The Welsh side of my family always used to joke about Communists, ex-Communists and Anabaptists( much crossover between all three) – they might want to share everyone’s else’s wealth, but boy they were tight when it came to their own money. The idea here is that although left-wingers might be fiscally spendthrift, at a budget level they hated spending their own money. This seems to be especially true of Russia, which is, of course, stuffed full of ex-communists (and current Communists).
It is ironic I think that the biggest wave of protests is currently over a fiscally conservative measure to increase the retirement age for citizens. Given the low life expectancy levels domestically I can see why so many are complaining but in a sense, the Russian’s are only doing what we’re all going to have to consider over the next few decades – rethink retirement and income. We’ve already had the first set of protests from France a few years back where teenagers were campaigning to keep the retirement age but we’ll see more of these problems internationally as the demographic time bomb ticks away. It seems to me that simply reneging on an implicit social contract without countervailing policy initiatives seems bound to generate tension but that’s a problem I’ll leave to policymakers.
The point here is that Russia looks to be biting the bullet – testament to the fact that its leaders are amongst the most fiscally conservative around. This isn’t a government stacked full of leftist Keynesians nor socialists. They don’t like debt, desire balanced budgets and are parsimonious on government spending except when it benefits the military or their chums.
Russia thus presents for investors a paradox. On one level, it’s a corporate governance nightmare with a host of terrible geopolitical personality disorders. On the other hand, it’s a proper functioning modern state, with an interesting consumer sector. It’s also one of the safer bets at a macroeconomic level, although the outlook is currently worsening. But even if there is an FX hit, my guess is that strong oil prices will continue to act as a balm. This benign view chimes with a recent paper from Renaissance Capital’s called “Russia: The land of contrast”. They’ve just softened their 2019 forecasts, but they are still predicting 1.4% growth and a RUB67/$ exchange rate (at a $60/bl oil price) if sanctions are unchanged. The paper looks at a number of scenarios which could hit the rouble and local asset prices, but even in their worst-case analysis, the macro shock might “be much milder than in 2009 or 2014/2015”.
On a side note, I do think that the West also needs to get smarter about its bluntest and most widely used weapon – sanctions. It feels like this is too widely used as a weapon and is hitting too many of the wrong people. I’m also really not sure that sanctions should be used as a surrogate policy for regime change. Target the very top players and work through their money laundering mechanisms but making ordinary Russians (or Iranians) pay every week seems to be a policy designed to create enemies.
Anyway back to the Renaissance note:
Russia offers the most contrasting macro story in the EM space
On the one hand, the Russian domestic macro story appears very predictable: Russian economic policy strongly prioritises stability (low inflation, fiscal discipline, reserve accumulation) over other goals. Ironically, in order to improve growth prospects, this summer authorities ended up raising VAT and halting rate cuts (which is of course rational but at first glance appears counter-intuitive). On the other hand, contagion effects from external factors are the opposite – no one is sure where the sanctions story will go.
2019 forecasts are softer even if sanctions are unchanged
We soften our 2019 forecasts due to recent capital outflows triggered by sanctions and higher VAT. In our base-case of $60/bl oil, we expect growth to decelerate to 1.4% (previous forecast: 2%) from 1.9% in 2018E (with budget changes shaving a net 0.3 ppts from growth) and the rouble to average RUB67/$. Annual inflation could almost double to >5.5% in March-April, triggering three consecutive 25-bpts rate hikes to 8.0%. However, if the oil price remains at $80/bl and there are no new sanctions, we believe rate hikes can be avoided. In 2020, we forecast 2.4% growth recovery, supported by a revival in domestic demand as well as an increase in the retirement age, a stable currency, 4% inflation and rate cuts, even if the oil price remains unchanged at $60/bl.
What could the impact be of potential new sanctions?
The major risk we see is the sanctioning of newly-issued state debt. We do not think this is likely but consider two risk scenarios for 2019: in a ‘soft’ scenario, we assume that non-residents reduce their exposure to previously-issued OFZs to 2Q15 lows (18% of the market), which would accordingly trigger additional outflows. A total >$40bn extra of capital outflows would weaken the year-average exchange rate by 7-10% (the short-term impact would be more significant), to RUB67-74/$ at $80-60/bl oil, but growth would remain positive. In a ‘hard’ scenario, with non-residents reducing their exposure to 10% of the OFZ market and a subsequent $70-80bn rise in capital flight, we estimate the year-average exchange rate would weaken by 14-18% to RUB82-72/$ at $80-60/bl oil and the rate would rise by 5-7% at year-end; however, the recession would not be deep (-1% growth). We estimate separately that a 10-bpts rise in Russia’s risk premium weakens the rouble by c. 1-1.5%. This simplified approach suggests that the rouble will stabilise at RUB71/$ if the Russia 2023 – UST spread widens by 40 bpts to 200 bpts