Change Is Coming

Change is coming

By Chris Weafer

By any measure the past three years have been very difficult for Russia, the people of Russia and, on a relative basis, for the expatriates working in the country. The economy came close to collapse, reporting a recession in each of the last eighth quarters.  Geopolitics and international headlines about Russia could hardly have been worse and, over the past twelve months in particular, Moscow and President Putin have been accused of a multitude of sins; everything from manipulating the US elections, to exacerbating the Mid-East refugee crisis to preparing for war with NATO.

So, as winter 2016 winter gives way to the spring 2017, is there a realistic basis to hope that the change in climatic conditions will be replicated in the economy and geopolitics? Might it be the case that expats travelling home for the May holidays will have to less often explain why they live is such a crazy country and, perhaps, may some of their friends, forced out because of the recession, soon be making plans to return? For once, the signs are hopeful.

Having hit a bottom with a headline recession of almost 4.0 percent in 2015 the economy spent 2016 drifting better. The preliminary estimate for 2016 shows a decline of only 0.2 percent, albeit that is after some base adjustments. Without those adjustments the contraction was still modest at approximately 0.6 percent. The estimate for January is that the economy actually grew by 0.3 percent, year on year, which confirms that the expected drift out of recession and back to growth is continuing. This year our team in Macro-Advisory expects growth to recovery to a relatively healthy 1.5 percent. I use the conditionality of relative because while 1.5 percent is the best growth number Russia has reported since 2012 it is still a long way short of being described as robust.

Part of the reason for that slow recovery is because we now actually have two distinct economies in Russia, each with separate growth characteristics. Companies in the consumer, construction and service sectors, i.e., those sectors which delivered the boom years of 2002-2008, are still in recession and are recovering at a slow and fragile pace. Retail sales dropped 5.9 percent in 2016 and the indicators are that the January decline was just under 2.5 percent. That is considerably better than the 10 percent drop in 2015 but it is still a recession. Output from the construction sector is estimated to have fallen by almost 5 percent in January, a roughly similar decline to that for 12 months of 2016. Still struggling is a good description for both sectors.

Balanced against these declines is the robust growth in sectors which are benefitting from the weak rouble, the Russian counter-sanctions and the general trend towards import-substitution. Agriculture sector output grew by almost 5 percent last year while many manufacturing sectors are also showing year on year growth.

On the geopolitical front the newsflow has also been a little calmer since the inauguration of President Trump and the whirlwind of news and accusations which almost spun into a destructive tornado in early February. Since then there has been a concerted effort, it appears by both sides, to try and calm the situation. In the Middle East the ending of the attack in Aleppo has come has a thankful relief, principally for the people on the ground, but also for foreign investors in Russia. In Eastern Ukraine the escalation of fighting, which almost always happens when there is speculation about sanctions relief for Russia, has eased now that the prospect of any sanctions adjustment has been kicked to touch.

There is of course always a fear that ‘something’ is about to start or re-start, whether in terms of political interference allegations or in the Middle East or Eastern Ukraine. But, at least as spring takes hold (or this article goes to press) it is a case of hope rising with every passing calm day.

As stated, the country is in a relatively better position today than has been the case for most of the past three years. But for an economy such as Russia, calm or modest growth is not enough. Staying in this situation for long enough will start to feel like stagnation. It is sometimes forgotten that Russia, as a modern economy, is only 16 years old – a stroppy and surly teenager. The rapid injection of almost $3.5 trillion of hydrocarbon earnings certainly fast-tracked some areas of development but by no means all. Some things, such as institutions and attitudes, need time rather than money to change.

The oil driver, as it was in the noughties, is now over. Oil revenues are certainly an important source of money for the federal budget but are no longer capable of driving higher growth. The government also does not want to even risk a return to that situation and is now pursuing a policy of trying to get the budget to balance at an average oil price of $40 per barrel. The so-called Fiscal Rule means that any tax revenue earned from the higher oil price, as is the case today, will go to reducing the deficit and, later, to rebuilding financial reserves. It will not be spent. At least that’s the plan.

In general, the message from the government and from the administration in the Kremlin is that fiscal policy will remain very conservative in the years ahead. It means that despite the fact that the Russian state has an almost negligible external debt load, there is no intention to rebuild debt and expand budget spending. This has been a frequent response from many governments in emerging markets over the years, i.e., borrow to spend your way to recovery, but it will not be Putin’s way. You don’t borrow money from strangers is one of his convictions, a conviction which saved Russia from a deeper crisis in 2014-15.

Another legacy from the crisis is the localization strategy. In essence this is the programme to reduce the country’s reliance on imports and to diversify exports by persuading investors to manufacture in Russia. But for that to happen the economy must remain competitive and that means the rouble must stay very close to 60 against the US dollar, or worse, and the taxation mix will shift from the corporate sector to a rising burden for individuals and households. The days of a 13 percent flat tax on all earnings are almost over.

Reform is such a discredited and almost meaningless word. Instead we should focus on the practical and pragmatic changes which are necessary to shift the economy from the stagnation it is now drifting into, and to push it onto the next phase of growth. The evidence emerging is that the government is finally serious about these changes, not least because the consequence of stagnation may, over time, be a disruption in the social-political stability the country has enjoyed since 2000.

By definition, emerging economies are fast changing. Russia is amongst the fastest to change because of oil and politics. Of course, this can be for the better or worse as we have seen since the early 1990s. But for now, as we look forward to brighter, longer and warmer days, there are more reasons to be hopeful than fearful. The caveat, which must be clearly stated, is that there cannot be a return to the old boom days. They are gone for good. The future is a long and slow slog upwards, at best. But at least that is better than the horizon of this time last year…