Russia: The slide continues Global Economic Outlook, Q3 2015

Russia is in the throes of a recession. A contraction in the first quarter is likely to be repeated as the effects of low oil prices and Western sanctions continue to dent the economy.


Russia is in the throes of a recession. A contraction in the first quarter is likely to be repeated as the effects of low oil prices and Western sanctions continue to dent the economy. Years of dependence on oil and gas have also prevented the creation of a strong non-oil domestic economy, which would have been helpful at a time like this. The fiscal response to the current crisis has been fuzzy at best, owing to the lack of a long-term economic strategy to tackle structural challenges prior to the crisis. Tensions with Ukraine and with the West are a distraction; the fiscal burden of the takeover of Crimea is another. So far, the sole bright spot in the economy, albeit a small one, appears to be the Bank of Russia’s (BOR’s) policy actions. The BOR hiked rates sharply late last year to prevent a currency crash, and therefore a spike in inflation, in response to the crisis. Due to this rate hike, a ceasefire in Ukraine’s troubled eastern region, and a bout of carry trade for higher returns, the Russian ruble has recovered some ground this year. Moreover, inflation, despite being in double digits, is starting to edge lower. But by no means does this bit of success mark an end to the bank’s challenges. Monetary policy formulation is still a daunting task in the face of a weak economy, high inflation, and currency and banking sector risks.

GDP decline in Q1 2015 was expected

The economy contracted 1.3 percent quarter over quarter in Q1 2015, the third consecutive quarterly contraction (figure 1). On a year-over-year basis, real GDP fell 2.2 percent in Q1; the drop was larger than the initial estimate of a 1.9 percent decline.1 A host of sectors fared poorly, dragged down by declining domestic demand in the face of economic instability. Reflecting a tightening of household budgets, wholesale and retail trade fell 7.6 percent in Q1. Within services, the other major sector to suffer was financial services (-3.8 percent), which has been hit hard by Western sanctions, ruble weakness, and economic contraction. Services, however, were not the only weak spot for the economy in Q1. Manufacturing and construction also did not fare well; while the former fell 0.6 percent, the latter contracted 4.1 percent.


The economy would have suffered more had it not been for a modest recovery in oil prices.

The economy would have suffered more had it not been for a modest recovery in oil prices. For example, after slumping to below $50 per barrel in mid-January, Brent crude has gone up about 38 percent since then (as of June 18, 2015). The impact of the oil price recovery is evident from the fortunes of the mining and quarrying sector, which expanded 4.9 percent year over year in Q1. A recovery in the ruble has also aided the economy. In fact, the ruble outperformed oil from February to mid-May (figure 2). The currency appreciated about 40 percent against the US dollar during the same period before weakening due to an intervention in the foreign exchange market by the BOR.


Challenging times for monetary policy implementation 

In May, the BOR announced its intention to bring foreign exchange reserves up to $500 billion within the next five to seven years.2 Toward this goal, the bank is purchasing foreign exchange worth $100–200 million every day. Data reveal that the BOR purchased $2.5 billion in May 2015, the largest monthly forex purchase since April 2012.3 As a result, the ruble has weakened since mid-May. A weak ruble aids Russia’s fiscal health by boosting ruble revenues earned from oil sales denominated in dollars. Traditionally, exporters benefit from a weak currency. However, it is doubtful whether Russian firms, other than arms manufacturers, can corner global market share in the wake of declining competitiveness.

The BOR’s intervention in foreign exchange markets to dent the ruble’s rise is not without criticism. First, it contravenes the idea of keeping monetary and fiscal policies separate. Also, a rising ruble is important for curbing inflationary pressures; the sooner inflation goes down, the better it will be for real incomes. In April, real wages dropped 13.2 percent year over year (figure 3), the sharpest decline since August 1999. Real disposable income declined 4.0 percent during the same period, accelerating from a 1.8 percent decline in the previous month. Add to this a deteriorating labor market—unemployment went up to 5.7 percent in April from 4.9 percent in January—and the stage is set this year for a sharp contraction in household spending, a key growth driver for Russia in recent years.


As inflation heads lower, it will be easier for the central bank to ease monetary policy and shift its focus to growth. Luckily, the BOR has been able to ease policy this year as inflation has eased slightly. On June 15, the central bank cut its key policy rate by 100 basis points (bps) to 11.5 percent. This was the fourth rate cut in 2015, a gradual reversing of policy from December 2014 when the BOR had raised rates to 17 percent to defend the ruble and consequent high inflation. Price pressures appear to have eased a bit after hitting a peak of 16.9 percent in March; in May, inflation fell to 15.8 percent (figure 4). Nevertheless, inflation still remains high, and the BOR would have to tread cautiously before easing policy any further this year. A lot will depend on global oil prices, currency movements, and the West continuing sanctions. An earlier-than-expected rate hike by the US Federal Reserve would, of course, complicate matters for the BOR even more.


