Thursday, August 28, 2014

27/8/2014: Russian Economy Outlook

Russian Economy Outlook

Main macroeconomic points:

First, at the aggregate level: Russian GDP grew by 0.7% y/y in the first seven months of 2014. On preliminary basis, Rosstat’s estimate posted Q2 2014 growth of 0.8% y/y down from Q1 2014 growth of 0.9%. On seasonally-adjusted basis, Russian GDP is now estimated to be marginally lower in the first half of this year than at the end of 2013.

We do not yet have an official recession, but output in the five core sectors of the Russian economy : industry, agriculture, construction, retail sales and transport rose by only 0.3-0.4% y/y in Q1-Q2 2014.

This means that main drivers for growth so far have been:
- Services other than retail and logistics,
- Investment, and
- Government spending

Bad news is, the above are changing for the worse since the beginning of Q3. Car sales tell the story: down 23% y/y in July 2014. Economy has contracted in June (-0.1% y/y) and July (-0.2%) after growing 1.3% in May. GDP grew 1.6% y/y in July 2013, so the swing is now 1.8% down. Retail sales were up only 1.1% in July before the heavier segment of the sanctions hit, which was a positive surprise (expectation was for 0.9% growth) and this is an improvement on 0.7% growth in June. In comparison, retail sales grew 4.5% in July 2013. But investment fell 2% in July, erasing gains recorded in June and this compares to growth of 2.2% in July 2013.

IMF latest forecast is for 0.2% growth in the economy in 2014. Official Economy Ministry forecast is for annual growth of 0.6% although some recent statements from the Ministry officials voiced a higher figure of 1%. You might as well say it will be -0.2%. Any growth for Russia below 2% is poor showing and the real issue here is - what will happen in 2015-2016.

So far, the cost of the Ukrainian crisis is relatively indirect, not hugely significant but rapidly rising.

Russian foreign reserves are down by USD42 billion at the end of July 2014, but gold reserves are up USD3.5 billion over the same period. This rate of depletion is sustainable for now, but presents two problems forward:
1) Ruble valuations; and
2) Companies and banks supports over the duration of the sanctions

It is worth remembering that during the Crimean crisis in March this year, the CBR intervened aggressively in the FX markets, selling more than $22.3 billion of reserves in just one month. This was followed by sales of USD2.4 billion in April and a net purchase of USD1 billion in May. The result was moderation in devaluation of the ruble. [The currency lost roughly 13% of its value against the dollar since August 2013.] And devaluation is ongoing.

On the first point above, Central Bank of Russia continues to push toward a fully free-floating ruble - a long-term policy objective of the CBR that is [for now] firmly in sight.

The CBR further adjusted its ruble exchange rate steering mechanism [a range for the exchange rate relative to a dollar-euro currency basket] in mid-August:
* The fluctuation band limits have been widened from 2 to 9 rubles.
* The CBR also committed to not intervening in the markets as long as the steering rate stays within the steering range. This is a departure from the previous practice of supporting ruble even within the bands.
* Bands limits sensitivity to market rates changes was also made tighter, to allow for more flexible adjustments in the bands in response to smaller appreciation or depreciation pressures on the ruble.

Net effect of the three recent changes is that ruble is moving closer and closer toward full free float; and CBR pressures to defend ruble will decline further, leading to stabilisation in the rate of FX reserves depletion and freeing more resources to deal with other crises and risks, such as banks' funding etc.

The above will likely increase effectiveness of the interest rates-setting policy, allowing the CBR to ease on the rates increases necessary to sustain capital outflows and contain inflation.

Capital outflows remain a problem: Russia saw some USD74.6 billion worth of outflows in H1 2014 (USD48.8 billion in Q1 2014 and further USD25.8 billion in Q2 2014). I suspect we will see acceleration of these outflows in September, assuming no significant stabilisation in Ukraine and absent capital controls. It is worth noting that currency swaps were included in the above figures. If swaps and foreign-currency accounts were included, the net outflows would have been around USD42 billion in Q1, marking the highest quarterly outflow since the 2008, and USD12.3 billion in Q2. []

To increase credibility of its commitment, the CBR did not intervene in the ruble markets since June this year.

