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The Russian Economy: Damn the Torpedoes – Half-speed ahead!

The economy is in surprisingly good shape, but corporate governance needs to improve, and Russia could get dragged down by a sinking EU
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This post first appeared on Russia Insider

One of RI's regular contributors, the author is a well known commentator on Russia in the global financial media.

By now, it should be abundantly clear that the Western sanctions against Russia have been an unmitigated failure, notably failing to bring about any inflection in Russian Crimea/Ukraine policy, strongly increasing Mr Putin’s popularity, and in all probability, causing substantially more damage to Europe than to their intended target.

<figcaption>The Bashneft catfight has hit confidence in Russian equities just when it is needed</figcaption>
The Bashneft catfight has hit confidence in Russian equities just when it is needed

Since imperial powers are never comfortable with the admission of failure they demand that their tame corporate media report that their torpedoes have struck the target which is now sinking – and the facts be damned.

In fact, the Russian economy is steaming along half-speed ahead. There is frankly no call for triumphalism, nor is any crisis even remotely visible. The glass is truly half-full/half-empty, though compared with the remainder of the appropriate peer group – the former-G8 – Russia is clearly in the top quartile.

The Good

Russian macros are certainly the most stable and sustainable of any large industrialised Western country. Given the memory of the 1998 crisis, and the 2008 mini-crisis, both fiscal and monetary policy have been extremely conservative. There has been no QE, no deficit spending, and the current account surplus (which increased sharply to $11.4bn in Q3 2014) has allowed the build-up of substantial reserves. Russia is a net foreign creditor, i.e. has negative net foreign debt, and has run modest budget and trade surpluses.

Compare and contrast with the US, where the Central Bank has been engaged in massive purchases of government debt in contravention to all laws of classical economics, and where increasing amounts of debt produce diminishing economic growth, or Europe, where debt/GDP levels widely exceed 100%, as contrast with the 60% threshold generally considered the limit of the sustainable, leading to the danger of a “Japanese” scenario where interest rates must remain at zero for eternity – since normalisation would trigger a death-spiral due to an explosion of the cost of debt service.

While the weakening of the rouble has been presented as a victory of foreign economic pressure – this suggests, at best, gross ignorance of macroeconomics, at worst wilful disinformation. In fact, the rouble float provides a vital buffer against falling energy prices, allowing Russia to maintain a budget surplus and for commodity exporters to remain profitable under adverse price scenarios.

While a disorderly or extreme fall in the rouble would indeed be very damaging, in fact, its valuation is very closely correlated with oil prices, and at ~40/$, it is currently close to fair value for Brent crude at $90.

While the Western media have been crowing about the “precipitous increase in inflation” driven by Russian agricultural countersanctions and the falling rouble, this is nonsense - given the contracting M2 money supply and slow GDP growth – the last read, an annualised 8%, represents a 0.8% increase over the trend at the beginning of the year, and is certainly no threat to macroeconomic stability.

One final urban myth - panicked capital flight - is constantly misreported, not just by foreign media but also domestically. The CBR capital outflow numbers are widely misunderstood, with the headline number encompassing Russian investment abroad, round-tripping Russian finance via offshore domiciles (Russian company owners recycling domestic capital via offshore loans for tax purposes), dollarization of local savings held onshore, as well as the “errors and omissions” line which represents true grey-scheme capital flight – running to a fairly trivial $5.1 bn for the first 9 months of 2014.

After a $61.7bn burst in outflows in Q1 2014 (pre-sanctions), in the third quarter net private sector capital outflows dropped to $5.7bn. More significantly still, net demand for dollars from households dropped to $1.5bn in Q3, suggesting that those who wished to buy dollars already have, and certainly, there is no panic in the streets. (We await the banner headlines on Bloomberg reporting that Russian capital flight has collapsed…also, a snowstorm in East Hell this weekend)

The Bad

Growth in the West is flat-lining and Russia is not immune to this trend. Guestimates for 2014 run to about 1%. This slowdown, which predated the sanctions, is a function of economic contraction in Russia’s principal Western trading partners, falling commodity prices, and hesitancy to invest by domestic players.

Against that - the combined effect of a falling rouble and Russian agricultural counter-sanctions are supporting growth at a low but positive level, as import substitution kicks in and imports of Western consumer goods have collapsed.

The Ugly

The current crisis represents both a huge challenge and a major opportunity; the outcome is not yet predictable, being largely dependent upon actions taken (or not taken) by the Russian government. Even were (God forbid!) the sanctions to be lifted tomorrow, Russia could never resume the childlike faith in the benevolence of the Western powers which persisted among segments of the local elite until quite recently, nor again allow herself to become hostage to the threat of economic blackmail for geopolitical motives.

The achievement of economic independence is, of course, a laudable goal, but simple declarations of intent are not sufficient; the conditions for such financial independence must created – by stick (de-offshorisation, anti-corruption, repression of financial fraud) but also by carrot, (create the perception of a level domestic playing field).

One of the failings of the otherwise hugely impressive transformation of the Russian economy since the new millennium has been the lack of deep domestic long-term capital markets able to provide domestic sources of funding for the development of Russian business. While the fixed income market has proved quite robust, the equity market remains largely dysfunctional - a string of corporate governance abuses have led to a total loss of confidence, and thus, to some of the world’s lowest P/Es.

This matters, and it matters very much – largely excluded from Western financial markets, Russian corporates currently have little or no access to equity capital and are thus overly reliant upon domestic debt finance.

Abstract issues of justice aside, the Sistema affair appears a spectacular own-goal at a time when confidence needs to be created – not so much among foreigners, but among Russian domestic investors. 

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