy was generated by the larger state-owned or part-state-owned enterprises. This figure excludes direct Government spending. In other words, state spending and state-owned companies revenues now account for close to 40% of the Russian GDP. As reported by BOFIT, state-owned enterprises “revenues are highly concentrated. Surveys by the Russian Presidential Academy of National Economy and Public Administration (RANEPA) show that just 54 large state-owned enterprises (SOEs) account for 8% of revenues [half of that accrues to only two companies: Gazprom and Rosneft]. When 20 indirectly state-owned firms are added the share rises to 12%.” This is in line with the figure of 11% reported by Expert.ru based on their list of 400 biggest companies in Russia.

Outright direct Government (local, regional and federal) expenditure amounts to slightly above 13% of GDP, based on Rosstat figures. This means that, raising the larger enterprises share to account for smaller and medium sized state-owned companies, the total state-owned enterprises and Government share of the economy can be around 38% mark, slightly above the 2010 estimate of 35%, provided by the ENRD. Interestingly, the above imbalances in the structure of the Russian economy do not seem to reflect too poorly on the country rankings in the World Bank Doing Business report. Out last week, the rankings put Russia in 35th place globally, our of 190 countries, placing it just below Japan and well ahead of China (78th).

In summary, Russian economy will not be able to get onto a higher growth path (from the current 1-1.5 percent range) until there is a significant shift in growth drivers toward capital deepening (necessary both to offset adverse demographics and the chronic under-investment in new capital over the recent years), and technological deepening (required to modernise industrial and services sectors). To effectively trigger these processes, Russia needs to hit, simultaneously. three policy targets:

1. Improve overall relationship with Europe, while continuing to build on positive trade and investment momentum with Asia-Pacific region;
2. Increase the share of private enterprise activity in the economy, by reducing the state share of the economy to below 35% of GDP; and
3. Focus on reforming institutional frameworks that currently hold Russian investors from investing in the domestic production, including closing gaps on product/services certification between Russia and Europe, and effectively (not pro-forma) reforming legal frameworks.

7/11/17: To Fine Gael or not: Employment Stats and Labour Force

Recently, Fine Gael party PR machine promoted as a core economic policy achievement since 2011 election the dramatic reduction in Ireland’s unemployment rate. And in fact, they are correct to both, highlight the strong performance of the Irish economy in this area and take (some) credit for it. The FG-led governments of the recent years have been quite positive in terms of their policies supporting (or at least not hampering) jobs creation by the MNCs. Of course, they deserve no accolades for jobs creation by the SMEs (which were effectively turned into cash cows for local and central governments in the absence of any government power over taxing MNCs), nor do they deserve any credit for the significant help in creating MNCs’ jobs that Ireland got from abroad.

Now, to briefly explain what I mean by it: several key external factors helped stimulate MNCs-led new jobs creation in Ireland. Let me name a few.

1. ECB. By unleashing a massive QE campaign, Mario Draghi effectively underwritten solvency of the Irish State overnight. Which means that Dublin could continue avoiding collecting taxes due from the MNCs. And better, Mr Draghi’s policies also created a massive carry trade pipeline for MNCs converting earnings into corporate debt in Euro area markets. The combined effect of the QE has been a boom in ‘investment’ into Ireland, and with it, a boom of jobs.
2. OECD. That’s right, by initiating the BEPS corporation tax reform process, the arch-nemesis of Irish tax optimisers turned out to be their arch blesser. OECD devised a system of taxation that at least partially, and at least in theory, assesses tax burdens due on individual corporations in relation physical tangible activities these corporations carry out in each OECD country. Tangible physical activity can involve physical capital investment (hence U.S. MNCs rapidly swallowing up new and old buildings in Ireland, that’s right - a new tax offset), an intangible Intellectual Property ‘capital’ (yep, all hail the Glorious Knowledge Development Box), and… err… employment (that is why Facebook et al are rushing to shift more young Spaniards and Portuguese, French and Dutch, Ukrainians and Italians, Poles and Swedes… into Dublin, despite the fact they have no where to live in the city).
3. EU. Not to be outdone by the aforementioned ‘academics’ from Parisian La Defence, the EU Commission helped. It waved in the utterly ridiculous, non-transparent, skin deep in fundamentals, Irish tax optimisation scheme that replaced the notorious Double-Irish Sandwich  - the scheme is the already mentioned above Knowledge Development Box. The EU Commission also aggressively pursued a handful of top MNCs trading from Ireland - Apple, Google, etc. This put more pressure on both the Irish Government and the MNCs to cough up some at least half-credible scheme that would show some sort of tangible business expansion and growth in Ireland.

So the result of all of the above has been a jobs boom in the MNCs-dominated sectors, a boom that soaked up quite a bit of the younger graduates from Irish Universities as well, but also helped to grow indigenous ICT sector in Ireland. The latter soaked up some more graduates. Unemployment fell. employment rose.

