The Russian Economy: Resilience But for How Long?

19 march 2015

Sanctions and Oil Prices Are Not the Be-All

Martin Gilman is a Professor at the Higher School of Economics–National Research University, Moscow.

Resume: Even in the absence of attempts to isolate Russia politically and economically resulting from the events in Ukraine, the flight of investors from emerging markets as a class and a re-evaluation of risks in emerging markets generally have provoked a move to safe havens.

In recent weeks, an increasing number of analysts and commentators have been referring to an actual or looming economic crisis in Russia. Many compare recent developments, and especially the likelihood of a further deterioration this year, with the Russia economic crisis of August 1998. This comparison is exaggerated at best. It also distracts from the real issue that threatens the country’s future economic prospects.

THE 1998 EXPERIENCE WAS UNIQUE

Harking back to the summer of 1998, the Russian economy confronted a set of contradictory challenges. Policymakers were adamant to maintain a managed peg of the ruble at about 6 per U.S. dollar as a point of pride demonstrated by the introduction of the redenomination of the ruble on January 1, 1998, at a rate of 1 new ruble = 1,000 old rubles. In a situation in which foreign exchange reserves barely covered 3 months of imports at the beginning of the year and contagion was engendered in all emerging market economies as a consequence of the Asia financial crisis in late 1997, it was understandable that financial markets were prone to test the resolve of the authorities. Moreover, Russia’s post-Soviet public policy was work in progress and economic management was weak.

We all know what happened. On August 17, 1998, unable to roll-over its domestic treasury bonds falling due or repay them (it was even having difficulty finding the cash to pay the army), the Government defaulted on its ruble-denominated debt (totaling the equivalent of almost $40 billion). Major Russian banks, having speculated wildly using borrowed dollars, were suddenly insolvent. Futile attempts by the Central Bank, under significant political pressure from the oligarch owners of the banks, to provide liquidity then completely undermined their new objective to stabilize the ruble at about 10 per dollar. In early September 1998, the ruble was floated and depreciated gradually to about 21 per dollar by the end of that year.

IT IS DIFFERENT THIS TIME

Objectively speaking, in early 2015, the situation is not analogous and there should be few causes for serious concern at least regarding the macroeconomic balances that undermined confidence in 1998. Of course, deep-seated institutional and structural policies to raise productivity and make the economy more flexible remain woefully inadequate, but the popular view that Russia is now in crisis stems from immediate concerns about the macro side. So how to explain the histrionics by both Russian as well as foreign experts lamenting the country’s seeming descent into chaos?

The precipitous slide in oil prices is the leitmotif in both stories, as well as being too facile an explanation. Between early January 1997 and late June 1998, Brent prices fell by 56 percent. From late June 2014 to mid-January 2015, Brent oil sank by 60 percent. However, the analogies end there.

In fact, the August 1998 debt crisis was a wake-up call and some important lessons were learned by Russian policymakers. Aside from major fiscal reforms such as the flat personal income tax, centralized Treasury control of all government spending, conservative budget assumptions, and the eventual creation of two sovereign funds as a buffer from rising oil prices, the most significant change was to allow the ruble to float. This has been especially important since the acceleration in the drop of oil prices on international markets starting in late 2014. The Central Bank of Russia (CBR) introduced its move to a free-float in mid-November 2014, that is, a few weeks in advance of the scheduled change, in order to preserve its foreign exchange reserves. Such a wise decision not only recognizes that, as a price-taker in the international oil market, the ruble exchange rate would be inevitably linked to the oil price, it also broadly protected the budget since almost all government spending is denominated in rubles.

As a result of this latter move, the breakeven oil price for the budget has been reduced from about $110 per barrel to about $75 per barrel, and the budget deficit in 2015 should not exceed 3 percent of GDP even if oil remains around $50 per barrel on average.

Prudent macroeconomic policies in recent years, especially since the last oil price plunge in the latter half of 2008 (when prices fell from $141 per barrel in early July to $35 per barrel in late December), make the Russian economy much less vulnerable to external financial disruption. Most notably, unlike in 2008, the Russian corporate sector is now a net external creditor and public sector external debt is minimal.

