14/1/17: Country Risks survey results for 2016

+Euromoney have published their @CountryRisks survey results for 2016: available here quoting, amongst other analysts, myself.

13/1/17: AID:Tech in Global Top 10 at IBM SmartCamp 2016

Another brilliant win for the AID:Tech https://aid.technology/ team placing into Global Top 10 Startups for IBM SmartCamp http://smartcamp2016.com/.

12/1/17: Betrayal Aversion, Populism and Donald Trump Election

In their 2003 paper, Koehler and Gershoff provide a definition of a specific behavioural phenomenon, known as betrayal aversion. Specifically, the authors state that “A form of betrayal occurs when agents of protection cause the very harm that they are entrusted to guard against. Examples include the military leader who commits treason and the exploding automobile air bag.” The duo showed - across five studies - that people respond differently “to criminal betrayals, safety product betrayals, and the risk of future betrayal by safety products” depending on who acts as an agent of betrayal. Specifically, the authors “found that people reacted more strongly (in terms of punishment assigned and negative emotions felt) to acts of betrayal than to identical bad acts that do not violate a duty or promise to protect. We also found that, when faced with a choice among pairs of safety devices (air
bags, smoke alarms, and vaccines), most people preferred inferior options (in terms of risk exposure) to options that included a slim (0.01%) risk of betrayal. However, when the betrayal risk was replaced by an equivalent non-betrayal risk, the choice pattern was reversed. Apparently, people are willing to incur greater risks of the very harm they seek protection from to avoid the mere possibility of betrayal.”

Put into different context, we opt for suboptimal degree of protection against harm in order to avoid being betrayed.

Now, consider the case of political betrayal. Suppose voters vest their trust in a candidate for office on the basis of the candidate’s claims (call these policy platform, for example) to deliver protection of the voters’ interests. One, the relationship between the voters and the candidate is emotionally-framed (this is important). Two, the relationship of trust induces the acute feeling of betrayal if the candidate does not deliver on his/her promises. Three, past experience of betrayal, quite rationally, induces betrayal aversion: in the next round of voting, voters will prefer a candidate who offers less in terms of his/her platform feasibility (aka: the candidate less equipped or qualified to run the office).

In other words, betrayal aversion will drive voters to prefer a poorer quality candidate.

Sounds plausible? Ok. Sounds like something we’ve seen recently? You bet. Let’s go over the above steps in the context of the recent U.S. presidential contest.

One: emotional basis for selection (vesting trust). The U.S. voters had eight years of ‘hope’ from President Obama. Hope based on emotional context of his campaigns, not on hard delivery of his policies. In fact, the entire U.S. electoral space has become nothing more than a battlefield of carefully orchestrated emotional contests.

Two: an acute feeling of betrayal is clearly afoot in the case of the U.S. electorate. Whether or not the voters today blame Mr. Obama for their feeling of betrayal, or they blame the proverbial Washington ’swamp’ that includes the entire lot of elected politicians (including Mrs. Clinton and others) is immaterial. What is material is that many voters do feel betrayed by the elites (both the Burn effect and the Trump campaign were based on capturing this sentiment).

Three: of the two candidates that did capture the minds of swing voters and marginalised voters (the types of voters who matter in election outrun in the end) were both campaigning on razor-thin policies proposals and more on general sentiment basis. Whether you consider these platforms feasible or not, they were not articulated with the same degree of precision and competency as, say, Mrs Clinton’s highly elaborate platform.

Which means the election of Mr Trump fits (from pre-conditions through to outcome) the pattern of betrayal aversion phenomena: fleeing the chance of being betrayed by the agent they trust, American voters opted for a populist, less competent (in traditional Washington’s sense) choice.

Now, enter two brainiacs from Harvard. Rafael Di Tella and Julio Rotemberg were quick on their feet recognising the above emergence of betrayal avoidance or aversion in voting decisions. In their December 2016 NBER paper, linked below, the authors argue that voters preference for populism is the form of “rejection of “disloyal” leaders.” To do this, the authors add an “assumption that people are worse off when they experience low income as a result of leader betrayal”, than when such a loss of income “is the result of bad luck”. In other words, they explicitly assume betrayal aversion in their model of a simple voter choice. The end result is that their model “yields a [voter] preference for incompetent leaders. These deliver worse material outcomes in general, but they reduce the feelings of betrayal during bad times.”

More to the point, just as I narrated the logical empirical hypothesis (steps one through three) above, Di Tella and Rotemberg “find some evidence consistent with our model in a survey carried out on the eve of the recent U.S. presidential election. Priming survey participants with questions about the importance of competence in policymaking usually reduced their support for the candidate who was perceived as less competent; this effect was reversed for rural, and less educated white, survey participants.”

