In Digest, Russia

August 18, 2015, full texts enclosed:
1. No end in sight to the ruble’s downward
slide, by Chris Weafer, The Moscow Times, Aug 18, 2015
2. Russia’s Second Quarter Contraction Is No Big Deal, by Alexander Mercouris, Russia Insider, Aug 18, 2015
3. Stagnation rearing its ugly head in Russi, by Mark Adomanis, The Moscow Times, Aug 17, 2015

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Ruble exchange rate Aug 2015 (Sergei Karpukhin, Reuters)

Ruble exchange rate Aug 2015 (Sergei Karpukhin, Reuters)

1. No end in sight to the ruble’s downward slide

By Chris Weafer, The Moscow Times, Aug 18, 2015

That Russian GDP contracted by 4.6 per cent in the second quarter comes as no surprise. This is a preliminary estimate and may well end up closer to a five per cent decline when the second reading is published. It will also not be a surprise if the decline in this current quarter is equally poor. But even with that worsening backdrop, the full year decline should still be close to 3.5 per cent rather than anything significantly worse. That is because the fourth quarter drop will be smaller and likely closer to the 2.2 per cent decline recorded in the first quarter.

That, however, is not to be taken as evidence of optimism that Russia will be pulling out of the slump by year end and resuming growth; it is simply the mathematical result of the base-effect, as the economy was already in significant decline toward the end of last year.

The main factor which will determine whether the consensus is correct or overly optimistic is the ruble exchange rate. More than anything else, the ruble is very much like the single bolt which holds a hang-glider together. If it breaks, then the glider will fall to earth and the pilot very likely killed.

The reason why the ruble has that critical role is because, on the one side, the ruble exchange rate is the end result of several other elements, such as the oil price, global currency trends and the actions of the Central Bank. On the other side are the many consequences of where the ruble trades, and that list includes inflation, interest rates, the competitiveness of domestic industry and, most important, end consumer and industry owner confidence.

That the rally in the oil price, which brought Brent up to $68 p/bbl in mid-May, was unsustainable was evident. It was a speculative move prompted by optimism that the weakness of late 2014 would force U.S. shale producers to close some wells and would lead to a supply cut from OPEC. In reality, neither was ever likely as U.S. producers are working on a marginal cost while Saudi Arabia has made it very clear that, for them and their core allies inside OPEC, this is a battle about longer-term market share.

The International Energy Agency (IEA) has recently cut back its growth forecast for U.S. oil output, but it still expects a gain from 11.9 million barrels per day (mln bbl/d) in 2014 to an average of 12.7 mln bbl/d this year and rising to 13 mln bbl/d for 2016.

Saudi Arabia has recently cut back slightly from the near record high of 10.6 mln bbl/d in produced in June but is still well ahead of the 9.6 mln bbl/d it averaged last year. On top of that, almost all other producers are pumping near maximum, including Russia which has so far been unaffected by sanctions and is pumping at a post-Soviet high.

To that we have to add some extra Iranian output. It will take many years and billions of dollars of investment to build up the country’s output to potential, but it can relatively quickly add an extra 500,000 mln bbl/d. For a market which is already over-supplied by 1.5 mln bbl/d, the consequences are obvious.

The other factor which is likely to hurt the oil price in the coming months is the expected rate rise by the U.S. Federal Reserve Bank. The evidence is that this is a question of when rather than if. When that happens, we can expect some further strengthening of the U.S. dollar and that, historically, is always a negative for the oil price.

How far the oil price may slide is always a difficult question. Traders will keep in mind the 2009 support price of $42 p/bbl while other speculators may be tempted into the market in the mid-$40’s p/bbl, as they were earlier this year, because of the risk of output disruptions from large producing nations, such as Venezuela, which are now facing severe financial problems, or as a result of an expansion of the various conflicts across the Middle East.

A voluntary cut in output by either U.S. shale producers or by Saudi Arabia seems most unlikely while any cut from Russia is impossible.

So, faced with either further weakness in the oil price or, at minimum, an extended period of low oil, what may we expect to see as a response from the Central Bank? In previous years, we would have expected the Central Bank to use a period of oil stability to try and rally the ruble with interventions. Those days have gone.

Over the past six months, we can see that government policy towards the ruble has shifted 180 degrees. Today, the policy preference is for a weak ruble.

The key message that a weaker ruble is better than a strong ruble started to be better understood when the first quarter macro report showed a significant gain in some parts of domestic manufacturing as a result of the competitiveness boost from the ruble weakness in late 2014.

