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Russia's Economy in 2015 Rolled With the Punches

Contrary to the doomsayers the country has coped with the oil price and other blows well

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This post first appeared on Russia Insider

By good chance, Jon Hellevig’s recent discussion of the state of the Russian economy has coincided with publication of a slew of information about how it performed in 2015.

This information bears out what Jon Hellevig has said.

The overall GDP decline is put at between 3.8% and 3.9% (the final figure has not yet been published).  

Industrial production fell by 3.5%, which is not surprising given the fall in demand and the high interest rates. It appears to have stabilised in the second half of the year.  

Agricultural output is responding dynamically to the opportunities offered by the rouble’s devaluation and the food sanctions, and is increasing rapidly.

At 104 million tonnes the grain harvest was very slightly below the previous year’s record harvest of 105 million tonnes - a fact entirely down to weather factors.  

Individual farm sectors such as pork, poultry and vegetables are however expanding rapidly and in some cases are showing double digit growth.  

Since the food import ban on EU produce was imposed in the summer of 2014 production of beef and potatoes has increased by 25%, of pork by 18%, of cheese and cottage cheese by 15%, of poultry meat by 11%, and of butter by 6%.

Last year’s vegetable harvest was also a record, with output overall growing by 3%

The picture is not uniformly good. Milk production apparently is still lagging. However overall at this rate of expansion it is likely that Russia’s objective of achieving food self-sufficiency by 2020 will be achieved.

Inflation was 12.9% over the whole year - lower than most of the forecasts that circulated towards the end of the year - and appears to be falling fast as the economy rebalances after the effect of the devaluation.  

It was apparently running at an annualised rate of just 12.3% in the first two weeks of January, causing Economics Minister Ulyukaev to revise his previous pessimistic forecast that inflation would only fall to single figures in the second half of 2016.  He now says it could fall to that level as early as the end of February.

The rapid fall in inflation in the last months of 2015, and its continued fall in the first weeks of 2016 despite the further fall in the rouble, shows the impact on inflation of the collapse in imports (down by around a third from the total of the previous year).  

As Jon Hellevig says, it is the constant rise in import prices that accounts for a large part of Russia’s inflation - a consequence of the degree of penetration that imports - especially food imports which are especially subject to price fluctuation - have achieved in the Russian economy.  

With imports collapsing this factor is rapidly diminishing - exactly as would be expected in an economy that is rapidly rebalancing.

This is nowhere more clear than in food prices. Food price inflation in 2015 at around 20.2% was much higher than overall inflation, which was 12.9%.  

The steep increases in food prices was directly linked to the one-off surge in the cost of food imports caused by the devaluation and the effect of the food import ban.  

As this factor diminishes, with food imports either banned or priced out of the market (food imports fell by around 30% in 2015 and are likely to fall further in 2016) and with imported food increasingly replaced on the Russian market by domestic products as Russia moves towards food self-sufficiency, the rate of food price inflation will fall, and will continue doing so in future, irrespective of what happens to the rouble. Indeed judging by the decline in inflation this effect is already underway.

Unemployment in Russia in 2015 remained low at 5.8% in November. Liquidations have been surprisingly few, home foreclosures are hardly in evidence and the level of non-performing loans has remained low. So far this has been purely an output recession.

The explanation for the low rate of unemployment despite the recession is almost certainly the cut in real incomes, which means that workers are not pricing themselves out of the labour market.

In some countries the combination of a high rate of inflation and a low level of unemployment would threaten a wage-price spiral - often accompanied by a wave of strikes - as workers fight to defend their living standards. I can remember precisely that happening in Britain in the 1970s.

There is no sign of anything like that happening in Russia - a sign of a disciplined and financially solvent workforce - rather like the one in Germany - and of a flexible labour market.

Russia’s dollar denominated trade surplus narrowed by 23% to $145.6 billion - a direct consequence of the oil price fall.  However the surplus on the current account actually increased to $65.8 billion.

The explanation for the improvement in the current account despite the fall in the dollar denominated trade surplus is the steep fall in capital outflow to $56.9 billion - down from a record $151.5 billion in 2014.

The fact that in most years Russia has capital outflow is an endlessly rehashed trope of the Russian economy’s critics despite the fact that as a matter of simple arithmetic an economy that runs a large trade surplus would normally expect to see a capital outflow.

I notice that as Russia’s capital outflow has fallen the subject has stopped being talked about.

The very large figure for capital outflow in 2014 is connected to the heavy foreign debt repayments that fell that year, which Russian banks and companies were unable to roll over despite the oil price fall because of the sanctions.

It was the very heavy debt payments in 2014 - and the resulting capital outflow - that caused the rouble in 2014 to fall at a faster rate than oil prices - despite the efforts of the Central Bank to stem the fall - leading to the collapse in December of that year.

The steep fall in capital outflow since then suggests the major period of foreign debt repayment is now over.  

The result is a marked fall in pressure on the rouble. Whereas on 17th December 2014 it fell to a low of 80 roubles to the dollar on a price for Brent crude of $58.70 a barrel, today (18th January 2016) as of the time of writing it is trading at just below this price despite a Brent crude price of under $28 a barrel.

It is this fall in pressure on the rouble, which explains why - in contrast to 2014 - the Central Bank has not so far felt the need to support the rouble with foreign currency interventions or further interest rate rises.  

