Russia's foreign-exchange reserves have been now been declining very rapidly since mid August, and as the money goes so does the faith that the large stock of reserves the country built up during the boom times would be sufficient to see them through any downturn in energy prices. As the money leaves, so it seems does the decade of economic growth and stability which they symbolised. Indeed so rapid has been the decline that Russia's international reserves, which are the third-biggest after those of China and Japan, have now fallen $161 billion, or 27% percent, since 8 August last, and decreased by $17.9 billion to $437 billion in the week to 5 December. Investors have now pulled $211 billion out of the country since August, according to estimates by BNP Paribas.
But just how difficult managing this process is proving to be was illustrated yet again this morning as Russia’s central bank found itself forced to accept a further devaluation in the ruble - for what is now the second time in a only a week - subsequent to which the ruble fell as much as 1.3 percent (to a four-year low of 37.5015 per euro) as Bank Rossii widened the trading band against the basket of dollars and euros used by the bank as the measure for attempting to manage the exchange rate.
Russia has now used some 27 percent of its reserves in these attempts to stem what has now become a 16 percent decline in the ruble following a 69 percent drop in the price of oil and last weeks decision by credit ratings agency Standard & Poor’s to cut its Russian credit rating on for the first time in nine years.
Thus over at Bank Rossii they have been having their work cut out "fexibilising" the trading band, and it this flexibilisation process that has now allowed the ruble to fall against its target exchange rate against a basket of currencies by 8.6 percent, down further from the 7.7 percent level facilitated last week and the 3.7 percent one of a month ago. Thus the currency has now fallen a net total of 5.9 percent against the basket in the series of six "adjustments" to the trading band implemented since 11 November. However this "slow and steady" approach to devaluation is creating uncertainty, as well as fomenting a loss of confidence with Russians withdrwaing a total of 6 percent from their ruble accounts in October alone, the fastest rate of withdrawal since Bank Rossii started collecting this data two years ago, while foreign currency deposits rose 11 percent. Thus instead of reinforcing confidence in the monetary regime, the slow, step-by-step adjustment of the nominal exchange rate may be perpetuating a steady stream of deposit withdrawals and dollar purchases, and some evidence for this can be found in November's 5.9 percent contraction in the money supply.
Apart from the financial turmoil, Russia's economy is really reeling under the weight of the sharp drop in crude prices, and the price of Urals crude, Russia's main export blend, is currently trading at around $44.13 a barrel, down 69 percent from the July peak, and well below the $70 average required to balance the country's 2009 budget.
GDP Growth Slowing Rapidly
It is hard to get a fix at the present time on what Russia's growth rate will look like in 2009, and estimates vary widely. Deutsche Bank recently cut its Russian growth forecast to 1 percent for next year, down from an earlier 3.4 percent, while the World Bank last month forceast a slowdown to 3 percent from what has been an average expansion of 7 percent a year since 1999. At the bottom end of the forecast range we have Oleg Vyugin, chairman of MDM Bank and a former central banker, who suggests the economy may contract by as much as 4% if the prices of raw materials exports do not recover. My own feeling is that the final figure may well be much nearer to Vyugin's estimate than to the World Bank one, especially if we don't get a strong rebound in commodity prices and given the sharp contraction in non-energy industrial output.
Analysts an OAO Sperbank have gone one step further and come up with two possible scenarios for possible impacts of the economic slump on property prices. For the first (or mild case) scenario they postulate a 2.5-3.5% growth in GDP, 11% inflation and a 30 ruble per dollar exchange rate in 2009. In this case, the bank anticipates a drop in Moscow real estate prices of 34.4% in ruble terms and 46.6% in dollars. On the second scenario GDP stagnates (or even contracts by up to 2.5%), there is higher inflation and an even larger devaluation of the ruble against the dollar. On this (worst) case scenario the Bank suggests that Moscow property prices would plummet by 38.1% in rubles and 59.6% in US dollars. You have been warned!