We also now hear government officials linking the more “competitive” currency with the import-substitution strategy. The same can be said for the plan to try to boost exports in sectors outside of extractive industries. A more “competitive Russia” may also become one of those slogans to be associated with this crisis.

One of the reasons why the second-quarter macro performance was weaker than in the first quarter is because the ruble strengthened too quickly over the first four months of the year. It meant that there was less of the positive import-substitution impact seen in the previous quarter. The current ruble weakness should help at least partially address that in the coming months.

The second reason why a weak ruble is now preferred is because it makes a lot easier the Finance Ministry’s job of trying to keep the budget deficit low.

So what is the ideal exchange rate? We know from comments made by both the economic development and finance ministers that they are happier with an exchange rate at 55.0 against the dollar rather than below 50. The Central Bank also supports that and announced that it would rebuild FX reserves (to a target of $500 billion) in periods where the ruble strengthened too far. At the other end of the scale, an exchange rate at 65, or worse, against the dollar will start to ring inflation and confidence alarm bells.

In many ways, the ruble equation is a lot less complicated than it used be. We no longer have to worry too much about speculative actions or even the contagion from Beijing’s actions, i.e. other than in so far as this may further strengthen the U.S. dollar or weaken the oil price. Today, the ruble equation is a straightforward balance between where the oil price trades and what the Central Bank does in response.

The optimistic view is that, at best, both the ruble and oil will hold near current levels into the autumn. There really is no basis for assuming a meaningful rally in either over the medium term. The greater likelihood is that the price of Brent crude will drift further down in the coming weeks and that would then push the ruble into the high 60’s against the dollar.

In that event, apart from some ad-hoc interventions to prevent a steep decline or a return of volatility, there is no reason to assume the Central Bank will take any meaningful, i.e. expensive, actions to prevent the ruble sliding toward the 70 mark.

Chris Weafer is a senior partner with Macro Advisory, a consultancy advising macro hedge funds and foreign companies looking at investment opportunities in Russia.

 

2. Russia’s Second Quarter Contraction Is No Big Deal

By Alexander Mercouris, Russia Insider, Aug 18, 2015

Confirmation from Rosstat – the Russian government’s statistical agency – of a 4.6% contraction in GDP in the second quarter, has led – predictably enough – to a resurgence of some of the apocalyptic predictions of the last year. There is no justification for this.

All recessions have their peculiar features. However the classic pattern of a recession in a market economy is that a fall in demand – usually caused by the bursting of a credit bubble – leads to a cut in production and investment, with producers preferring to draw down their existing inventories rather than buy in new products.  In time, demand recovers, production rises as demand has to be met and as depleted inventories have to be replenished, and the recession ends. This is the pattern the Russian economy is following.

The fall in demand that struck Russia in the early months of 2015 was not caused by the bursting of a credit bubble. The Russian authorities have a horror of bubbles, and whenever there has been any sign of such a bubble – as in the early months of 2012 – they have always acted decisively to stop it.

Rather, what caused demand to fall at the start of this recession was the combination of the inflation and the high interest rates caused by last year’s devaluation of the rouble. That devaluation of the rouble was in turn caused by last year’s collapse of oil prices, energy products being for historic reasons Russia’s main export product.

In the early weeks of 2015, food price inflation in Russia was running at over 20%. By some estimates real incomes fell by as much as 9%. The inevitable result was a fall in demand, causing a recession.

I saw evidence of this when I visited Moscow in February, as did Dr. Gilbert Doctorow when he visited Russia a few weeks later. It was apparent that the inflation spike was hurting badly, especially those with low and fixed incomes.

As well as the inflation spike, the very high interest rates – caused by the Central Bank’s need to damp down inflation and to support the rouble – increased the cost of borrowing, cutting demand for expensive items such as cars that are usually bought on credit, and hitting investment. With producers responding to the fall in demand as one would expect by cutting inventories, production inevitably fell.

Since it takes time for information to be passed down from consumers to producers down the supply chain, the major cutbacks in production and spending took place in the second quarter rather than the first, as decisions made in the first quarter were fully implemented in the second. This is why with a GDP contraction of 4.6% in the second quarter, the recession appeared deeper in the second quarter than the first, even as sentiment in the economy actually began to improve. This is the picture that the statistics have been reflecting. As I have pointed out on several occasions, given what happened at the end of last year it could not have been otherwise. The point is that as the inflation spike burns its way through and as interest rates fall, demand will first stabilise and then recover.

