OUTLOOK 2013: Confused picture for Russia (Part 1)

(Business New Europe – bne.eu – Ben Aris in Moscow – December 22, 2012 – click here to see original article with charts)

Overview

The world and Russia both passed through the trough of the global crisis in 2012, say investment banks in Moscow, and the question for 2013 is: if the upswing starts, how fast will it go? Going into 2013, the world should start to recover, which will lift the Russian economy over the course of the year, but the speed will depend heavily on what happens in the rest of the world.

Externally, analysts are expecting the US to successfully negotiate the fiscal cliff and the economy was already starting to grow close to long-term trend by the end of 2012, according to Goldman Sachs. Europe will take a little longer to recover as its problems are worse, but should reach long-term trend growth rates by the end of 2013 or the start of 2014, the bank said. However, even in Europe economic growth was starting to accelerate by the end of 2012. In the US, most of the problems are purely of a fiscal nature whereas in Europe there are deeper structural problems to overcome.

Russia will be one of the better performers amongst the BRICs and the pattern of growth should mirror 2012: the economy will start the year with growth of about 3% but accelerate in the second half, as the growth drivers of investment and low inflation kick in.

There is a wide disagreement amongst the observers over how strong in the second half will be, ranging from Goldman Sachs that says it will be strong and driven by investment, to Danske which believes it will be modest and driven by consumption.

There is a chance for surprises as the Krmelin has launched a comprehensive package of reforms and a high-profile anti-corruption campaign. However, most analysts are taking a wait-and-see posture to these. Of the reforms that the government has made, the most advanced and effective are all in the fiscal sphere. The Central Bank of Russia (CBR) has changed over to inflation targeting so the ruble is a de facto free floating currency now. Capital market reforms will kick in from January opening Russia up to investors from the rest of the world that most are expecting to translate into some $20bn of fresh inflows.

First quarter trough, second half acceleration

Russia always seems to have a game of two halves, but 2013 in keeping with the preceding one looks more likely than any of the preceding three years to have a strong second half.

There is no disagreement amongst analysts that the first part of 2013 will be difficult for Russia. The economy was already slowing sharply in the second half of 2012 and this sluggishness is expected to spill over into the start of 2013.

“We believe that economic growth will stabilize at 3% year-on-year in 2Q13 provided that key risks (economic deterioration in Europe and the fiscal cliff in the US) do no materialize. Therefore, Russia’s economic expansion will stay ahead of developed countries and Eastern Europe, keeping pace with emerging markets such as South Africa, Brazil and Turkey,” says Uralisb.

Uralsib’s prediction of growth slowing to 2.5% in the first quarter of 2013 but then accelerating to 3.5% by the end of the year is pretty typical.

“Weak consumer demand will lead to a deceleration in industry to 2.5% year-on-year in 1Q13 (we expect industry to grow 2.8% year-on-year in 2013). While resource extraction and utilities will continue to grow 1-1.5% year-on-year in 2013-15, manufacturing will decelerate more significantly ­ to only 3.5-4% year-on-year from the current 4.5% year-on-year (in 9M12),” the bank said in its end of year summary.

The key factors behind a manufacturing slowdown (beyond weak demand) are a deceleration in corporate credit growth to 13-15% year-on-year in 2013-15 (from 17.7% year-on-year in October), lack of free production capacity, and deteriorating demographics.

“We believe that stable retail credit (20-25% per year) and real income (4-5% per year) growth will sustain retail trade growth of 5-6% year-on-year in 2013-15. In addition, stable credit and real income growth will support transport, communications, and banks,” say analysts at Uralsib.

Goldman Sachs is an outlier in expectations for the second half of the year in that it expects growth to be much stronger at the end of the year thanks to the combination of higher than expected investment and low inflation ­ although both these numbers are being debated.

Political risk

The appearance of the protest movement in December 2011 caught the headlines, but over the last year the opposition has failed to capitalise on their strong start and protests have fizzled.

While the Russian population has become politically conscious for the first time in 20 years it is still not politically active or organised in any meaningful way. There is no unified political opposition, which has already fragmented. The attitude of the population is they want improvement and especially to be more involved in the political process, but they don’t want to jeopardise the material gains of the last decade.

The upshot is a healthy pressure on the Kremlin to respond to popular demand, but the chances of political violence of some kind of “colour revolution” are small.

Oil

There is a perennial fear that oil prices will fall and wreck the Russian economy, and while almost everyone agrees that the long-term price of oil is likely to fall to about $80 this is still several years away.

