The Economy Shows Initial Signs of Stabilization. Following the sharp decline in 1H15, we saw the first signs of economic stabilization in 2H15 as real GDP dynamics improved modestly (y-o-y) in 3Q15. In 2016, we expect inventories and net exports to contribute to growth, although private consumption is still going to suppress the economy as real wages and pensions will remain in negative territory. As a result, we forecast the economy to contract a modest 0.6% in 2016 and to return to growth in 2017.
Downside Risks Remain High. Nevertheless, the relative stabilization in 2H15 is fragile as the oil price shows no signs of recovery following OPEC’s abandonment of quotas, new volumes coming from Iraq and Iran, and no major output cuts by Russia or the US. Our estimates show that the Russian economy will survive a prolonged period of very low (US$33-35/bbl) Brent prices. However, should this transpire next year the economy would contract by 2%, the dollar would cost 80-83 rubles, and the budget deficit would surge to 5% of GDP.
Worst Seems Behind for Russia’s Economy But No Oil Price Recovery in Sight
Economy Reaches (False) Bottom
Russia’s economy shows initial signs of stabilization in 3Q15. After a sharp decline in 1H15 following the deep slump in oil prices and dramatic ruble depreciation in 2H14, there are initial signs of economic stabilization evident in 2H15. For instance, industrial production contracted by 4.2% (y-o-y) in 3Q15 after a 4.9% (y-o-y) drop in 2Q15, retail trade shrank by 9.5% (y-o-y) in 3Q15 after a 9.1% (y-o-y) contraction in 2Q15, and services dropped by 2.6% (y-o-y) in 3Q15 after a 1.6% (y-o-y) decline in 2Q15. Following the sharp decline in 4Q14- 1Q15, Russia’s composite PMI is fluctuating in the vicinity of 50 points, which means the economy has probably reached bottom. Real GDP dynamics improved to a 4.1% (y-o-y) contraction in 3Q15 from a 4.6% (y-o-y) decline in 2Q15.
Growth in developed countries continues to support Russia’s economy despite sanctions.The eurozone economy accelerated to 1.6% (y-o-y) growth in 3Q15, with the composite PMI reading hitting 54.2 points in November. Growth remains quite strong in the US, even though the US economy decelerated to 2.2% (y-o-y) growth in 3Q15, down from 2.7% (y-o-y) in 2Q15. In addition, US manufacturing PMI dropped to 52.8 points in November from 54.1 points a month earlier. We believe the recent deceleration in the US economy is one of the key reasons why the Fed had postponed the widely expected monetary tightening. However, we believe that relatively low energy prices and soft monetary policy will continue to support economic growth in developed countries in spite of the monetary tightening by the US Fed. We also believe that although Western sanctions against Russia will remain in effect formally for some time to come, Russia’s economy will continue to adjust gradually to the financial and technological restrictions.
Low oil prices and weak ruble continue to suppress economic growth. Nevertheless, we emphasize that the relative economic stabilization seen in 3Q15 is fragile due to faltering oil prices and a relatively weak ruble, which continues to suppress consumer demand and capital investment. We forecast oil prices to remain low in 2016 (we expect Brent to average US$45/bbl in 2016) and then to rise moderately to US$50-55/bbl in 2017-18.
OPEC’s abandonment of quotas will maintain market oversupply. The oil market is still feeling the impact of December’s OPEC meeting, which ended in a communiqué that the market largely interpreted as the cartel’s effective abandonment of production quotas. OPEC’s concluding statement suggests that every OPEC member is encouraged to produce at maximum capacity. OPEC’s November output was reported to be 31.7 mln bpd, the highest monthly level in two years, and 6% above OPEC’s official quota then in force, 30 mln bpd.
Iraq and Iran to add new volumes in 2016. Iraqi crude exports have been the principal driver behind the growth in OPEC output: the country’s November production was 32% above its 2014 average. We do not expect this trend to end in 2016, as both Iraq’s central government and the Kurdish administration are willing to export as much crude as possible to meet their budget requirements. In addition, Iranian exports are likely to reach the market on top of the current export rate of 1.0-1.5 mln bpd – an incremental increase of 0.5 mln bpd in 1H16 and 1 mln bpd in 2016 – and pose the largest downside risk to the oil price this year. It appears that Persian Gulf producers with the largest spare capacity, i.e. Saudi Arabia, Kuwait and the United Arab Emirates, are unwilling either to reduce output to support the price or to punish overproducers by flooding the market with very cheap oil, as was the case in 1986.
