In Digest, Russia

By Alexander Mercouris, Russia Insider, Nov 12, 2015

As more economic data comes in, it is looking increasingly as if Russia is indeed starting to climb out of recession. The evidence is still tentative – as it always is at the start of recoveries. However, the evidence is accumulating and it points to a slow but steady improvement in economic conditions.

Russian rubleFirstly, though year on year GDP is still falling, this is now becoming an historic indicator.  It seems that GDP began growing on a month by month basis in August.

Economics Minister Ulyukaev says that the year on year fall in GDP will be significantly less in the fourth quarter than it was the third.  He is predicting an overall GDP contraction this year of perhaps 3.8%. Given that the GDP contraction was 4.6% in the worst period of the recession in the second quarter, that also points to a return to growth in the third and fourth quarters.

This gradual return to growth has been written about as if it was somehow unexpected.  In fact it is exactly in line with the government’s economic forecasts. These predicted that the worst period for the economy, the point when the fall in borrowing and investment caused by the sky high interest rates at the start of the year and the fall in demand caused by the inflation spike that resulted from the rouble’s devaluation last year, would hit the economy hardest, would be the second quarter. The economy would then start to recover.

That is exactly how it appears to be turning out.

The fact the economy is moving in line with the government’s forecasts gives further confidence that the recovery is for real. There is now a high probability of an end to the recession and a return to growth next year.

Looking forward, there are in fact more grounds for optimism. Year on year inflation is still hovering around 15%. That, too, is now an historic indicator. Though there are variations in official forecasts, the consensus is that inflation will fall to single figures in 2016, and may be as low as 7% by mid-year.

The likely fall in inflation should lead to a fall in interest rates. Economics Minister Ulyukaev is predicting they could be in single figures by early next year.

In my opinion, the Central Bank missed its window to bring down interest rates in the late spring and early summer. Had it done so the effects on inflation and the exchange rate would have been minimal, but the recession would have been less deep than it has been.

By contrast, I think the Central Bank’s latest decision to maintain interest rates at their present level at its last meeting in September was the correct one.

The end of the year is a traditional period of rouble weakness. It is a time when many Russian companies pay their foreign currency debts, causing them to sell roubles to buy dollars and euros so that they can pay their debts.

The reason the rouble crashed in December last year was because the Central Bank underestimated this, and did not raise interest rates and provide foreign currency support to the banking system, as it should have done.

With the US Federal Reserve Board once again indulging in its tiresome fan dance – keeping everyone guessing whether or not it will raise interest rates in December – this is not a good time to cut interest rates and risk more problems with the exchange rate. Besides, the fact the economy is gradually recovering suggests that for the moment it doesn’t need a rate cut.

The likely fall in inflation and interest rates should result in a recovery of demand and investment in 2016, leading to a rise in output, bringing the recession to an end.

In fact, if one wants to be optimistic, one could point to facts that in the medium term point to a boom. Bank balance sheets – in poor state at the start of the year – are now looking increasingly healthy. Russian companies are awash with cash. Imports have been choked off by the low rouble. Inventories must be running low given the cuts in output and the fall in imports.

There must also by now be substantial pent up demand. Car sales, for example, are expected to fall 30% in 2015, which should lead to high demand for cars when consumers resume buying. It is not difficult to see how all this could translate into an investment and output boom once demand recovers.

Should such a take-off take place, the lingering effects of the recession probably mean it will happen towards the end of next year or perhaps in 2017. That is also the usual pattern in recoveries – a period of tentative growth followed by a surge as confidence recovers.

Are there any risks on the downside?

In the latest in his seemingly endless series of scaremongering pieces about the Russian and Chinese economies, this time illustrated with a picture of Stalin, Ambrose Evans-Pritchard, writing in the Daily Telegraph, says Russia is running out of money and faces a period of autarchy and poverty.

He says the accumulated budget deficit this year will be 4.4% of GDP – a figure he apparently gets from Standard & Poor’s. He also repeats without comment a fantastic claim that inflation is running at 30% – twice the official level.

He says the weakness of Russia’s financial system makes it impossible for Russia to finance its budget deficit or indeed run any budget deficit at all.

The government says the budget deficit in the first 10 months of this year was actually 1.3% of GDP. This would be a significant fall from the 3% of GDP it hit at the time of the worst period of the recession in the second quarter – a fact that points to a higher tax take, which may also be an indicator of recovery. The government does expect to run a budget deficit next year.

The worst case scenario the Finance Ministry currently forecasts is that it will need $15 billion of extra funding over and above what it can draw from the Reserve Fund. It beggars belief that an economy the size of Russia’s cannot find $15 billion or make savings of that amount.

It should be stressed that for the moment, this is a worst case scenario.  If growth rate forecasts are met or exceeded (which is not impossible) this scenario will not arise.

