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Dealing with an alarming situation, Russia is forced to implement a credible and coherent economic policy

THE ESSENTIAL

Russia has relatively strong fundamentals (structural surplus in its current account, sound public finances, and high foreign exchange reserves). Nevertheless, strong inflationary pressure (related to the depreciation of the rouble and the drop in oil prices) and political tension stemming from the Russia-Ukraine conflict have led to a very rapid deterioration in the economic outlook and a heavy strain on the strength of its fundamentals.

Russia must therefore take on the challenge of establishing a coherent and credible economic and political strategy, under tense conditions. While the budgetary policy is severely constrained, the change that the monetary policy will undergo in the coming months will be decisive. In particular, an overly accommodating policy could be interpreted as an intention to monetise the debt in local currency. If the rouble continues to depreciate, Russia’s ability to service its external debt could then be jeopardised by the markets.

 

 

 

PUBLICATION

If the current situation carries on, Russia’s leeway could quickly dwindle away

Russia’s economic situation has deteriorated very quickly in recent months and is not expected to stabilise any time soon, since the Russia-Ukraine conflict does not seem to be leading toward a quick resolution. Recent events are putting a strain on Russia’s safety cushion (in particular structural current account surplus and sound public finances), which now appears to be much weaker than Russia suggested.

Russia: gripped by a severe economic crisis

Under enormous strain due to a highly unfavourable economic environment and outside political pressure, Russia is facing signifi cant obstacles.

First of all, the economic situation is very sluggish, with a barely positive GDP growth (+0.6% in 2014) and significant inflationary pressure (with consumer prices up +15% year-on- year in February). The Russian economy has been notably affected by the current Russia-Ukraine crisis and the resulting sanctions imposed by the West. Restrictions on imports are driving inflation1, and the evolution of capital flows is intensifying the depreciation of the rouble and reducing the potential for external financing. Combined with the effects of very low oil prices, with oil constituting one of the country’s main sources of income (fuel and mining products represented over 70% of Russian exports in 2013), such an economic environment offers a rather poor outlook for Russia for the coming year (the IMF expects a 3.0% recession for 2015, and our scenario of 4.5% is even more pessimistic).

1 In 2013, 43% of Russian imports of goods came from the European Union, and 5% came from the United States.

 

Constrained external financing

The recent change in the political context and economic environment has had repercussions on external financing. On the one hand, the Russian government is having trouble finding enough buyers on the markets for its Treasury bills and had to cancel its weekly issuances of sovereign debt for several weeks in a row since last September (and those that ultimately took place weren’t very successful). Russia was recently downgraded by Standard & Poor’s to speculative grade (along with a negative outlook), and yields on Russian debt have reached a historically high level. In fact, in January, Russia’s EMBI spread exceeded that of Pakistan (which Standard & Poor’s rates as highly speculative) and was more than 80% of that of Argentina (classified in the “default” category for its foreign currency debt). Therefore, Russia’s difficulty in raising funds could increase in the coming weeks.

On the other hand, fiscal discipline and control of its public debt remain a priority for the Russian government, also characterised by the willingness to limit recourse to external financing, even if it means setting up an even more restrictive federal budget. Therefore, while the stock of debt held externally goes down, particularly due to the reduced issuances, the government could decide to intensify this strategy by buying back its own debt on the secondary market.

A budgetary dilemma

Russia has sound public finances, with a limited deficit (around 1% of GDP in 2014) and a debt-to-GDP ratio (16% of GDP in 2014) that is well under control. Furthermore, the debt burden represents only about 2% of government revenues, which demonstrates that the Russian government’s finances are in good shape.

And yet, the government is now facing a budgetary dilemma :

  • While the 2015-2017 budget was initially established based on an optimistic oil price of $100 per barrel, its abrupt decline has cast major doubt on a balanced federal budget. Russia therefore had to slash public spending because, besides wanting to remain financially independent, its financial resources are dwindling. In fact, domestic savings decrease1 (which goes hand in hand with the significant inflationary pressure) and, as mentioned above, Russia is having trouble getting financing abroad. A 5% annual decline in spending for three years would thus have been announced.
  • But on the other hand, the economic reality provides every reason to spare some expense categories (including social services), and even setting up support in the economy in order to preserve a certain amount of support within the population, which is already suffering due to a difficult economic environment. In January, Russia announced a $35 billion Russian anti-crisis plan, intended to support business and the banking sector.

Toward greater exchange rate flexibility

Beyond its budgetary impact, the drop in oil prices is accompanied by a collapse of the rouble (which has lost half its value in one year). Even though the decline of the rouble caused the dollar value of rouble-denominated debt held abroad (which represents less than a third of the Russian debt held overseas) to drop, the imbalance between the value of revenues (earned in roubles) and the external debt burden (essentially paid in foreign currency) -known as “currency mismatch”- has grown. While Russia’s relatively significant stockpile of foreign exchange reserves has now become one of the country’s safety buffers (international reserves of $415 billion in late 2014, covering the equivalent of 18 months of imports in 2014), they have come into play significantly in recent months, especially since the Bank of Russia has tried to slow down the rouble’s decline. Russia’s stock of foreign currency reserves has thus dropped nearly 30% between early 2014 and February 2015, which is considerable. Because of these significant interventions in the foreign exchange market ($27 billion in October 2014, compared to around $75 billion in 2014 and $25 billion in 2013), the Bank of Russia, pressured by the drop of the rouble, took an additional step toward a more flexible exchange rate regime. In November, it announced a new step in its foreign exchange market intervention policy, by limiting the amount of daily interventions and thereby removing the rouble’s restricted fluctuation range.