According to Rosstat, prices stopped growing in the second half of July and weekly price inflation has now been zero for several weeks. This is usually the case in Russia in the summer months. However, the fact that it is happening this year so soon after the inflation spike of the winter shows how quickly the situation is returning to normal.

At the same time as inflation has fallen, interest rates have been cut.

With both prices and interest rates falling, early indications are that demand has stabilised and stopped falling at its previous speed in July – and may even have increased that month.

As always, the process takes a little time to work itself through, so that while the fall in industrial output appears to have slowed in July, manufacturing continued to contract.  However as demand recovers and as it becomes necessary to replenish inventories, industrial output will rise, bringing the recession finally to an end. As I have said previously, the Economics Ministry is predicting the end of the recession in the final quarter, and this remains its opinion and the general consensus.

This recession – as all recessions do – has exposed weaknesses in the Russian economy. Of these, the most important is not that Russia’s major export is energy products. This a grossly overhyped issue that wildly overestimates the importance of foreign trade to a continental sized economy which the World Bank estimates on a purchasing power parity basis is now the fifth biggest economy in the world.

The economy’s vulnerability to movements in oil prices is anyway now largely mitigated by the floating exchange rate (see for example the opinions of Aleksey Ulyukaev – Russia’s Economics Minister – given at the beginning of July when the oil price appeared to have recovered – about why Russia would not be worried by a $40 a barrel oil price).

As I have also previously said, further downward movements in oil prices and the rouble are now unlikely to change the underlying inflation position or affect Russia’s recovery.

The Russian economy’s key weakness is not the fact that it exports mainly energy products, but the weakness of its financial system – a fact recently acknowledged by the Central Bank, which described Russia’s financial system as “shallow”. For an economy of Russia’s size, the financial system is too small, which is why Russian banks and companies have until recently looked outside Russia to western Europe for part of their finance.

It is because the financial system is too small that the rouble is so volatile and the government is unwilling to run a budget or trade deficit, even at times such as these when oil prices are low and when the recession could be smoothed by the government running a bigger deficit.

By contrast, Saudi Arabia, with an economy far less diversified than Russia’s, is able to maintain a currency peg with the dollar and cover a budget deficit estimated at 20% of GDP by borrowing from its banks, which are much more liquid than Russia’s.

The weakness of Russia’s financial system is a reflection of its youth. It has only been functioning properly for about 10 years. It would be asking a great deal to expect a financial system this young to achieve levels of depth and sophistication comparable to those of Western financial institutions in such a short time.

The weakness and small size of Russia’s financial system is not however something written in stone.

A country as large and wealthy as Russia can certainly develop a financial system big enough to fund the needs of its economy.

As Russia Insider has discussed previously, the great benefit for Russia of the sanctions is precisely that it is obliging Russia to make reorganisation of its financial system a priority.

Thus, we are finally seeing steps to create a new interbank payment system alongside SWIFT, a new credit rating agency, and a new bank card independent of MasterCard and Visa, at the same time as the Central Bank has been busy withdrawing licences from unstable banks.

Above all, it is reflected in the Central Bank’s and the government’s single-minded focus on reducing inflation to an annualised level of 4%. As the Russian authorities understand well, the Russian financial system cannot fully expand and modernise whilst inflation remains as high as it has historically been in Russia.

With younger people – some of whom have experience working in Western financial institutions – now joining Russia’s banks in increasing numbers, what these steps mean is that the modernisation and expansion of Russia’s financial system to the point when it finally becomes fit for purpose is now only a question of time.

In the meantime, if the recession has exposed weaknesses in Russia’s economy, it has also highlighted its strengths. Despite the fact that the country is in recession – and despite the very high interest rates at the start of the year – there have been no mass redundancies (unemployment has barely risen), no mass plant closures, no flood of bankruptcies or of home repossessions or of farm foreclosures. So far, this has been almost entirely an output recession.

This reflects the low level of debt in the economy. This low level of debt is partly a reflection of a lack of investment in the economy caused by the weakness of the financial system. It is, however, also a reflection of the authorities’ deep aversion to credit bubbles and the steps they have repeatedly taken to prevent them.

The result is that in Russia – as in the West until the 1980s – demand has risen on the back of higher wages, not through credit growth. This explains the country’s resilience in the face of recession.  It is why the country can absorb the inflation and high interest rates of the start of the year, and the temporary drop in output they caused, without this affecting the country’s underlying stability.

