Apart from the worsening macro indicators the more fundamental threat is the veering of Russia’s economic policy towards self-sufficiency and import-substitution away from economic integration into the global economy.
The disconnect between improvements in Russia’s macro figures in Q2 and the deterioration in the political crisis around Ukraine that became so glaring in the past several months appears to be increasingly likely to be bridged. With Western sanctions on the rise again, there is the possibility of the resumption of elevated rates of capital outflows, pressure on the ruble and the broader macroeconomy. Apart from the worsening macro indicators the more fundamental threat is the veering of Russia’s economic policy towards self-sufficiency and import-substitution away from economic integration into the global economy. Russia’s only way to cope with mounting challenges is to render the system more efficient and productive, something that has largely been out of reach throughout the past several decades of transition.
The latest growth figures present a mixed bag, with Russia avoiding a technical recession in second quarter, but exhibiting deterioration in growth performance in June. According to the preliminary estimate by the Ministry of Economy (MoE) Russia’s GDP growth in second quarter of 2014 amounted to 1.2% Y, after 0.9% YoY in in the first quarter of 2014. Over first half of 2014, GDP growth reached 1.1% YoY, with Economy Minister Ulyukaev naming the acceleration in industrial production a major driver for the improvement in the growth dynamics.
Our estimates suggest that the main impact of possible sanctions on the economy will be via capital outflows from Russia. In our base-case we assume that with additional sanctions Russia will experience net outflows of USD 100 bn, which in itself would be the second highest net outflows in Russia’s history after the record-high USD 130 bn registered in 2008. We estimate that every USD 10 bn worth of net outflows generates depreciation in the ruble exchange rate vs the US dollar of 2.4% and a loss of GDP of around 0.2-0.3 percentage points.
On the growth side we see fixed investment growth, which only in June started to crawl back into positive territory, as being the most vulnerable part of the growth equation due to the possibility of higher capital outflows. The impact on consumption is likely to reflect a combination of downward pressure on consumer confidence as well as the effects of higher rates and inflation on loan growth and the propensity to consume. The direct effect of the new round of sanctions and the possibility of their further escalation may exert renewed pressure on the ruble.
In terms of the overall effect on GDP growth, the Ministry of Finance estimated the sanctions impact at USD 4-6 bn, with the possibility for the growth rate to decelerate to 0.2-0.3% YoY in 2014. We believe that at this stage the impact of the sanctions is not yet elevated to the scale reflected in MinFin’s estimates, though there may be a lagged effect in terms of the impact of sanctions on confidence indicators, with such effects possibly taking their toll into next year as well.
The direct effect of the new round of sanctions and the possibility of their further escalation may exert renewed pressure on the ruble exchange rate. We note, however, that several factors may result in a more moderate effect on the ruble this time around, in particular, the scale of capital outflows is likely to be more subdued, while relatively high oil prices (supported by elevated geopolitical risks globally) serve to limit the scale of the downside. Furthermore, Russia’s current account surplus exhibited a pattern of recovery in first half of 2014 thus reversing the significant decline observed in second half of 2013, which relieves the concerns about the external balance going to zero in the very near term. Finally, elevated interest rates and the hawkish stance of the CBR in view of the high levels of inflation also weigh in ruble’s favor.
In terms of potential policy measures designed to moderate the impact of sanctions on Russia’s economy, the most likely course of action is increased fiscal spending, including on infrastructure projects. In case the pressure on the sanctions front becomes significantly higher we may witness a renewed emphasis on the part of the government to increased social outlays as has been the case during the period of massive capital outflows of 2008-2009. Monetary stimulus appears to be less likely in the near-term given the high inflationary pressures. Another problem is the high capacity utilization in Russia’s industry, which is leading additional stimulus to result in higher inflation rather than acceleration in growth.
The more important part of the problem is the financial sector and Russia’s high corporate debt. In terms of external debt payments Russian corporates need to repay more than USD 130 bn in the next 12 months. The prospects of restrictions in accessing financing from international capital markets will raise the importance of domestic financing sources as well as enterprises’ own funds. In this respect, according to the CBR Russia’s corporates have accumulated nearly USD 150 bn on their balance sheets in hard currency, which may be employed to cover the payments coming due.
The one factor that raises Russia’s capability to cope with external adversity is the relatively strong sovereign balance sheet. On top of the fiscal surplus posted so far this year, Russia also has very low public sector debt of a little over 10% of GDP. This is further reinforced by the reserves in the two oil funds, namely the National Wellbeing Fund and the Reserve Fund, which in total have around USD 180 bn. In the monetary sphere Russia’s strengths include still high forex reserves of close to USD 480 bn and a more flexible exchange rate regime compared to past periods of economic difficulties. In the foreign trade/balance of payments sphere Russia still has a current account surplus, though as is the case with the positive balance in the fiscal sphere, this is largely predicated on high levels of oil prices prevailing currently in the world economy.
While at the macro level Russia has made advances in terms of its economic policy in the past decade, at the micro level of companies and in the structural sphere less progress has been attained. The main obstacles to growth and development in the structural area include lack of diversification of the economy, i.e. continued reliance on oil and gas proceeds, low efficiency, poor corporate governance at the micro level of individual companies. There is also a severe lack of economic vitality in the form of SME development as well as a lack of competition within the economy more broadly.
Under these circumstances, the only viable course of action for Russia is to finally undertake a qualitative transformation of the economic system via higher efficiency and productivity. This kind of economic transformation proved to be largely elusive for Russia throughout the past several decades – the essence of the market transformation was more geared towards a redistribution of assets/wealth, rather than higher competition and productivity. What is needed is a comprehensive programme that sets efficiency targets at different levels of Russia’s state sector, including the regions, state companies, and federal agencies. For state companies cost control is paramount and should feature among the key efficiency/performance criteria for management. It is via such conditionality that targets lower profligacy from the state that the authorities can restrain the state segment of the economy from further inexorable expansion at the expense of the more efficient private sector. Without such a qualitative turnaround Russia’s economy will continue to be at the mercy of external shocks and the whims of volatile commodity markets.
Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.