Russia: Too early for optimism Global Economic Outlook, Q4 2016
Signs indicate that Russia’s recession might be coming to an end. But despite some good news, several concerns remain: Foreign investment is down to a trickle, international sanctions continue to weigh on the energy sector, and real incomes are still in decline.
EXPLORE THE Q4 2016 OUTLOOK
Special Topic: Helicopter money
Russia might well be nearing the bottom of its painful recession. After contracting for five straight quarters, a sixth quarter of milder contraction, despite being rooted in a weak base quarter from a year ago, brings hope that the worst has passed. The Russian ruble has stabilized, inflation is slowing, monetary policy has eased, and oil production is booming. Additionally, Russia’s return to the international bond market, though troublesome at first, indicates a large investor appetite for Russian debt, despite sanctions. Ruble-denominated bonds and equities have gained as well. However, despite the pockets of good news, there is no dearth of concern regarding the Russian economy. Foreign investment flow has been reduced to a trickle, and Russia’s ambitions in the energy sector continue to be stymied by international sanctions. A pivot toward Asia has failed to produce any traction beyond commodity- and energy-related ties. Moreover, Russia’s strategy of import substitution continues to be marred by a lack of integration into global value chains (GVCs) and underinvestment on the domestic front. A fiscal shortfall is unlikely to help the situation. Finally, Russian citizens continue to withstand the worst of the downturn. Given such a cloudy picture, it is far too early for optimism.
Russia’s return to the international bond market, though troublesome at first, indicates a large investor appetite for Russian debt, despite sanctions.
Russia returns to international debt markets
Russia returned to the international debt market for the first time in three years by issuing 10-year dollar-denominated sovereign bonds in May. International sanctions that shut out western capital markets to Russian firms proved to be far reaching as international banks, particularly in Europe, navigated away from handling Russia’s sovereign bond offering. Chinese banks, invited to step in, were not forthcoming either, primarily because of a lack of reach in the capital markets of the United States and Europe. Moreover, international clearing houses in Belgium and Luxembourg, critical components of the global financial mechanism for servicing international debt issuance, remained skeptical lest the money raised by sovereign bonds be funneled back to Russian firms under sanctions, thereby raising the possibility of penalties being imposed by the United States and the European Union. These uncertainties resulted in only $1.75 billion of the $3.0 billion bond sale being placed in the initial offering.1 However, as soon as international clearing houses agreed to service Russian debt, the remaining $1.25 billion of sovereign bonds were snapped up by international investors, with investors from the United States, United Kingdom, and Europe accounting for 96 percent of the purchase, and Asian investors accounting for just 4 percent.2 In all, Russia’s sovereign bond offering of $3 billion registered total demand of $7 billion.3 Encouraged by the issue of sovereign debt, Russian companies not covered by sanctions have also returned to international debt markets, primarily to refinance existing debt that is due to mature in the short term.
Ruble-denominated debt has also attracted foreign investors. Russia’s 10-year bond yields declined from 15.0 percent in January 2015 to 8.0 percent in August 2016.4 Russian equities are also in demand. The dollar-denominated RTS index has risen 33.0 percent relative to the beginning of the year, while the ruble-denominated MICEX has risen 16.0 percent during the same period (figure 1).5 All of this flies in the face of an ongoing recession and international sanctions. Debt and equity investment in Russia have been buoyed by the rebound in oil prices compared with the beginning of the year, relative stability of the ruble, a scarcity of Russian debt in international markets, and, most importantly, attractive yields on assets in comparison to western markets. As a result, net capital outflow from the private sector slowed to just $2.4 billion in Q2 2016 (from $152 billion for the whole of 2014), even turning positive in August.6
Declining FDI may weigh on future growth
Apart from some positive news in debt and equity markets, Russia’s foreign direct investment (FDI) landscape has not attracted much interest. FDI flows into Russia have slowed markedly since the United States and the European Union imposed political and economic sanctions on the country. In addition to international sanctions, business risks associated with macroeconomic uncertainty have kept foreign investors away. Annual FDI flow into the Russian economy fell from $69.2 billion in 2013 to $6.5 billion in 2015, a drop of 91.0 percent (not revised for “round tripping”7). In fact, FDI flows in 2015 were down 82.0 percent relative to 2009 ($36.6 billion), when foreign investment slumped at the peak of the global financial crisis (figure 2). Russia’s pivot toward China looked promising when FDI from China surged in 2014. However, in 2015, FDI from China fell to almost half of the 2014 level as oil prices collapsed, China’s growth rate slowed, and Russia’s economy started contracting.
In addition to international sanctions, business risks associated with macroeconomic uncertainty have kept foreign investors away.
The drying up of foreign investment in Russia is likely to add to the challenge of diversifying the economy by revitalizing industrial production. For instance, without the transfer of technical expertise, industrial production is likely to remain sluggish. The average 12-month percentage change in industrial output for the first eight months of 2016 was just 0.1 percent; this is despite industrial output declining year over year in every month through 2015 (figure 3). The pause in technology transfer from western economies could also affect Russia’s ambitions in its large hydrocarbons sector, particularly in the Arctic and the shale reserves of the Bazhenov formation. In 2014, a US-Russia joint venture to explore the Arctic for oil was taken off the table due to sanctions. Sanctions also prohibit the transfer of equipment or services for exploring shale reserves—which is pertinent, as Russia is home to the largest shale oil reserves on the planet. However, Russia’s oil production has increased since 2014 despite sanctions. This is mainly due to an increase in drilling in western Siberia’s Soviet-era brownfields. In essence, Russia has expanded and advanced the timeline of conventional production by reinvesting in existing fields.