Here you have it: classical behavioural bias of betrayal aversion explains why Mrs Clinton simply could not connect with the swing or marginalised voters. It wasn’t hope that they sought, but avoidance of putting hope/trust in someone like her. Done. Not ‘deplorables’ but those betrayed in the past have swung the vote in favour of a populist, not because he emotionally won their trust, but because he was the less competent of the two standing candidates.



Jonathan J. Koehler, and Andrew D. Gershof, “Betrayal aversion: When agents of protection become agents of harm”, Organizational Behavior and Human Decision Processes 90 (2003) 244–261: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.11.1841&rep=rep1&type=pdf

Di Tella, Rafael and Rotemberg, Julio J., Populism and the Return of the 'Paranoid Style': Some Evidence and a Simple Model of Demand for Incompetence as Insurance Against Elite Betrayal (December 2016). NBER Working Paper No. w22975: https://ssrn.com/abstract=2890079

12/1/17: Breaking EU Rules? Often and Freely

EU's Fiscal Discipline in one table: here is a summary of the EU member states' performance when it comes to 3% deficit ceiling set out as a core fiscal criteria:

Yes, even after a large scale fiscal 'retrenching' of 2016, on average, EU member states have been outside satisfying fiscal deficit ceiling criteria 41 percent of the time, with EA12 average being worse - at 43 percent.

Six EU states are more than just serial violators of the rule, with their respective frequencies of falling outside the rule constraints being in excess of 2/3rds. It is worth noting that in this group, all states are violating rules predominantly during the years of economic expansion.

Another 11 states are frequent violators, breaking the rule more than 1/3rd of the time but less than 2/3rds. Here too, with exception of Cyprus and Slovenia, more violations took place during the times of expanding economies than during the periods of recessions. All in, 17 states of the EU are breaking the EU fiscal rule on deficit ceilings more than 1/3rd of the time. Only 7 states break the rule less than 25 percent of the time and only 5 break the rule less than 10 percent of the time.

Surely, nothing to worry about.

12/1/17: NIRP: Central Banks Monetary Easing Fireworks

Major central banks of the advanced economies have ended 2016 on another bang of fireworks of NIRP (Negative Interest Rates Policies).

Across the six major advanced economies (G6), namely the U.S., the UK, Euro area, Japan, Canada and Australia, average policy rates ended 2016 at 0.46 percent, just 0.04 percentage points up on November 2016 and 0.13 basis points down on December 2015. For G3 economies (U.S., Euro area and Japan, December 2016 average policy rate was at 0.18 percent, identical to 0.18 percent reading for December 2015.

For ECB, current rates environment is historically unprecedented. Based on the data from January 1999, current episode of low interest rates is now into 100th month in duration (measured as the number of months the rates have deviated from their historical mean) and the scale of downward deviation from the historical ‘norms’ is now at 4.29 percentage points, up on 4.24 percentage points in December 2015.

Since January 2016, the euribor rate for 12 month lending contracts in the euro interbank markets has been running below the ECB rate, the longest period of negative spread between interbank rates and policy rates on record.

Currently, mean-reversion (to pre-2008 crisis mean rates) for the euro area implies an uplift in policy rates of some 3.1 percentage points, implying a euribor rate at around 3.6-3.7 percent. Which would imply euro area average corporate borrowing rates at around 4.8-5.1 percent compared to current average rates of around 1.4 percent.

11/1/17: Mr. Trump's Plan for Addressing Conflicts of Interest is a Fig Leaf of Corporate Governance

Why PEOTUS Donal Trump’s plan to donate hotels profits earned from foreign government payments to the U.S. Treasury is a fig leaf of corporate governance measures?

Photo credit: GettyImages

There are several reasons why a commitment to donate profits arising from foreign governments' payments to his hotels will not reduce, nor even alleviate, business incentives for potential conflict of interest that may arise in the future.

Firstly, donating profits from such activities requires that profits are declared on these activities in the first place. Since profits are declared across the entire business, not on the basis of individual transactions, Mr. Trump can use full extent of tax laws and accounting procedures, including cumulated losses deductions and tax shields on investment, to effectively reduce such denotable profits to nil over the next 4-8 years. 

Secondly, profits are not the most important financial line on which Mr. Trump operates. Mr. Trump operates on the basis of business (net) worth (value of his business) which reflects not so much the declared profits, but rather the earnings generated by his businesses (cash flow basis, e.g. EBITDA) and also reflects earnings over the longer term time horizon (timing factor). 