The consensus forecast for oil is about $115, although Citi are predicting $95 and the Russian budget assumes a price of $91 for oil.

However, Goldman Sachs is arguing that Russia is becoming less sensitive to the oil prices thanks to the number of new projects online or close to readiness. If there was some 5m barrels a day of recoverable oil available to tap in 2007, says Goldman Sachs, then now the number is closer to 20m barrels a day. While the supply market is still tight, the supply curve is already a lot flatter than it used to be which is adding some stability to the prices. A drop to $80 or below that some analysts have predicted looks increasingly unlikely and if the fall is to come it is unlikely to arrive before 2016, says Goldman Sachs.

“We think the oil market has peaked in 2012,” says Clement of Goldman. “It is inevitable that prices will go down but this is not likely to happen before 2016. As the supply curve is flatter the prices will remain stable or may even rise in the short term.”

Indeed, oil sector’s share of the budget has been falling: in 2012 it was 51% but this is expected to fall to 40% in 2013, simply because of the growth of the rest of the economy ­ services and retail already account of over 50% of GDP and this will continue on the back of diversification driven by consumption.

Deficit days

The government forecasts a deficit of RUB521bn for 2013 but will actually run a flat budget once the contributions to the oil reserve fund are netted out.

This deficit will be financed with a planned RUB448bn on the domestic market and another $6bn on the external market ­ both modest goals, as well as RUB387bn from privatisation, which is less certain.

The domestic borrowing target in particular looks very modest and several analysts expect that Russia will borrow nothing abroad and raise up to RUB1 trillion from the domestic markets (in which foreign investors can participate from 2013).

But with shrinking surpluses the state is clearly on the hunt for revenues. Putin has ruled out tax hikes, leaving other revenue-raising options that will have both positive and negative consequences. On the upside is a new focus on reducing graft, encouraging small business, and increasing both productivity and efficiency. On the downside, it looks like the Kremlin will cut contributions to the state pension fund and is also playing with tariffs to create more cash.

2013 budget for austerity

The 2013 budget is going to be tighter with cuts in real spending in many areas, although the contentious heavy spending on military spending will start in 2013. The Duma approved a federal budget for 2013 with a slight deficit at the end of November.

The budget calculations, based on the economy ministry’s 2013 forecast, assume a rise of 3.7% in GDP, a drop in the average price of a barrel of Urals oil to $97 (the budget breakeven price of oil in 2012 was $108) and inflation at end-2013 at 5.5%.

Public sector revenues next year are projected to grow 7­8% in nominal terms. Accounting for inflation, real growth would be around 2%. Revenues should decline slightly to less than 38% of GDP. Spending will increase about 10%, rising to more than 38% of GDP (a level still below pre-crisis levels). The public sector budget deficit is expected to come in at around 0.5% of GDP.

“We are expecting a tight budget in 2013. There was a small surplus in 2012 of 0.3% on spending equivalent of 20.5% of GDP. In 2013 the budget will be flat and a slight reduction in spending in real terms,” says Clement of GS. “It could be drag on growth, but it depends on what they do with the oil money and the reserve fund.”

The Ministry of finance has been pushing to reduce the cut off level after which oil money is freed to be spent by the govt after the reserve fund reaches 5% of GDP not the current 7% and he has already said that RUB100bn will be taken from the fund to invest into infrastructure projects. Just how this will play out is not clear yet.

Revenues & spending

Federal budget revenues next year are expected to be nearly the same as this year, while growth in expenditures will slow to a couple of percent. The lower spending growth reflects the fact that transfers to regional budgets are being cut, although a third of the federal budget spending will still consist of transfers to regions and contributions to social funds. Hikes in federal budget other spending are intended to keep pace with inflation.

Defence is the fastest growing category of federal budget spending, rising 15% in 2013 and nearly 20% a year in 2014 and 2015. Defence constitutes about a tenth of all public spending and over 3.5% of GDP. Actual defence spending exceeds the budget figure, and the Stockholm International Peace Research Institute (SIPRI) puts it at about 4% of GDP in 2011. Defence spending in 2011­2020 will be boosted by a massive upgrade in hardware and weaponry. While annual spending on armaments, equipment and facilities are not published, they are estimated to constitute about half of defence spending last year and this year.

