Russia: Leaving the Crisis Behind

Russia has not had a good crisis. It has suffered markedly more than its BRIC peers, and also more than was to be expected given the country’s seemingly sound pre-crisis fundamentals. After nine years of close to 7% annual economic growth on average, and with a federal budget surplus of 4.1% of GDP in 2008, a sizeable current account surplus and pre-crisis international reserves of USD600bn, the country seemed to have become a safe haven. Things didn’t turn out that way, however. In 2009 the Russian economy probably shrank by 8.5% to 9%, the ruble is still more than 20% below its pre-crisis level relative to the USD (despite having recovered sharply since February), the federal budget is likely to post a deficit of 6.5% of GDP (implying the economy will shrink by a whopping 10%), and more than a third of foreign exchange reserves were depleted at one point, reflecting the Central Bank’s efforts to defend the ruble and mitigate the fallout from the financial crisis.

Optimism prevails for 2010
In line with international trends, the Russian economy bottomed in H1 2009, with leading indicators pointing upwards since Q2. However, the actual rebound in H2 started later than it did in, for example, the Eurozone or China, and it has been relatively meek. Industrial production started picking up during the summer, but the moderate signs of recovery have so far failed to inspire the Russian consumer. Retail sales have remained flattish. Still, the recent flow of data and the global economic backdrop point to faster economic growth in 2010 than originally expected. Recently, Russian officials raised their GDP forecast for 2010 to 2.5-3%, while the OECD lifted its forecast to 4.9%, which is above even the projections of most brokers.

So far, the recovery of the Russian economy has been driven mainly by external developments, and this is unlikely to change going forward. As always, the outlook for Russia will be determined by commodity prices, in particular the price of crude oil. The surprisingly strong upturn in China, together with substantial capital inflows to emerging markets, have fuelled a rebound in commodities which is likely to continue in the first half of 2010. Whether the boom will be sustainable for the whole year depends heavily on the global outlook. A key factor in this context will be when and how quickly governments in the US and Europe start reversing their expansive policy stance. While the global economy performed better in 2009 than one would have assumed a year ago, there are probably still substantial risks hidden in the financial system (just think of Dubai and Greece), and the real sector looks far from healthy in many places around the world. We therefore take the view – in line with consensus, it seems – that both the US and European authorities will be slow to end their current policies and that money will remain cheap well into the second half of 2010.

In addition to a benign global economy, we assume that over the course of 2010 domestic developments will also increasingly support growth. We expect the Central Bank to continue to lower interest rates, facilitated by a further decline in inflation. Price-growth will probably be in the single digits in both 2009 and 2010. In addition, fiscal policy is likely to remain supportive. The fiscal stimulus for 2009 will turn out to be weaker than previously thought, but we do not assume that the budget deficit will drop significantly (if at all) in 2010. Particularly, attempts to use fiscal policy to support the low-income bracket of the population should stimulate domestic consumption.

Among the unknowns for 2010 is the exchange rate. Recently, the authorities have tried a combination of allowing higher ruble volatility and intervening verbally to discourage ruble strength. While this approach may have its merits in the short term, we are less sure that it can prevent the ruble from strengthening further in 2010. Combining an exchange-rate target, independent monetary policy and international capital mobility is a wellknown trilemma that can typically only be resolved by abandoning one of the three. Given Russia’s need for capital inflows and the weakness of the banking system, limiting capital mobility (such as Brazil’s recent attempts to restrict short-term capital inflows) may not be appropriate. Thus the CBR will probably have to accept a stronger ruble in 2010, and exporters will have to adjust.

The triumph of hope over experience?
Lately the focus has shifted again toward the longer-term prospects of the Russian economy. This move was prompted partly by President Medvedev’s “Go Russia” article and recent state-of-the-nation address detailing a number of well-known deficiencies in the Russian economy, and partly by earlier discussions in the financial community on whether Russia would lose its BRIC status because of its dismal performance during the crisis.

We think the latter debate is of limited relevance because of (a) the vagueness of the BRIC concept and (b) empirical facts. In their recent update on the longterm outlook for BRICs, the analysts at Goldman Sachs (the guardians of BRIC status) pointed out that even including the crisis, the Russian economy has grown by more than 5% a year since 2003. Moreover, another look at the data shows that Russia has been growing faster than Brazil over the past decade. Given that rapid growth and size are the only obvious criteria for membership in this exclusive club, we are fairly certain that any reference to BRIC in, say, ten years will include Russia. The “R” will stay in BRIC.

President Medvedev’s comments deserve more attention because they have raised hopes that the government will finally launch another wave of economic reform to address some of the country’s seemingly eternal problems. Medvedev rightly pointed out that Russia’s heavy reliance on “the old raw materials economy” did not significantly change during the past cycle. The basic commodity sector still accounts for about four-fifths of total export revenues, which is of course a major concern. The president’s criticism of the bloated and inefficient state-owned industrial sector was also spot-on. The remedies he proposed, however, left us unconvinced. We do not share the widespread view espoused by Russia-skeptics that the country has not carried out any successful reforms since the collapse of communism, and that its respectable performance in recent years was due only to surging prices for oil and commodities. However, Mr. Medvedev’s reform ideas, including the proposed focus on five main areas of modernization, generally reflect a topdown view of the economy and may be nothing more than a plan to build state capitalism repackaged for the 21st century rather than a genuine acceptance of market principles in industrial restructuring. These doubts were confirmed only a couple of days after the president’s comments, when the Finance Minister came out in favor of letting a state-owned bank invest half a billion US dollars in the equity of one of the country’s largest basicmaterials groups.

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Risks to the near-term outlook
The short-term risks to Russia mainly stem from the global economy, and to a lesser degree from domestic developments. While the global rebound has been stronger than anticipated, there are good reasons to assume that global growth will not return quickly to its pre-crisis trajectory. Moreover, there is a clear risk of a double-dip recession, particularly if governments around the world fail to carry out the delicate balancing act of supporting growth until the economy gains sufficient momentum and ending fiscal and monetary policies that are unsustainable in the long run. Russia’s upside – both in economic terms and for equity investors -- comes from its high beta on global growth, and therefore any disappointments – and their adverse impact on commodities in general and oil in particular – would be a major setback. On the domestic side, one of the main concerns is the banking sector. The recent news flow has been positive, both in terms of operating results and the outlook for NPLs. However, loan growth remains anemic, indicating that domestic demand – including business investment as well as private consumption – may be stalling. Upside risks dominate, but it would be careless to ignore how fragile the economic situation still is.