Russia: To China with love

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Russia: To China with love

Russia: To China with love

Global Economic Outlook, Q3 2014

Tensions with the West have scared away investors, weakened the ruble, and forced the central bank to raise rates. A large natural gas deal with China is nudging Russia closer to lucrative markets in Asia, which might hold the key to Russia’s long-term economic progress.

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In May, Russia’s Gazprom signed an agreement with China National Petroleum Corporation to supply 38 billion cubic meters of natural gas annually from 2018 for 30 years. The deal, estimated at about $400 billion by analysts, marked a shift away from Russia’s dealings with the West amid growing geopolitical disagreements with the United States and Europe. Western sanctions, albeit minor ones, on Russia over Ukraine perhaps added to the urgency of closing the deal during President Putin’s recent visit to China.

For Russia, the gas deal could not have come at a better time. Tensions with the West over the crisis in Ukraine have scared away investors, weakened the ruble, and forced the central bank to raise rates. Add to this slowing economic growth, and one can imagine policymakers’ relief at closing the deal with China. The deal also nudges Russia closer to lucrative markets in Asia. Better economic relations with countries like China, India, Japan, and Indonesia might just hold the key to Russia’s long-term economic progress.

For Russia, the gas deal could not have come at a better time. Tensions with the West over the crisis in Ukraine have scared away investors, weakened the ruble, and forced the central bank to raise rates.

China-Russia gas deal may have wide implications

The price of gas under the Russia-China deal has not been revealed yet. Analysts believe that it could be $10–10.5 per million of British Thermal Unit (BTU), lower than what Russia charges Europe and well below the current $13 (average) spot price for Asia. For Asian importers, this is a positive development. It is also a move away from the monopoly of Middle Eastern and Central Asian suppliers, thereby opening up more opportunities for Russia in the region. For example, Japan, South Korea, and Taiwan could emerge as potential buyers. Japan, which imported about $70 billion of natural gas last year, has already evinced interest with lawmakers, urging the government to speed up the process.

For Russia, the deal with China is likely to boost infrastructure investments in oil and gas. As part of the deal, Gazprom is likely to receive $50–55 billion of credit from China to invest in pipeline and related infrastructure. This is much needed foreign capital, especially at a time when Western investors are turning their backs. Chinese firms are also eyeing other investments in Russia; stakes in Gazprom’s Vladivostok LNG terminal and in Russian oil company Rosneft could materialize soon. For Gazprom, credit from China will likely boost the company’s capital position. Surprisingly, Gazprom investors do not seem to be too enthused by the deal; the company’s stock is down 2.5 percent since then.

The Russia-China deal is also a break from the past when both countries did not often see eye to eye. This was particularly so when the Soviet Union was in existence. Evidently, times have changed. For Russia, the deal is a means to diversify its hydrocarbons customer base amid political rivalry with Western Europe, its main export market. Interestingly, the deal could nudge the United States to rethink its policy on energy exports. If the United States starts exporting natural gas to allies in Europe, it would lessen the latter’s dependence on Russia.

Russia Figure 1

Economic growth continues to falter

GDP growth fell to 0.9 percent year over year in Q1 2014 from 2.0 percent in the previous quarter on the back of slowing consumption growth and a dip in fixed capital formation. On a quarterly basis, the economy contracted 0.5 percent. The Ministry of Economy has warned of a possible recession by the end of the second quarter.1 The ministry’s pessimistic view is in line with the International Monetary Fund’s (IMF’s) outlook for the Russian economy. The IMF recently cut its growth forecast for 2014 to 0.2 percent from an earlier estimate of 1.3 percent; this was the fourth consecutive downward revision.

Fixed investment was the hardest hit in Q1 2014, contracting by an estimated 3.1 percent year over year relative to a 0.5 percent rise in Q4 2013.2 Consumer expenditure, which has been a key driver of the economy in recent years, also faltered during this period with growth slowing to an estimated 3.0 percent from 4.1 percent.3

Russia Figure 2

Outlook for investments remains negative

The dip in investment in Q1 2014 is not surprising, given sharp outflow of capital and reluctance of foreign firms to invest in the country. In a recent note, Vienna’s Institute for International Economic Studies stated that foreign direct investment (FDI) into Russia is expected to fall by about 50 percent this year to $41 billion.4 What adds to the problem is the country’s poor track record of protecting investors. In the World Bank’s doing business rankings, Russia ranks a low 115 among 189 countries in the sub-index of protecting investors.5

Domestic investment has also suffered as state-owned enterprises cut down on their investment plans. A tight monetary policy regime has not helped either. Unfortunately, the ruble’s weakness has not translated to higher exports. This is not surprising since exports are dominated by hydrocarbons, which are priced in US dollars. The latest data from the manufacturing purchasing managers’ index indicates that export orders fell yet again in May; it has been on a downward trend since September 2013. With the overall scenario not likely to change much, fixed investment growth will likely remain negative in 2014. The gas deal with China is not expected to impact investments this year.

