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