Now, consider the following hypothetical scenario: suppose Mr. Trump’s hotels receive USD1 million in foreign government’s bookings in 2017. Suppose he earns 10 percent profit margin on these earnings (so we neglect the issue raised in the first argument above). The profit is declared and Mr. Trump donates USD100K to the U.S. Treasury in 2017. The problem is that the 10% profit margin is across the entire group of hotels, not across the individual rooms and services supplied in exchange for the USD1 million foreign Governments' payments. As the result, 10% margin reflects costs and investments undertaken by the whole group. Foreign earnings, therefore, can be used to fund internal investment activities, ammortization and capital replacement costs, hiring costs, new services deployments etc. All of which will increase the value of Mr. Trump's hotels, including hotels that did not collect foreign payments.

In the mean time, Mr. Trump's business earnings did increase in 2017 by USD1 million as the result of the assumed foreign governments' payments. If this increase is viewed as organic or permanent, rather than a one-off windfall, his business value will increase as the result of these 2017 earnings even independent of the aforementioned investment. Why? Because companies are valued on the basis of their cash flow. Not on the basis of declared profits.

Furthermore, foreign governments' paid earnings will increase Mr. Triump's businesses capacity to borrow and raise equity. These increased borrowings and equity raises can further be used to invest in new business capital. This too will enhance business valuations for Mr. Trump.

In simple terms, even after donating his profits, Mr. Trump will be able to still gain substantially from increased revenues paid for by foreign governments. 

Thirdly, there is a host of other implications relating to Mr. Trump’s plan. 

1. It will be hard to account for all payments by ‘foreign governments’ because many such payments can come via private foreign and even domestic companies, foreign organisations and foreign individuals, or for that matter, via domestic agents and agencies acting on behalf of these foreign governments. 
2. How will the donations to Treasury be treated under the U.S. tax laws is material as well. If these are treated as charitable donations, they can be tax deductible, creating a tax shield for Mr. Trump. This tax shield can be extremely valuable, especially if his businesses use foreign-funded earnings to borrow for investment (effectively transferring these payments into future interest-related tax benefits). 
3. Mr. Trump announced today that his companies will not be permitted to make any new foreign deals during his presidency tenure. However, domestic deals will be allowed. The problem is that this does not preclude use of foreign governments’ payments/earnings for the purpose of reinvestment in the U.S. Which cycles us back to the argument that these payments can still be used to enhance Mr. Trump’s business valuations.

In simple terms, Mr. Trump’s plan to prevent conflicts of interest arising does not add up to reducing incentives for conflict of interest. It is a fig leaf of corporate governance.

10/1/17: For Love or Money: Gender Gap in Online Labor Markets

The issue of a gender gap in the workplace, relating to gender differences in terms of occupations, is a highly contentious, politically charged and, despite a wealth of research on the subject, not fully explained to-date. One thing that economists generally agree on is that it is not one caused by a single factor or even a confluence of factors stemming from a single origin (e.g. access to education, time taken for maternity leave or concerted discrimination against women in the workplace, or any other set of closely linked factors). Instead, a range of exogenous, endogenous, personal, institutional, social etc factors determine the size of the gap, its existence and its evolution over time.

Hence, any new research identifying new factors is both - confusing (especially to those of us, who would stress the social equality dimension of the labour market outcomes) and important (especially to those of us, who prefer evidence-based policy and institutional responses to the issue). Note: the two sets of ‘us’ identified above are not mutually exclusive. In fact, I would suggest that majority of us - researchers, policymakers, analysts, and generally-speaking people, belong to both groupings, being concerned simultaneously with the social justice dimension of the labor market gender gaps and the need for well-designed policy responses to the problem.

With this preamble, here is a new piece of research on the subject. In their paper, titled “For Love or Money? Gender Differences in How One Approaches Getting a Job”, UC Berkeley researchers, Ng, Weiyi and Leung, Ming D (March 22, 2015: https://ssrn.com/abstract=2583592)note that current theories of the labor markets “conclude that women and men apply to different jobs”. However, these theories fail “to explain differences in how [men and women] may behave when applying to the same job.”

The authors “correct this discrepancy by considering gendered approaches to the hiring process. We propose that applicants can emphasize either the relational or the transactional aspects of the job and that this affects getting hired.”

What do these two approaches mean?

• “Relational job seekers focus on developing a social connection with their employer.”
• “Transactional job seekers focus on quantitative and pecuniary aspects of the job.”