Russia: Forced to implement a rigorous policy mix

Without immediate structural reforms, a coordinated policy mix seems necessary in the short term

To address the rapid deterioration of its economic environment, Russia should adopt adequate economic policies, likely to convince the markets. In structural terms, Russia would have to overcome the difficulties posed by the lack of diversification in its economy and its economic isolation. However, in the short term, objectives to revive the economy will already be difficult to achieve, particularly because the energy sector no longer seems to be able to provide an obvious opportunity in the foreseeable future, as it has done in the past. In fact, even if oil prices gradually creep back up, it is likely that the demand from the European Union, the top importer of Russian goods, will decline over time, due to the Russia-Ukraine conflict. The geopolitical environment remains very tense and sanctions from the United States and the European Union could increase if the cease-fire adopted in Minsk does not result in lasting peace (which is by no means certain, at least initially).

The structure of the Russian economy does not appear to be changing in the near future, due to the current context and especially Russia’s desire to persevere with its policy. It is therefore up to the Russian government and the Bank of Russia (which recently named one of its veterans as the new Head of Monetary Policy) to first implement economic policies that can put the economy back on its feet, at least in the short term. Only a credible and coordinated policy mix could allow Russia to claim effects on business, exchange rates, inflationary pressure (and especially inflation expectations) and possibly trigger the start of recovery.

Return to the 2008 crisis

At first glance, this gloomy landscape (inflationary pressure and upcoming recession) resembles what Russia experienced after the financial crisis of 2008, since GDP growth plunged at -7.8% in 2009.

Russia previously enjoyed very strong growth and a highly unfavourable external position (7% annual growth of GDP and current account averaging 9% of GDP from 2000 to 2007). Because of the crisis, a change of economic regime seems to have happened in Russia, where growth was less than 2% annually from 2008 to 2014 (with a current account of 4% on average). Nevertheless, the current crisis, more than in 2008, calls for an appropriate and well-planned response from the government. Infl ation of 14% in 2008, oil prices below $40 per barrel in late 2008, and a 30% depreciation of the rouble between mid-2008 and early 2009 probably already brought to light, at the time, the evidence of the low diversifi cation of the Russian economy. But that episode did not generate a major change in the monetary policy or an economic policy that substantially altered the structure of the Russian economy, particularly its increased dependence on energy revenues. By comparison, the central bank’s increase of the reference rate by «only» 400 bp was gradual between early 2008 and February 2009, going from 6.5% to 10.5% and resulting in negative real interest rates.

 

While Russia seems to be at a budgetary impasse, the monetary policy trend in the coming months will be decisive

The Bank of Russia, which drastically increased its key rate by 750 bp to 17% to stem off the development of inflation and the depreciation of the rouble last December, adjusted the shot in late January by lowering it further to 15%, the same level as inflation in February. It holds that this action is the result of the change in the balance of risks between inflationary pressures and the deteriorating economic situation. Therefore, while the Russian monetary policy was now moving toward targeting inflation, the central bank decided, betting on the upcoming slowdown in the acceleration of prices, to rebalance in favour of growth support, as the economy was going to overly suffer from these restrictive financing conditions.

In the coming months, the right balance will need to be found between a monetary policy that is accommodating enough not to impede recovery and calibrated enough not to let prices fly away

If monetary policy was not restrictive enough and if the central bank allowed the rouble to depreciate at the same time, it might be interpreted as an attempt to monetise the rouble-denominated debt, and would accentuate the currency mismatch (see above), and a fortiori the default risk on servicing the dollar-denominated debt. Such a situation is now possible through a more flexible interest rate regime. In fact, with a fixed exchange regime, monetising the debt is harder to achieve because it requires significant foreign exchange interventions to maintain the stability of the currency, a constraint from which Russia has gradually tried to free itself.

It appears that Russia has finally recognised the critical nature of the situation. While the geopolitical situation remains very tense and the price of oil - even if it increases in 2015 - will likely remain below the Russian breakeven point2, it is now up to Russia to adopt a more rigorous policy mix and to do so credibly. To this end, we will keep an eye both on real interest rates (which were near zero in February) – which carry information on the future direction of the monetary policy – and also on budget changes (savings in expenditure and the establishment of an “anti-crisis” plan). If the monetary policy was too restrictive, it could impede potential recovery too substantially, despite inflation control. By contrast, an overly accommodating monetary policy (and negative real interest rates) would increase inflationary pressure and depreciate the currency, further aggravating the difficulty of obtaining financing.

1 Gross domestic savings dropped about 5% of GDP from 2010 to 2013. 

2 The barrel price that could balance Russia's budget is around $115.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Russia’s difficulty in raising funds could increase in the coming weeks

 

 

 

The government is now facing a budgetary dilemma

 

 

 

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The collapse of the ruble increases the currency mismatch

 

 

 

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Cross Asset of March 2015 in English

Cross Asset de Mars 2015 en Français

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PARET Anne-Charlotte , Strategy and Economic Research at Amundi
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Dealing with an alarming situation, Russia is forced to implement a credible and coherent economic policy
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