Russia’s economy continues to stagger under the weight of subdued investment, a weak manufacturing sector, and lack of a strong reform agenda that addresses long-term productivity concerns, population decline, and overreliance on hydrocarbons. It was therefore not surprising that Q2 2013 GDP growth dipped to 1.2 percent year over year from 1.6 percent in Q1 (see figure 1). This was the sixth straight quarter of slowing growth, and it would have been worse had it not been for strong resilience in consumer spending. Meanwhile, exports continue to face pressures from a muted recovery in Europe even as slowing growth in emerging markets dent the prices of hydrocarbons, Russia’s key export item. Given these trends, Russia’s Economy Ministry has lowered its GDP growth forecast for 2013 to 1.8 percent from April’s projection of 2.4 percent. Although the ministry expects economic growth to improve to 2.8–3.2 percent in 2014, the figure is way below President Vladimir Putin’s ambitious 5 percent target.
Russia seems to be moving away from the radar of foreign investors. In addition to a slowing economy, foreign firms are faced with an elevated level of political and regulatory risk.
Investments continue to be a drag on the economy
The slowdown in investments this year shows no signs of abating. Total fixed investment fell by an estimated 0.5 percent year over year, down from a paltry 0.1 percent rise in Q1 and way below the 9.7 percent expansion in Q2 2012. Private sector investment has been hampered by high interest rates. Demand conditions also remain challenging due to restricted fiscal spending, reduced demand from Europe, and slowing trends in the consumer durables segment. For example, car sales fell 10 percent year over year in August; this sixth straight month of decline was worse than the 8 percent dip in July.
Meanwhile, industrial output eked out a marginal 0.1 percent year over year rise in August (see figure 2). Manufacturing also fared poorly during the month; the purchasing managers’ index recorded a second straight month of contraction. Worryingly, although new orders gained during the month, the rise was marginal. This does not augur well for Russia’s manufacturing sector in the short term.
Furthermore, Russia seems to be moving away from the radar of foreign investors. In addition to a slowing economy, foreign firms are faced with an elevated level of political and regulatory risk. In Q1 2013, Russia recorded a net foreign direct investment outflow of $26.5 billion, the worst figure since the breakup of the Soviet Union. Under such a scenario of slow domestic and foreign interest, fixed investment is not likely to record any growth this year. This is despite a possible loosening of monetary policy in Q4 2013 as the lagged effect of lower interest rates will not filter in before 2014.
Private consumption yet again rescues the economy in Q2 2013
Private consumption will continue to be a key driver of economic growth this year. The segment expanded 6.1 percent year over year in Q2 2013, almost the same as in Q1. A tight labor market has ensured gains in wages with a slowdown in inflation in the coming months also likely to benefit Russian consumers. Inflation has been edging lower since the peak of 7.4 percent in May, with August recording a figure of 6.5 percent. A possible easing of food prices due to a good summer harvest is likely to push inflation down further, thereby benefitting consumers. This is partially evident from an uptick in retail sales growth since May; sales rose 4.3 percent year over year in July, up from 3.5 percent in June and 2.9 percent in May (see figure 3).
Nevertheless, upbeat consumer demand is not enough to propel Russia to a higher growth trajectory. With the segment having grown steadily in the past year, the base effect is likely to work against the segment in the next 2–6 quarters. At the same time, wider concerns about the slowing economy are likely to weigh on consumer sentiment. The central bank’s efforts to stem unsecured consumer credit will also act against private consumption growth in the short to medium term.
Monetary easing in sight: Bank of Russia moves in to curb unsecured retail lending
Both consumption and investment are likely to find support from a probable lowering of policy rates by the Bank of Russia (BOR). Although inflation is still above the central bank’s upper target of 5–6 percent, and the ruble has edged lower since indications of a tapering of quantitative easing in the United States, BOR looks set to ease monetary policy to stimulate the economy (see figure 4). Analysts expect BOR to cut its policy rate by a total of 25–50 basis points (bps) in Q4 2013, followed by cuts of 75–100 bps in 2014.