The Inflation Worm Is At The Heart Of The Problem
The real difficulty facing Russia's macroeconomic managers is that after two years of shocking inflation domestic industry is in no position to compete with its overseas competitors while the ruble remains at its present rate, while any sharp devaluation will have a serious impact on the balance sheets of those who took advantage of cheaper interest rates available abroad to do their borrowing using forex loans. This situation is not that different from that which is to be found in many other economies across the region, in Latvia, Hungary, Ukraine and Romania (for example), with the added rider that the IMF representatives who are in dialogue with policy makers in these very fragile economies would do well to bear in mind the potential knock-on effect of any coming downward adjustment in the ruble.
In annual terms inflation is now slowing, and was down to 13.8% in November, from 14.2% in October. Still, these are very - unacceptably - high numbers, and those who so willingly acquiesced in them earlier will now feel the downside of their negligence, although unfortunately it is - as ever - the poor old Russian in the street who will really pick up the bill.
Basically, the credit driven consumer boom which accompanied the commodities one severely distorted the always delicate balance between Russia's commodities and manufacturing sectors, leaving the manufacturing sector strongly uncompetitive. It is this lack of competitiveness which now exaccerbates the severity of the downturn, just as many commentators, including yours truly, where arguing it would do. Frank Gill from Standard and Poor's puts it like this.
Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.
The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.
Frank Gill, director of European sovereign ratings at Standard & Poor's in London, writing in the Moscow Times
The critical part of the overheating process was to be found in the evolution of real wages which continuously outpaced productivity growth, thus undermining competitiveness. According to Rosstat, average real wage growth in the first nine months of 2008 was 12.8 percent, down from 16.2 percent during the same period in 2007 (see chart below). Meanwhile unemployment has continued to decline, and reached 5.3 percent in the third quarter, suggesting that at that point the economic slowdown had still not reached the labour market. But this is expected to change quite dramatically now, as the credit seize up and construction slump lead to lay offs in one enterprise after another.
The Russian government has implemented a programme - worth about $200 billion - involving a mixture of loans, tax cuts and other measures to boost liquidity and reduce borrowing costs as the 50-stock RTS Index heads for its worst year since 1998, while the ruble denominated Micex stock index is down 64 percent since 1 August.
``It's a vortex of despair,'' said Julian Rimmer, head of sales trading at UralSib Financial Corp. Russian stocks are weighed down by ``an economy rendered sclerotic by the vanishing of credit, a market paralyzed by margin calls and illiquidity, the opacity of earnings through 2009 and the ruble quivering while speculators circle''.
Finance Minister Alexei Kudrin has said the government has already spent 90 billion rubles ($3.3 billion) out the available total of 175 billion rubles set aside for investing in domestic stocks and bonds. VTB Group (Vnesheconombank), Russia's second-biggest bank, lent 190 billion rubles ($6.9 billion) to companies in November alone as part of the plan following the supply of 120 billion rubles to what Finance Minister Alexei Kudrin termed the "real sector" (or non financial companies) in October.
FDI Drying Up?
Russia's supply of foreign direct investment seems to be steadily drying up. During the first nine montsh of this year the country attracted 2.3 percent less foreign direct investment than it did in the same period in 2007 as the global credit squeeze reduced investor appetite for emerging market projects. Direct investment was running at $19.2 billion over the period, while total foreign investment, including credits and flows into securities markets, was $75.8 billion, a drop of almost 14 percent over 2007, according to the most recent data from the Federal Statistics Service. Foreign investment in stocks and bonds fell 16 percent to $1.3 billion. Foreign direct investment was at a record $27.8 billion in 2007, up 100% over 2006, and thus the fall has not been that dramatic, so far, but the numbers for the last quarter will undoubtedly be much worse than those for the earlier part of the year.
Russia’s long-term debt rating was lowered earlier this month - for the first time in nine years -by ratings agency Standard & Poor’s, who cited capital outflows and the “rapid depletion” of the foreign currency reserves as their justification. Russia's rating was cut one level to BBB, the second-lowest investment grade, and down from BBB+. The last time S&P downgraded Russia was in January 1999, when the country had a rating of SD (or ‘selective default’) following the government's decision to default on $40 billion of debt. Russia’s outlook remains “negative.”
