Never Waste a Good Crisis


Selection_060“Men and nations behave wisely when they have exhausted all other resources” is a quote often incorrectly credited to Winston Churchill but which was actually delivered by Israeli politician Abba Eban in 1967. It certainly summarizes a core part of human nature which is the effort many spend trying to avoid taking unpleasant actions when easier short term solutions are available. That is until the point is reached when all the easy alternatives have been exhausted and only the tough course remains.

The Soviet Union reached that point in 1991 while Russia was forced into making country transforming changes in 1998/’99. The question now is whether this current economic and geo-political crisis also represents a sort of T-junction when the country, unable to stay on its previous course, must take a left or right turning? The adjunct question is whether this crisis is of sufficient magnitude to force changes in a timely manner or whether the present situation can drag on for many more years before eventually leading to change?

There has been a lot of recent optimism that the economic crisis has peaked and the country is now out of danger. Certainly the data for the first four months of the year is encouraging for that viewpoint. From January to end April the rouble rallied by almost 20 per cent against the dollar and by over 25 per cent against the euro. The RTS equity index rose by over 40 per cent, the best performing major index in the world, and debt market investors shrugged off the credit ratings downgrade by Moody’s and S&P to also record an impressive price recovery. The headline macro picture was also relatively good, pointing to a 1st quarter GDP decline of just over 2 per cent compared to the same period of 2014. The mood of optimism also stretched to the Central Bank which cut its benchmark interest rate at three consecutive meetings, to end April at 12.5 per cent from 17 per cent at the start of the year.

That’s an impressive performance especially when compared to the many predictions of an economic collapse and credit defaults widely touted towards the end of last year. But it also removes the immediate sense of urgency to start forcing through changes to both the business environment and investment climate which many have been hoping to see for a long time. The fact that the price of oil has also defied gloomy predictions and has been recently trading in the $65 to $70 per barrel range also helps stabilize the economy and the rouble but works against the interests of the reformers.

However, the strength of the positive momentum cannot last. The rouble was pushed higher with several Central Bank and Finance Ministry actions which are short-term in nature and, besides, several ministers are already complaining that the rally was overdone and the rouble, when trading close to 50 against the dollar, was damaging recovery prospects. Near term an exchange rate clinging to either side of 55 to the dollar is to be expected. The oil price will also have more of an impact than seen in the February to April period. At Macro-Advisory we hold an end year rouble-dollar exchange rate at 65 because of the peak external debt repayments period at year end and because we expect the economy to continue sliding and end with a contraction in GDP of 3.5 per cent. The year-end rouble-euro rate will be a derivative of the dollar rate and determined by whether the US Fed finally starts to raise interest rate and/or the Eurozone solves its internal problems.

The danger is that the government is satisfied not only with a frozen conflict in eastern Ukraine, as the lesser of evils, but also with a sort of frozen economy. The threat of a collapse has been avoided and remains perfectly avoidable until past the next election season which comprises the Duma elections in December 2016 and the presidential election in March 2018. If the tough decisions, which include tax rate changes and to the pensions system and retirement age can be kicked past spring 2018 then very few politicians in the world would do otherwise.

It means that while the economy can avoid a steep and immediate crisis it faces, almost at best, a several year period of very low growth in the range 1 to 2 per cent. For an economy at Russia’s stage of development that is borderline stagnation. That is the real crisis and the one which the Kremlin will eventually be forced to react to rather than to the destruction predicted for this year.

Selection_061To better understand the nature of this particular crisis it is worth placing it into two separate contexts, one economic and the other political. For the economy the base issue is that the reason for the strong growth recorded from 2002 to 2008, and the driver of the recovery in 2010 to 2012, was the rapid expansion the consumer and related service sectors. The $3 trillion of oil and gas export earnings had a strong influence via the budget spending and so-called trickle-down effect but, of itself, it was not the main driver of headline growth. That became obvious during 2013 when growth started to slow even though the oil price averaged close to $110 per barrel. Even President Putin was forced to acknowledge that this phase of growth was over in Russia and the economy needed to find a new driver of growth based on a much higher volume of investment. That was the economic backdrop coming into the 2014 crisis and remains unchanged today. It will remain the core problem even if oil stabilizes at a higher price and sanctions start to ease later this year.

The geopolitical context is also relevant to the position in which Russia now finds itself. For the past two decades the country has been very western focused and the majority of investment and expertise has come from that direction. That relationship has now been severely reset if not altered for many years to come. Certainly past 2024 assuming Vladimir Putin is returned to the Kremlin in 2018. The Kremlin is now much more active in building political and economic ties with China, southern Asia and amongst the other so-called BRICS nations. The push to create the Eurasian Economic Union, as evidenced by the many concessions agreed by Moscow, is also part of the Kremlin’s wish to see a multi-polar world in terms of political and economic power.

It is already clear enough that while Russia has definitely shifted its political alliances and it will get some inward investment from China, in particular, this will be limited in size and scope. Beijing makes no secret of its interest in investment in extractive industries and transport infrastructure but little else. To advance the economy to again achieve 4 per cent, or better, growth and to see meaningful progress in such areas as import-substitution, the theme-slogan of this particular crisis, Russia needs to retain the involvement of experienced western companies. And to be fair, there is absolutely no evidence that the reset in politics is disadvantaging any western company working in Russia today. If anything, the evidence suggests that those who commit to staying and investing will be able to drive some deals or resolve problems, which previously might have been difficult.

I remain optimistic that, with an historical perspective, the crisis of 2014-15, will be viewed as a critical turning point when the government finally started to get more serious about improving the business and investment climate and the frustrations of reformers started to ease. As an economy Russia will never again deliver the high growth rates which some industries, especially in the consumer and services sectors, enjoyed over the past dozen years. Some new industries, such as online retailing and other technology based services, probably will for many years to come. The economy is, however, perfectly capable of delivering above developed market average returns for most businesses. The precondition for that is, when the T-junction is finally reached, the country turns in the direction of an improved investment environment and continued openness to western businesses rather than in the direction of nationalism and isolationism. For me the main question is not which direction but whether it will take the crisis of 2014-15 to reach that point or the crisis of 2013-2018?