No major output cuts from Russia or the US. The two largest non-OPEC producers have shown surprising resilience in maintaining oil output in 2015. Russia’s production is likely to have grown by 1% (y-o-y) to 10.7 mln bbl in 2015 and its 2016 output is likely to be down just negligibly. US production is down by less than 5% from its peak in June 2015 to the level observed in early January 2015 – a modest decrease in response to the oil price decline considering the flexibility of US crude producers to shut down and restart wells.
High inventories globally may amplify the impact of supply increments. We cannot rule out the possibility of additional supply coming simultaneously from certain OPEC producers, a move that could push the oil price further down over the medium-term in the absence of production quotas. That scenario would include Iran raising its output by up to 1 mln bpd in 1H16 and by 1.5 mln bpd in 2016, Libya restarting production from its south-western fields with a capacity of 0.5 mln bpd within 12-18 months, and Iraq expanding production capacity by a further 0.5-1.5 mln bpd in 2017-18. In addition, we note the high level of inventories both in OECD and non-OECD countries, both crude and oil products, and the continuing stock buildup, which indicates that a speedy rebound is unlikely for the oil price. Indeed, a short-term plunge to US$30/bbl or below remains a possibility.
Figure 1: Economy Shows First Signs of Stabilization
Industrial Production, Retail Sales, Real GDP, % y-o-y
From Deep Recession to Stagnation in 2016
Industry Will Benefit from a Weak Ruble Despite Dwindling Consumer Demand
Consumer demand will weigh heavily over the economy … Following an estimated 3.8% contraction last year, we expect the economy to contract by a modest 0.6% in 2016 and return to growth in 2017. We expect inventories and net exports to contribute positively to growth in 2016, although private consumption will continue to weigh heavily on the economy. On one hand, we expect real incomes to grow by a moderate 1.6% in 2016 as a result of an expected sharp reduction in consumer inflation and strong growth in entrepreneurial income driven by a weak ruble and an expansion of the import substitution theme. On the other, we expect real wages and pensions to remain in negative territory. In addition, we forecast lending activity to be quite weak, as the population will continue to build-up precautionary savings due to the high degree of uncertainty regarding employment and income. As result, we expect retail trade volumes to contract by 6.3% this year in spite of the moderate growth anticipated in real incomes.
… while import substitution will support industry. Despite weak consumer demand, we expect industry to benefit from a sharp reduction in imports over the medium-term. According to Rosstat, the volume of imports dropped by 29.9% (y-o-y) in 2Q15 due to the sharp ruble depreciation in 2H14. Despite relatively high capacity utilization in key segments and rapidly deteriorating demographics, the substantial reduction in imports paves the way for significant import-substitution potential. We forecast domestically-oriented sectors (production of chemicals, petrochemicals, and fertilizers in particular) to grow moderately this year. We also expect agriculture and the food industry to get considerable support from the ban on European and Turkish food imports in spite of the substantial growth in domestic food prices. Growth in the defense budget will support certain segments of machinery and equipment production. Despite the moderate 0.6% real GDP contraction we project for 2016, we forecast industry to grow by 1.4%. At the same time, because most services are non-tradable, the services sector will remain under pressure due to weak consumer demand and a decrease in government spending on healthcare and education.
The Ruble Will Continue to Remain Under Pressure This Year
Weak oil and persistent monetary easing drag the ruble down. Following quite substantial appreciation in March-May 2015, the ruble lost all of its gains in 2H15 due to weak oil, as Brent dropped from US$63.5/bbl in 2Q15 to below US$40/bbl in December. In addition, the persistent monetary easing in 1H15 and gradual reduction in hard currency repo operations in 2H15 by the Central Bank of Russia (CBR) contributed to ruble weakness. We expect the ruble to continue depreciating in 2016 due to the expected decrease in oil prices, further reductions in the key rate, and gradual monetary tightening in the US.