Additionally, the Russian oil sector has started extracting unconventional tight oil from deposits in Tyumen and Achimov, classified as “hard-to-recover resources” from formations that are geologically different from shale and therefore not under the purview of sanctions. However, ramping up production also implies increased taxation, as Russia’s energy sector is taxed on production and not on profits. This tax system has served as a disincentive to further investment in existing projects. Tax breaks for greenfield projects are meant to attract foreign investors, but with sanctions in place and global oil prices low, there is not much of an incentive for foreign money. More importantly, if Russia does not have access to western technology to explore the Arctic deepwater and shale reserves, production from conventional sources are likely to drop in the medium term. The length of US-EU sanctions as well as the trajectory of oil prices are likely to become progressively more important to Russia’s energy industry and overall economic progress.
If Russia does not have access to western technology to explore the Arctic deepwater and shale reserves, production from conventional sources are likely to drop in the medium term.
Ties with Asia continue to be resource driven
Russia’s pivot to Asia has been characterized by commodity- and energy-related deals. In March, the Bank of China extended a $2.2 billion five-year loan to Russia’s largest state-owned gas producer, which is likely to be used as refinance.8 Additionally, in April, two Chinese state-owned banks agreed to extend $12 billion in funding for a Russian liquefied natural gas project in the Arctic.9 This follows a $400 billion 30-year gas supply deal between Russia and China, signed in 2014. The China National Petroleum Corporation has also expressed an interest in acquiring a stake in Russia’s Rosneft, which is looking to shed a 19.5 percent stake in order to finance Russia’s fiscal shortfall.10 Increased dependence on China as a source of finance, coupled with the relatively low price of oil and gas, will likely increase China’s bargaining power in fixing the terms of current and future energy deals with Russia.
Greenfield investment projects in Russia’s far east have been dominated by another large importer of commodities and energy: Japan. Japan accounted for 25.0 percent of the total capital expenditure in the region between January 2003 and July 2016.11 Investment during this period has been predominantly in metals and hydrocarbons.
Import substitution stifled by isolation and underinvestment
While the hydrocarbon industry is strongly driven by global developments, Russia’s strategy of import substitution is geared toward economic sovereignty. In order to achieve this goal, Russia needs to diversify its economy away from a dependence on hydrocarbons. Russia’s vast manufacturing sector, for instance, presents a great opportunity for economic diversification. However, Russia’s import substitution efforts in the manufacturing sector have failed to overcome a dependence on the import of machinery and equipment.12 In fact, the manufacturing industrial production index indicates a sector in retreat (figure 4). Part of the reason behind this is that Russian industry as a whole is not well integrated into GVCs; participation in backward linkages is weak, while participation in forward linkages is primarily driven by the hydrocarbons sector.13 The large manufacturing sector is therefore comparatively uncompetitive on the global stage and continues to depend on expensive imports. Furthermore, manufacturing output is consumed domestically. Activity in the manufacturing sector and in the economy as a whole is therefore strongly dependent on the earnings of the hydrocarbon sector. As a result, when hydrocarbon prices fall, economic activity across other sectors declines as well.
In order to break its dependence on the hydrocarbon sector, Russia needs to invest in infrastructure and skills, apart from making efforts to integrate into GVCs. However, domestic investment has not been forthcoming; gross fixed capital formation has declined year over year for eight straight quarters.14 Similarly, the development of workforce skills has been sluggish: Labor productivity has declined year over year for seven straight quarters. Investment and development plans will probably be constrained by a fiscal deficit likely to exceed 3.0 percent of GDP in 2016. The focus is therefore likely to be on privatizing state-owned assets rather than on investing in infrastructure or skills.
Russian industry as a whole is not well integrated into GVCs; participation in backward linkages is weak, while participation in forward linkages is primarily driven by the hydrocarbons sector.
Russia’s consumers bear the brunt
Russia’s consumers, critical to the future of the economy, continue to weather the worst of the recession. Real incomes are still in decline (figure 5), and pensions for the elderly, having been deindexed from inflation, represent a loss in real income. As a result, real retail sales declined 5.1 percent year over year in August—the 20th month of decline. A voter turnout of less than 50 percent in the recent parliamentary elections is a likely indicator of dissatisfaction among consumers. Ironically, the near-term outlook for Russia seems brighter than a year ago, as the economy contracted 3.7 percent in 2015 but is likely to contract by less in 2016 (1.2 percent). Annual growth in 2017, if any, is likely to be weak, at 1.0 percent.15 Even if the economy does indeed return to growth in the medium term, continued dependence on hydrocarbons (particularly in an environment of low prices), underinvestment in diversification of the Russian economy, and the persistence of sanctions will limit growth in the long term.