Regional and municipal budget revenues are expected to rise over 10% next year on higher revenues from key taxes and despite cuts in transfers from the federal budget. Some observers see current regional and municipal budget estimates as very optimistic. Regional and municipal spending growth will accelerate to 13% next year due to factors such as public sector wage hikes promised by president Putin.

Revenues of social funds (Pension Fund, Social Security Fund and Health Insurance Fund), nearly 45% of which comes out of the federal budget, will rise over 10% next year. Rapid expenditure growth will continue (at 13%), reflecting increases in pension and other social spending. Social spending will remain at over a third of public sector spending, and correspond to about 13% of GDP.

Fiscal rule reduces risks to government finances

The government has introduced a “fiscal rule” which means that instead of guessing the price of oil for the next year, they average the price of oil over the last few years and use that in the budget calculations. For 2013 the price comes out at $91 per barrel, whereas most analysts predict prices well over $100.

The idea is to make the budget less vulnerable to swings in the oil price by using a long-term average. In the good years the extra revenue will be squirreled away in a reserve fund, which can be tapped in the bad years and so smooth out spending plans over the long term.

For 2013 this means that the state has imposed a measure of austerity on itself. The crisis saw oil prices fall so the average used in the budget is less than is expected on the market in 2013 hence the government has had to cut spending, which will slow growth.

“In real terms, the budget expenditure is projected to decline 2.3% in 2013: this is mainly due to lower expenditure in health care (down 14.0%), the national economy (down 9.8%), media (down 10.1%), social policy (down 4.8%) and education (down 3.0%), despite the increased expenditure on national security (up 8.7%), transfers to regional and municipal budgets (up 7.1%) and for state organizations (up 3.1%). We believe that austerity will firmly lock Russia’s economy in the so-called “inertial scenario” characterized by 3% growth and significant resource dependence,” say analysts at Uralsib.

Consumption

Much of the growth of 2012 was due to strong consumption that was in turn fuelled by a borrowing binge with growth in consumer lending running at over 40% mom. However, as 2012 came to an end both retail sales and consumer borrowing were slowing and will continue this trend in 2013, although consumer borrowing is expected to stay high and over 30%.

However, retail sales were growing much more slowly than consumer borrowing at 7% to 8%, and following in lock step the growth in pensions and wages.

Given Russian unemployment is down to 20-year lows it would be expected that wages would start to rise quickly, but that didn’t happen. It seems that a pall of gloom has settled over the population who are happy for what they have and are not pushing fro more, as a similar trend was seen in imports, which have also failed to increase with the rise in incomes or economic growth.

This may change in 2013 if confidence returns quickly and brings that “feel good factor” of a boom, but given 2013 is expected to be a transition year out of the crisis years no one is expecting this, so wages increases will continue to be modest and hold back retail turnover.

The factor that is most likely to affect retail is inflation, as this is expected to fall back towards its core rate of between 4.5% and 5.5%, which is a de facto increase income most of which will be spent by the public. Most of the inflation fall is expected in the second half the year after the harvest starts coming in, which is expected to be good at this point.

Inflation & overnight rates

Russia had a disappointing inflation performance in 2012 mainly due to a poor harvest; the CBR missed its 5-6% target and inflation came in at 6.8%.

However, prices rises were already starting to slow by the end of the year and in 2013 inflation is expected to trend down to core inflation levels of 4.5-5.5%.

More pertinent is what the CBR will do to overnight rates in 2013. The central bank hiked rates by 25 basis points in September, which main economists, worried about the effect on slowing growth, thought was a mistake. But the move was significant as it showed what the CBR’s priorities were:

1. inflation was running above the CBR target range;

2. stop commercial banks financing the consumer lending boom using repos;

3. core inflation looked like it might start rising;

4. but the CBR was most concerned to establish its reputation as an inflation fighter.

Inflation has slowed and the OFZ curve flattened in November and December by 250 basis points, plus the repos stabilised so the CBR looks to have achieved all it set out to do and set itself up for 2013.

Economists are now convinced that the tightening cycle is over and given the conflicting pressures on the currency in 2013 like a better than 2012 harvest, but hikes in tariffs and investment spending on balance the CBR is expected to leave rates where they are at 8.25%.

Balance of Payments & imports

There has been a lot of talk about the falling currency account, but while it will shrink over time Russia is still running a healthy surplus of $195bn in 2012, and will continue to do so in 2013.

One of the factors holding the balance of payments up is the slow growth of imports, which will also be slower in 2013 as inflation slows down.

