Russia: Marching backward

Russia: Marching backward

Russia: Marching backward

Global Economic Outlook, Q2 2014

Even before the recent political crisis, Russia’s economic performance was modest at best. High inflation, a declining currency, and constraints on monetary policy are also taking a toll on economic performance.


Economic growth declined for the third straight year in 2013 and was also much lower than President Putin’s 5 percent target set in 2010.

Russia’s intervention in Crimea has dominated airwaves in the past few weeks. It has raised tensions in Europe and forced geopolitical risks back to the center stage of the global economy. For Russia’s economy, the move could not have come at a worse time. Economic growth declined for the third straight year in 2013 and was also much lower than President Putin’s 5 percent target set in 2010. The scenario looks bleak this year as well, especially due to the Crimean venture. Equities are down, the ruble is much weaker, interest rates are up, and inflation is still high. In fact, things could get worse if sanctions are imposed by the West. While growth will be a casualty in that case, of greater worry is a possible isolation of Russia in the global economic order.

Growth disappoints yet again

In Q4 2013, Russia’s economy grew only 1.2 percent year over year, pulling down annual GDP growth for 2013 to just 1.3 percent from 3.4 percent in 2013. A subdued commodities sector was one of the key contributors to slowing growth in 2013. For example, the price of Urals crude dipped by 2.2 percent in 2013 compared to a 1.1 percent rise in 2012. During the same period, commodity exports growth (in dollar terms) fell to –0.9 percent from 2.4 percent.

Slowing investments have not helped the economy either; gross fixed investments fell last year after a strong rise of 6.4 percent in 2012. Investments suffered due to lower spending close to the Sochi Olympics, reduced investment by state-owned companies (SOEs), poor company profits, and lower foreign direct investment (FDI). Most worryingly, household spending—a key growth driver in recent years—expanded by just 4.7 percent in 2013, down from 7.9 percent in 2012. Households seem worried by high inflation, rising debt, tight monetary policy, and slowing economic growth.

Russia Figure 1

Russia Figure 2

Prospects not bright for consumers

High inflation is a major factor weighing on consumer spending. Annual inflation in 2013 was 6.8 percent, up from 5.1 percent in 2012 and way above RCB’s 4 percent target. High price pressures have dented real wage gains despite a rise in nominal wages due to a relatively tight labor market (unemployment was 5.6 percent in January 2014). Real disposable income grew 3.3 percent in 2013, down from 4.6 percent in 2012. This, in turn, weighed on consumer confidence, which fell in Q4 2013 for the second straight quarter.

Sentiments have not improved this year, and things are likely to get worse given current tensions in Crimea. The ruble’s fall is likely to keep inflation high while the Bank of Russia’s (BOR’s) rate hike will dent credit demand. Economic sanctions by the United States (US) and the European Union (EU) would make the situation worse. In such a scenario, household spending will remain subdued in 2014; it will likely grow at just 2.0–2.5 percent with strong downside risks if the conflict in Crimea escalates.

Russia Figure 3

A falling ruble forces monetary tightening

On March 3, the day Russia intervened in Crimea, the ruble fell 2 percent against the US dollar (see figure 4). Currently down 10 percent, the ruble is one of the worst performing emerging market currencies this year. The ruble’s fall has forced BOR to intervene (see figure 5). On March 3, it hiked the policy rate by 150 basis points (bps) and changed the rules for the ruble’s managed float. It also spent an estimated $10 billion of reserves to defend the ruble. BOR’s intervention in currency markets is not surprising given that a weak ruble kept inflation high in 2013 despite tight monetary policy.

Late last year, it seemed likely that BOR would lower its policy rate (then at 5.5 percent) in 2014. In contrast, rates were hiked with more tightening likely if possible sanctions lead to further capital flight. Even if normalcy returns to financial markets, BOR is not likely to ease rates by more than 50 bps. From an institutional perspective, the recent crisis has dented BOR’s progress on two critical objectives: a pure inflation targeting mechanism by 2015 and a flexible exchange rate system.

Russia Figure 4

Russia Figure 5

Rumble in equity markets

The ruble is not BOR’s only worry. The impact of the Crimean crisis on financial markets has been equally bad. For example, on March 3, the benchmark MICEX fell 11 percent, leaving investors poorer by $60 billion. By March 14 (two days before the Crimea referendum), the MICEX fell to its lowest level since October 2009 (see figure 6). By that time (from February 28), the top 50 companies has lost about $110 billion in market capitalization.1 The downtrend is not expected to end there; an escalation of the conflict will push equities much lower.

