RUSSIA: Putin’s Crimea victory risks economic defeat
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RUSSIA: Putin’s Crimea victory risks economic defeat

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Putin’s Ukraine gamble might have paid off from a political standpoint — his popularity at home has soared since the annexation of Crimea — but it is in real danger of wrecking an already weak Russian economy

When Russia’s president Vladimir Putin embarked on his big adventure, deploying his country’s military and economic power to annex Crimea and raise hopes in Ukraine’s Russian speaking eastern regions, he was probably confident of a clear and instant impact.

While there is no doubt his intervention wrong-footed the West and sent his approval ratings at home shooting up, it has had an equally clear, immediate — but negative — effect on the Russian economy.

The short term reaction saw billions of roubles wiped off the Moscow stock market and triggered a slump in the currency. The RTS equity index fell by 12% on one day alone in March and has failed to recover.

On the same day, March 3, Russia’s central bank raised its main interest rate to 7.0% from 5.5% as the rouble plunged to historic new lows against the dollar with the US currency buying 37 roubles. It hiked rates again to 7.5% on April 25.

“This is investors reacting even before we have had any serious sanctions,” says Laza Kakic, regional director for Europe at the Economist Intelligence Unit. “There has been an impact that we can attribute to the Crimea effect.”

The long term consequences too threaten to be profound. The question is not whether Russia will suffer, but by how much and which sectors of the economy will be hardest hit.

SELF-INFLICTED WOUND

Prime minister Dmitry Medvedev has claimed Russia’s recent economic woes cannot be exclusively tied to Ukraine, saying the impact from the geopolitical tensions was “artificial” and there were several other factors contributing to the contraction.                                                            

It is fair to say economic slowdown was already underway. Analysts agree that industrial output, investment and consumer and business confidence were already weak before Russia’s annexation of Crimea.

In 2013 Russia’s economy only grew by 1.3%, a three percentage point drop from 2011 when GDP expanded by 4.3%. But consensus forecasts of a 2.2% annual growth in the first quarter turned out to be just 0.8% — a rough measure of the Crimea effect.

Kakic points out external conditions were actually improving for emerging markets and that Russia is alone in suffering a major downturn. “They can’t really blame the outside world,” he says. It looks like a self-inflicted wound.

But on top of this negative trend comes the likely impact on growth from financial and trade sanctions imposed by the US and European Union and the broader impact on consumer and business confidence.

SLASHING FORECASTS

Forecasters have rushed to add to their downgrades and the forecasts range from the good to the bad to the downright ugly. At the positive end of the spectrum the IMF cut its growth forecast to 1.3% in 2014, although that was less than half the 3% it envisaged in October last year.

In April Russia’s own ministry of economic development cut its growth forecast for 2014 to 0.5% from the 2.5% it had pencilled in just four months previously, citing weaker demand for exports, falling consumer activity, capital outflows and a decline in investment.

Two weeks later finance minister Anton Siluanov struck an even more downbeat tone, saying that the current conditions were the “most difficult” since the crisis of 2008. He confirmed the 0.5% forecast but added: “Perhaps it will be around zero.”

IHS Global Insight has cut its 2014 GDP forecast from 1.7% to 1% and put in a 30%-40% chance of a recession. “While the sanctions so far have been directed only  at certain individuals and their private banks, shifts in investor sentiment are already taking a toll,” says chief economist Nariman Behravesh.

One threat hanging over Russia is a decision by Europe to impose sanctions in energy imports, which would have a devastating impact on Moscow’s tax revenues. Crude oil exports to OECD Europe represent 71% of Russia’s total crude exports — or $123bn a year. “This is an amount which Russia can’t afford to go without,” says Jaroslaw Janecki, an economist at Société Générale CIB.

But the most negative outlook comes from the Institute of International Finance (IIF), the association of global banks, which has an “upside” prediction of a 1% contraction this year and a stunningly grim forecast of a 4% slump if Ukraine breaks up.

The data for the first quarter of 2014 show that all the main sectors of the economy slowed in the three months to June. However, analysts warned that with the crisis in Ukraine escalating on a daily basis worse could be yet to come.

Retail sales and industrial production slowed from the last quarter of 2013 but were still positive. To the extent that any part of the economy has collapsed it has been investment, according to Liza Ermolenko at Capital Economics, which estimates Russian GDP contracted by 1% over the quarter.