On the second point, companies and banks in Russia are starting to feel the heat from the restrictions on their access to funding markets in the US and Europe.

Moscow gave approval to National Welfare Fund (USD86.5 billion SWF) to buy new preference shares worth some USD6.6 billion (RUB239 billion) in two major banks hit by the sanctions:
* VTB Bank - some USD5.9 billion (RUB214 billion)
* Rosselkhozbank - balance.

The real problem here is that demand for new funding is coming on foot of already contracting household investment and tightening credit conditions in the economy. VTB reported an 80% decline in profits to RB1.9 billion in 12 months through July 2014.

Another area is corporate funding, exemplified by Rosneft. Last week, Economic Development Minister Alexei Ulyukayev told the company that is will be provided with state support but at the levels "significantly less than asked for". Rosneft head Igor Sechin said earlier this month that the company will require RUB1.5 trillion (USD41.5 billion) from the state to help the company meet the repayment of debts of RUB440 billion (USD12 billion) by year-end and another RUB626 billion next year. The debt was raised to finance Rosneft's USD55 billion acquisition of Anglo-Russian oil firm TNK-BP. Rosneft has taken steps to mitigate refinancing risks by selling forward oil contract with China's CNPC back in June 2013. Rosneft and CNPC agreement will double oil exports to China to 600,000 barrels per day in a deal worth USD270 billion over 2018-2037. The contract includes partial pre-payments.

But just to make things more complicated, the company that is at the top of the US and EU sanctions list has just been given green light to bid for drilling in Norway's Arctic, despite the fact that Norway fully backed EU sanctions. Rosneft has also signed a long-term agreement on offshore drilling with the Norwegian company North Atlantic Drilling Ltd that involves long-term purchase out of six offshore rigs for offshore production, including for work in the Arctic. Also in August, Rosneft bought a stake in one of the world’s largest oilfield contractors – Swiss Weatherford.

Russian corporates need funds to roll over maturing debt coming due 2014-2015 and they are facing difficult funding conditions regardless of their corporate balance sheets health. Non-financial firms’ external debt totals USD432 billion, of which USD128 billion is due within 12 months and further USD47 billion due in the subsequent 12 months period.

And another problem looms on the horizon. In the short-term future, sanctioned Russian banks should be able to replace European funds with liquidity provided internally (CBR can deploy a range of options tested in EU and US during the GFC, such as ELA and LTROs) or in the Asian markets. In the medium-term, a switch to Asia-Pacific funding can take place.

But… the proverbial but… the Asian markets will come with a price tag: higher funding costs, lower coverage ratios and pressure from the US. To continue trading deeper into Asian markets, Russia will need to control for US pressures on China, Indonesia and Singapore. It can be done, but it will be tricky and costly.  Issuance in Asian markets is already constrained. Take the issue of Dim Sum (renminbi denominated, Hong Kong-issued bonds). Just over a year ago, JSC VTB Bank, Russian Agricultural Bank OAO and Russian Standard Bank ZA raised USD482 million in Dim Sum paper. This outstrips USD477 million issued by Chinese companies. However, overall volumes of Dim Sum bonds are shallow, markets are not highly liquid and even with this, yields on Russian corporate bonds denominated in renminbi are now rising, driven by two factors: credit slowdown in China and Western sanctions.

For example, yield on VTB’s 4.5% October 2015 renminbi bonds rose from 4% to around 6% in less than two weeks following July 17 shooting down of MH17 Malaysian flight in Eastern Ukraine. Russian Agricultural Bank’s 3.6% February 2016 Dim Sum bonds yields shot up from 4.7% on July 16th to over 6.5% within a week. The yield on Gazprombank’s 4.25% January 2017 Dim Sum bonds rose from 5% on July 16, to 6.5% at the end of the month. []

Meanwhile, domestic economy capacity to sustain higher retail rates to fund margins is questionable. Russian banking sector’s total external debt is USD214 billion. Of this, USD107 billion is due within 12 months, USD22 billion more is due in the following 12 months.