Worries about the banking sector continue

At the heart of Russia’s economic contraction is a weak banking sector. Challenges arising from sanctions, the rollover of external private sector debt, ruble volatility, and declining loan demand have dented the sector’s performance. Nevertheless, troubles in the banking sector in Russia are not new. Challenges have been growing over the past few years, primarily due to a slowing economy; the current crisis has just made them worse. For example, after improvements during 2010–12, the ratio of nonperforming loans (NPLs) to total gross loans has been edging up (figure 5); in Q1 2015, the figure climbed to 6.9 percent.


Declining asset quality amid a weakening economy has hit earnings and profitability; both return on equity and return on assets nearly halved in 2014 from a year before. And this is likely to get worse as the economic downturn continues. In April 2015, for example, the banking sector incurred losses of $400 million. Although the figure might be minuscule considering that the sector holds assets worth $1.5 trillion (as of April 2015), it indicates the rough journey ahead.4 Challenges in the banking sector and high interest rates, in turn, have eroded confidence in banks in general. In a survey conducted by the National Agency of Financial Research in April, only 56 percent of respondents expressed trust in banks (either fully or mostly), down from 74 percent in a similar survey a year ago.5

The current scenario, however, offers an opportunity for major changes in the banking sector. For one, consolidation is important and should be encouraged by policymakers. Currently, there are more than 820 banks; as weak banks either go out of business or are acquired by healthier competitors, the sector will become stronger. Banks also need capital, especially given the current crisis. Encouragingly, the BOR has responded by announcing a $35 billion anticrisis package, including a recapitalization package of 1 trillion rubles for the banking sector, in January 2015.6  Furthermore, the BOR’s banking sector stress test in May revealed that capital adequacy will remain above the required 10.0 percent even in a “shock scenario” (GDP declining 7.0 percent, inflation at 16.0 percent, and oil at $40 per barrel).7 It is, however, a bit early to judge the impact of the BOR’s bail-out package.

Also, there is concern over Russian companies’ external debt obligations, given the weak ruble relative to 2014 and the current sanctions regime. Russian companies have debt worth $100 billion to be refinanced or repaid over the next two years.8 It is highly likely that the BOR and the government will have to extend assistance to indebted companies if the companies are to meet their debt obligations. However, the process of selecting beneficiaries (if any) for assistance by the government or the BOR is clouded by the lack of transparency surrounding Russia’s public sector. Russia ranked 136 out of 175 nations on Transparency International’s 2014 Corruption Perceptions Index, which measures the perceived levels of public sector corruption.9

Amid deteriorating fundamentals, GDP concerns abound 

Current trends indicate that the economy is set for a contraction this year. In April, Russia’s monthly index of GDP growth fell 4.2 percent year over year, down from a decline of 2.7 percent in March. Then, in May, the contraction in industrial production and manufacturing activity accelerated. The BOR expects the economy to contract 3.2 percent in 2015.10 Any recovery next year would depend on oil prices. For example, according to the BOR, if oil prices average $60 a barrel next year, the economy will contract 1.2 percent; instead, if prices rise to $70 a barrel, GDP will grow about 0.7 percent.11

Declining investments not only pose risks for growth in the near term but also threaten to pull down potential GDP growth.

Among key components of the economy, declining investments is arguably a more long-term concern. In 2014, total fixed investments fell 2.0 percent. This year, the contraction is likely to be worse. For example, production of machinery and nonelectrical equipment, an indicator of investment activity, fell 14.9 percent in May; this was the fifth straight contraction, and the largest this year. Declining investments not only pose risks for growth in the near term but also threaten to pull down potential GDP growth. According to Oxford Economics, potential GDP growth in Russia will average 1.5 percent per year between 2014 and 2023, much below that of key emerging-economy peers and less than half the country’s figure for 2004–13 (figure 6).12 With the working-age population set to decline at an annual rate of 1.0 percent between 2014 and 2023, a revival in investments is critical. Also needed is a push to upgrade technology and improve the quality of human capital, both of which have been in relative decline given the slow erosion of legacy assets from the erstwhile Soviet Union.


Finally, not much can be achieved without a thriving private sector economy with credible institutions in place. Russia fares poorly in both areas. State intervention in the economy has been rising and has dented efficiency. It is estimated that state ownership of the economy is up to 50 percent of GDP, much higher than the international average of 30 percent.13 Similarly, in the World Economic Forum’s global competiveness rankings, Russia’s institutions (ranked 97 out of 144 countries) do not bring much cheer.14

Without addressing these structural flaws, it is unlikely that the Russian economy will improve in competitiveness and hence move to a higher sustainable growth trajectory. The current crisis should serve as an opportunity for policymakers to implement some tough reforms. Without them, the economy will just mirror the ebb and flow of global hydrocarbon markets.