Russian Prime Minister Medvedev – possibly concerned that the Finance Ministry’s warning might be mistaken for a forecast – has rushed out a statement in which he points out that the government’s forecast for 2016 is more optimistic, though he is careful to say that the government stands ready if the situation unexpectedly deteriorates.

Are there any other big downside risks that could darken the picture? The big uncertainty is what will happen to oil prices.

The oil market is still in glut. The Saudis have however made absolutely clear they have no plans to cut output to wipe out the glut, and they anticipate oil prices remaining low for at least another year and possibly even longer.

Contrary to some wild talk, the Saudis are not going to run out of money.  They definitely have the financial firepower to outlast the shale producers, who are their main target.

As I discussed recently, the Saudis are neither ill-informed nor naive about the oil market.  On the contrary they know more about it than anyone else. When the Saudis decided last year to maintain production at existing levels so as to keep oil prices low, they knew exactly what they were doing. They must have calculated that it would take several years of low prices to choke off the shale producers. That is exactly what the Saudis are now saying and common sense says they are telling the truth.

One should not confuse the self-interested pleas for what amount to output cuts made by certain people in the oil industry – spiced up with predictions of doom for the Saudis if these people don’t get what they want – with what is actually happening in the real world.

Oil prices, therefore, are unlikely to rise significantly in 2016, and because of the glut there is a possibility they may fall.

Since the start of the year, oil has generally traded within a range of $50-60 a barrel.  Occasionally it has gone above or below this range, but after a time it has always reverted to it.

Trying to predict with any confidence where oil prices will go over the next few weeks or months in a very volatile market is a fool’s game. On balance, assuming US interest rates do not rise in December by more than expected – which is unlikely – further steep falls in the oil price below the current range of $50-60 a barrel look counterintuitive in winter when demand for oil normally goes up.

If there is a further major oil price fall then – with Russian banks and companies far better capitalised than they were last year and with imports already slashed – Russia’s ability to ride out the fall will be much greater than it was last year, especially since Russia now has the protection of a floating exchange rate.

The never-spoken truth is that it actually suits the Russian government to have oil trading at roughly the current level for at least another year – and arguably even longer – precisely because the low oil prices are keeping the exchange rate of the rouble down whilst making investment in the economy’s non-energy sectors more attractive.

In his article in the Daily Telegraph, Ambrose Evans-Pritchard talks of how Russia suffered an acute case of Dutch disease because of a hugely over-valued exchange rate pumped up by sky-high $100 a barrel oil prices.

Though Evans-Pritchard certainly exaggerates, there is some truth to this picture, though it is worth saying that he never noticed the excessive over valuation of the rouble whilst it was actually taking place. To my knowledge the only commentator who did was Eric Kraus.

If the rouble was overvalued before, then it is arguably undervalued now. The result is that Moscow has gone from being one of the most expensive cities in Europe for a foreign visitor to being one of the cheapest.

Given that the effect of an undervalued rouble is to choke off imports and make domestic production more competitive, it suits the government’s current purposes perfectly. Since the government’s policy is to boost domestic agriculture and manufacturing whilst weaning the country off imports, it needs a period of rouble weakness and low oil prices to make that happen.

That is the same policy China followed in 1994, when it devalued its currency against the dollar by 70%. It was that devaluation that laid the foundations for the Chinese manufacturing and export boom which followed.

In fact, in the not so long term the rouble is likely to harden irrespective of what happens to oil prices.

The major effect of the sanctions is that they are forcing Russian companies to pay off their foreign debts far more rapidly than they would have otherwise done. Since mid-2014, total foreign indebtedness has fallen by more than a third – from $730 billion to less than $500 billion now – something which would certainly not have happened against a background of falling oil prices if the sanctions had not been in place.

This process of deleveraging is probably still continuing. Whilst it is underway, it is dragging down the exchange rate – as well as slowing the economy – by forcing Russian companies to sell roubles to buy foreign currency to pay their debts. The likelihood, however, is that by the middle of next year, or possibly a little later, this process will have run its course.

At that point, demand for foreign currency to pay foreign debt will fall, with the strong probability that the government’s foreign exchange reserves (currently $370 billion) will by then be greater than the total amount of foreign debt which remains outstanding across the whole economy. To these reserves should be added the substantial amounts of foreign currency and foreign assets that will continue to be held by Russian banks and companies.

When that happens, the rouble should finally harden and its period of volatility and its lock-step connection to oil prices should finally end.

A rouble both stable and floating – and freed from the link to oil prices – should make inflation targeting easier, causing inflation to fall further and allowing the Central Bank to reduce interest rates even more. With the economy hopefully by this point enjoying the full benefits of the rouble’s devaluation, the rebalancing of the economy would then be complete.

At the start of the year, Putin predicted that after two years the Russian economy would have fully adjusted to the fall in oil prices. It is starting to look as if he might be right.

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