So do the math: 300bps hikes in average funding cost will take out USD16.2 billion out of the economy in the next 24 months. Give it 500bps and Russian economy has to fund USD27 billion of additional costs.

In the longer term, things might get easier, but it will take a while for renminbi markets to build up and it will take improvements in Chinese credit supply to support more issuance by Russian banks and corporates. On a positive side here, at a BRICS summit in Brazil in July, Russia and China  agreed to set up a bank-clearing system to increase payments settlements in renminbi and rubles. The two countries aim to increase their bilateral trade from USD90 billion in 2013 to USD200 billion by 2020.

Meanwhile dollar funding for Russian banks is running at 16-months high. 5-year cross swaps on RUB / USD pair are hitting negative 120 bps, signaling that forex traders are paying a premium to swap rubbles for dollars. The swaps rose sharply by roughly 20% in a month of August. But Russian swaps are in the negative territory while other emerging markets swaps are all over the shop, so the pricing is not solely down to the sanctions.

On the positive side, deposits funding is easing: Ruble Overnight Index Average rate, or Ruonia, was down to around 8.1% last week, just above the CBR reference rate of 8.0%. July 28 marked Ruonia peak of 8.96%.

There is room for CBR to engage in more aggressive repo operations, as cash supply conduit for banks, as repos fell to USD71 billion (RUB2.58 trillion) at the end of August, compared to the year high of RUB2.96 trillion back in July.

Back to the macroeconomic performance.

Russian external balance is improving, driven primarily by declining imports. Nothing new here - it has been thus in every slowdown/recession.

In H1 2014, value of Russian goods imports fell to USD153 billion, a decline of about 5% y/y. Imports contracted broadly across almost all categories of goods, down to sluggish demand, ruble weakness and tighter credit markets, but not to sanctions. Imports from non-CIS were down less than imports from CIS.

Goods exports rose by just over 1% y/y to $256 billion. Sources of increases - exports of petroleum products such as gasoline. This was offset by drop in crude oil exports.

The EU accounted for half of Russian goods trade, APEC countries about a quarter and the CIS countries 13%. The biggest drop in Russian trade volume was registered with the CIS countries.

But Government finances are showing strain.

Urals oil price has been gradually slipping under USD100 per barrel (p.b.). Mid-August it fell to USD98 p.b. - the lowest level since May 2013 and over the last 12 months, the price is down around 11-12%, most of which came about since January 2014 (-8-8.5%). Part of this is seasonal. But part is structural: a 25% rise in Libyan output is here to stay, most likely. On the other side, Iraq uncertainty is likely to remain in play.

Crucial point, however, is Urals trending below USD114 p.b. which is the assumed annual average for the Russian Federal Budget and balanced budget is deliverable at around USD110 p.b., assuming no significant ruble devaluation ahead. The fiscal position is not a short-term problem right now, especially considering the CBR is moving to allowing free float of the ruble and considering interventions in FX markets have declined dramatically. In other words, more devaluations are coming. But scope for devaluation-induced rebalancing of the budget will be more limited in the Winter-Spring period, since devaluation implies higher cost of imported food, consumer goods and capital goods, compounding unpopular pains of Russian counter-sanctions.

To counter potential risks of Urals falling below target, Russian oil majors have been scaling back their expectations for longer-term prices. For example, in May this year, Gazprom announced that it is basing its 2014 business outlook on an average Urals price of USD111.5 p.b., but its longer term projects are proceeding on the assumed price of USD95 p.b. [Note: during the GFC, Urals price dropped from USD147 p.b. to USD40 p.b. in June-December 2009].

Fiscal exposure is large: in 2013, oil, gas and related earnings amounted to 52% of Federal revenues (in direct and indirect revenues), in 2014, the proportion is likely to be around 45-46%.