The authors “hypothesize that the approach women take in applying for a job will differ from men. In particular, we believe that women, enacting their gender will focus on the relational aspects of the exchange: they emphasize the social, emotional aspects of the employment relationship and focus on mutually beneficial interests. On the other hand, men will be more transactional in nature: they focus more on the task at hand, their own qualifications and achievements, and highlight the quantifiable, observable and tangible aspects of the job.”

The evidence in support of these hypotheses is presented in the paper (for example, see Chart below).

Crucially, the authors note that “while both these approaches have their merits, this difference should result in variation in a person’s likelihood of being hired.”

The study then applies this theoretical hypothesis to see if it can account for “the hiring gap
between male and female job applicants we observe [in the actual data], net of controls for underlying ability, in an online market for contract labor, Elance.com.”

The reason the authors chose the online labor market data is that

1. “The online setting provides a richness and granularity of data which allows us to further unpack the nuances in the strategies employed by job seekers. The transparency of the setting provides a glimpse into the black box of the hiring process. For example, the data provides insight and access to the details of every job posting, the applicant pool, background work histories of each applicant, their photographs, how much they were willing to work for, the text of their job proposal, and the eventual winner of the job.”
2. Secondly, there is an “increasing trend towards self-employment whereby labor market participants eschew the long-term role as a corporate employee and instead participate on a contract basis, moving from job to job and working for different employers” which further validates the use of online labor market data. 

Based on the data and a barrage of econometric tests, the authors concluded that “women are more likely to be hired than men by about 5.2% [in the Elance.com type of the labor market]. Quantitative linguistic analysis on the unstructured text of job proposals reveals that women (men) adopt more relational (transactional) language in their applications. These different approaches affect a job seeker’s likelihood of being hired and attenuate the gender gap we identified.”

Besides own interesting insights and conclusions, the paper is well-worth reading for the quality of discussion it presents relating to existent social and economic literature on the subject of gender gaps. If anything, this discussion itself is worth paying close attention to, for it highlights the wealth of our knowledge on the subject as well as posits some serious questions about the future of gender gap research.

10/1/17: Losing Trust and Social Capital: U.S. and Europe

The U.S. National Intelligence Council January 9, 2017 report on future global trends titled “Paradox of Progress” cites income inequality as one of the reasons for emergence of anti-free-trade sentiments in the West (see page 12 here: https://www.dni.gov/files/images/globalTrends/documents/GT-Full-Report.pdf) and links income inequality to declining public trust in U.S. institutions (page 32, above).

These risk assessments are supported by recent research from the IMF.

A recent IMF research paper by Gould, Eric D. and Hijzen, Alexander, titled “Growing Apart, Losing Trust? The Impact of Inequality on Social Capital” (from August 2016, IMF Working Paper No. 16/176: https://ssrn.com/abstract=2882614) observes that “There has been a sharp decline in the extent to which individuals trust one another, and other social capital indicators, over the past forty years in the United States”

So, observe the first fact: trust and social capital have declined in the U.S. over time.

Next, the IMF paper notes that “income inequality has tended to increase” in the U.S. over the same period of time. The paper then goes on to examine “whether the downward trend in social capital is responding to the increasing gaps in income.” The authors use U.S. data to test this possible relationship and contrasts the dynamics against the data from the EU. Beyond this, the analysis also “exploits variation across [U.S.] states and over time (1980-2010), while our analysis of the [european data] utilizes variation across European countries and over time (2002-2012).”

Per authors, “The results provide robust evidence that overall inequality lowers an individual's sense of trust in others in the United States as well as in other advanced economies. These effects mainly stem from residual inequality, which may be more closely associated with the notion of fairness, as well as inequality in the bottom of the [income] distribution.”

Some more on the findings:

1. “The results suggest that inequality at the bottom of the distribution lowers an individual’s sense of trust in others – in the United States and in Europe,” and per IMF, the relationship is causal: greater inequality at the bottom of income distribution causes loss of trust.
2. “For the United States, it appears that inequality at the bottom of the distribution is the main component of inequality that reduces trust, and this phenomenon is mainly confined to those that are negatively impacted by that component of inequality – individuals who are less educated and those at the lower third of the income distribution.” Were these ‘negatively impacted’ not at least a subset of the voters that Hillary Clinton described as ‘deplorables’?
3. “The trust levels of Europeans are also negatively affected by increasing inequality levels. However, in contrast to the United States, the impact of inequality on trust in Europe is more general. Inequality at the top and bottom of the distribution seem to have a negative impact, and the negative effect is shared across education groups.” Again, any wonder that Europe nowadays has emerging Left and Right wing populist political movements, that are more sustained over time than either Bernie Sanders’ and Donald Trump’s campaigns in the U.S.?
4. 4) Interestingly, in the context of ‘1%-er’ arguments: “For both the United States and Europe, the results do not provide any support for the idea that increases in inequality at the very top of the distribution, such as the top 1 percent or top 5 percent shares, have led to a decline in overall trust levels. The significant negative effect of inequality on trust is apparently not driven by inequalities at these extreme ends of the distribution.”

