Russia: In austere times Global Economic Outlook, Q2 2016
Russia’s dependence on oil is likely to intensify its economic troubles. Though oil prices have recovered slightly, they remain below the level required to balance Russia’s budget, requiring a further cut in expenditure that will hit the working class and pensioners hardest.
Russia’s economy is deep in recession. The contraction in real GDP in 2015 is likely to continue in 2016. The primary determinant of the depth of Russia’s recession will be oil prices, given the country’s heavy dependence on the export of oil as a source of income and subsequent funding. Though oil prices have recovered since mid-January 2016 (as of March 22, 2016), they remain below the levels required to balance Russia’s budget. The shortfall in revenue continues to result in a drawing down of Russia’s foreign exchange reserves and will likely force further cuts in expenditure. This could impact domestic consumption and investment. Furthermore, even though monetary policy has been eased through 2015, interest rates remain relatively high due to the high risk of an acceleration in inflation stemming from the likelihood of persistently low oil prices and a weak ruble. Reduced social services expenditure, falling real wages, and tight monetary conditions are likely to result in Russia’s working-class consumers and pensioners bearing the brunt of the recession.
Russia’s budgetary shortfall could swell closer to 6.0 percent of GDP.
Russia’s fiscal squeeze is likely to tighten
Russia’s economic dependence on hydrocarbons is stark—crude oil and petroleum products account for nearly half of Russia’s total export revenue (figure 1).1 More importantly, almost half of Russia’s federal budget revenue is in the form of tax on the sale of oil and gas.2 In fact, it is estimated that close to 70 percent of the country’s GDP is directly or indirectly dependent on oil.3 Russia’s budget for last year was based on the assumption that oil would average $80 a barrel in 2015. This was later revised down to $60 a barrel. However, oil averaged approximately $54 per barrel in 2015, resulting in a federal budget deficit of 2.6 percent of GDP (2.8 trillion Russian rubles), up from 0.4 percent of GDP in the previous year.4 In fact, the budget deficit could deteriorate further, given that Russia’s budget for 2016 assumes oil will hold at $50 a barrel. On the contrary, even though the price of Brent crude has risen since mid-January, it averages only $35 per barrel thus far (as of March 22, 2016). Moreover, the US Energy Information Administration forecasts that Brent crude will average $34 per barrel in 2016, $20 below the average price in the previous year.5 In such a situation, Russia’s budgetary shortfall could swell closer to 6.0 percent of GDP.6
Lower oil prices, however, result in a weaker ruble (figure 2). This translates into more rubles in revenue per dollar of crude oil sold. However, currency markets take their cue from Brent crude. Russia, on the other hand, sells Urals crude. And while Urals crude is usually priced $2–3 below Brent, this gap could widen without compensation in the form of a weaker ruble. Downward pressure on Russia’s crude oil price is likely to stem from competition for market share with Saudi Arabia, Venezuela, Iraq, and, most recently, Iran. The provisional deal between Russia and Saudi Arabia to “freeze” production at January levels is likely to be inconsequential if all the big producers do not join in. Iran, in particular, is keen to ramp up production to pre-embargo levels. In fact, both Russia and Saudi Arabia increased production in February 2016 despite their agreement a month earlier.7 Any agreement between major producers to freeze production at current levels, which are already high, is unlikely to raise oil prices significantly. Furthermore, efficiency gains in US shale production could result in increased US production volumes even while crude oil prices remain low. Given the dynamics of the oil market, Russia is likely to face an uphill task in reining in the budget shortfall in 2016.
The numbers, however, are not particularly menacing—a federal budget deficit under 3.0 percent of GDP and total government debt under 10 percent of GDP.8 However, funding the shortfall is where the problem lies. The Reserve Fund is one of Russia’s two buffer funds (the other being the National Wealth Fund) built from increased revenue during periods of high oil prices. The primary purpose of the Reserve Fund is to finance budget deficits during periods of suppressed energy prices, but the rate at which the fund is being drawn is alarming—a 41 percent drop in February 2016 from the same period a year ago.9 If Russia runs a similar budget deficit for the next two years, the Reserve Fund could well be exhausted within that period. In fact, at the current rate of expenditure, both the Reserve Fund and the National Wealth Fund could be exhausted by 2019.10 As of February 2016, Russia’s foreign exchange reserves stand at $313.5 billion—this includes almost all of the sovereign wealth funds (figure 3), with the exception of long-term illiquid assets and ruble-denominated assets of the National Wealth Fund. A less grave view is that Russia’s government assets would be exhausted in a little less than three-and-a-half years (at projected budget deficits).11 Of course, Russia’s foreign exchange reserves are far healthier than in the wake of the financial crisis of 1998–99, and sovereign debt is much lower, but oil prices are highly unlikely to climb the way they did between 1999 and 2008.