“The rapid depletion of reserves in order to resist a more substantive adjustment of the nominal exchange rate increases the chances of discontinuous exchange-rate movements later, at a lower level of international reserves, with even more severe consequences for the private sector,” said Frank Gill, S&P’s primary credit analyst in London, in the statement.
S&P said it expected Russia’s current-account surplus to swing into a deficit equivalent to 2.6 percent of gross domestic product next year, compared with a surplus of 5 percent in 2008 due to a “sharp deterioration in the country’s terms of trade”. Russia’s GDP growth is expected to decline “sharply” in 2009, according to the agency.
Energy, including crude oil and natural gas, accounted for 73 percent of exports to countries outside of the former Soviet Union (not counting the three Baltic states), in the first 10 months of this year, according to data from the Federal Customs Service, while the federal budget is likely to “shift into deficit” as the government implements emergency tax cuts, commodities prices remain low, and a weaker economy generates less tax revenue, according to S&P. Russia’s budget surplus amounted to 7.8 percent of GDP in the first 10 months, according to Finance Ministry data, but so sharp is the turnaround that Russia may need to use most, or even all, of the money in its two oil funds to cover the budget deficit and recapitalize banks should oil prices stay at about current levels. These funds - the National Wellbeing Fund and the Reserve Fund - held a combined $209 billion as of 1 December.
Moody’s Investors Service also changed Russia’s rating outlook at the end of November - to stable from positive - citing their opinion that the defense of the exchange rate has been "ineffective and extremely costly for official reserves".
“Russia is now facing a perfect storm of falling commodity prices, weaker external demand, tighter credit conditions and slower real incomes growth for which no amount of currency adjustment can compensate,” Neil Shearing, an emerging-markets economist at Capital Economics Ltd. in London, said in a research note today.
Russia's response to the crisis seems to be what might be termed a "process in development", with new measures being continuously announced. In one of the latest such "developments" Finance Minister Alexei Kudrin said the government is thinking of using some of the funding to buy bank mortgages and will also provide 300 billion rubles ($11 billion) to guarantee corporate loans in a bid to boost liquidity. “In order to strengthen guarantees for loans, including loans for two and three years, the state must be ready to provide 300 billion rubles,” Kudrin said in a televised broadcast on the Russian state channel Vesti-24. “If necessary we can increase this limit.” Thirty billion rubles in loans are also to be provided to large airlines like Aeroflot and Transaero, according to First Deputy Prime Minister Igor Shuvalov, while Vnesheconombank, Russia’s state-run development bank, has now requested a total of 950 billion rubles ($34 billion) in government funds. To put all this in perspective, the latest amount requested by VEB represents more than 7.5 percent of Russia’s foreign-currency reserves.
Services And Manufacturing Contraction
Russia's real economy is shrinking very rapidly under the weight of all this. Russian service industries shrank in November at the fastest rate on record, and the VTB Bank Europe Services Sector Purchasing Managers’ Index was in contraction mode for a second consecutive month (registering 37.2, a sharp acceleration in the rate of contraction from the 47.4 reading in October). On such indexes a reading of 50 is the dividing line between expansion and contraction. The contraction in service industries was “by far” the biggest since the survey began in October 2001, according to the VTB statement. “Activity, new business, employment and backlogs all registered much steeper contractions than in October.”
VTB Group’s Manufacturing Purchasing Managers’ Index also showed a decline in November, this time for the fourth consecutive month, and the index registered a record low of 39.8, even lower than that of September 1998, when Russia defaulted on $40 billion of domestic debt and sharply devalued the ruble.
The manufacturing reading is also confirmed to some extent by the November industrial output data from Rostat, since output contracted year on year by 8.7 percent after a 0.6 percent rise in October. Production shrank for the first time since new methodology was introduced in 2003 and, again, this was the biggest decline since 1998. Manufacturing fell an annual 10.3 percent compared with growth of 0.3 percent in October. Steel pipe production dropped an annual 36.9 percent and coking coal output fell 38.7 percent. Truck and car production dropped 58.1 percent and 7.2 percent respectively. Russia’s largest steelmaker, OAO Severstal, have announced they are cutting output by half and plan to reduce spending 20 percent in 2009, while Ford Motor announced on 8 December it was closing its St. Petersburg factory between 24 December and 21 January.