The vulnerability of Russian equities is due to the large share of foreigners (more than two-thirds) in freely traded shares; the United States, which favors sanctions, accounts for 40 percent of these. According to the Deputy Economy Minister, capital outflows from Russia could amount to $70 billion in Q1 2014; this is higher than the $63 billion figure for the whole of last year.2 Any escalation of the conflict and resultant sanctions could make this worse while also making it harder for Russian companies to raise funds abroad.

Russia Figure 6

Russia Figure 7

Bond yields move up, but healthy fiscal and external balances will help

Bonds markets have not escaped the Crimean turmoil. The benchmark February 2027 security saw its yield rise on March 14 (two days before the Crimean referendum) to a record 9.6 percent. Yields have risen by more than 120 bps so far this year. Credit default swaps for Russian federal government debt has also risen during this time. This is not surprising given market anxiety over the current tensions. In fact, among the 31 countries in the Bloomberg’s Emerging Market Local Sovereign Index, Russia has fared the worst this year.

For now, despite rising yields, Russia can breathe easy due to healthy public finances and external balances. Total public debt is low (8 percent of GDP in 2013) with the government budget at a small deficit (–0.5 percent of GDP in 2013). External debt is manageable (25 percent of GDP in 2013) with average maturity relatively long at about 15 years. On the external front, the current account is still in surplus (1.5 percent of GDP in 2013) despite deterioration in the last few years. Foreign reserves are also high at more than $500 billion, offering imports cover for 16–17 months.

Negative scenario for FDI and investments

The crisis in Crimea has also reinforced opinion that Russia is a difficult place to do business. In 2013, net foreign direct investment (FDI) outflow was about $12 billion, down from a net inflow of $2 billion in 2012 (see figure 8). This year, outflows will increase if the West imposes sanctions and Russia reacts by nationalizing foreign assets. This does not bode well for investments in the country, given that major SOEs have slashed their capital expenditure plans. The private sector is not likely to step in, given the political climate and rise in interest rates.

In such a scenario, fixed investments will likely rise by a mere 0.5–1.0 percent this year. This, in turn, will impact industrial production, which fell 0.2 percent year over year in January 2014, reversing a mild gain in the previous month. While rising global growth could have been a positive for domestic industry and investments, Russian firms (especially in manufacturing) will not benefit given their declining competitiveness. In such a scenario, growth in industry will be subdued at 1.5–2.0 percent in 2014.

Russia Figure 8

Trade links under threat

The Crimean misadventure does not augur well for Russia’s exports, especially if sanctions are imposed. Currently, the European Union accounts for more than half of Russia’s exports; if the European Union imposes sanctions, exports will be hit. The crisis will also negate the gains Russia made after its accession to the World Trade Organization (WTO). Already, the United States has put trade and investment related talks with Russia on hold with Europe likely to follow suit.

Russia could react to possible sanctions by restricting natural gas exports to Europe. Currently, Russia accounts for more than 25 percent of Europe’s demand.3 However, any restrictions on gas exports to Europe are likely to be counterproductive. First, natural gas stocks are currently high in Europe after a relatively mild winter. Moreover, other gas-rich European countries are likely to pitch in to reduce the shortfall. Second, Russian threats could just be the catalyst that prompts US lawmakers to ease natural gas exports; this is likely to benefit both Europe and the United States while denting Russia’s long-term prospects. Finally, foreign funds and expertise in Russia’s oil and gas sector will be hit, thereby making exploration and production in areas like the Arctic more difficult, especially at a time when oil production in Russia has peaked.

Russia Figure 9

Not much to hope for the short term

For the past few years, economists have been sounding the alarm bell for the Russian economy. Key concerns include the country’s overreliance on commodities, its low share of investment in GDP, adverse business conditions, and unfavorable demographics. So it was not much of a surprise when in January 2014, the RCB forecasted a growth of just 1.5–1.8 percent for 2014. But, the crisis in Crimea is likely to push growth further down to 0.5–1.0 percent this year; sanctions could force the economy into a contraction. In addition to slowing economic activity, Russia’s policymakers should be more worried about the crisis’s long-term impact on the country’s position in the global economy. Any isolation in the global economic community will mean that Russia cedes further ground to more agile competitors, and it will be hard to reverse these losses.

For the past few years, economists have been sounding the alarm bell for the Russian economy.


View all endnotes
  1. “Russians fret about economic impact of sanctions over Ukraine,” Wall Street Journal, March 2014.
  2. “Russia Faces Recession Risk as Capital Outflows Bleed Economy,” Bloomberg, March 2014.
  3. “Europe less reliant on Russian gas through Ukraine,” Reuters, March 2014.


Akrur Barua

Akrur Barua is an economist and a manager at Deloitte Research, Deloitte Services LP.

Russia: Marching backward
Cover Image by Jessica McCourt (Cover), Maria Corte Maidagan (Russia)