So, perhaps it is the structure of the U.S. and European institutions and the ways in which these institutions function on the ground that are causing the deterioration of trust and social capital? And, perhaps, looking at broader income and jobs outcomes, rather than focusing on '1%' arguments, can be a more productive approach to starting reshaping U.S. and European systems to address the ongoing loss of public trust and social capital?

8/1/17: Corporate Cash: Organic Capex Still Sluggish

In 2016, based on data from Goldman Sachs, 26 percent of aggregate S&P500 company cash went to fund shares buybacks, matching 2013 ratio of buyback to cash for the highest in 9 years. At the same time, Dividends rose to 19 percent of cash compared to 18 percent in 2015, and M&As contracted to 14 percent of cash from 18 percent in 2015.

As the result, CAPEX and R&D spending by S&P500 companies managed to rise to 41 percent of cash in 2016 from 40 percent in 2015, making this the third (after 2015) lowest CAPEX & R&D spend year (as a share of total cash) since 1999.

CAPEX & R&D represent organic investments by the firms and are jobs additive. M&As and Buybacks are forms of financial allocations and are not supportive of jobs creation. In 2016, based on the data, the split between financial and organic investment was 40:41, which is slightly better than in 2015 (42:40), but still represents the fourth worst year on record (since 1999).

Charts below illustrate:

Controlling for volatility, on trend, share of cash diverted to organic investment continues to trend down and is forecast to fall below 40 percent in 2017. Meanwhile, share of cash going to financial allocations is trending up and is forecast to reach 43 percent of total cash in 2017.

And, financial markets are once again starting to reward buybacks relative to organic growth:

All in, the trends suggest that CAPEX improvements are unlikely to materialise any time soon and the secular decline in investment, consistent with supply and demand sides of secular stagnation thesis is here to stay. Which is bad news for the  S&P500 constituents - lack of organic investment spells lack of value added growth and market potential in the long run. Glut of M&As and Buybacks spells rising risks from misallocation of cash (M&As) and superficial priming up of equity valuations (buybacks-sustained asset bubble). Neither are good.

6/1/17: U.S. Mint Gold Coins Sales in 2016: One Solid Year for Hedging

Updating the data set for U.S. Mint sales of Gold coins (covering both Buffalos and Eagles) for 2016, here is the end-of-the-year data:

• In 2016, U.S. Mint sold 1,204,500 oz of gold coins, which is 17.9% increase on 2015. Remember that in 2015, sales of U.S. Mint gold rose 45.6% y/y. The series are generally quite volatile, but 2016 total sales by volume marked the best year of U.S. sales since 2010 and the third best year on record (since 2006).
• Sales of coins totalled 2,188,000 coins in 2016, up 6.2% y/y, following a 55.8% jump in sales in 2015. 2016 marked the busiest year on record for the U.S. Mint in terms of number of coins sold.
• Despite increase in the number of coins sold, average weight of coins sold came in at impressive 0.551 oz/coin in 2016, up on 0.496 oz/coin in 2015 and the highest average weight sold over the last three years.

Chart below illustrates the trends:

Gold prices tend to have very insignificant impact on demand for U.S. Mint coins, as much of purchasing of these assets is non-speculative and used for longer term store of wealth function. There is, statistically, zero relationship between changes in gold prices and changes in demand for gold coins. To see this, here is an updated chart plotting log-change (m/m) in demand for gold coins from the U.S. Mint against log-change (m/m) in gold prices:

Overall, 2016 has been a strong year for sales of gold coins.

While some of the improved demand is quite possibly being driven by increased interest in gold as a store of value and a longer term safe haven against such matters as increased geopolitical tensions, monetary and currency wars etc, much of this increase in demand is probably also down to more prudent savers taking some of their cash and putting it into the U.S. coinage.

Which, in turn, implies that gold is acting as a counter-cyclical buffer: taking out surplus savings during the period of recovery and setting these aside against potential larger scale risks.

Exactly as it should be, thus.

6/1/17: Euromoney Country Risk Review 2016

Euromoney article on "Country risk review 2016: Populism is risky" quoting, amongst others, myself: http://www.euromoney.com/Article/3650139/Category/0/ChannelPage/207410/Country-risk-review-2016-Populism-is-risky.html.

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.