FOREIGN CASH DRYING UP

New investment projects and joint ventures are being put on hold. There is anecdotal evidence that Western investors are calling in loans to Russian entities. As a result, Russian banks and companies will face a growing credit squeeze. “Russian companies are already experiencing difficulties tapping international markets,” says Kakic at the EIU.

“I would not expect a major financial crisis to result from this but given the general uncertainty, raising money will be more difficult than it would otherwise have been, especially from the point of view of foreign investment.”

Lubomir Mitov, chief European economist at the IIF, whose members would be expected to provide private sector finance, says that in the negative scenario non-resident inflows would “all but disappear” leaving banks and companies to roll over debt falling due this year.

Although the West appears to have accepted that Crimea is now under Russian control, Kakic says Moscow must be aware that the EU and US will not stand by if Russia invades Ukraine. “Then you ain’t seen nothing yet.”

Ermolenko says the full impact of the Ukraine crisis has yet to be felt. “The impact on business confidence will continue to hold back much-needed investment.”

The World Bank’s high risk recession scenario includes a deeply negative investment shock — a plunge of 10.3% ­— as well as further slowdown in consumption growth.

Infrastructure is a key component of the Russian economy. When two major projects — the Nord Stream Pipeline and the Sochi Winter Olympics — came to an end in late 2012 and early 2013, the effect on aggregate investment demand was immediately felt in the economy.

Russia has set a target infrastructure budget of Rb1.8tr ($56bn) of which Rb660bn ($20bn) is expected to come from private sector investors. The 2018 Fifa World Cup alone has been budgeted at around $21bn — of which a third will come from private sources.

The pipeline faces the twin threat of declining tax revenues hitting the central government budget, and a drought of private sector finance as overseas lenders pull back and domestic banks suffer a funding squeeze.

“It is reasonable to assume that these plans will be far more difficult to finance than they would otherwise have been,” says Kakic.

The first project that may fall victim to the crisis is Gazprom’s South Stream gas pipeline to Europe, which has run into opposition from the European Commission since the crisis broke out.

The latest sanctions announced by the US government on April 28 targeted a number of infrastructure companies including pipeline builder SGM Group, construction giant Strotransgaz Group, transport firm Sakhtrans and aviation-related builder Avia Group.

CHINA TO THE RESCUE?

Aside from political problems, Russia may struggle to access finance for infrastructure. Unlike other emerging markets, Russia is almost at a standstill. In the year up to April 2014, debt capital market issuance fell 74% on the same period in 2013 to stand at $9.1bn, the lowest year to date volume since 2009.

As one senior Moscow-based corporate adviser puts it, few investors will want to “pour billions of dollars into Russian infrastructure” in the turn-up to a possible escalation of military activity. Kakic agrees: “It will be more difficult than it would otherwise have been especially from the point of view of foreign investment.”

One potential source is China, a fellow member of the Brics (Brazil, Russia, India, China, South Africa) group of emerging economies. Last month Kirill Dmitriev, chief executive officer of the Russia-China Investment Fund, a joint venture of the two states, said China planned to invest $20bn in its partner with a focus on highways, ports and airports.

If private sector or external finance does not materialise — at least in the short term — Russia may be forced to fund the investment itself. The World Bank says Russia’s National Wealth Fund can invest up to Rb450bn ($14bn) into priority infrastructure projects.

Russia had $724bn of external debt at the start of the year, according to Trading Economics. While this is 36% of GDP and so much lower than the 106% in the US, much of this is held by companies and banks.

Moody’s, which expects the economy to contract by 1% this year, warns that lower credit growth could “reveal weaknesses in some banks’ previous underwriting criteria and practices”.

“Weaker corporate profits, slower growth in household income and higher interest rates for some loans will foster asset quality deterioration across all loan segments,” it said in a report on banks’ asset quality.

Although the Russian government has $470bn of foreign reserves to provide emergency funding in the face of capital flight, which has already seen $70bn exit the country this year, and the central bank has room to raise rates, Kakic warns against complacency.

“Reserves are quite high but as we have seen in Russia in the past, these can easily be spent very quickly so it is a cushion that is not that secure. I would not assume this is a lasting guarantee of stabilisation,” he says.

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