Russian Medium-Term Growth and Policy Implications

The IMF had barely taken off from Sheremetyevo Airport and the Ministry of Economics was already busy modifying its medium-term forecasts for 2030 down from the government’s 4.5% figure it held to during negotiations with the Fund’s and MicEc now forecasts a 2.5% trend to 2030 (the IMF 3%).

So what has happened for this stark posited change in the Russian fundamentals? And what does this mean in the short term as regards economic policy?

In practice nothing has fundamentally altered for the Russian macro-economy. The medium-term structural challenges remain the same as before whilst the external outlook is, if anything, a wee bit more positive than a few months back – both for the underway cyclical rebound of developed economies critical for external demand for Russia’s hydrocarbons and over the longer-term the expected continual rise in global demand for oil in a world that is going to have more oil-guzzling middle-income consumers.

My guess therefore is that this rather staid, less-than-rosy medium-term scenario for Russia for 2030 highlights that the economists in government are beginning to put down realistic markers for Putin Inc. and using the IMF discussions as justification for the downward adjustments.

While policy makers-cum-politicians see the long term to be the next election, the bureaucrat-cum-politician-cum-Putin chum axis in Russia means that the 2030 scenario may have more policy traction in terms of at least genuine acknowledgement of structural challenges and medium-term fiscal vulnerabilities that would be the case in many other Emerging Economies where these documents tend to be donor-driven strategies…but the real test will be if there are credible measures to unlock the Russian growth potential.

Recent monthly and Q3 data have not changed the expected growth trajectory for 2013 that is now more likely to be closer to 1.7% rather than the 2-3% range anticipated just a month or so back.

Nominally the economy is at full pelt (the output gap is close to zero) with unemployment close to a record low. This in turn limits the potential lasting impact of policy easing on either the monetary or fiscal fronts without risking cost-push inflation.  And why external agencies ranging from the IMF to the EBRD are helping to push the message that the adjustment requires a significant shift on the supply side where Russia does so badly relative to EM peers: from labour market reforms to ease of doing business.

So what does augur for policy?

1.  Fiscal loosening to boost Investment in 2013-14 is likely if external demand remains weak. This may involve fancy footwork to comply with the new Fiscal Rule through off-budget operations or (dodgy) securitisation of loans from the reserve funds to State-Owned investment projects.
2.  No change in the monetary stance that is shifting toward full-fledged Inflation Targeting (IT) by 2014-15
3. The policy rate will remain unchanged: i) for the simple reason that the central bank recognizes that the transmission channel remains weak for it  have any real impact on lending ii)  inflation remains above or close to its headline inflation target and iii) given tight labour market and high capacity utilization 

Serbia’s Incomplete Transition and Country Risk: Mind the Gap

Serbia is one of those CEE States that is an enigma.  A Serb friend who was in both the Federal Yugoslav government and in the post-Yugo declining rump into the Serbia bit once Montenegro had gone its own way in 2006 reminds me regularly that Yugoslavia had negotiated 80% of the acquis for EU Membership during the 80s.

And as a kid growing up in Berkshire, I would often play football in the park against Yugoslav kids so travel was not an issue for a country seen as a half-way house breaching both sides of the iron curtain.  Indeed taking the train from Yugoslavia to Trieste for your jeans to flog off back home or to proudly wear was essentially the stamp of adulthood!

Fast forward three two decades.

Whilst the grand air of the capital of the Balkans remains (even the Slovenes come to party at weekends in Belgrade) in substance a lot has changed.  Aside from the Cyrillic alphabet and proximity of languages there are similarities – but also key differences – with another city coming to terms with loss of empire, Moscow.

For a start Belgrade lost a major trump card that Moscow retained by not retaining its high-calibre Federal civil service. Yes the EU annually rubber-stamps that the Serbian government has good administrative capacity, but drill down into actual mechanics and you’ll find a lot of bright well educated cadres but lack of a joined up government. Meaning decisions often lack clear strategic thinking or where – as for say for macro-stabilisation there seems to be some semblance of grey matter – alas it is often on the back of external conditionality (DC or Brussels).

