Russia’s GDP is likely to plunge in 2015. Indeed, it would be prudent to expect a slump on the order of 10 percent. In many ways, Russia’s financial situation is eerily similar to the fall of 2008, when then-Prime Minister Vladimir Putin called his country a safe haven in the global financial crisis. In 2009, Russia’s GDP dropped by 7.8 percent.
In other ways, the situation seems even worse.
Macroeconomic forecasting is inadequate when major changes are under way in a country, because it is marginal and linear by nature. It is at a loss to predict the future when multiple dramatic changes of a qualitative and non-linear nature are at play; nor is it able to model the interaction between several interwoven shocks.
In late 2014, the Russian economy entered a serious financial crisis. In order to understand its likely economic consequences, we are better off looking at various scenarios, comparing what happened in analogous situations in other countries, while at the same time stressing Russia’s differences from those countries. The three key factors having an effect on Russia’s economy are the financial sanctions regime imposed on it by the United States and the EU, the effect of falling global oil prices, and poor structural economic policy.
On July 16, the United States imposed “sectoral” sanctions on Russia, including financial sanctions against major state banks. On July 31, the European Union followed suit. Initially, sanctions advocates worried that they would not be tough enough. By November, it became evident that they were stricter than anybody had presumed. The Dodd-Frank Act and similar EU regulations have reinforced the powers of U.S. and EU financial regulators, compelling international banks to exercise extreme caution. The banks’ internal due diligence departments are far more strict than the actual law, and they prevented loans to Russian companies from going through even when the transactions were formally legal, because they feared that the rules might suddenly change. Even Chinese state banks are now reluctant to lend to Russia. As a consequence, Russia has become exposed to a liquidity freeze.
A liquidity freeze or “sudden stop” of international financing is a frightful condition. It hit much of the world after the Lehman Brothers bankruptcy on September 15, 2008. The smaller and the more financially exposed an economy was, the greater the damage. Three of the worst-hit economies were the Baltic countries—Estonia, Latvia and Lithuania—which faced GDP slumps of 14-18 percent in 2009. Interestingly, these three countries had state finances that were as stellar as Russia’s, with more or less balanced state budgets and minimal public debt, before the crash, but it did not save them. Thus these Russian virtues are beneficial, but are no guarantee of financial stability. The key commonality of these four countries is that they all lacked access to international finance. For the Baltic countries, the liquidity freeze lasted only three quarters. It is likely to last much longer for Russia.
The Kremlin contends that Russia can withstand the financial sanctions regime due to its vast international reserves, amounting to $510 billion on January 1, 2014. This is a big positive factor, but it is hardly sufficient. Last year alone, Russia lost about $130 billion of its reserves, leaving it with $380 billion at the end of the year. Interestingly, the Russian authorities have delayed publication of the final number. Russia’s move to freely float its exchange rate late last year has reduced Russia’s losses of reserves, but its starting point in 2014 was lower than in 2008, when its reserves had peaked at $600 billion.
In fact, only $175 billion of these reserves are liquid and held by the Central Bank of Russia (CBR); two sovereign wealth funds, currently with holdings of $169 billion, are jealously held by the Ministry of Finance, and $45 billion of the CBR reserves consists of gold. Considering that Russia has a total foreign debt of about $600 billion, with an annual foreign debt service of $100 billion, and currently has no access to refinancing, Russia’s external financial situation is precarious, to say the least. Capital flight, bank runs, and currency runs are likely to aggravate it further. And as long as the Kremlin does not withdraw its troops and armaments from eastern Ukraine, there is no reason to anticipate that the West will ease its financial sanctions against Russia.
In the second half of 2014, the ruble-dollar exchange rate plummeted from 34 rubles on June 30 to 66 rubles per dollar on January 14. By and large, the exchange rate has fallen with the oil price. Commodity prices as well as credit expansion move in long cycles. The world has just gone through one of the greatest commodity, credit, and growth booms of all time, from 2000-2013. Last time we saw a major oil boom was 1973–80. It was followed by two decades of low oil prices.
This oil boom has lasted for even longer, which means that more investment has been made in supply as well as in energy saving. Overwhelmingly, these investments are long term and irreversible. You do not knock out the second window pane in a double-glazed window because energy has become cheaper. Nor do you reinstall obsolete blast furnaces in steelworks. As long as current costs are lower than the going price, oil producers will increase rather than reduce output as prices fall to stay in the black. A reasonable assumption today is that the oil price will stay low for a decade or so. It is reasonable to assume an average oil price of $50 per barrel in 2015, half of the price in 2014, and a commensurate ruble exchange rate of around 65 rubles per dollar.
The low oil price and ruble exchange rate will have a radical impact on the Russian economy. In 2013, Russia’s GDP at current exchange rates was $2.1 trillion, according to the IMF. Anticipating that the dollar exchange rate will be halved, the Russian economy stagnated last year and inflation peaked at 11.4 percent. Russian GDP at current exchange rates is $1.25 trillion or about 1.5 percent of global GDP, slightly less than that of Spain or South Korea. In one year, this depreciation of the ruble has reduced Russia from the eighth-biggest economy in the world to the fourteenth at current exchange rates, being also overtaken by Italy, India, Canada, and Australia.
Since oil and gas account for two-thirds of Russia’s exports, and the oil price is likely to be half in 2015 of what it was in 2014, Russia’s merchandise exports are likely to fall by one-third from around $508 billion in 2014 to $339 billion in 2015. If merchandise imports would fall by an equal amount, they would dwindle from a forecast $310 billion in 2014 to $141 billion in 2015. That would mean that imports would correspond to only 13 percent of GDP, which is rather little by international comparison. On their own, the higher import costs would only raise domestic prices by 13 percent.