Figure 4. Inflation and broad money (M2) supply growth
A concern for the central bank is the sharp growth in unsecured retail lending. So far, BOR’s measures have helped bring down the pace of expansion of unsecured loans to about 40 percent this year from more than 60 percent in 2012. However, the central bank wants to bring this down further to a more manageable 10–15 percent by 2016. A spike in unsecured consumer credit with subsequently high interest costs does not bode well for consumers and banks. According to the National Bureau of Credit Histories, Russia’s leading credit bureau, the credit health of Russian consumers fell to a three-year low in July 2013. Moody’s has also warned of rising credit risk due to a sharp rise in unsecured consumer loans, including credit cards. This could dent banks’ asset quality and force banks to infuse more capital, record greater loss provisions, and post lower profits in the coming years.
In September, BOR directed banks which issue loans at annualized interest rates of 45–60 percent to set aside a reserve fund of 300 percent of that loan’s principal—higher than the previous reserve requirement of 170 percent. This directive comes on the heels of another one in July that had hiked reserve requirements for banks that hand out consumer loans with annualized rates higher than 25 percent. BOR is also debating about whether or not to set a maximum rate that banks can charge for consumer loans.
A few baby steps to improve public finances
On the fiscal side, Russia’s overreliance on oil and gas continues, with the non-hydrocarbon deficit in 2012 at about 10.6 percent of GDP. Overall, the federal deficit is small (0.1 percent of GDP in 2012) and will likely remain close to that figure this year as well. On the negative side, hydrocarbon revenues are likely to be dented by lower crude prices this year due to slowing growth in emerging markets. The average price of Urals crude for the first eight months of 2013 was 4 percent lower than in the same period a year before.
In positive news, the country has taken a few encouraging steps to spruce up public finances (see figure 5). Tighter budget rules, including limiting the federal budget deficit to 0.5 percent of GDP in 2014–2016, have been implemented. The government is also likely to postpone some of the expenses related to the country’s $700 billion defense modernization plan. The finance ministry has also called for reforms in healthcare and pensions. As a first step, it has suggested that the growing deficit of the pension fund, which is covered by federal budget, be adjusted by raising employers’ mandatory social security contributions.
In reducing its dependence on hydrocarbons, Russia could perhaps take a cue from Mexico, where President Peña Nieto has made efforts to raise the share of taxes on GDP, reform social programs, and seek private investments in the oil sector. However, Russia faces less urgency than Mexico to reduce oil dependency, given that the former’s oil and gas reserves are significantly higher than the latter. Also, political opposition to expanding reforms in the oil and gas sector is higher in Russia. In fact, reforms that go any further than the ones already enacted in social security, health, defense, and privatization are likely to face strong opposition from the Kremlin.
Ukraine’s EU ambitions dent Russia’s Eurasian project
For some time now, Russia has been trying to prevent Ukraine from moving toward European Union (EU) accession. Instead, Russia wants Ukraine to join a Eurasian customs union that consists of former Soviet states. With energy sops failing to sway Ukraine, Russia responded in August with tough trade restrictions on Ukrainian exports. The use of harsher measures points to Russia’s increasing fears about losing influence in the region. To Russia’s dismay, Ukraine seems unperturbed. In September, the country took one more step toward EU integration by agreeing to sign a number of trade agreements with the EU. This is a blow to Russia’s Eurasian ambitions, and it has implications for the region.
Meanwhile, a spat between Russia and close ally Belarus has had a more global impact. In September, Uralkali—a Russian potash company—withdrew from a cartel (with Belarus) for potash, a key ingredient in fertilizers. Belarus reacted by inviting Uralkali officials for talks and then arresting the company’s Chief Executive Officer. This angered Russia, and it has retaliated with a number of trade-related measures. Interestingly, breakdown in cooperation between Belarus and Russia has led to a dip in global fertilizer prices. The longer it takes for any compromise to emerge, the better it is for farmers across the world.