Gradual reduction in capital flight will moderately support the ruble. On the other hand, we forecast capital outflows to slow from an expected US$70 bn in 2015 to only US$50 bn in 2016 due to some improvement in sentiment driven by the relative stabilization of Russia’s economy. Capital outflows should also be constrained by low oil prices to some extent (which limits the amount of oil income that can be withdrawn from the country) and reduced payments on Russia’s external debt (according to the CBR, Russia will have to repay US$76.6 bn of debt in 2016 versus US$113.6 bn in 2015). However, we note that up to 40% of external debt can be refinanced in spite of Western sanctions against Russia, which means that the real amount of debt to be repaid this year may be as low as US$45-50 bn. We expect capital outflows to weaken further to just US$37 bn in 2017 and to stabilize to around US$30 bn per year in 2018 and beyond.
The CBR will use ruble weakness to rebuild reserves. We expect an average ruble rate of RUB70.9/US$ (down 12.5% from RUB 62.1/US$ in 2015) based on our Brent forecast of US$44.5/bbl for 2016 (which is down 17.6% from US$54/bbl in 2015). Weaker oil will result in lower exports, which we expect to reach US$309 bn in 2016 (from US$326 bn in 2015), while the weaker ruble will result in lower imports, which we expect at US$176 bn this year (from US$187 bn in 2015). As a result, the trade surplus will contract to US$133 bn (from US$139 bn in 2015); however, due to improvements in the balance of services, the current account surplus will only moderately decline to US$66 bn (from US$69 bn in 2015). We expect the current account surplus to remain between US$50 bn and US$70 bn over the medium-term; that would allow the CBR to reach its US$500 bn international reserves target by 2020.
Figure 2: IEA Sees Weaker Demand Growth in 2016
Estimates of global demand, y-o-y, %
Source: EIA, IEA, URALSIB estimates
Weak Ruble, Ban on Turkish Food Imports, And Road Toll for Heavy Trucks Will Fuel Inflation
Inflation to gradually subside … Ruble depreciation in 2H15 and the indexation of regulated tariffs in July pushed up consumer inflation which, having peaked at 16.9% (y-o-y) in March 2015, began to gradually recede in 2Q15. In November, inflation decelerated to 15% (y-o-y), which means that ruble weakness in 2H15 has added at least 1.5-2 ppt to (y-o-y) inflation so far. However, we expect that inflation will gradually ease over the medium term, albeit not as fast as one could hope for due to the 12.5% ruble depreciation expected in 2016, the Turkish food import ban and the introduction of road tolls for heavy trucks on federal highways. However, year-on-year inflation will drop sharply over the next few months due to the high base effect: we expect inflation to drop from 12.9% (y-o-y) in December, to below 10% (y-o-y) in January, and to 8.8% (y-o-y) by the end of 2016.
… but not as fast as the CBR promises. We maintain our view that the Bank of Russia will gradually reach its 4% inflation target, but expect that it will take more time than the CBR currently promises. Our calculations show that inflation will remain above the 4% target for the medium-term (we expect 6.5% inflation in 2017 and 5.2% in 2018) due to the above mentioned non-monetary factors. We note that after attempts to restrain regulated tariff growth in the past, tariff growth accelerated last year. In our view, this increases the likelihood of aggressive tariff indexations and, hence, creates additional inflation risks going forward. As inflation risks subside, we believe the CBR will continue to reduce the key rate. However, monetary easing will be gradual – we expect the key rate to be cut to only 8.5-9% by the end of 2016.
Fiscal Austerity Becomes Number One Priority on Government Agenda
Budget deficit to exceed government target of 3% of GDP this year. We expect government finances to remain in decent shape over the medium-term. At the same time, we expect the federal budget deficit to reach 3.5% of GDP in 2016, which exceeds the official deficit of 3% of GDP. Our calculations are based on a more conservative Brent forecast for this year: we expect ruble-based Brent to average RUB3,150/bbl, while the government expects RUB3,400/bbl. In addition, we use a more conservative GDP growth forecast (we expect a 0.6% GDP contraction in 2016 while the government assumes 0.7% economic growth). In any case, we believe the government will finance the deficit with the money from the Reserve fund, which as of 1 December 2015, contained RUB3.9tn.
