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Recovery may stymie reform in Russia

With the six-month drop in the global oil price stinging the Russian economy, it looked as if the country's government would introduce reforms to protect it against future shocks. But with prices on the brink of a recovery, this positive momentum towards change is being lost. 
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Recovery may stymie reform in Russia

In a country hugely dependent on oil, a slump in the oil price can derail the whole economy. In Russia, oil and gas revenues have made up more than half of government earnings since 2012 – a trend that is likely to reverse in 2015. And, while the Russian rouble has recovered from its huge slumps in December 2014, it is still trading under value. Russia is in recession, and economic growth is not expected until 2016 or 2017.

The contraction in the oil price, which began in July 2014 and really gained momentum between October and January 2015, saw oil halve in value from a high of $115 a barrel of Brent crude oil on June 19, to about $50 a barrel in January. In the same period, the rouble devalued from Rbs33.80 per $1 on July 9, 2014, to Rbs69.20 per $1 as of January 31, 2015. A significant 6.5% hike in the key interest rate followed, as did a troubling few weeks for the banking sector (see article on the Russian banking sector and interview with the governor of the National Bank of Russia).

Russia’s nominal gross domestic product (GDP) increased by Rbs4782bn equivalent in 2014, according to research by Moscow-based investment bank VTB Capital, with real GDP growing by a marginal 0.6% year on year. And, because of Russia’s strong reliance on oil, the future of the commodity is largely correlated with the country’s economic growth.

According to research by the World Bank, Russia’s economy is likely to decline by 2.9% in 2015 if the oil price averages at $69 per barrel, while an average of $53 would see GDP contract by 3.8% and, in a worst-case scenario, an average of $45 would see a 4.6% contraction. In the medium to longer term, the ministry of finance expects the budget to be balanced at $70 per barrel.

Structural reform

Most experts agree that what Russia needs is structural reform. But reforms are unpopular because people associate them with the hardships of the 1990s that brought poverty, uncertainty, criminalisation and privatisation, according to Yulia Tseplyaeva, the director of the centre for macroeconomic research at Sberbank.

“Fortunately, [president Vladimir] Putin seems to be strongly inclined to the liberalisation idea,” she says. “He knows that structural reforms, as an idea, are not popular among people, and reforms would have to be followed through to achieve the intended effect. From a psychological point of view, it is much easier to promote structural reforms if a crisis is severe because people can understand that it comes as a result of events we can’t control."

On the agenda are reforms of the pension system and government management, de-bureaucratisation and stabilisation of government institutions.

Yaroslav Lissovolik, board member and chief economist at Deutsche Bank Russia, says that the micro-level of companies, especially in the state sector, is where the “main focal point of inefficiencies in the economy” lies and he hopes that the reforms will focus on this area.

Another issue is the generally low level of competition in the economy, says Natalia Orlova, chief economist and head of macro insights at AlfaBank. “In some sectors it is because there is a very high presence of state companies, in others because of private or quasi-state companies, but the main problem is that the economy is not efficient,” she says. “We have cost inflation and high energy inefficiency, which is resulting from this lack of competition and, therefore, this should be the main target structural changes should address.”

New opportunities

If the government follows through with the needed reforms, then today’s economic difficulties could improve the country's long-term economic outlook. Other opportunities could spring from the weak rouble and Russia’s food import ban. “At the moment, government measures are focused on supporting strategically important industries and import substitution,” says Maria Pomelnikova, macro-analyst at Raiffeisenbank Russia, who adds that there are opportunities within the country, especially in textiles and food production.

With markets closed to some food importers, Russian producers have an advantage in this market. But the companies benefiting from this so far are those that are already established, as any kind of fresh investment is sparse.

“It could be possible to crowd out imported goods, but a real diversification of the economy is difficult to achieve because the employment level is so high,” says Ms Tseplyaeva. “We need spare labour resources and capacities, which could be achievable if labour productivity increases, but for that we need investment."

Despite economic difficulties, the unemployment rate is only expected to rise from 5.3% as of 2014 to an average of 7% in 2015 and 2016, according to Raiffeisenbank research, which would still be lower than during the global financial crisis of 2008/09.

Rouble recovery

VTB Capital’s chief economist for Russia, Vladimir Kolychev, notes that the country’s recent sharp drop in imports – by 19% year on year in the fourth quarter of 2014 – points to a rising current account surplus. “Russia is likely to generate about seven to nine percentage points of GDP in current account surplus this year,” he says. “Should oil prices stabilise, strong current account flows and a moderation in internal capital flight could also support the currency.”

Indeed, since the beginning of April, the rouble stabilised from Rbs58.14 per $1 on April 1, to Rbs49.13 on April 15 – the day Brent crude oil saw a jump to a (then) 2015 high of more than $63 a barrel intra-day. Still, Mr Lissovolik warns, this temporary respite in the economy should not be confused with a longer term stabilisation or improvement.

“Some, including the ministry of the economy, say that we are now potentially in a growth phase starting from the second half of the year,” he says. “But one has to understand the fragile nature of the current improvement, because it really is still driven by the same factors that brought Russia down before.”

Accordingly, Deutsche Bank still expects a contraction in GDP of 5% in 2015 and 3% in 2016, based on an exchange rate of Rbs55 per $1, while the ministry of the economy is much more optimistic, predicting a 4% fall in 2015 followed by 2% growth in 2016.

Rethinking the budget

In early March, the Russian government adjusted its 2015 budget to account for the lower oil prices and the economic downturn, and now expects both lower oil and non-oil revenues. Spending was cut by 1% net to about Rbs15,200bn after the ministry of finance had to account for the anti-crisis package extended to the banking sector, as well as increases in foreign exchange-denominated expenses, provisions for unemployment benefits and transfers to the pension fund due to the higher than expected level of inflation.

As of March, inflation stood at 16.9%, compared with about 6% at the beginning of 2014. For 2017, the Central Bank of Russia is targeting a rate of 4%.

“There are two reasons why inflation accelerated last year and keeps accelerating now,” says Ms Orlova at AlfaBank. “First, the rouble dropped by 40% and there was a pass-through, for which the consensus averages at about 15%, which means about six percentage points should be added to inflation just because of the weakening of the rouble – in that case a level of about 12% would be normal.

“Second, Russia introduced import bans in August last year, which affected the price dynamics in the food area.” She expects that once both factors are incorporated into the prices, inflation should normalise to about 10% by the end of 2015.

Damaging recovery?

At 16.9% inflation, a deceleration in retail lending and a wage freeze for public sector employees will likely cause a decline in household consumption in 2015, according to Raiffeisenbank research, while real income across public and private sector workers is also expected to fall.

“Consumer spending is collapsing,” says Mr Kolychev. “It is already down almost 10% and it still has some room to catch up with in the decline in incomes.” This points towards a normalisation of inflation from the demand side, he adds, and since households are again saving roubles in the form of bank deposits, the Central Bank of Russia should have some scope to lower interest rates further to help support the economy.

VTB Capital expects the key rate to be lowered to 11% by the end of 2015 before decreasing to 8.5% by the end of June 2016.

There is still a long way until recovery, but experts are much more optimistic than they were in January. A full-blown banking crisis has been averted, the government’s anti-crisis package is ready to provide support for the banks, and even the oil price development seems to be supportive. Nevertheless, there remains the issue that “the faster the economy recovers, the less pressure the government faces to implement structural reform”, says Mr Lissovolik.

“In 2008 to 2009, the recovery in oil prices from $40 a barrel was very rapid, and the authorities didn't deem it necessary to engineer anything significant in that regard – we are facing the same danger today.”

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Read more about:  Central & Eastern Europe , Russia