 

3. Stagnation rearing its ugly head in Russia

By Mark Adomanis, The Moscow Times, Aug 17, 2015

Ever since I first started to study Russia, I’ve read that is it on the verge of “stagnation.” Virtually every other week, even as Russia’s economy was rocketing along at 7 percent annual growth, The Economist, The Guardian, or The Wall Street Journal would write an aggrieved editorial bemoaning the country’s descent into a mire of corruption and inefficiency and the weakening of vital reforms passed during the 1990s.

Now stagnation is, in every country, an extremely negative term. But Russia is the only country that I know of where “stagnation” refers not just to some kind of vague abstract malaise, but to a very specific historical context: the late Brezhnev years.

Russia’s period of stagnation wasn’t just an economic problem — although the Soviet economy did begin to noticeably slow down — it was an all-encompassing sense of political, social, and moral decay. The Soviet state had always been brutal, but during the Khrushchev years from 1953 to 1964, there was a brief moment where it appeared that a better future was, if not imminent, then at least possible.

It’s easy to exaggerate the impact of Khrushchev’s Thaw — the Khrushchev years also saw a renewed and quite brutal crackdown on religious expression, and the mechanisms of state control remained completely unreformed — but the Brezhnev years saw the end of any illusions about progress via the system. The party was on top, it wasn’t going anywhere, and it was increasingly disinterested in justifying its control through anything other than force and inertia.

But what has always fascinated me about the Brezhnev stagnation was that, even though it had a moral and cultural component, it manifested itself in very concrete, measurable ways. This is particularly true when it comes to demography.

Under Brezhnev, the Soviet Union experienced deterioration in an enormous range of social indicators. The number of alcohol poisonings began to slowly increase. The infant mortality rate began to creep upwards. Life expectancy started to tick downwards. Death rates from a host of diseases — particularly cancer and heart disease — began a relentless march upwards.

The situation got so bad that the Soviet authorities, who despite their incompetence and corruption were able to recognize failure when they saw it, resorted to classifying demographic data. That’s right: the government was so humiliated that it simply banned the publication of the offending figures.

In order to calculate basic data points, Western researchers were forced to consult a bewildering array of specialized medical journals, painstakingly assembling data in much the same way a jigsaw puzzle is put together.

From a comparative perspective, the Brezhnev-era trends were unprecedented for a modern country. Even in the worst years of 1970’s “stagflation,” Western countries continued to achieve modest annual improvements in public health. For a country to suddenly start marching in reverse, as the Soviet Union did under Brezhnev, bordered on the inexplicable.

And this is why, throughout most President Vladimir Putin’s leadership, I found the constant exclamations about “stagnation” to be so tiresome: they just weren’t being reflected in any of the places that you would expect them to be. When you looked at the data, regardless of what you wanted to believe, it simply was not true that public health was deteriorating. In fact, public health measures were improving rapidly.

Over the past few years Russia actually reached a new record high average life expectancy. The death rate from alcohol poisoning, although still much higher than in any Western country, was falling by almost 10 percent a year, and in 2013 hit the lowest level on record. Russia was even starting to make modest progress in confronting its out-of-control epidemic of cardiovascular disease.

But nothing is set in stone. Recent data suggest that the improvements in public health which have broadly characterized the past 15 years of Russian history are now coming to an end. Throughout the first six months of 2015, the overall mortality rate has increased by about 2.3 percent.

From 2013-2014, state statistics service Rosstat data indicate that the death rate from alcohol poisoning shot up by almost 6 percent (though this figure is likely complicated by the recent inclusion of Crimea and Sevastopol) while in the first half of 2015 it is up by a further 1.5 percent.

The actual levels of mortality are still much better than at any other point in recent history, and vastly better than the 1990s, but for the first time since Putin came to power, the overall demographic trend is not of improvement but of decline.

Does that mean that Russia is fated to reprise the 1970s? I don’t know. It is entirely possible that the data from 2014 and 2015 reflect unique one-off circumstances (the annexation of Crimea, the crisis in Ukraine) rather than genuine long-term trends.

But in Russia “stagnation” isn’t just a state of mind: based on historical experience it is a condition that is easily identifiable via public health statistics. And for the first time in a long time, those statistics are suggesting that, on average, things are getting worse, not better.

Mark Adomanis is an MA/MBA candidate at the University of Pennsylvania’s Lauder Institute.

Read also:
Russian carmakers feeling the pinch, Reuters, Aug 17, 2015

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