Is Russia On The Brink Of Outright Recession?
Russia may well already be in its first recession since 1998, according to what may well have been a slip of the tongue by Deputy Economy Minister Andrei Klepach while Evgeny Gavrilenkov, chief economist at Troika Dialog, estimates that the word's largest energy exporter may already be running a current account deficit.
“The recession has already begun and, I’m afraid, it won’t end in two quarters,” Klepach said in comments made in Moscow today that were confirmed by his press secretary.
Klepach added that the economy would grow by less than the ministry’s current forecast of 6.8 percent for 2008, and that industrial output growth will slow to around 1.9 percent for the whole year.
Gross domestic product growth dropped to 6.2 percent in the third quarter, and this was already the slowest pace in three years. Russia’s last economy fell into recession in the first quarter of 1998, and only returned to growth in the second quarter of 1999. Growth has averaged over 7 percent a year since 2000.
As I said, Klepach's declaration may well have been a (Freudian?) slip of the tongue (or tongue twister) since he later qualified his statement, saying there had been some linguistic confusion given that the Russian words “retsessiya” (recession) and “spad” (decline, slump) “mean the same thing". "This isn’t a technical recession in the American sense.” he said - referring to the fact that a recession is often defined as two consecutive quarters of negative growth. Actually the sticklers among us will note that the two quarters negative growth rule of thumb is not in fact the US criterion (since the NBER business cycle dating committee use their own "in house" methodology, as I explain in applying this methodology to Spain here), but he may be right, and what we have on our hands may best be termed a "slump" rather than a recession, but which ever it is, of one thing I am sure: the contraction has already started.
Whatever the confusion, what Klepach did make clear is that he expected Russia’s economy to grow by only 2.6 percent year-on-year in the fourth quarter (giving total growth for the year of 6 percent) and this does seem to suggest that the economy is already contracting on a quarter on quarter basis.
Equally worrying is the evolution in the current account deficit. The full impact of the fall in oil prices will only be noted in the trade and external current account data in the fourth quarter, when export deliveries based on the new lower oil prices will be effectd. But to this evident oil price impact we need to add the fact that the non-oil external current account deteriorated significantly in 2008 as import volumes shot up considerably faster than non-oil exports (the competitiveness problem). In the second quarter of 2008, the non-oil external current account deficit reached almost US 60 billion, and this was followed by a further USD 62 billion in the third quarter, making Russia’s balance of payments position particularly vulnerable to a continuation in the low level of oil and gas prices.
We also need to consider the problems Russia may now have in financing any such current account deficit (remember this one one of S&Ps concerns). The World Bank estimates Russia’s external debt maturing in the third and fourth quarters of 2008 at around USD 100 billion, of which about USD 45 billion is due in the last quarter of 2008. After including on-demand deposits held by the banking sector, the total debt that requires repayment or refinancing may well exceed USD 120 billion. The external debt maturing for the entire 2009 fiscal year is slightly less, at around USD 100 billion. It is clear, however, that some sectors, especially private financial corporations, are going to face challenges in rolling-over their external debt under current conditions. Further, higher prices for debt refinancing are inevitable, and to all of this you need to add-in the sharp drop in the stock values used as loan collateral which will have resulted in sizeable margin calls on lending facilities with 1-2 year maturities.
All in all the World Bank reached the conclusion that the total debt due in the fourth quarter of 2008 could amount to about USD 60-65 billion. Even so, they concluded that systemic risk to the banking sector, while rising, remained limited due to the government’s resolve in supporting the systemically important banks and the sizable package of measures taken to date. It is hard to assess whether or not they are right in this evaluation, but in any event we are all just about to find out, so those of us who don't especially like mysteries won't have too long to wait.