Russian Economy Today: Major Risks and Challenges

Alexandre RepkineNovember 12, 2014

• Kiev originally the center of Rus, a federation of East Slavic tribes, ca 882-1240

• 1223: invasion of the Mongols

• 1240: Total destruction of Kiev, end of Kievan Rus

• 1480: end of the Mongolian domination

Kievan Rus

Grand Moscow Duchy• Late medieval state centered on

Moscow, 1283-1547

• Moscow first mentioned in a 1147 chronicle

• In 1547 Ivan the Terrible proclaimed the Tsardom of Russia

• Ukrainian lands dominated by Polish and Lithuanians from the end of Mongol rule in 1480

• Crimean Khanate established in 1449, existed until 1783: neither Russian nor Ukrainian

Tsardom of Russia

• 1547-1721

• Grew 35000 sq.km. a year

• 1654: Bogdan Hmelnitsky, a Ukrainian leader, offered the Tsar to make Ukraine part of Russia to avoid Polish domination

New Russia

• 1764: Russia conquers the lands to the North of Black Sea from the Ottoman Empire

• The new region is called New Russia, active migration by Slavs: Russians and Ukrainians

• 1783: Russia annexes Crimea after defeating Crimean Khanate

The Soviet Time• 1917: Communist revolution in Russia

• 1918: Ukraine proclaims an independent Ukrainian Socialist Republic

• 1922: the USSR formed that included Russian Federation, Ukrainian Socialist Republic (formed in 1918), Belarussian Socialist republic, and TranscaucasianSocialist republic

• Ukraine becomes an autonomous republic within the Soviet Union

• 1954: Crimea transferred from the Russian Federation to Ukraine

• 1991: Collapse of the Soviet Union, Ukraine’s independence

Ukrainian Crisis

• 21 November 2013: President Yanukovitch backs out of signing the Association Agreement with the EU, accepts $15bn loan from Russia

• 22 November 2013: Protests break out in Kiev, the capital• 20 February 2014: large-scale clashes between police an protesters• 21 February 2014: Peace agreement signed between opposition leaders

and Yanukovitch, also signed by Foreign Affairs ministers of Germany and Poland

• 22 February 2014: Radical opposition leaders refuse to recognize the peace agreement, make Yanukovitch leave Kiev

• 23 February 2014: Turchinov proclaimed enacted President of Ukraine• 23 February 2014: Law granting Russian the regional status language

abolished• 27 February 2014: Crimean parliament decides to declare independence• 16 March 2014: referendum in Crimea on independence• 18 March 2014: President Putin signs a decree on Crimea re-joining Russia

Sanctions: History

• First Round: – Immediately after March 16, 2014 following on Crimea’s joining

Russia– Target: individuals banned from visiting EU, Canada, the US;

doing business is also prohibited with them

• Second Round:– April 28, 2014– Further visa bans, 17 Russian companies

• Third Round:– July 17, 2014: Malaysian MH17 crash– Government-owned Russian banks, trade restrictions on

defense industry, additional visa bans– Inability to borrow for more than 30 days

Ruble Depreciation

RUB/USD

RUB/EUR

• Depreciation by 23% (RUB/USD), 14% (RUB/EUR)

• Most depreciation occurred after the third (sector) round of sanctions

• Capital flight due to increased geopolitical uncertainty

• Exports did not grow proportionately to ruble’s depreciation due to global economic slowdown

• Ability to borrow abroad restricted by sanctions, limiting supply of foreign currency

Inflation AccelerationJAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC

2014 0,59 0,70 1,02 0,90 0,90 0,62 0,49 0,24 0,65

2013 0,97 0,56 0,34 0,51 0,66 0,42 0,82 0,14 0,21 0,57 0,56 0,51

2012 0,50 0,37 0,58 0,31 0,52 0,89 1,23 0,10 0,55 0,46 0,34 0,54

2008 2,31 1,20 1,20 1,42 1,35 0,97 0,51 0,36 0,80 0,91 0,83 0,69

• Inflation picked up significantly shortly after the first round of sanctions

• Inflation rate kept roughly at or below the similar inflation level of 2008, the year of the global crisis

• January--September 2014: 6.27%

• January—September 2008: 10.57%; January-September 2013: 4.72%

Capital Flight

• Sharp increase in capital outflow in January 2014 was attributed to looming Western sanctions

• Capital outflow is not much different relative to the average of previous years

• Capital outflow does not increase dramatically as sanctions mount

• Capital outflow is probably more the result of Russia’s structural problems rather than sanctions

Russian Stock Market Response

March 2014 Sanctions

September 1995

March 2004

August2008

March 2014 Sanctions

3 November2014

• RTSI grew after the first round of sanctions

• Market as a whole appears to be ranging

• 2008 crisis had much larger negative effect

Source: RBK quote.rbc.ru

Russia’s Food Imports Ban

• Import ban on food imports from the EU, US, Canada, and Australia seems most important response so far (7 August, 2014)

• In August alone– Moscow food prices up by 7%

– St. Petersburg, 10%

– Pork and chicken prices up by about 25%

• Poland, Finland and Lithuania most affected by the Russian food ban

Abolishing Bilateral Corridor on November 10, 2014

• The Ruble was allowed to move within bounds for a bilateral currency basket prior to the sanctions

• Corridor bounds were adjusted tens of times since the start of 2014

• Discount rates increased three times since January 2014

• Interventions until 2015 only at the bounds

• Floating exchange rate introduced in 2015

Source: Roskomstat

What Measures Would Really Hurt the Russian Economy?

