Russia Is Well-Positioned to Weather COVID-19's Economic Fallout
Russia is in a relatively good position to survive the COVID-19 crisis and several months of low oil revenues. This is because of the changes it was forced to make to its monetary and fiscal management as a result of the sanctions and the previous oil price collapse in 2014. While the economy does look set to contract by between 0.5 and 1 percent, instead of the expected growth of 2 percent, Russia will avoid a financial crisis and the government has enough financial resources to fund recovery programs when conditions improve. It may not even have to scale back existing spending plans by too much or too early.
Russian President Vladimir Putin’s government has spent the last three years meticulously, i.e. at a painfully slow pace, preparing a fiscal and industrial strategy that the president hopes will lead to sustained economic recovery. More than that, his ambition is to also use these programs to improve social conditions. This means he would have greater public support for whatever succession strategy he chooses in 2024, as opinion polls show that support for the president has become closely linked with economic wellbeing.
The Russian economy grew by 1.3 percent in 2019, more or less the same as in 2017 and, when adjusted for a one-off boost from the Yamal LNG project, as in 2018. For an economy at what is still a relatively early stage of development, such a rate of growth is borderline stagnation. The headline growth has been supported by extractive industries and some emerging growth sectors, such as agriculture and ecommerce, but in sectors where a majority of people are employed, such as in construction and most consumer sectors, growth has been much weaker, if at all present. Rosstat data shows that real disposable incomes fell for five straight years until extra budget spending boosted the number into a modest positive last year.
Putin has set his government a target of doubling GDP per capita from $11,500 to $23,000 during this term. That will only be possible if the target growth rate of 3.5-4.0 percent is reached by 2022. The expected drivers of that growth were supposed to have been export growth and investment expansion. This latter driver is particularly important. It is a 26 trillion ruble spending plan ($345 billion at the current exchange rate) spread across thirteen separate categories with the aim of changing Russia’s economy and society. It is Putin’s legacy plan.
And it was all going to plan. The economy started the year with very positive indicators. GDP was on track to deliver the expected 2 percent growth for this year with sectors such as construction and retail leading the way. But that has all now come to a hard stop. The price of Urals crude is down almost 50 percent since the start of the year, dragging the ruble-dollar exchange rate down 18 percent. Before this week’s oil price rally, Brent crude was down 62 percent and the ruble had lost 22 percent versus the dollar since the start of the year. As a consequence, investment and consumption indicators have fallen steeply. The IHS Markit Services Indicator has collapsed from an expansionary 54 at the end of January, to 37 at the end of March, indicating that a steep contraction is already under way.
There is now no question that the economy is in near lockdown and the data for Q2 will be dreadful. A contraction in GDP close to 10 percent this quarter is expected. Q3 may be better, but not by much if current expectations for the course of the global pandemic are correct. For Russia, it is now a case of what can it expect coming into Q4 and 2021? In particular, what adjustments will have to be made to budget spending plans and to national projects funding?
The one positive is that the need to adjust to the 2014 sanctions and the oil price collapse that year has left Russia in a strong financial position. Total national debt is less than 14 percent of GDP and external sovereign debt is less than 3 percent of GDP, meaning there is no debt service pressure in the budget. The total value of foreign exchange reserves plus gold reached $571 billion at the end of February, with the latter accounting for approximately $115 billion of this. That total has fallen by over $20 billion in March because of the ill-advised move away from the U.S. dollar, a decision made in order to reduce exposure to U.S. assets out of fear of fresh sanctions. Most currencies have weakened relative to the dollar since the pandemic worsened.
In early 2015, the combination of sanctions and weak oil tax receipts forced Putin to agree to let the ruble devalue very steeply. It was either that or risk running down financial reserves to a level that would have left the country politically vulnerable. The weak ruble has not only accelerated investment and export growth in such sectors as agriculture, but it has also created a counter-balance to the price of oil. Budget revenues are protected in rubles as the currency weakens with a falling oil price. In addition to this change, the government also adopted the so-called “Fiscal Rule.” This mandates that the budget must only assume an average oil price of $42 per barrel and all additional tax receipts are diverted monthly to the National Welfare Fund. This fund was valued at $150 billion on March 1 and is there primarily to fund national projects and Putin’s promised social programs.
This combination of a free-floating ruble and the Fiscal Rule means that Russia may balance this year’s budget with a combination of $42 oil and a ruble-dollar rate at 75. Compare this with a requirement for $115 oil in 2013 and Saudi Arabia’s $85 requirement for its current year budget. For Russia, any deficit resulting from a less favorable oil and exchange rate can easily be covered out of the National Welfare Fund, at least for this year.
But, what about the viability of Putin’s ambitious economic and social plan? This depends to a large extent on how much money Putin will have from oil receipts and how much investment Russia can attract to help fund the national projects. An improved relationship with OPEC is key to the former, and avoiding further damaging sanctions is critical to the latter. But even without further sanctions, Russia will struggle to attract any meaningful new investment. One of the consequences of the COVID-19 pandemic is that cross-border investment capital will be greatly reduced for several years. So-called risk investments, which covers most emerging economies, always struggle for new investment in such an environment.
The big policy and spending decisions will likely be made after the summer when, presumably, there is a better sense of the damage caused, both domestically and globally, by the pandemic. By then the oil price trend should also be clearer. If both look favorable, then expect few major changes to the current recovery strategy. But, if the oil price remains well below the breakeven and is in danger of staying there into 2021, then we can expect big changes to spending plans and to economic, social and political expectations. Putin would not approve a budget deficit for two years in a row because of the risk of financial erosion and leaving the country vulnerable to future sanctions risk.
Existing sanctions, while acting as a positive catalyst initially, are proving a big drag on inward investment. Investors are reluctant to engage more with Russia because of perceived reputational and business risk. That is certainly slowing the pace of recovery and increasing the financial burden on the federal budget. Hence, it is the size of oil tax receipts that matters more over the medium term than additional sanctions.
Longer term, investment flow is critical for the development of any economy. Russia can make progress during the remainder of Putin’s current term, and come very close to the ambitious economic and social targets he has set, if the oil price recovers and COVID-19 is dealt with in 2020.
Trade with China, especially with expanding crude oil, petrochemicals and both piped gas and LNG, will compensate for a slow pick-up in other exports. The value of trade between the two countries, predominately hydrocarbons and agriculture produce from Russia, has doubled to over $100 billion in the past three years. It is expected to double again, mostly with higher volumes of gas and LNG exports, in the next three to four years. That expanding trade will help China secure energy supply routes and help Russia to boost budget receipts. It may not be enough, on its own, to transform the economy as Putin would wish, but it will underpin the country’s financial stability and ensure there is always enough money to buy political stability, with or without additional Western sanctions.
In summary, it is a case of good news and bad news for Russia. On the one hand, the country is in good shape financially and should be able to ride through the combination of COVID-19 and lower oil receipts without a crisis, at least for this year. But, on the other, Putin is not going to be able to deliver on his growth promises without being able to maintain a high level of budget spending and without being able to attract a lot more inward investment. Without that investment, stability may morph into stagnation in the latter part of his presidential term.
Chris Weafer is a founding partner of independent macro consultancy Macro-Advisory.
Photo by Paolinio shared under a Pixabay license.