As mentioned above, devaluations offer restricted scope for dealing with budget imbalances. Primary due to their inflationary effects. And inflation is rising, not falling. Latest data points to inflation running at 7.5% and rising, despite normal seasonal pattern that implies decline in inflation during summer months. In my view, this is the beginning of the sanctions-induced inflation, with overall effect on price likely to be around 1.2-1.5% uplift in inflation in 2014. It is worth noting that groceries and food account for 37% of Russian official 'consumer basket' - a high proportion due to relatively low cost of housing. All of this is clearly despite the CBR hiking rates by 250bps over the year to 8%. As a reminder, CBR target inflation for 2014 was 5% and this is likely to be revised up.

Problem with Russian sanctions is that imports substitution is
1) Difficult and
2) Costly.

From the cost basis point of view, logistics networks and supply contracts need switching, which takes time even if there is supply in the market available for shipment. Often, there is none and this is especially true for the current pre-harvest period in the Northern Hemisphere. In the Southern Hemisphere, supply can be built into new crops plans. Which goes to the difficulty of securing substitute supply from abroad. The scale is large - sanctions are impacting directly some USD9 billion worth of imports, though Agriculture Ministry is now estimating the end loss of some USD5 billion in EU food exports to Russia.

Domestic substitution is also problematic. Crops are already in place and cannot be altered until next year. Producing substitutes for partially imports-covered demand will require some investment and time to uplift production. Producing substitutes for goods more reliant on imports will require very substantial investments.

Just how substantial? Prime Minister Medvedev last week called for amendments to the state's development plans to increase self-sufficiency of Russian agriculture. Existent plan offers more than RUB1.5 trillion (USD42 billion) in state funds for farming supports over 2013-2020 horizon.

Agriculture Minister Nikolai Fyodorov said in late August that Russian agriculture will require
RUB137 billion (USD3.8 billion) more to meet demand for imports substitution. Overall, the sector needs some USD16.7 billion (RUB600 billion) in investment between 2014 and 2020 to fund expansion of output to achieve 90% self-sufficiency targets set by the Government from current 66% (excluding small farmers output) or 78% (including small farmers). And the time frame for getting there is around 5-7 years, not in the next 12 months. On positive side, over recent years small milk producers started receiving direct subsidies, boosting their milk output by 5% in 2013 alone.

Again, key stumbling block is that even with state subsidies, as the National Association of Milk Producers puts it: lending rates to the dairy sector in Russia are on average between 8 and 10 percent, against 2 to 4 percent rates in the EU and U.S. Logistics and transportation costs are also higher. This, alongside growing state arrears on subsidies, have led to production of raw milk in Russia falling by 6 to 8 percent y/y in 2013.

There is, however, some experience and a road map for hitting the long-term targets. Russian meat sector saw increased Government funding since 2006. Poultry production is up and is now delivering 90% of the domestic markets demand. Pork production is very close to self-sufficiency levels: over 70% of Russian pork demand is being delivered from larger domestic producers, and this is growing - expectation is that 2014 will see output rising by 200-250K tons. However, major bottleneck remains in beef production, which depends on imports for more than 50% of domestic consumption.

In summary:

Russian economy is showing signs of stress, both in structural terms and in terms of the fallout from the Ukraine crisis.

In structural terms, reforms of 2004-2007 period now appear to be firmly shelved and are unlikely to be revived until the sanctions are lifted and some sort of trade and investment normalization takes place. Structural weaknesses will, therefore, remain in place.

In dealing with the crisis fallout, even if Russia were to switch to self-sufficiency in food production and tech supplies for defense sector and oil & gas sector, as well as re-gear its corporate borrowings toward Asia-Pacific markets, the reduced efficiencies due to curtailed trade and specialisation are likely to weigh on the economy. There is absolutely no gain to be had from switching the economy toward an autarky.

Politics aside, it is imperative from economic point of view that Russia starts to make active steps to disentangle itself from Ukrainian crisis. Rebuilding trade and investment relations with the West and Ukraine – both very important objectives for the medium term for Russia – will take a long, long time. It’s best to hit the road sooner than later.

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