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.
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 :
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.
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
The collapse of the ruble increases the currency mismatch