Putin’s Russia braced for new storm front
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Emerging Markets

Putin’s Russia braced for new storm front

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There are signs that Russia may have come through the worst of its crisis, but all depends on commodity and energy prices, both of which are plummeting

It has been a strikingly bad two years for Russia’s brittle economy. Heavily dependent on exports of energy and commodities to meet its budgetary needs, Moscow has struggled to cope with the slump in the price of oil, currently mired below $50 a barrel.

Western sanctions levied against many of the country’s largest lenders and corporates in response to President Vladimir Putin’s annexation of Crimea irritated the economic wound.

Both factors pushed a chronically underdeveloped economy that had been slowing for years into free fall. Gross domestic product contracted 4.6% year-on-year in the second three months of 2015, according to data from the Federal Statistics Service (FSS), and is on course to shrink by a similar amount in the third quarter of the year.

In late August, economy minister Alexei Ulyukayev projected Russia’s economy would shrink by 3.3% in 2015, against previous official estimates of a 2.8% contraction, before returning to growth in 2016. Yet within weeks, Ulyukayev had again revised his estimate downward, tipping GDP to contract by 3.9% this year, with consumer inflation topping 12%.

Alex Nice, Russia-CIS economist at the Economist Intelligence Unit in London, says it is “now increasingly likely that Russia will face a second straight year of contraction in 2016, a fact that now appears to be understood and accepted by the central bank.

“It all depends on commodity and energy prices: if they tick up, things could improve sooner than expected. Our view is that there is little chance of positive growth in the Russian economy before the second half of next year.”


CAPITAL FLIGHT

The flight of capital looks set to continue. Net outflows hit $32.6bn in the first quarter of 2015 according to central bank data, putting it on track to top $130bn for the full year.

Lower oil prices and a weaker rouble have dented corporate and consumer confidence. Real disposable incomes fell 2% year-on-year in July according to FSS data, while fixed-capital investment tumbled 8.5% over the same period, the biggest fall in six years. Retail sales declined 9.2%, slumping for a seventh straight month.

“Wherever you look, the economic indicators make for pretty grim reading,” says Liza Ermolenko, emerging markets economist at Capital Economics. “During the financial crisis, the consumer data was bad — but it was never this bad.”

Yet even these figures may underestimate the true state of Russia’s financial fragility. Anastasia Nesvetailova, director of City University’s Political Economy Research Centre in London, reckons that Russia’s dual federal reserve funds, currently valued at Rub5.8tr ($88bn), will be entirely depleted by the end of 2015, having been rapidly drained by various “anti-crisis” measures.

With a slew of international debt repayments by Russian borrowers set to come due in late 2015 and 2016 and with little capital set to flow into the country over that period, corporate defaults have become a real possibility, she believes.

Even metrics such as foreign direct investment may be deceptive, concealing a previously unnoticed flaw in the Russian economic and financial model under Putin. FDI was once heralded as a rare onshore success story, with annual net inflows averaging $48bn over the five years to end-2014 and hitting $70bn in both 2008 and 2013, according to World Bank data.

Yet Nesvetailova notes that most of the country’s top inward investors are firms and funds based in Cyprus, Bermuda, the Netherlands and the British Virgin Islands, all noted destinations for Russian money. “The data suggests that it is the capital of Russian-owned structures, recycled out of Russia through a chain of offshore jurisdictions, that has been recycled back into Russia as FDI,” she says.


STAMPING ITS MARK

Of course, Russia has been here before. This is a nation accustomed to strife and struggle. Centuries of toil under the Tsarist and Soviet yokes yielded to a turbulent dalliance with private ownership, a lost 1990s, and two crises, in 1998 and 2008, that originated far beyond its borders.

Many other countries would by this stage in the current crisis have endured some sort of political upheaval. So far, aided by a pliant state media, President Putin and his inner circle have escaped the wrath of a public mostly proud at an emboldened Russia finally stamping its dubious mark on the region, if not the world.

Sanctions have hurt the country, isolating it almost entirely from international funding markets. Russia’s attempt to draw institutional investors from Asia into its orbit — and to convince them to buy bonds issued by domestic firms — failed almost entirely, bar a few smaller sales by local energy firms to Chinese development banks.