Normally risks concerning sovereign debt are assessed by the main Western credit rating agencies on the basis of their capacity and willingness to repay their debt. From a macroeconomic perspective at least, their actions in recent weeks to downgrade Russian sovereign debt, even threatening to reclassify it as below investment grade or “junk,” look overdone. Since the sharp drop in the ruble exchange rate has shielded the government’s oil revenues in local currency, the oil shock is therefore unlikely to have a large impact on the fiscal position. And, although the foreign exchange sell-off has increased the stock of foreign exchange-denominated debt in ruble terms, the aggregate balance sheet of the corporate sector should actually improve as the stock of foreign exchange-denominated external assets is even larger. Since sanctions have made it all but impossible for Russian corporates to borrow in the West, net repayments have caused Russia’s external debt to shrink to about $600 billion from $729 billion at the beginning of 2014. In principle, Russia’s total foreign debt of $363 billion remains completely covered by CBR reserves of $386 billion in CBR reserves, once the debt is adjusted for debt in rubles (about $106 billion) and inter-company debt (about $131 billion).

Another strong point in Russia’s advantage in coping with the current oil price decline is the continuity of senior policymakers in both the Ministries of Finance and the CBR. These are people who have already lived through and managed possibly even more serious economic challenges in 1998 and again in 2008. They provide some reassurance that at least earlier mistakes in policy will not be repeated.

One of the major challenges to economic policy under current circumstances of weakening oil prices and a lack of confidence in the ruble as inflation accelerates as a result of the pass-through of the earlier, rapid ruble depreciation is how the CBR will manage the difficult trade-off between the Scylla of financial stability and the Charybdis of a tight monetary policy to stabilize the exchange rate and bring down the rate of price inflation. The weak growth prospects and a flight to quality within a banking sector with too many small banks create enormous pressure on the CBR to provide liquidity support. Yet in doing so, the monetary authorities must know that this ruble liquidity will flow into the foreign exchange market, undermining their very efforts to stabilize the exchange rate. And even though policymakers recognize that there is an urgent need to rationalize the banking sector, they are understandably reluctant to apply such a hard-nosed policy which risks a serious run on the banks. Nevertheless they need to be more ruthless in bank restructuring.

RUSSIA IS NOT ALONE

It should be stressed that, while Russian economic performance in recent months has seriously deteriorated, this should not be seen in isolation. There has been a tectonic shift in the global economy in which Russia has been adversely affected along with many other emerging market economies, especially among the energy and commodity producers. The U.S. economy, for the moment, is one of the few bright spots whereas most of the rest of the world, including China, is slowing down and, in the case of the Eurozone countries, actually deflating. Desperate monetary measures to stoke domestic demand have been employed in most advanced economies and the attempt to export unemployment via currency war, most blatant in the case of Japan, are stoking rising volatility in international financial variables.

The fear of secular stagnation, as Larry Summers, one of America’s leading economists, calls it, evokes experimentation by policymakers around the world, many with uncertain and no doubt unintended consequences. With the global context so fraught, the Russian economy is buffeted by more than the crash in oil prices as in 2008. Even in the absence of attempts to isolate Russia politically and economically resulting from the events in Ukraine, the flight of investors from emerging markets as a class and a re-evaluation of risks in emerging markets generally have provoked a move to safe havens. The U.S. dollar and American financial markets have been the principal destination for this redistribution of assets. Effectively this portfolio reallocation has impacted on the decisions of Russian investors as well as foreign investors holding Russian assets. Plunging oil prices and the ruble exchange rate have exacerbated these pressures, resulting in substantial capital outflow from Russia. 

AND THE SANCTIONS?

The economic and financial sanctions imposed on Russia progressively during 2014 by a large group of Western countries, led by the U.S., have also played a role. In part, the direct impact of the sanctions has raised the cost of capital and created uncertainties about debt roll-over as well as new financing. Even worse would seem to be the chilling effect on Western business and banks across the board in view of the uncertainty about the future path and timing of sanctions. Many accounts in recent weeks have blamed the sanctions, in conjunction with falling oil prices, on the seeming sudden deterioration in the Russian economy. It is a compelling narrative for both those imposing the sanctions to be able to claim that they are working as intended (post hoc ergo propter hoc) as well as those in Russia who would like a convenient scape-goat for the deteriorating economic situation.

