Myths and Realities in the Russian Market

Selection_517It is an obvious understatement to say that 2014 has been a very tough year for the economy and business in Russia. As winter approaches the pace of growth has slowed to a trickle with only the modest boost to domestic manufacturing from the weak rouble and the continuing high spending on defence equipment preventing a slide into recession. A technical recession in the fourth quarter or the first quarter of 2015 is, however, still very likely.

2014 has also been a very tough year for expats working in Russia, especially those paid in roubles. The value of the rouble has fallen by one-third against the US dollar and by one-fifth against the euro since the start of this year and that follows a 10 per cent decline against both in 2013. With a movement like that the relatively low domestic income tax rate is largely irrelevant. As at the start of November it is a tough call to say that the rouble is near a support level. That primarily depends on where oil trades, on what happens to sanctions and also on how the Central Bank (CBR) responds to the decline.

2015, in economic terms, is starting to look similar to an expat’s second winter in Russia; the first was a novelty and had something of an exciting unpredictability about it. By the time the second winter comes around you know exactly what to expect and it will be miserably long. Unfortunately the economic outlook for 2015 looks no better than has been the case in 2014.

Selection_516Inflation will rise further this winter and interest rates will remain high until the CBR is convinced that the peak in inflation has passed. This may happen sometime next spring. State budget spending will depend on oil revenue and, if that remains as low as is the case today, on a willingness to delay non-essential spending such as in the defence sector. And then there is the sanctions question. There is a wide spread of growth projections for next year from minus 1.0 per cent to plus 1.5 per cent with the key difference being the assumption on whether sanctions, especially those blocking access to western debt markets, get worse or start to get better from the spring. At this stage most optimism is reserved for a recovery in 2016 and a return to meaningful growth in 2017. To be clear, while I expect a tough winter and spring in the economy, I am firmly in the optimist’s camp for 2016.

But apart from one’s rouble earnings buying less during the trip back home or on vacation, not to mention the very high double-digit inflation rate on imported goods, expats also have the perception issue to deal with. It is a cliché to say that truth, or facts, are the first victims in any war. By any measure, 2014 has been an extraordinary year for propaganda both for and against Russia. If one only looks at Russia TV the message is that sanctions have back-fired spectacularly against the EU and are actually providing a much needed boost to the local economy. If one only reads some western publications, including much of the mainstream, the message is that the Russian economy has already slipped over the edge of the abyss and Soviet-era queues are inevitable this winter.
As always, the truth is somewhat obscured in the middle. So what are the myths which have been propagated and what are the, probable, realities?

Sanctions make Russia stronger. In theory that has some basis of truth for some sectors of the economy but only if sufficient investment is applied in an efficient manner and only after several years. Agriculture and food production is one obvious area where Russia could be more self-sufficient and undoubtedly this is one reason why the retaliatory actions have come in this sector. But after two decades of low investment and a loss of the skilled workforce, improvements to domestic production will take years. The same applies, only much more so, to the technology sectors and across much of the country’s manufacturing base.

Russia faces a 1998 style default. No it does not. Sovereign external debt to GDP is only 3 per cent and total Russian external debt is only about 33 per cent of GDP. For sure there are many companies queuing for access to the country’s sovereign wealth funds and other state resources and using the money this way will hurt other recovery options. But to suggest that a default is possible one would have to assume a series of events, which would crash other economies long before Russia defaulted.
The rouble will collapse. It has already collapsed by one quarter against a basket of dollars and Euros so far in 2014 and that followed a 10 per cent loss in 2013. At the current level the rouble is pricing in $80 per barrel oil, financial market sanctions remaining for twelve months, and then some. In financial terms the currency is weaker than it should be given the combination of factors, which usually influence the exchange rate. The one unpredictable factor is sentiment and that has been made worse by the fact that the CBR is firmly sticking with the plan for a free float in early 2015 but meantime is still setting currency trading bands. That latter tactic simply tempts traders to play poker against the CBR. When the free float happens, and assuming the oil price stays at least at $80 per barrel and sanctions get no worse, then the rouble should strengthen rather than collapse further.

Weak oil will destroy Russia. Here again some observers are too quick to equate the current situation with what happened in 2008. A collapse in the oil price from mid-2008 directly led to the destruction of $200 billion of financial reserves and a near 8 per cent collapse in the economy in 2009. The big difference this time is that the CBR has allowed the rouble to take the hit and that has both protected the budget and created an indirect stimulus for manufacturers. Of course that has not been enough to prevent the sharp slowdown in the economy and it doesn’t, in singularity, create a recovery catalyst. But it does mean that the state has spending options coming into 2015 and the economy can sustain either very modest growth or confine any decline to less than 1 per cent. $80 average oil, based on current spending plans, plus today’s rouble exchange rate would mean a 2.5 per cent budget deficit in 2015. This is hardly a default scenario.

When sanctions end the economy will return to normal. Yes and no. Yes the economy will return to the problems which were starkly evident in late 2013 and which will be more difficult to redress because of the events of 2014. No it does not mean that Russia can return to the 4 per cent annual growth it needs to sustain long term if the economy is to expand and diversify. Recall that growth in 2013 ended at only 1.3 per cent instead of the 3.5 per cent expected at the start of the year. Russia needs a new long-term growth driver and that can only come from an increase in foreign investment and the continued participation of experienced western companies. The so-called Asia-pivot can only add to diversification but cannot be a substitute for western partnerships. Despite the current rhetoric, that is a fact, which appears to be well understood in government.

There are many other myths and realities which are beyond the scope of this note. Some are beyond the current political and sanctions noise. For example, the dire predictions of a huge decline in the country’s population have already been proven false but Russia still has a serious workforce demographic and pensions deficit problem to be addressed.

All expats know that while winters are regularly tough in Russia they do eventually give way to spring and summer. By the time you get to the start of a third winter you learn to buy a thicker coat.