And there tend to be  a lot of governments… where each new minister brings his mates along for key positions in the civil service. Meaning a continuous dilution of capacity and institutional memory in the ministries.  Again, not so in Moscow.

Russia remains a good risk but faces real challenges of how it reaches the nirvana of a broad-based economic landscape that often escapes resource rich economies. Serbia on the other seems often to be on the cusp of another macro shock, often due to failure to keep to terms on the previous stabilisation programme, and lacks any real resource endowment.

Whilst CEE watchers no doubt review the macro numbers and compare with other EM economies, what they often miss is the transition gap it still has to overcome, certainly relative to the CEE economies in the EU.

Although Serbia underwent a rapid transformation in the immediate period after the ousting of Milosovic in 2000 (cherry picking reforms that had worked elsewhere as someone from the World Bank once said) there has been not much reform since the early 2000s and Serbia rode the long cyclical wave of benign global and CEE growth when it was all about convergence plays.

Whilst the new EU Member States had to go through (some) hoops, Serbia had no such external anchor. And whereas the likes of Estonia or even Slovenia saw themselves very much in the western European family (if only to get away from the Ruuski bear), Serbia has until recently remained very agnostic if not plain disinterested (again the post-empire blues that also affected Britain’s initial two-fingers at the EU before its eventual entry in 1974 – although the fingers haven’t quite descended!).

Result: an economy with enormous structural issues, a bloated civil service, massive unemployment, fundamental issues for the business environment, an uncompetitive trade sector and economic growth that has relied on domestic absorption, often on the back of credit – where a lot of the bank credit is owned by a coterie of banks from the Euro-risk economies of Greece, Austria, Italy and to a lesser extent France – and where there is a high FX-debt profile through Euro-isation of loans.

Can Serbia manage the transition and macro-fiscal challenges? I helped put together the EU’s Emergency Budget Support for Serbia in 2009 and worked on budget reform prior to that and  whilst I have confidence in the Central Bank that sits on reasonable reserves I am less convinced about political will beyond short-term fixes on the fiscal side.

The country’s metrics on transition are often only beaten to bottom by Kosovo or Bosnia. I am also not entirely convinced about the magnetism of the EU despite promise of greater aid flows. Serbia is surrounded by the EU so has no choice but to integrate although it can affect the speed of convergence. But one wonders if the spectre of the EU of the 2020s that is moving toward a more German-led model of an integrated federation will be palatable to the Serbian politicians – although the same could be said for the Hungarians or Romanians.

But at least the latter are in the EU club. And with it have the implicit EU-put that entails through soft EU loans or via Structural Fund transfers.

What does this mean for Serbian investors and Serbian country risk?

1.       There is a fat tail risk on the downside, despite recent IMF-led efforts for fiscal consolidation announced last week and the likelihood of another Eurobond issue or putative loan from Manchester City…sorry UAE. 

2.       From past experience, the fiscal plan will be implemented in part but then fade away 

3.       With the real exchange rate still 1/5^th overvalued and continuing current account pressure there is a risk  of further devaluation that the authorities will want to prevent from becoming excessive, even with the reserve buffer which in turn will feed into higher imported inflation

4.       The US taper-risk will lead to EM differentiation and which will affect Serbia dis-proportionately when it happens in 2014. 

5.       Getting back to the tube-metaphor, Serbia risk is under-priced. Mind the Gap.

Russia’s Fiscal Options: Trick or Treat?

Yup, its Halloween Day! The thing about trick-or-treat is that someone opening the door will ask to see the trick before the kids get the treat. As many a little one found out this evening!

Faced with slow growth and anaemic private demand policy-makers often opt for the treat to assuage their voters: we’ll spend our way out of the downturn.  

Russia is at least one of those economies that has had genuine “fiscal space” and discretion for Putin and co to press on the accelerator.

