Analysts are forgetting the positive impact import substitution driven by ruble devaluation could have on Russian economic health
In 2014 Russia GDP was 70,676 billion Rubles; which on current exchange rates values Russian GDP at 1.03 trillion dollars. That compares to a GDP of 2.1 trillion dollars in 2013.
This is not an equilibrium level of prices – in one year the true value of the Russian economy has not contracted by 50%!
Of course to the Western analyst they will point out that Russia is an oil based economy and oil has fallen 50% and hence it is exactly right. Yet, oil rents represent a mere 13% of Russian GDP and oil made for export an even lower 7%. So, Russia lost 50% of 13% in 2014 - 6.5% as a result of the oil price collapse.
Where did the other 43.5% go? – According to dollar gdp, it came from everything else that is consumed in the economy. But, in pure volume terms (industrial production, which as measured by Rosstat measures everything physically produced in Russia from water to chairs) the Russian economy increased by 1.7% in 2014 – consequently, if dollar gdp is an accurate measure, then the true price of water and chairs should have fallen by some 44% in 2014.
But the true value of water and chairs did not fall by this amount – instead statistical noise just created this illusion. For reasons like this, many economists like to use GDP Purchasing Power of Parity which adjusts for price differences in fixed goods across countries to use a more representative exchange rate for economic value.
A good measure of the imbalance is the fact that Russia’s trade balance – measured in dollars – grew by 6.6% in 2014 to reach around 190 billion dollars. In %’s, the surplus has grown from 8.5% of GDP to 19%. In 2015, this imbalance will almost certainly start to correct.
It does this through a real exchange rate appreciation which can happen one of two ways; firstly, the Ruble essentially rallies back to its old levels of 32 against the dollar, or secondly, inflation jumps to around 20% but the Ruble remains at today’s level – meaning that dollar GDP growth would run around 20%.
Economic history shows that when such imbalances occur the correction process typically comes through inflation and not exchange rate appreciation – for instance in Russia this occurred after 1998. For myself, as an investor this means I am particularly interested in asset classes which move with inflation (equities and real-estate). However, I would not rule out a modest exchange rate appreciation as the oil price strengthens and sanctions are removed in the second half of the year.
In my opinion, analysts world-wide could well be in for a major shock in 2015. Currently, almost every analyst is predicting that real GDP will contract by 1% to as much as 7%. This reminds me greatly of 1998, when the average forecast growth for 1999 was -5.5%. What followed stunned everybody as growth was +6% (the first ever year of growth since the break-up of the Soviet Union).
This happened because of import substitution; the trade balance grew and domestic production surged on the back of the currency collapse. Analysts got too hooked on the negative causes of the exchange rate move (Russia’s default) that they forgot the actual impact of the enormous positives of an exchange rate move – industrial production grew by 8.1% in 1999.
I personally expect the first quarter to show a fairly sharp deterioration in growth of around negative 2% to 3%. This is mainly because a large chunk of consumption was transferred from Q1 2015 to Q4 2014 on the back of the ruble slide.
However, by the second half of the year I expect growth to have returned on surging domestic production, import substitution, the removal of sanctions and a higher oil price. At the time of writing there are early indications that such import substitution is well underway as preliminary data shows that imports in January fell by 40%.
The reason why 1999 won’t be fully repeated in 2015 is the role of the financial sector. The Russian financial sector has become an integral part of the economy – something that was not entirely true in 1999. As a consequence; higher interest rates, foreign exchange losses, sanctions and a general over-extension of credit created a financial crisis in Russia in the final quarter of 2014.
Not only was the Russian financial sector indirectly through lending one of the greatest contributors to growth, but its direct value added contributed greatly to the rise in GDP post 1998. 2015 will be a very painful and difficult year for the banking sector, however, the sector as a whole is in better shape that it was in 2008.
Consequently, I predict that Russian GDP will contract by a mere 0.5% in 2015 with inflation reaching around 13%. I expect the Ruble to end the year at 48 Rubles to the dollar.
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