All’s not well with personal consumption

Personal consumption in Russia appears to be running out of steam. Although low unemployment (4.9 percent in May) has ensured that wage gains remain solid, high inflation and a tightening credit market seems to be weighing on consumer confidence. Consumer sentiment fell for the fourth straight month in May with high inflation and rising cost of borrowing weighing on consumers’ ability to purchase goods and services.

Declining consumer confidence is also evident from data on retail and auto sales. Retail sales growth fell to 2.1 percent year over year in May from 2.7 percent in April. Cars and light truck sales contracted 8 percent in April, continuing from an average 2 percent decline in Q1 2014.

Given that the macroeconomic outlook is not likely to change, consumer expenditure will remain subdued for the rest of the year. The segment is expected to expand by only 1.0–1.5 percent in 2014, a far cry from the strong growth rates witnessed in previous years (7.9 percent in 2012 and 4.7 percent in 2013).

Russia Figure 3

Ruble weakness continues and S&P cuts Russia rating

The currency’s weakness is not likely to go away in the coming months, at least not until the Ukraine crisis is over. Despite a mild recovery since March, the ruble is still down about 5.6 percent against the US dollar this year as foreign capital moves out. While the West has imposed only minimal sanctions—asset freezes and visa restrictions on people and firms close to President Vladimir Putin—the mere threat has been enough to scare off investors. According to data by the Bank of Russia (BOR), capital outflows amounted to about $68 billion in the first four months of 2014.6 The IMF expects this to increase to $100 billion by the end of the year.7

Equity markets seem to have left behind some of the woes of March, regaining lost ground since then. Surprisingly, this is despite a rating downgrade by Standard & Poor’s (S&P). In April, S&P cut Russia’s sovereign debt rating by a notch to just one level above junk. The rating downgrade indicates heightened risk perceptions about Russia despite a current account surplus and healthy public finances. For Russian firms, the rating downgrade could lead to a hike in borrowing costs. This comes at a time when ruble volatility has already deterred domestic companies from borrowing in Western markets where cost of capital is relatively low.

BOR holds firm and rightly so

Ruble weakness has been a key factor in keeping inflation high and weighing on consumer spending. So far, the 2 percent hike in the policy rate by BOR this year has not helped much. Inflation rose to 7.6 percent year over year in May 2014 from 7.3 percent in April; May’s reading was the highest since August 2011. Apart from ruble depreciation, high food inflation (9.5 percent in May) has also pushed up overall consumer prices. Meat prices shot up due to a ban on imports from the European Union after reports of swine fever in Lithuania and Poland.

For the central bank, the worry is that even if the ruble strengthens and food prices ease, the pressure from aggregate demand on inflation will continue. For example, the labor market is tight, and capacity utilization is high relative to the historic average. In such a scenario, BOR is not likely to reverse any of its interest rate hikes this year. Monetary policy is set to remain tight with any loosening not likely before Q1 2015.

Russia Figure 4

Passage to a better future

The gas deal with China is not a panacea for what currently ails Russia’s economy. Russia needs a tough dose of reforms along with efforts to prop up physical and human capital. Most importantly, it needs to boost free market policies, the absence of which has dented manufacturing competitiveness and made the country ever more dependent on oil and gas. Hydrocarbons have a role to play: they can aid the economy and provide much-needed capital, but the sector cannot be a substitute for a diversified economy.

This assumes even greater importance, given the threat to potential GDP from an expected decline in population. According to Oxford Economics, the working age population in Russia is expected to decline at an annual rate of 0.9 percent between 2013 and 2017.8 Expanding geographical boundaries is definitely not a solution to this. Instead, Russian policymakers need to focus on the long term. Hopefully, the gas deal will encourage more ideas. Most importantly, even as the country taps opportunities in the East, Russia needs to mend fences with the West for global economic and political stability. If Russia moves positively, it could indeed foster the winds of change that the world is waiting for.

Russia Figure 5

The gas deal with China is not a panacea for what currently ails Russia’s economy.

Endnotes

View all endnotes
  1. Bloomberg, “Russian GDP growth slows as investment sags on sanctions,” May 2014.
  2. Oxford Economics, “Country economic forecast: Russia,” June 2014.
  3. Oxford Economics, “Country economic forecast: Russia,” June 2014.
  4. Bloomberg, “Russian FDI to Fall 50% in 2014 on risk, institute says,” May 2014.
  5. The World Bank, “Ease of doing business in Russian Federation,” 2014, http://www.doingbusiness.org/data/exploreeconomies/russia.
  6. Reuters, “Russian economy to grow by 0.5 percent in 2014: Central bank’s Nabiullina,” May 2014.
  7. Reuters, “IMF cuts Russia growth outlook, cites Ukraine risk,” April 2014.
  8. Oxford Economics, “Country economic forecast: Russia,” June 2014.

About The Author

Akrur Barua

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

Russia: To China with love
Cover Image by Jessica McCourt (Cover), Maria Corte Maidagan (Russia)