And which makes the current situation in Russia very much the Trick or Treat scenario. With domestic demand flat and external demand –  with oil in particular the major driver – keeping the trade and current accounts close to balance (together with a deepening services deficiet and increased interest payments to pesky foreigners), “what do we do?” or perhaps “Что мы делаем?” is the big macro-cum-political question in Moscow.

And Russia has ample public resources, taking into account both fiscal and monetary reserves. The two fiscal reserves each have $86bn or a combined fire-power equivalent to 8.5% of GDP. And FX reserves at the central bank another $0.5 trn or 26% of GDP.  A bag of treats indeed.

The trick? Capital expenditure ain’t easy: shovel-ready projects don’t materialise and take time to plan.

And anyone familiar with the economics of the Soviet Union – and by implication the source DNA of current politician-policy makers in Russia – will attest to the massive failure of past investments in terms of rate of return (a Sahay and Fischer paper from the Fund comes to mind) that in part led to its ultimate bankruptcy and dissolution.

So what to make of the current appetite for grand projects or counter-cyclical expenditure in the jargon?

The structural adjustment in Russia or the lack of remains the biggest hurdle to medium-term growth. This means the rule of law, bankruptcy and creditor rights and ease of doing business and a major clamp down on corruption. A checklist that – unless you’re a Georgian – is unlikely to be fast-tracked in Russia, whatever Putin 2.0 stands for.

The Ministry of Economy has proposals for 3 major projects – a new ring road III, a high speed rail-link and railway upgrade as well as for high tech and aerospace projects . Gosplan back in action?

To be fair these are the same ideas coming out of western capitals and lets be fair, there have been many a white elephant project in the EU. But there tends to be greater feasibility analysis and accountability of expenditure assignment (just look at the airtime our Public Accounts Committee in the UK has or the sterling work of the National Audit Office, its erstwhile cousin) – needed when you ain’t flowing in hydrocarbon manna.

So Trick or Treat?

1. I expect a rebound in external demand to push growth above the 1.5% the IMF was projecting (now oddly 2.5% although hidden away in the tables of its Article IV Report)  and at or above the 1.8% the government expects so the demand for increased capital spend will decline
2.  MinFin has a good cadre of bureaucrats and I expect them to win the initial turf war with MinEc – barring a further tail-off on growth into 2014. And in fact the budget submitted to Duma, all 15Kg of it, is more about expenditure restraint than expansion. 
3. The ­de facto securitisation model proffered by MinEc has significant flaws.   Briefly, the idea that the lucky companies for the new capital expenditure will issue bonds to MinFin backed on future cashflows  lacks credibility – remember many of these companies remain state entities and subject to price controls and quasi-fiscal liabilities.

No trick, no treat.

Russia and Tapering, continued...

And yet?

Purveyors of the short-term will no doubt home in on the solid country-risk fundamentals that I highlighted in my last blog. In short, the Russia-story since the 90s has been of a transition economy transforming itself from plan to market, backed by an oil-bonanza helped with some semblance of co-ordinated government under Putin after the volatility of the Yeltsin era.

This broad-sweep narrative remains essentially unchanged.  And yet the concerns that Russia’s reliance – and therefore vulnerability – to oil continue to be key to understanding the policy framework, and market risks, on Russia.

Two decades after the Soviet collapse Russia is a less diversified economy than in 1991. Put another way it is more vulnerable to a demand shock for hydrocarbons (principally for oil but also gas in a world of ever increasing shale gas) and terms of trade shocks through falling prices for the hydrocarbons.

The data on growth for the year is likely to show growth between shy under 2%. The IMF’s 1.5% has ruffled feathers in Moscow and expect a little bit more of monetary and fiscal easing to help tick along GDP toward the 2% mark to at very least blow a big raspberry towards the Fund. A positive tail-risk of upside to EU growth should also help propel external demand even though the rest of domestic demand will remain moribund.

From a policy perspective the 2-decade concern about the Dutch-disease effect of a rising real exchange rate remains a longer-term concern even though it has been less of an issue in 2013 given the devaluation of the RUR and Central Bank interventions to defend it to the its target range…sorry inflation target!