It also explains why - contrary to some predictions - the Central Bank’s foreign currency reserves have remained steady at roughly $360-370 billion since they hit that floor at the end of the first quarter of 2015.

Last but not least, the fall in the level of foreign debt payments undoubtedly explains the relaxed attitude of the Russian authorities to the rouble’s renewed fall since the summer. With fewer debts to pay and the effect of the rouble's fall on inflation subsidising, the authorities can afford for the moment to remain calm.  

Unfortunately if the events of December 2014 show anything it is that there is no room for complacency where oil and the rouble are concerned.  

As oil falls towards $25 a barrel and possibly even lower, the Central Bank has acted to steady nerves by saying it stands ready to raise interest rates if the rouble crashes again  

It is to be devoutly hoped this does not prove necessary, but saying it should make it less likely. 

The Russian budget deficit, about which so much ink is being spilled, turned out in 2015 to be just 2.6% of GDP - below the government’s final predictions.

This compares with a budget deficit of 2.5% of GDP in the US  - during a “recovery” and after 6 years of improvements - and a budget deficit in the UK believed to be roughly 4.9% of GDP (final figures not yet available) - also during a period of “recovery” and following 6 years of “austerity”.

The fall in the oil price is expected to result in a higher deficit this year, though it is impossible as of the time of writing to say by how much.  

Putin has insisted that the budget deficit must not grow above 3% of GDP and already the government is looking at spending cuts to bridge the gap.  

Most people think the budget deficit will in the end turn out bigger than Putin’s target of 3% of GDP if oil prices remain below $50 a barrel - which is likely but not certain - but any prediction at this point of the total size of the deficit can only be a guess since so much depends on the overall performance of the rest of the economy - with a return to growth leading to a lower deficit because of higher tax receipts.

Assuming a - very improbable - worse case scenario of a budget deficit of 5-6% of GDP, is it really true as many seem to think that Russia will struggle to finance it?

The US and the UK have financed much larger deficits despite having no financial reserves and having a government debt to GDP ratio of - in the US’s case in excess of 100% of GDP - and in the UK’s case in excess of 80% of GDP.  

Russia not only has substantial reserves in its Reserve Fund - almost certainly enough to fund the deficit fully this year - but has a government debt to GDP ratio of just 18%.

Russia also runs large trade surpluses and large surpluses on its current account. By contrast the US and UK run large deficits on both.

In light of all this it is difficult to understand all the alarm. 

It is no doubt true that the US and UK can raise funds to cover their deficits far more easily than Russia can though the common claim used to explain this - that neither country has ever defaulted on its debt - is simply untrue.

However this misses the point that Russia - with minimal existing interest payments, a far smaller budget and a small deficit - has no need to raise funds on anything like the scale the US and UK do.

Let me repeat again, since the point does not seem to have been grasped (see for example this article by Ben Aris) that the sanctions do not prevent Russia from borrowing in the international money markets and it is debatable whether - short of a declaration of war or the imposition of UN Chapter VII sanctions - it is legally or technically possible to prevent Russia from doing so.

Jacob Dreizin may be more correct when he says the sanctions may deter some people from buying Russian government debt, but - given that there is no legal reason why they should not buy it - that is very debatable and is in my opinion almost certainly wrong.

My view on the contrary is that given the exceptionally strong underlying position - the government’s early repayment of its 1990s debt, its very low level of current debt, its minimal current interest payments, Russian companies’ success in repaying their existing debt despite low oil prices and sanctions, and the Russian government’s well-known determination to keep its deficit under control - many potential buyers will see Russian government debt - despite its absurdly low rating - as a safe and (because of the high interest rates) attractive investment.

Certainly that seems to be the opinion of the Central Bank, which has made it clear that it prefers the government to borrow the money to pay the deficit rather than try to finance the deficit out of the National Welfare Fund, which is intended to finance the payment of pensions.

Personally, as I have said previously, I don’t think it will come to that. Putin is determined to avoid borrowing if he possibly can and - unlike Ben Aris - I am sure he will make the necessary economies and even cut defence spending if he has to in order to avoid having to do so - though I should quickly add in the case of cuts to defence spending I doubt it will come to that either.

Which brings me to the key point.

One of the best things about Jon Hellevig’s discussion is that it completely ignores the sideshow of the Russian budget, and concentrates on the thing that really matters - which is interest rates.

It is the sky-high interest rates that pulled the economy into recession in 2015, and it is the still very high interest rates which are prolonging the recession now.

With inflation falling rapidly, bank balance sheets largely - though not completely - repaired, and foreign debt substantially paid off, the one thing that is preventing further cuts in interest rates are worries about the rouble.

Whether those concerns are justified or are sufficient to justify keeping rates as high as they are at present is another matter. Jon Hellevig - who is far better informed about the Russian economy than me - thinks not.

The key point is that sooner or later - and now almost certainly sooner rather than later given that there simply isn’t much room left for further falls - both oil prices and the rouble will find their floor.  

When that happens interest rates will fall as inflation - the other reason for keeping interest rates high - is already in the process of a fall.

At that point - with the two factors - inflation and interest rates - that chiefly caused the recession out of the way, the economy will move from its present position of rough stabilisation back towards growth.

 When that happens, for the further reasons Jon Hellevig says, growth is likely to be both rapid, and sustained for a long time.

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