Russia: Signs of recovery Global Economic Outlook, Q2 2017

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With oil prices rebounding, the ruble regaining some of its lost value, and inflation falling sharply, Russia’s economy seems to be on the road to recovery. However, conservative monetary policy and fiscal consolidation are likely to keep growth subdued.

Introduction

The Russian economy is in better shape than it was a year ago. Global oil prices, critical to the health of the economy, are up; the Russian ruble has regained some lost value; the outlook on Russia’s sovereign debt ratings has been upgraded; and inflation has fallen sharply. However, the economic recovery is still nascent. Conservative monetary policy and fiscal consolidation will likely keep overall growth subdued. Furthermore, international sanctions are likely to remain in place, and the Russian economy’s strong dependence on the price of hydrocarbons will persist.

The ruble rises

As global oil prices edged up through 2016, the ruble, which is closely linked to global crude oil prices, also strengthened against the US dollar (figure 1). Oil prices spiked in December 2016 on news of a deal by the Organization of the Petroleum Exporting Countries (OPEC) to cut global oil production. However, higher global oil prices also serve as an incentive for US shale oil producers to increase production. In fact, the number of US oil rigs have increased 83.0 percent compared with a year ago (as of March 31, 2017).1 Increased shale production and skepticism among investors about the effectiveness and longevity of the production-cut agreement led to oil prices falling in March. Though 32.0 percent higher than a year ago, they were 6.0 percent lower than in the previous month.

The ruble rises on higher oil prices

However, though oil prices declined in March, the ruble remained relatively unchanged in relation to the dollar, falling just 0.5 percent. The relative delinking of the ruble from crude oil prices is because investors have flocked to the ruble in the carry trade market.2 Comparatively high interest rates in Russia make the ruble attractive to speculative investors who borrow in currencies with lower interest rates. The ruble has also been buoyed by the fact that a major ratings agency upgraded the outlook on Russia’s sovereign debt ratings from stable to positive in March because of improved growth prospects and the reduced risk of capital outflows.3

The relative delinking of the ruble from crude oil prices is because investors have flocked to the ruble in the carry trade market.

Monetary policy eased

An immediate advantage of the strong ruble is lower inflation. Russia’s inflation rate fell to 4.3 percent in March—its lowest level since June 2012 (figure 2).4 Apart from the strong ruble, inflation declined because large harvests in 2015 and 2016 contributed to greater food stocks and lower food prices.5 In response to slowing inflation, the Central Bank of Russia (CBR) cut the policy rate by 25 basis points, from 10.00 percent to 9.75 percent, in March.6 Another likely reason behind the CBR’s easing of monetary policy is to check speculative investment in the ruble. Lower inflation results in higher real interest rates, which keep the ruble attractive to investors relative to other emerging-market currencies. Before the CBR cut interest rates in March, the finance ministry attempted to weaken the ruble through foreign exchange purchases in February.7 However, this proved ineffective as speculative carry trade kept the ruble strong.

The CBR cuts policy rate as inflation falls

Further cuts in policy rate are likely in the near term as inflation drops closer to the target of 4.0 percent. However, as indicated by the CBR, the easing of monetary policy will be gradual.8 Real interest rates are therefore likely to remain relatively high. This is likely to keep the ruble an attractive investment. Prolonged strength in the ruble will be a concern for Russian exporters in the near term. Furthermore, relatively high real interest rates will likely limit an increase in consumption expenditure.

Fiscal policy may remain tight

In addition to a conservative monetary policy, fiscal policy in Russia will continue to focus on consolidation. If there is effective implementation of the OPEC production-cut deal, coupled with improving global economic activity, global oil prices are likely to rise above current levels. However, if US shale oil producers continue to counterbalance the effect of the production cut, or if the deal is not adhered to by participating countries, global oil prices are likely to decline. Russia’s budget for 2017 is based on the more pessimistic assumption that global oil prices will average $40 a barrel.9 Furthermore, the finance ministry’s proposal in July 2016 was to freeze nominal expenditure for the next three years.10 Provided oil prices do not go below $40 a barrel in 2017, the government expects revenue to rise by 1.8 percent.11 However, in keeping with the ministry’s announcement in February, increased government revenue is likely to be accumulated in foreign exchange reserves rather than transferred to the budget.12 Nonetheless, reduced expenditure and improved growth prospects will likely lead to the budget deficit declining below the 2016 level of 3.5 percent of GDP. However, though fiscal consolidation will help Russia deal with economic sanctions and relatively low oil prices, and even support the possibility of an improved credit rating, it will weigh upon overall growth in the near to medium term.

Russia’s budget for 2017 is based on the more pessimistic assumption that global oil prices will average $40 a barrel.

Growth in 2017 could be subdued

Russia’s return to growth in 2017 is likely to be subdued, at 1.0–1.5 percent.13 The recovery of important drivers of economic growth such as household expenditure is likely to be protracted due to tight macroeconomic policy. For instance, a recovery in real disposable income and lower inflation could lead to improved household expenditure, but high real interest rates are likely to keep expenditure in check. Indeed, real retail sales have been in decline since December 2014, and the balance of the consumer confidence index continues to be skewed toward pessimism.14

Another factor that will keep the Russian economy from growing quickly is international sanctions. These appear unlikely to be lifted in the near term, which is likely to keep pressure on business confidence and investment. Furthermore, Russia’s fortunes are likely to remain linked to the price of hydrocarbons in the medium term. Therefore, the price of crude oil will probably continue to determine how Russia’s economy performs relative to expectations.