Russia: The bear slows down

Russia: The bear slows down

Russia: The bear slows down

Global Economic Outlook Q3 2013

Higher wages and consumers’ willingness to borrow have made Russia’s consumer sector a growth driver. But the outlook is uncertain due to tighter lending and muted global demand for commodities.

GEO Q3 Russia

Russia is entering a new phase of economic uncertainty. GDP growth is slowing, and extraction industries are suffering a decline due to muted global demand for their commodities. Russia’s continued dependence on commodities has come at the expense of other sectors where both domestic and foreign investments have suffered. Meanwhile, to counter the slowing economy, any fiscal response has been complicated by a probable deterioration in the budget balance in Q1 2013. In such a scenario, monetary policy easing would have helped, especially when businesses are complaining about the high cost of financing. Unfortunately, with inflation high, any immediate rate cut is not likely. The only silver lining for the economy is the strength in private consumption expenditure, which has been boosted by low unemployment, rising incomes, and access to consumer credit.

Commodities and investments have been a drag on the economy

Russia’s dependence on commodities has proved to be a bane this year, especially with slowing demand from key markets. Commodity prices have fallen as Eurozone weakness continues, US recovery is muted, and growth falters in key commodity-importing emerging markets—primarily China and India. For example, Urals crude, the country’s main export blend, averaged a little less than $111 a barrel in Q1 2013, about 5 percent down year-over-year (see figure 1).

Figure 1. Crude oil price and industrial production growth

No wonder then that resource extraction—oil, gas, coal, and metals—was the key drag on the economy in Q1 2013, declining 4.9 percent year-over-year. This in turn dragged down real GDP growth during the quarter to 1.6 percent year-over-year, the worst performance since Q4 2009 and much lower than the annual 3.4 percent growth reported in 2012 (see figure 2).

Figure 2. Growth in real GDP, personal consumption, and total fixed investment (%, YoY)

Growth in gross fixed investments has fallen sharply since Q1 2012; it was a mere 0.4 percent year-over-year in Q1 2013. Slowing external demand has prompted companies, including those in the extraction industry, to scale down investment plans. High borrowing costs have not helped either. Meanwhile, with preparations for the 2014 Sochi Winter Olympics nearly concluded, construction activity has slowed, thereby weighing on fixed capital formation.

Russia’s continued dependence on commodities has come at the expense of other sectors where both domestic and foreign investments have suffered.

Private consumption will yet again be the key driver of economic growth this year

Private consumption was the key driver of GDP growth in 2012 and is likely to be so this year as well. It grew 6.8 percent in 2012, and was up 4.7 percent year-over-year in Q1 2013. Consumers have benefitted from a host of factors, including strong labor markets, rising incomes, and easy access to credit. Unemployment fell to 5.2 percent in May 2013, one of the lowest levels ever, and it is likely to remain low in the short term. Incomes have increased by about 12.5 percent year-over-year in the first five months of 2013, with real wage gains of over 5.0 percent. Meanwhile, low household debt (about 12.0 percent of GDP) has encouraged consumers to take recourse to credit for spending. Consumer lending swelled in Russia by about 40.0 percent in the past year; credit card loans were up by about 80.0 percent.

However, the pace of lending is likely to slow as the central bank has been urging banks to cut consumer lending, given the risks that such fast-paced lending pose. This is likely to marginally weigh on consumer spending growth this year. The other problem for consumers is high inflation, which is likely to dent growth in real wages, thereby weighing on consumer purchases. The impact of these and a slowing economy on private consumption is partially evident from a dip in retail sales growth (see figure 3). Sales grew 2.9 percent year-over-year in May 2013, down from 4.1 percent in April and 4.4 percent in January. Nevertheless, consumers are not likely to reduce their spending, and total private consumption growth is likely to be 4.4–4.6 percent this year. This will drive overall GDP growth of 2.2–2.4 percent in 2013.

Figure 3. Retail sales growth and unemployment

Any sharp easing of monetary policy not likely given high inflation

The Bank of Russia (BOR) kept its key interest rate unchanged at 8.25 percent for the ninth straight month in June 2013. The BOR has been hesitant to cut rates to stimulate the economy, given high inflation and strong growth in consumer credit. Inflation has been edging up since 2012 due to a rise in food prices (courtesy of a poor harvest) and strong growth in consumer demand. In May 2013, inflation accelerated to the fastest pace in 21 months to 7.4 percent, up from 7.2 percent in April, way above the central bank’s target range of 5.0–6.0 percent. Meanwhile, consumer credit and broad money (M2) growth have also been edging higher this year. M2 growth was 15.2 percent year-over-year in April, up from 11.9 percent in December 2012.