The fall in the Current Account this year – and the Trade balance in particular – has been ostensibly around the falling oil revenues. Russia’s budget is based on a $115 barrel of oil and where 1 in 4 jobs is in the public sector. And the reduction in external demand has directly affected the exchange rate – through both the current account decline and increasing volatility on the capital account including a large dose of capital flight but also partly due to a rise in access to the Russian bond market for outsiders – see below.

The large size of the share of the public sector in GDP and employment means that the cyclicity of growth on the back of hydrocarbons is much greater than would otherwise be the case. And explains a much greater focus in the last few months on structural aspects of growth – including statements by the president, PM and the minister of Economy to improve business environment more generally.

Whether we can expect anything of substance I’ll comment upon separately.

As regards the short-term impact on investment in Russia and the impact of the tapering discussion,

1.  Russia’s greater inclusion in the EM space is more prevalent following the change in law in February that allows for greater participation of foreign investors -  central securities depositories Euroclear and Clearstream were given permission to participate directly in trading of ruble-denominated paper. The Central Bank has grumbled about keeping its beady eye on the situation given greater potential volatility on the domestic bond market and the exchange rate – and  I concur: Russia will be hit by the financial wave of portfolio outflow from EM.
2.  But also expect a reversion of flows once the dust settles and country segregation amongst the EMs resurfaces– simply on the back of fundamentals over the herd-instinct impulse to bunch Russia to the rest. Its $7bn Eurobonds were 4-times over-subscribed on the back of a strong sovereign balance sheet.
3.  I don’t expect the half-baked ideas floating in Moscow for de facto rise in public investment to make a serious dent on fiscal policy (again worth a separate piece).
4.  And monetary side? The key interest rate (repo rate)  will not change – the talk has been to ease financing for SMEs but with exchange rate wobblies of late the CBR will not do this. Instead the CBR has been busy putting in place a batter of interest rate tools to allow it move toward full-fledged inflation target by 2015 and a slight uptock to a 5% inflation target and this will take effect once rubber-stamped by the Duma.

Tapering, CEE and Russia

Please click here or see below

A taste of the would-be portfolio shifts was given some flavour following suggestions in May that the Fed’s de-facto QE programme might be coming to a halt – aka tapering – before the volte-face in September. Yet the flow-of-funds data – particularly for cross-border bank flows – shows that central and Eastern Europe remains below the levels of late 2008 whilst LatAm and Asia are 80% and 40% up over the period.

The strong flow of funds into LatAm and Asia has in turn helped fuel the stellar growth in these regions relative to the rather sedate growth seen in the CEE region since 2008. It also provides a good gauge for the reversal of flows from EM and the likely amplitude of effects across the EM space when the US tapering ends, itself probably now put back following the delayed release of the US Payroll data on October 23rd, and for the eventual rebooting of conventional monetary policy in the mature economies.

The CEE region is less exposed and vulnerable to any outflows related to portfolio adjustments globally on the back of expected and actual adjustment of the direction of US monetary policy. Part of the explanation for the higher country risk has of course been the wider impact of the on-going sovereign/Euro/bank crisis in the Eurozone that has essentially torn up the song-sheet on a Single EU-wide market for capital and banking in particular – worth a separate focus.

With signs of green shoots in Germany and pukka growth in the offing in Britannia, CEE growth is likely to tag along, particularly given the strong supply-chain links with Germany in central Europe – even without a return to the pre EU-accession convergence plays and oodles of capital into these newer economies.

That said, I remain queezy about a couple of the CEE block – I’m not entirely convinced on the 3 not-so-new EU Member States: Hungary, Slovenia or Czech Republic and remain deeply concerned about the situation in the Balkans, particularly Serbia.

Russia’s economic situation is a fascinating case study…not least for anyone following the economy since the fun-days  of the Yeltsin era. The country retains strong fundamentals that make it a good credit risk – ample reserves of a half a trillion dollars, an oil-fuelled fiscal stance with ample goodies in the bag through a wealth and reserve funds each with a touch over $80bn in the kitty each. And yet…and yet…tbc