Expenditure likely to be cut, and working class and pensioners to be affected
Russia will likely have to reduce expenditure if it is to keep budget deficit within 3.0 percent of GDP in 2016. An overall expenditure cut of 10 percent has already been proposed. This follows a 10 percent reduction in 2015. In fact, it is likely that even military spending, which has been left untouched thus far, will be cut in 2016, despite Russia being in the midst of a rearmament plan. Spending on health care, education, social security, and pensions are likely to be subject to downward revision. This would impact Russia’s working class and its aging population. The official unemployment figure of 5.8 percent is likely misleading as firms usually reduce hours of work or hold back wages instead of dismissing employees—a measure used to conform to official targets and maintain social calm. Year-over-year growth in real disposable income has been in negative territory for the last 16 months.12 Wage arrears are on the rise, and retail sales have declined year over year for every month since the beginning of 2015 (figure 4).13
Moreover, the burden is growing, particularly in Russia’s regional administrations, which were entrusted with a large portion of social spending by the federal government four years ago to keep federal balance sheets healthy. As revenue streams dry up, and the federal government puts the brakes on expenditure, regional administrations carry the burden of reducing social services spending and limiting wage growth in an environment of rising prices. While the federal government has foreign exchange reserves to fall back on, the regional administrations have no buffer apart from the federal government. This could mean a quicker draining of Russia’s sovereign wealth funds. The alternative for regional administrations is to borrow at hefty commercial rates. Russia’s aging population is also likely to be affected. State pensions were deindexed from inflation in 2016, a loss in real terms.14 This is significant, considering that almost 30 percent of Russia’s population comprises pensioners.15
Initiating and fostering an economic environment of competition will likely have long-term benefits for Russia’s economy. Recent plans to privatize state-owned enterprises, though a desperate measure to raise money, are a step in the right direction.
Monetary policy is likely to stay tight
Against a negative economic backdrop, the Bank of Russia’s (BOR’s) monetary policy has been a relatively positive aspect. The BOR’s decision to switch to a free-floating, inflation-targeting regime in November 2014, a few months ahead of schedule, has had its advantages, particularly in the form of curtailing sudden drops in the value of the ruble due to speculation and cushioning of the ruble-denominated loss from oil exports. Additionally, by not intervening to defend the ruble, the BOR does not deplete the foreign exchange reserves necessary for fiscal measures.
However, interest rates are likely to remain high. In its most recent meeting (March 18, 2016), the BOR decided to hold its policy rate steady at 11 percent (down from a high of 17 percent in December 2014).16 While the policy rate was cut through 2015 due to a moderation in inflation and greater stability of the ruble (figure 5), the risk of inflation in 2016 remains high. This is because oil remains well below its average price through 2015, with further declines still a possibility. This would mean further weakening of the ruble, higher prices, and, probably, higher interest rates. Another factor that could exert downward pressure on the ruble and stoke inflation is Russia’s plan to rebuild foreign exchange reserves by using rubles to buy foreign currency. Though this is a relatively long-term plan spanning five to seven years, it is likely to contribute to a weakening of the domestic currency.
Russia is likely to experience another year of contraction
Russia’s economic outlook for 2016 is looking bleak. The economy contracted 3.7 percent in 2015 and is likely to contract further in 2016, though not by the same degree (due to base effects). Estimates point to a likely contraction of 1.5 percent.17 The price of oil, which is expected to remain lower in 2016 than in 2015, will be the deciding factor behind the country’s economic performance. Maintaining fiscal discipline will likely stand Russia in good stead if oil prices dip further than expected. The short-term economic outlook is paltry; careful planning is required if Russia is to restructure its economy in the long term. Specifically, initiating and fostering an economic environment of competition will likely have long-term benefits for Russia’s economy. Recent plans to privatize state-owned enterprises, though a desperate measure to raise money, are a step in the right direction.18 If Russia can chalk out an economic framework that allows for meaningful private competition, it can likely steer away from its dependency on the price of its hydrocarbon resources, something it has little control over.