At the same time there are the first signs of import substitution starting to kick in. This is most obvious in the automotive sector where the new investment deal struck with the major manufactures will lead to a ten-fold increase in domestic production over the next five years. Car sales in 2012 were at the same level as car sales in 2008 however, the volume of car imports are down by 38% this year on the level of imports in 2008.

Russia is still a very long way from meaningful import substitution, however a lot of direct investment and FDI is aimed at products in the consumer sector and this will be a ongoing trend going forward.

Capital flight

Capital outflow has been much in the press but it is largely a red herring. Some $85bn left Russia in 2011 and $60bn is expected to leave in both 2012 and 2013, but about half of this money is mere accounting as opposed to the $30bn-40bn of “real” outflows.

Roughly a quarter of Russia’s capital flight is actually profits earned by Russian companies abroad that are reinvested into their foreign assets. Another quarter has been money lent by Russian subsidiaries of foreign banks to their parents at home. And another big chunk is debt payments made by Russian companies to foreign creditors.

“The point with the currency capital flight is the same amount of money was leaving in 2007,” says Clement. “But then more foreign money was arriving so the net flows were zero. What has changed is not that Russians are taking money off shore but that foreigners have stopped bringing it onshore.”

Capital flight will only become a real economic problem if the currency account surplus shrinks too much; then it will become necessary to raise money from aboard to fill the gap.

Investment

Russian fixed investment slumped in the second half of 2012 and even turned negative in November. However, investment fell in all the BRIC markets and by comparison Russia suffered less than the others.

Despite a strong start to the year (16.6% year-on-year in 1Q12), capital investment decelerated sharply in second half of 2012. In September 2012 investment growth moved to negative territory (minus 1.3% year-on-year) for the first time since the start of 2011, when a contraction followed the sharp increase in social security tax rate. What happens to investment in 2013 will be a key factor in how the year turns out and views diverge. Goldman Sachs is expecting a significant increase in investment whereas Danske Bank says that there will be little change.

At bne we think the chances for an significant increase in fixed investment in 2013 are good for several reasons. First is the state will start investing again. In the middle of 2012 the Kremlin was clearly panicked by the prospect of a meltdown in Europe and started hoarding cash. By the same rational many companies also put investment plans on hold until the situation in Europe was clearer.

As 2013 dawns it seems the worse has been avoided in Europe and so these plans can be restarted. The Kremlin was in the middle of a big investments programme into infrastructure and the comments from ministers at the end of 2012 all indicated that hundreds of millions of dollars are being earmarked for these projects.

At the same time FDI is slowly increasing as European and international companies become increasingly aware of the size of the Russian consumer market. In 2011 and 2012 there was already a wave of big food processing multinationals moving into Russia ­ PepsiCo’s $3bn purchase of dairy company Wimm-Bill-Dann started the trend off ­ but since then companies coming into Russia are slowly moving more towards the production and manufacturing middle of the industrial scale.

Still, Russia’s companies will need a pick up in growth to be able to finance this investment: capital investment decelerated due to a contraction in corporate revenues and capital outflows and about 60% of capital investment is still financed by corporations themselves.

As 2012 came to an end there were early signs that investment was already rising on the back of a recovering global economy. Construction and cement production were rising; the PMI manufacturing index over the last three months of the year was up to 52.6 — well ahead of the 50 ‘no change’ level; and container and trail cargo were both growing in the mid teens. As 2012 was such a nervous year many of the investment projects that were delayed could start being put in place in 2013, which will add to the impetus.

At the end of 2012 capital investment was running at just under 20% of GDP, however, economist say it needs to get up to about 30% of GDP to produce long-term sustainable growth. As corporates remain reluctant to financing this investment it is currently down to the government to come up with the money, which it is doing: the state has launched a massive investment programme into infrastructure which it is hoped will bring “multiplier” effects to economic growth and encourage companies to increase their investment. However, in this area of economic activity it is still very much the government that is taking the lead.

“Russia needs to substantially increase the share of investment in GDP (to 28-30%) to improve its infrastructure, which will require about $200bn in extra capital investment per year. A sharp increase in investment can be achieved only if capital outflows, which we estimate at $75-80bn in 2012 and $50- 60bn in 2013, are replaced with capital inflows. At the same time the share of FDI to Russia remains insignificant ­ according to the balance of payments data, Russia’s non-bank sector received $47bn (2.5% of GDP) in FDI in 2011, and we estimate it at $45-50bn in 2012,” say analysts at Uralsib.