Policymakers have been forced to tinker with rules in an attempt to free up investable capital. Rules that once shackled private pension funds, which hold $26bn in savings, have been loosened, allowing them to buy domestic corporate bonds. Russia’s finance ministry reckons these funds bought Rb129bn ($2bn) worth of local corporate bonds in the second quarter of 2015.

Overall debt sales meanwhile have held up surprisingly well. Rouble-denominated corporate debt prints actually rose slightly in the first eight months of 2015, to $9.81bn, against $9.27bn in the same period a year ago, according to data from Thomson Reuters.

Debt capital market bankers say domestic credits have remained reasonably financially attractive to international institutions due to their maturities and generous yields.

There are also signs of life for Russian corporates beyond the country’s borders. Norilsk Nickel met with investors in September with the aim of becoming the first Russian corporate issuer to print benchmark-sized international bonds in almost a year.

The nickel and palladium miner hopes to raise around $500m, though any deal may be stymied by commodity prices, which remain mired at multi-year lows. Natural gas major Gazprom is also hoping to sell €1bn ($1.13bn) worth of Eurobonds as early as this month.


UNEMPLOYMENT PUZZLE

Jobless figures, a key measure of the structural health of any emerging market, have remained surprisingly resilient to the economic downturn, with Russia’s unemployment rate hovering around the 6% mark for the past four years.

The reasons for this are complex and varied — and not necessarily due to genuine signs of healthy job creating conditions at home. One mooted reason for this is that a larger share of workers than at any time since the break-up of the Soviet Union are employed directly by the state.

City University’s Nesvetailova reckons that 20 million workers, or 28% of the nation’s workforce, were classed as state employees at the end of 2014 against 16.4m in 2004. Governments have long found it hard to fire their own, a problem shared by developed and developing markets alike.

In a September report titled Russia’s unemployment puzzle, Capital Economics suggests another reason for the country’s exuberant jobs figures: political pressure.

With government-owned enterprises now the dominant force in Russia — state firms now control 50% of the economy and rising, against a world average of 30%, according to Nesvetailova — major employers have been quietly strong-armed into keeping workers on their books, whether by cutting their hours or putting them on paid leave.

Capital Economics says this means the “pain for workers has been felt not in a rise in layoffs but in sharp falls in real incomes”. Employment numbers actually increased in the first two quarters of 2015.

Other reasons for the rosy outlook include the cost of sacking personnel and the country’s woeful demographics. Russia’s workforce is shrinking as the fertility rate declines and as some workers retire while others head abroad to find well paid jobs.

Capital Economics says the poor demographic is “causing firms to hoard labour. Companies don’t want to lose workers... because of concerns about the difficulty of finding new workers when the economy eventually stabilises and demand for labour starts to pick up.”


CREDIT AND CRUDE

And improve it will, sooner or later. Indeed, there are signs that Russia may have come through the worst of a crisis it did so much to create. Western sanctions are likely to last into the medium term: few expect European curbs on Russian interests to be lifted in 2016 and US restraints against domestic firms and individuals are set to remain in place for far longer. Yet domestic firms are tentatively testing the level of international demand for local corporate credits.

Another positive sign, says Oleg Kouzmin, Russia & CIS economist at Renaissance Capital in Moscow, is that “total foreign redemptions of external Russian corporate debt are set to halve in 2016 to $40bn, offering some relief to the rouble”.

And then there’s oil. Much will depend on the impact of energy prices. The Russian economy and its president were shocked by last year’s unforeseen decline in global energy prices — and perhaps even more startled when, after a brief rally in early summer 2015, they fell again, settling in below $50 per barrel.

Yet for all the fragility of its wider economy, a sharp rise in oil prices would, as it has done for so many years, allow Russia to paper over the cracks, at least for a while longer. In a September report, RenCap tipped global oil prices to average $60 per barrel in 2016, slightly up from a predicted average of $55 for the full year 2015.

If oil settled around that level next year, the wider Russian economy would be “likely” to return to growth by the second half of 2016 according to RenCap’s Kouzmin. Add in another $20 a barrel and, he says, “you would see 2% economic growth for the full year”.

Western sanctions trouble Russia’s leadership — they isolate the country and its leading corporates and are a diplomatic thorn in its side. But global energy prices, adds Kouzmin, matter far more. “Everything comes down to oil,” he says. “It’s vital for Russia’s future: a few more dollars per barrel, then a few more, and suddenly things don’t look so bad.”



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