If this sounds like Nirvana, it ain’t. Because above the silver lining of the good and strong employment/unemployment numbers there is also a cloud of rather darker hues. That club is the Labour Force Participation Rate.

As Chart above shows, seasonally-adjusted LFP for Ireland stood at 59.8% in 2Q 2017 - matching the lowest recorded levels for the entire 16 years since the end of !Q 2001. And the lowest level in 13 consecutive quarters. Worse, as the chart above clearly shows, the dismal performance of the economy in terms of LFP has been in place since the Great Recession. In other words, all the recovery to-date has not been able to shift Irish participation rate.

Which brings us to the real point of the crisis: the current levels of LFP are much much worse than the comparable headline rates attained in 1999-2000. How? Simple.

• Unlike in 2000-2001, we have years of net outward emigration (and continued net outward emigration for Irish nationals). This should increase LFP, and yet it clearly does not.
• Unlike in 2000-2001, we have widening retirement age, not shrinking as was the case in 2000-2001. This too should have supported LFP to the upside. And again, it clearly is not happening.
• In contrast with the 2000-2001, we also have more students in the third level and above education today. Which, again, should have supported current LFP to the upside relative to the early 2000s. 

And so on… in simple terms, our starting conditions (post-crisis environment) and our demographics all suggest that current LFP is reflective of deeper structural problem than the same LFP reading back in 2000-2001 was.

So, yes, Fine Gael can claim some strong record of improvements in the economy that took place on its watch. But, no, this is not the time to enjoy the laurels. Until such time when more Irish people go back to search for jobs, train for jobs and the LFP rises to 63.2% range (2005-2008 average), it is way too early for us to declare a victory over the Great Recession.

Now, what does 3.4% increase in LFP mean? To keep current rate of unemployment fixed at 6%, that means adding 70,450 new jobs and adding roughly 4,500 new unemployed to the Live Register. What that would take in terms of time? Given the current rate of 17,150 new employment added per quarter over the last 4 quarters, this implies about roughly 13 months of jobs creation.

Of course, attracting the disillusioned folks back into labour force is not as easy. So the more important bit is not whether we can achieve it, but rather, what would it mean in terms of economic policies necessary to achieve it? I expect answers from the various FG departments and may be even some Ministers…

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

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.

29/12/16: Drowning in Debt

Recently, I posted about the return - with a vengeance - of one of the key drivers of the Global Financial Crisis and the Great Recession, the rapid rise of the debt bubble across the global economy. The original post is available here: http://trueeconomics.blogspot.com/2016/12/161216-root-of-2007-2010-crises-is-back.html

There is more evidence of the problem reaching beyond corporate finance side of the markets for debt. In fact, in the U.S. - the economy that led the de-risking and deleveraging efforts during the early stages of the recovery - household debt is now once again reaching danger levels.

Chart 1 below shows that, based on data from NY Federal Reserve through 3Q 2016, full year 2016 average household debt levels are likely to exceed 2005-2007 average by some 3 percent. In 3Q 2016, total average household debt was around USD98,312, a level comparable to USD98,906 in 2006.

And Chart 2 shows that overall, aggregate levels of household debt and per capita levels of household debt both are now in excess of 2005-2007 averages.

Finally, as Chart 3 below indicates, delinquencies rates are also rising, despite historically low interest rates and booming jobs markets. For Student Loans and Car Loans, 3Q 2016 delinquencies rates are 1 percentage points and 3.8 percentage points above the 2005-2007 average delinquency rates. For Mortgages, current delinquency rates are running pretty much at the 2005-2007 average. Only for Credit Cards do delinquency rates at the present trail behind the 2005-2007 average, by some 2 percentage points.

Now, consider the market expectations of 0.75-1 percentage increase in Fed rates in 2017 compared to 3Q 2016 (we are already 0.25 percentage points on the way with the most recent Fed decision). Based on the data from NY Fed, and assuming average 2015-2016 growth rates in credit forward, this will translate into extra household payments on debt servicing of around USD1,085-USD1,465 per annum depending on the passthrough rates from policy rate set by the Fed and the retail rates charged by the banks.

Given the state of the U.S. household finances, this will be some tough burden to shoulder.

So here you have it, folks:
1) Corporate debt bubble is at an all-time high
2) Government debt bubble is at an all-time high
3) Household debt bubble is at an all-time high.
Meanwhile, equity funding is slipping even for the usually credit-shy start ups.

And if you want another illustration, here is total global Government debt, based on IMF data:

We’ve learned no lessons from 2008.


Sources for data:
https://www.nerdwallet.com/blog/average-credit-card-debt-household/
https://www.newyorkfed.org/microeconomics/data.html
http://www.imf.org/external/pubs/ft/weo/2016/02/weodata/index.aspx