Reserve fund will be depleted in early 2017. Considering the government still needed to cover a RUB1tn budget deficit last year (we expect the federal budget to receive RUB1.3 tn of revenues versus RUB2.3 tn of expenditures in December) and that it needs to finance another RUB2.8 tn deficit in 2016, we expect the Reserve Fund to be depleted in early 2017. In 2017-18, we expect the government to increase domestic borrowing, to use money from the National Welfare fund, and to considerably reduce budget expenditure growth. As a result of fiscal austerity, we expect real budget expenditure to shrink by 2-3% per year in 2017-19, which will help to reduce the deficit to below 1% of GDP by 2020. We maintain our view that the government should on one hand concentrate on reducing (postponing) some military programs and on increasing the efficiency of budget expenditure, while on the other we believe it should increase investment in human capital and support the national economy.
Figure 3: Inventories to Keep Growing, Albeit Slower
Global oil supply and consumption, mn bpd
Source: US EIA, URALSIB estimates
Russia’s Economy Will Survive US$33 Per Barrel
Our Pessimistic Scenario Assumes a Pronounced Recession This Year
Economy to shrink 2% in 2016 … We would like to note that even though our base-case scenario assumes a US$44.5/bbl Brent average this year and US$50-55/bbl in 2017-18, we see substantial downside risks to our oil price forecast due to excess supply in the oil market. Our pessimistic scenario envisages Brent averaging US$33-35/bbl in 2016-18. The good news is that our calculations show that Russia’s economy will survive a prolonged period of very low oil prices. The bad news is that further declines in the oil price will trigger another round of recession in the economy as a result of a weaker ruble, higher inflation and slower consumer demand. If oil drops to an average of US$33-35 bbl over the medium-term, we would expect real GDP to contract 2% in 2016. However, the economy will gradually adjust to low oil prices in 2H16, and growth will resume in 2017. However, the pace of recovery will be slower than in our base-case scenario.
… ruble to drop to RUB80-83/US$ … If the Brent average drops to US$33-35/bbl, then we would expect the ruble to weaken to an average of RUB80-83/US$ in 2016-18. A weaker ruble will heat up inflation, which would decrease to only 9.2% (y-o-y) by the end of this year, versus. 8.8% (y-o-y) in our base-case scenario. At the same time, inflation growth will be contained by the weaker economy; we expect inflation to drop to 6.2% (y-o-y) at the end of 2017, versus 6.5% (y-o-y) in the base-case scenario.
… and budget deficit to surge to 5% of GDP this year. A prolonged period of very low oil prices will be a challenge for government finances, as our calculations show that if the Brent average drops to US$33-35/bbl, then federal budget revenues will shrink to just RUB12 tn this year, versus RUB 13.3 tn in our base-case scenario. Given current expenditure plans, this implies a 5% of GDP budget deficit this year. Such a deficit will be quite difficult to finance as the government will run out of Reserve Fund money in 2H16 already. We expect the government to resort to a combination of aggressive borrowing, larger disbursements from the National Welfare fund, and compulsive attempts to cut budget expenditure. We believe that over a 2-3 year horizon, the government will primarily rely on fiscal austerity to balance the budget. However, we also believe that in the event of prolonged low oil prices, the likelihood of tax increases on businesses will rise considerably.
Russia Retains 2-3% Long-Term Growth Potential
Economy Will Begin to Recover in 2017 Provided no Further Shocks
Russia continues to need deep structural reforms. Following the anticipated stagnation in 2016, we expect the economy to accelerate to 3.5-4% growth in 2017 as a result of a moderate recovery in oil prices (we expect Brent to average US$50-55/bbl in 2017-18 after a US$44.5/bbl average in 2016) and growth in developed countries. A fast recovery may be possible in 2017 due to spare production capacity emerging as a result of the deep recession last year. However, by 2020 Russia’s economy will slow to its long-term growth potential, which we continue to estimate at 2-3% per annum. We continue to believe that reforms, including a more efficient state procurement system, lower corporate tax, large scale privatization, stronger property rights and an independent judicial system, are needed. We are also of the opinion that Russia needs to intensify its efforts to seek political solutions and reduce tensions with the developed world in order to have Western sanctions lifted.
Figure 4: CBR Will Use Ruble Weakness to Build Up Reserves
Current account, Capital flows, and International reserves in 2015E – 18E, US$bn
Source: URALSIB estimates