• Restrictions on gas and oil exports

• Exclusion from financial networks: VISA, Mastercard, SWIFT etc

• Persuade OPEC to increase oil production

Oil and Gas in the Russian Economy

Budget crucially depends onthe oil-gas revenues

30% of all Russian gas production is meant for exports

Rising energy prices increased oil-gas revenue component of the Russian budget without any growth in the physical volumes

Non-oil deficits persisting

Oil Price EvolutionIf the trend continues:

• Further deterioration of the government budget

• Depreciation of the ruble

• Further pressure on the National Welfare Fund to finance budget deficits risk of social unrest (2018?)

EU’s Dependence on Russian Energy Supplies

EU depends on about 1/3 of its energy consumption on imports from Russia:

• 34% crude oil• 26% solid fuels

(mainly coal)• 32% natural gas

Germany, Italy, and Eastern European countries are the most vulnerable importers

EU and Russia’s Dependence on Ukrainian Transit

UKR

BR

TRK

POLRU

GE

SW FI

North Stream

South Stream

• 42% of Russian gas exports depends on Ukrainian transit

• Ukraine’s inability to pay the contracted prices led to gas supply shortages in 2006 and 2009

• Ukraine’s current debt reached $5bn

• To avoid dependence on Ukraine, Russia started constructing the North and South Stream pipe routes

Gas Dependence and Sanctions

• One way to really hurt the Russian economy is to limit her gas and oil exports

• Cutting Russian gas and oil imports is:– Difficult since alternative suppliers are difficult to find– Politically impossible since the voters will not

welcome electricity and heating shortages

• Therefore, the most potent measure to ‘punish’ the Russian economy will not be taken in the foreseeable future

Other Potent Sanctions• Ban VISA, Mastercard etc from doing business

with Russia– Private companies are unwilling to lose their business– Byron Pollitt, VISA’s CFO, in April 2014:

• "We are caught between the politics of the United States and the politics of Russia. We're clearly seeing a drop-off in cross-border volume, and sanctions are expected to have some impact on volume."

• "We have 100 million cards there and it is not in anyone's best interest, inclusive of the Russians, to make those cards not available to their own citizens.”

• Exclude Russia from financial networks e.g. SWIFT– Applied to Iran in 2012– May be difficult to apply to Russia since that would

hurt EU’s trade with Russia, including energy import deals

SWIFT Statement

SWIFT Statement: http://www.swift.com/about_swift/shownews?param_dcr=news.data/en/swift_com/2014/PR_swift_sanctions_statement.xml

Brussels, 6 October 2014 - SWIFT and its stakeholders have received calls to disconnect institutions and entire countries from its network – most recently Israel and Russia.

SWIFT is a neutral global cooperative company set up under Belgian law. It was established by and for its members to create a shared worldwide messaging service and a common language for international transactions. SWIFT provides services to over 10,500 financial institutions and corporations in over 200 jurisdictions around the world. SWIFT is a critical service provider to the financial industry and plays a pivotal role in supporting international commerce and trade.

SWIFT services are designed to facilitate its customers’ compliance with sanctions and other regulations, however SWIFT will not make unilateral decisions to disconnect institutions from its network as a result of political pressure.

SWIFT regrets the pressure, as well as the surrounding media speculation, both of which risk undermining the systemic character of the services that SWIFT provides its customers around the world. As a utility with a systemic global character, it has no authority to make sanctions decisions.

Economy Near Potential Output

• Growth rate of 7% prior to the crisis of 2008– High carbohydrates prices– Spare capacity

• Growth rate of ~1% during 2009-2013– ~5% for similarly large emerging economies– ~3% for resource-rich countries

• Currently– Weak credit growth– Slow rate of new business creation

• Structural problems, not cyclical ones, mostly constrain the expansion of potential output

Resource Rents and Red Tape

• Resource-rich countries are prone to high resource rents– Short-termism– High extent of reliance on subsidies and transfers

• Red tape restrictions– Far Eastern tuna / sanctions– Incumbent bureaucracy has few incentives to promote

competition

• Importance of performance-oriented public sector– Weaning bureaucracy off the resource exports revenues– Linking size of compensation to performance indicators

Oil/Gas and Hard Budget Constraints

• Carbohydrates-based growth ensures persistence of soft budget constraints– Janos Kornai (Econometrica, 1979)– Bailing out loss-making state enterprises during the Soviet time– Source of government transfers and subsidies to pay for social

obligations e.g. pensions currently

• Hard budget constraints– Shown to increase aggregate production efficiency– Are spurred by

• US/EU sanctions• Dwindling oil prices

– Are Russia’s chance to diversify its economy away from being a carbohydrate-oriented one

Diversification• Tangible assets: not a major problem

– a wide range of industries – decent GFCF rates– Improving infrastructure

• Intangible assets: institutional framework– MAJOR problem– Contract law– Independent courts– Police corruption– Accountable public sector

• Geographical– Decreasing extent of dependence on EU for hard currency flows– Reorientation to emerging Asian markets, specifically China

• “Power of Siberia”• Transsiberian link to Korean railway networks

– Payments in rubles/yuan