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.
[http://online.wsj.com/articles/russia-sees-further-rise-in-capital-flight-1404918861]
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. [http://www.ifrasia.com/asian-markets-no-quick-fix-for-russia/21158400.article]
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.