These changes would be devastating for Russia. Presumably, net exports would be approximately the same, neither adding nor deducting from GDP. As Putin has pointed out, if the ruble exchange rate falls with the oil price, the impact on the state budget revenues, half of which are financed with oil taxes, would be neutral. The problem lies on the import side.
The prices of current imports are set to double with the big depreciation. For imports of manufactures, this is likely to mean a shift from high-quality goods from Europe to goods of lower quality and lower prices from China, India, and Indonesia. For basic foods, however, world market prices rule, and their prices are likely to rise proportionately to depreciation. Shortages and an inflation of 70 percent were recorded for buckwheat, an important Russian staple, in 2014. The strains on regular people’s standard of living will be considerable.
Also the state budget will suffer seriously from the rising import costs. Russia imports most pharmaceuticals from the West. The Ministry of Finance has called for initial overall cuts of expenditures by 10 percent. That is a lot, but it might not suffice to make ends meet; even so the Ministry of Finance has been forced to reduce its cuts. On December 1, Putin suddenly and to widespread surprise abandoned the long-planned South Stream gas pipeline from Russia to the Balkans through the Black Sea. He will need to call more large projects into question. But since his loyal cronies sit behind many such projects, he will need to balance economic expedience with political concerns.
The higher import costs will cut both consumption and investment, and thus output. Inflation is rising fast and, as noted earlier, has already reached 11.4 percent at the end of 2014. The CBR is perceived as hawkish, having hiked its policy rate repeatedly, as high as 17 percent in December. Meanwhile, bank interest rates have skyrocketed to 20-25 percent, which will further dampen investment and consumption.
Optimists claim that the doom-saying around depreciation has been overdone, and that Russia will benefit from import substitution as it did in 1999. Unfortunately for Russia, that is unlikely. In 1999, the Russian economy contained significant slack. Today, the labor market is tight, with the lowest unemployment since the end of communism at only 5 percent, but with high and rising inflation present. Russia’s economy is in fact overheating without any of the attendant signs of growth.
The reason for this is Putin’s overall poor structural policy, which favors state companies run by insiders that now account for half the economy. This is blocking the creative destruction that was thriving in 1999. In the wake of the financial crisis of 2008, the Kremlin simply pumped up the old state and oligarchic corporations, laying the ground for the stagnation which Russia is now struggling with. Some import substitution is inevitable, but the costs of bankruptcies in sectors suffering from the depreciation, such as the travel industry and retail trade, may be larger. The net devaluation gains are overall likely to be minimal.
Before the crisis, Russia’s banks were considered well capitalized, but now they are being exposed to tremendous stresses. The collapse of the 32nd-biggest Trust Bank at Christmas time was presumably only the beginning of a larger trend, and it cost the government $2.4 billion in recapitalization. The government has also already recapitalized the state banks VTB and Gazprombank. With the big state banks widely considered to be key elements of Putin’s kleptocratic apparatus, rescuing them all may put big holes in Russia’s public finances. BNP Paribas assesses that Russian banks are likely to need $45 billion in recapitalization in 2015.
According to the United Credit Bureau, Russian banks approved only 5 percent of loan applications in the third quarter of 2014. How can any bank dare to lend anybody in the current fluctuating situation, and why would anybody want to invest? The CBR has recorded that the share of non-performing loans rose from 5.8 percent in January to 8.1 percent in December.
An even bigger hole is the big state corporations, in particular Gazprom and Rosneft. Gazprom’s production fell substantially—by 9.2 percent—in 2014 because of its outrageous treatment of its customers. Russia’s oil production grew marginally by 0.7 percent for the year, but mainly due to Bashneft, whose production rose by 10.7 percent while the rest stagnated. Because of its success, Bashneft was summarily renationalized and is expected to be folded into Rosneft so that it can keep up its production. What private businessman would dare to invest in oil after the seemingly unjustified arrest of former Bashneft owner Vladimir Yevtushenkov?
Rosneft is repeatedly refinancing its short-term debt of $40 billion after its purchase of the best-performing oil company in the world, privately-owned TNK-BP, whose production started contracting after Rosneft chased away its outstanding managers and replaced them with its own amateurs. In early December, Rosneft’s issue of $12 billion of ruble bonds unleashed the collapse of the ruble. These two companies stand out as the major sources of destabilization of the Russian economy.
In December, the Russian economy was rocked by extraordinary uncertainty. A major source was the government, which has stopped coordinating its policymaking among its branches, with the CBR, the Ministry of Finance and the big state corporations each acting on their own. They all take orders from Putin, but they do not coordinate their policies. One consequence has been that the ruble exchange rate has swung back and forth, often as much as 5 percent a day, because one state authority or the other intervened too much or too little, while the CBR has lost its dominant role in currency intervention. The instability became so severe that many foreign companies closed their shops temporarily because they did not know how to price their goods. This continued uncertainty and instability must hurt investment severely.
President Putin even refuses to utter the word “crisis.” This is no way to run an economy, and it could end very badly. Because of lack of financing, investment is likely to fall by 25–30 percent. With an investment ratio of 20 percent of GDP, that reduces GDP by 5–6 percent.
Public and private consumption or the standard of living is likely to fall sharply, but it is difficult to predict by how much. In November, annualized real incomes fell suddenly by 4.7 percent and that was only the beginning. Particularly badly hit were workers in health care, with wage drops of 9 percent, and in education, with 14 percent. Six percent appears a minimum, that is, a decline of GDP of 4.8 percent because of declining consumption. As before, I presume that net exports will be unchanged.
That would mean a fall in GDP of about 10 percent. Admittedly, these are only informed guesses, but in the face of a radical change sensible guesses help us to land in the right ballpark, unlike conventional forecasts. Indeed, consumption may fall more.