Various numbers have been mentioned in Russia and abroad about the quantitative impact of the sanctions. More important, in my view, is the change in perceptions. Focusing on the Russian side of the equation, it seems that, after the initial shock effect, the economy is absorbing the impact, leading to a diversification to other markets and sources of financing. A suddenly much more competitive ruble may not do much to mitigate some of the adverse effects from the sanctions but over time it may help promote a healthy reorientation of the economy that policymakers had been reluctant to pursue. Another silver lining in this dark cloud is that not only have Russian corporates significantly reduced their foreign debt, but the sanctions have no doubt prevented them from a serious borrowing spree in low-cost dollars last year that would by now have become a huge repayment burden. And let’s be clear: if oil prices had not plunged in world markets, there would be little cause for concern in the short-term about the Russian economy. Even so, I am still not convinced that Russia will suffer more than a minor recession in 2015.

Even if some of the more dire predictions for Russia’s GDP in 2015 are realized, it should be understood that Russia would still be a major economic player in the world. It is surely wishful thinking by some in the West who act as if Russia can be safely ignored as if it were a Cuba, North Korea, or an Iran. First, the reality is that Russia is a traditional European power of more than 140 million well-educated and aspiring middle-class consumers. Furthermore, Russia is a highly globalized economy with its international trade (exports + imports) accounting for a larger share of GDP than in Brazil or the United States, and about on par with China and the United Kingdom according to World Bank data. Second, the longer Russia is ostracized by Western-dominated institutions and business, the more it will shift its economic and financial focus to Asia and other regions of the world. Over a longer period of time, much of this shift may not be reversed.

THE WORST IS YET TO COME

In any case, Russia will have to navigate a much more difficult international environment, not just because of sanctions. There is an unusual degree of fragility in the entire international monetary system nurtured by six years of exceptional policies and experimentation by central banks in most of the advanced economies.

This is not the worst challenge facing Russia. To varying degrees, almost all observers of the Russian economy blame the deteriorating situation on some combination of oil prices and sanctions. However, even a cursory view of the data is more disturbing and defies simple explanations. Perhaps the really bad news is that Russia’s poor economic performance began well before oil prices started to drop and sanctions were imposed. Real GDP decelerated to 1.3% in 2013, from 3.4% in 2012, and was slowing down in 2014 well before sanctions and especially the oil price drop. Clearly something else, more disturbing, is going on, and is being conveniently masked by oil prices and sanctions.

It is an old mantra that, unfortunately, bears repeating. Russia must diversify away from energy and raw materials to economy modeled on the use of human capital and a dynamic, productive private sector. This has been official policy at least since the Gref Plan for structural reforms was formulated back in 2000. The President, Prime Minister and other senior officials have reiterated this approach ever since and yet there is little to show for it.

The pity is that Russian policymakers limited themselves only to the necessary macroeconomic policies as a result of the 2008 oil price debacle when Brent fell by 75 percent in the second half of the year. The sufficient policies to lessen Russia’s oil dependence never happened as oil prices then bounced back up to about $70 per barrel by mid-2009, and grew gradually to the $100 per barrel range by early 2011 until mid-2014. As German Gref and Alexei Kudrin, among others, have remarked, the country avoided the tough decisions that might have lessened its dependence on oil and other commodities. Instead, its dependence grew all the greater. Some commentators have even drawn the facile comparison with the late Soviet regime, implying that the current tendency is irreversible without a change in the power structure.

What is clear is that the growth model underlying the economy in the previous decade, of using existing capacity better and expanding the services sector, has reached its limits. A dearth of productive private investment impedes progress to a new growth oriented economy. The policies needed to move in that direction are well known. These comprise, inter alia, the strict application of the rule of law and contract enforcement, an impartial and efficient judiciary, transparency in government at all levels, privatization and deregulation, and vigorous anti-corruption measures.

The concern must be that there is a manifest lack of political will to pursue the opportunity offered by recent events. Perhaps later is better than never. Maybe when the Brent price falls to $25 per barrel and stays there for a while, the attitude towards serious institutional reform will change. If not, the future prospects are indeed somber whatever the oil price or Russia’s foreign relations. On this will depend, more than anything else, Russia’s position as a world power in the 21st century.

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