High price pressures notwithstanding, a partial loosening of monetary policy is likely in the latter part of the year. Inflation is expected to ease in the second half of 2013 due to a high base effect and a better harvest (see figure 4). This would enable the BOR to cut rates by a total of 25–50 basis points (bps) in the second half of 2012. If inflation falls below the BOR’s upper limit of 6.0 percent, another 25 bps cut cannot be ruled out. Meanwhile, a change of guard at the BOR has raised expectations of a move away from inflation bias in monetary policy. However, Elvira Nabiullina (the new chief) has reiterated that any rate cut would depend on movement in price pressures in the short term. She is also not expected to entertain calls to intervene in the currency market to make the ruble more competitive. Instead, it would be better if she focuses on formalizing an inflation targeting mechanism for monetary policy, reducing concentration of big banks, increasing regulatory supervision of non-banking financial companies, and improving information symmetry on risks and credit practices.

Figure 4. Inflation and broad money (M2) supply growth

Toward greater fiscal prudence

Fiscal consolidation is likely to remain a key theme over the next couple of years, with the government aiming for a balanced budget by 2015. Although the budget is likely to have been in a small surplus in 2012 (0.1 percent of GDP), slowing revenue flows due to dipping GDP growth and lower commodity prices are likely to push it into deficit this year (see figure 5). Of more concern is, perhaps, the non-hydrocarbon deficit, which was at 10.6 percent of GDP when the year started, much worse than the 5.0 percent medium-term target recommended by the World Bank and the International Monetary Fund. To achieve this target, the government has to find ways to cut spending, especially in the medium-to-long term. Encouragingly, the federal government has already initiated a more realistic way of budgeting spending by using the long-term average oil price, rather than the forecasted oil price. The long-term average oil price is the average price for the past five years, and this would be raised to ten years by 2018. However, this in itself is not enough to bring the non-oil deficit to a more manageable level.

Figure 5. Public debt and central government balance (% of GDP)

Tapping reserves to boost growth

With economic growth faltering, President Vladimir Putin, in a recent speech, announced plans for $43.5 billion of investments, most of it directed to infrastructure. Of this, $13.6 billion would be in the form of loans from its National Welfare Fund (Russia’s sovereign wealth fund) for three key infrastructure projects—modernizing the Trans-Siberian Railway, constructing a 500-mile high-speed rail line between Moscow and Kazan (capital of the Tatarstan region), and building a superhighway ringing Moscow. Private investments would also be invited into these projects with government guarantees to minimize risk. Although this would be a welcome boost to the economy, sustainable growth is not possible without better investment climate, economic diversification, and productivity growth. The investment plans also set a dangerous precedent of digging into the Welfare Fund, especially at a time when the government is moving toward greater fiscal prudence.

Need to improve the business climate, diversify the economy, and enhance productivity

Investor perceptions have suffered in recent years, following the seizure of large and medium businesses due to alleged economic crimes. Although the president’s recent announcement of amnesty to many of those convicted of white collar crimes would help to improve the business climate, investors are likely to wait for developments on the ground. To attract foreign investment, progress is also required on deregulation and improving transparency in business, including better corporate governance rules. Interestingly, moves to diversify the economy away from oil and gas would also boost investments into myriad sectors across manufacturing and services. A strong non-hydrocarbon economy supported by a highly skilled workforce and state-of-the-art technology is crucial for sustainable growth and healthy public finances.

Technology and skills enhancement are also important for achieving the productivity gains the country needs to stave off risks from a declining working population. Russia’s working-age population will decrease at a steady pace of 0.9 percent every year up to 2020. Combined with an already-high participation ratio, it would mean a rise in the burden of pension and health care costs on future workers, businesses, and the government. This is not possible without strong productivity gains, especially given that potential GDP growth is also likely to edge lower due to a declining labor force.


Akrur Barua

Akrur Barua is a manager at Deloitte Research, Deloitte Services LP

Global Economic Outlook, Q3 2013: Russia
Cover Image by Jessica McCourt