Russian rou(b)lette

It is a time of currency turmoil with the euro losing some value against the dollar, the Swiss franc strongly appreciating, the Danish krone under speculative pressure and, of course, a major depreciation of the Russian rouble, in particular in December 2014.

I will try to argue here that the impact of this rouble depreciation, of too high dependence on oil and gas, of a banking system in deep trouble, of high(er) inflation and of a neglected economy outside the oil and gas sector paints a very dark picture of the Russian economy in the short run as well as in the longer term.

Since it is a rather long entry I have divided it into 14 sub-sections.

1) Some facts: Russia is indeed dependent on oil and gas. This constitutes some 70% of exports, 50% of government budget revenue, some 20% of GDP but less than 10% of employment.

2) The much lower oil price, down about 50% from about 110$ a barrel to around 55$ per barrel implies much lower dollar earnings for Russia and thus much lower inflows of dollars. Add to that the persistent capital outflows from those who prefer to park their savings elsewhere, e.g. here in Latvia, and the rouble is no longer strengthened by net inflows of dollars that used to be converted into roubles. Most are familiar with the picture but I add it nevertheless below in yet another rather poor graph. It can (hopefully…) be seen that the rouble during most of 2014 hovered between 45 and 50 RUB/EUR and then depreciated to some 70-75 RUB/EUR, an increase of more than 50% of the price of EUR or, equivalently, a 35-40% loss of the value of a rouble.

Figure 1: Roubles per euro, January 2014 – February 2015

Source: European Central Bank

3) To support the rouble and avoid its decline the Russian central bank has intervened using 97 bill. USD of its foreign reserves in 2014. This is substantial – remaining reserves are at somewhere between 200 and 400 bill. USD (some claim that the difference is in two of Russia’s sovereign funds and is not supposed to be touched). Furthermore, the Russian central bank hiked its interest rates from 10.5% to 17% on 15 December 2014 to avoid capital outflow but to little avail.

4) The impact on Russia’s economy of this oil price decline is indeed quite big. Russia produces about 10 million barrels of oil per day with about half of those being exported. That becomes a daily loss of 55$ per barrel (the oil price decline) times 5 million barrels = 275 million dollars or about 100 bill. USD in lost export revenue per year. Russia’s GDP for 2014 was about 2 trillion USD so this implies a loss of about 5% of GDP. For comparison (quick calculations, very back-of-the-envelope type…) this would be equivalent to all of the Latvian foodstuff exports vanishing.

5) The decline in the oil price creates a so-called terms of trade effect. With oil prices cut in half, one barrel of oil buys just half the amount of imports it used to buy – Russia becomes poorer (just like Latvia improves its terms of trade; oil and thus gasoline is cheaper and with the same income people here can buy the same petrol plus some extra goods – we are (a bit) richer!).

6) With less export revenue, less demand will be created in the Russian economy. Russian authorities predict a GDP decline of 4.5-4.7% this year; some other economists are less pessimistic while Danske Bank is quite hawkish with an expected drop of 7.9%. Whatever, it will be a tough 2015.

7) Although dollar revenue from oil sales is down the government budget will not be much affected since it is in roubles. Half the dollar revenue translates into about as many roubles as previously due to the rouble depreciation.

8) But that is a government budget position before reacting to the impact of higher inflation due to a fall in the rouble’s value. With an increase of more than 50% of the price of a euro, goods from the Eurozone will see their rouble price go up dramatically. This has already happened for many goods, inflation has surpassed 10% and will go higher. To compensate civil servants, teachers, pensioners etc for these price increases more expenditure will required. The Russian authorities have thus also announced some tentative plans for budget cuts (austerity!) in parts of the economy. Needless to say, not for the military. But maintaining the purchasing power of public salaries and pensions will put considerable strain on the Russian government budget.

9) And financial markets are not happy with this scenario, making it more expensive to borrow for Russian firms and the government. Although Russia does not have much government debt to speak of, Standard and Poor’s nevertheless lowered its rating from BBB- to BB+, putting it into junk territory. Should either Fitch or Moody’s follow suit, which is very likely, Russia will no longer be seen as investment grade and various funds will be forced to sell Russian assets, which will have a further negative impact on the rouble.

10) Russian firms have loans of some 500 bill. USD that they need to repay or roll over in 2015-16. With a depreciated rouble some of these loans will be very difficult to service for Russian firms – many defaults should be expected. Furthermore, the western sanctions make it difficult to provide such loans. Alas, expect roll over to be limited. The alternative, borrowing in roubles is very expensive due to sky-high interest rates. To me, this smells like a banking crisis. Russia has announced a one trillion rouble (some 14 bill. euro) bank recapitalization plan. This amount does not sound like much, as far as I can see.

11) And the longer term does not look good either. With high Russian interest rates and with limited loans from abroad, Russian firms will find it hard to invest in the Russian economy, which will have a negative impact on current and future economic development. Add to this the possibility of low oil prices for quite a while and more misery ensues since developments of new oil fields in Russia requires high oil prices in order to be viable.

12) What about other Russian industries then? Prime Minister Medvedev has tried to put a positive spin on the rouble devaluation by stating that it will be good for the competitiveness of Russian firms. Indeed – but which firms is he talking about? Russia has lost competitiveness due to a combination of a (semi-) strong rouble and high inflation, see Figure 2, where the real effective exchange rate measures the development of domestic prices against foreign prices adjusted for the exchange rates. With new data coming in (this series from Eurostat currently stops in late 2014) the blue line for Russia will come down sharply due to the rouble depreciation.

Figure 2: Real Effective Exchange Rates, Russia and selected trading partners, 2005 = 100

Source: Eurostat

But whereas Russia gains considerably in terms of cost competitiveness with a weaker rouble, it may not easily translate into big exports from (non-oil and gas) Russian companies since Russia has put little emphasis on the non-oil part of the economy and since it constitutes, for now, a very small share of exports. If successful, this reorientation will require several years plus a much improved business climate in Russia. Wanna bet on that happening?

13) Summing up, 2015 will be a troublesome year in Russia and GDP will shrink. In particular, look out for trouble in the banking sector. In the 21st century Russia built its economy around windfall revenues from oil and gas exploration with scant attention to the rest of the economy. This neglect now comes back with a vengeance.

14) One last note: It is often said that sanctions and embargoes against countries don’t really work. In this case, as I see it, we do have an example where financial market sanctions from the west actually do have an impact, helping to exacerbate an already bad economic outlook in Russia.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and member of the Fiscal Discipline Council of Latvia