Market Commentary Russian economy and markets in the recent turmoil Oil prices have declined by 30% since June, to its lowest level since 2009. The drop of oil prices was accompanied by currency depreciation and the ruble has lost 20% since June. Russia is a commodity driven economy and swings of commodity prices have a strong impact on its performance. As shown in the chart, the GDP is moving closely with oil prices, as oil and gas constitute 70% of exports and additional 20% are closely connected to oil or commodities. However, there have been crucial changes that may have softened the impact of low oil prices. In 2008, Russia was forced to relax its fixed currency regime in favor of a more flexible automatically shifting operational band, which was completely abandoned last year. Now, the Central Bank operates under managed floating exchange rate regime and intervenes only occasionally. The Central Bank also suspended the program of accumulation of new reserves. The Bank managed to buy 10.1bn USD since mid-may in an attempt to boost the reserves back to USD 500bn (currently USD 363bn). 1
We see two key channels in how the currency helps to withstand low oil prices. Firstly, it leads to large currency gains for exporters and the federal government that have ruble denominated expenses. This allows them to maintain spending without deep cuts. Oil exporters are protected also by the progressive construction of the Russian tax system (especially export duties) that leads to a lower tax burden for the companies in low oil price environment. Secondly, Russia imports mainly consumption and investment goods. Sharply higher prices of imported goods and falling domestic demand led to a sharp drop of imports (-21% yoy in real terms in 1Q 2015) that offsets the impact of falling domestic demand on the real GDP (see chart below). Of course, there are also negative effects of weaker exchange rate, especially higher inflation and higher interest rate that are detrimental for consumption and investments. Fortunately, we haven t observed a full return of market stress that was typical for previous periods of oil price drops. To formalize the counterbalancing effects of oil prices and exchange rate, we constructed a simple rule of thumb model that combines different levels of oil prices and exchange rate. For simplicity, we assume linear short term relations between key macroeconomic variables and we calibrated the sensitivity of variables to oil prices and exchange rate according to available academic research and our own empirical estimates. We assume the sensitivity of the real GDP to oil prices 0.2, to the real effective exchange rate -0.1 and the exchange rate pass-through to inflation 0.2. Our model provides an estimate of 3.7% real GDP decline under the assumption of an average oil prices USD 54 and USDRUB exchange rate 62 in 2015, which is consistent with stability of oil prices and currency near current levels (Brent 44 USD, USDRUB 67). The results of our simulations for 2015 real GDP growth are shown in the table below. 2
Current account will likely improve in 2015 thanks to the sharp drop of imports of goods and services that compensates the negative effect of low oil and commodity prices. The table shows estimates for different combinations of oil prices and exchange rates. In praxis, both variables move in opposite direction, which makes extremes unlikely. However, even a large current account surplus may not be enough to stem the ruble's depreciation, as Russia faces large capital outflows that reflect continuing efforts of companies and households to diversify into foreign assets. The capital outflows tend to peak during crisis periods. They reached USD 153bnin 2014 and USD 20bn in 1Q 2015. High sensitivity to oil and gas prices remains the key structural weakness of the Russian budget. In reaction to lower oil prices and economic recession the parliament approved the revised federal budget based on assumption of an average oil price USD 50 and a 3% real GDP drop. The new federal budget foresees a deficit of -3.7% and non-oil deficit of 11.4% despite cuts to nominal spending including wage freeze in large parts of the public sector. We expect the general budget deficit to reach 4.5% in 2015, as also local budgets will record significant deficits and the GDP contraction may be deeper than assumed. The debt/gdp ratio should stabilize close to 20% despite the high budget deficit, as part of the deficit will be covered by the Reserve fund (USD 73bn or 6% of GDP) withdrawals and nominal GDP growth continues to be relatively high. 3
The combination of the bad economic situation, high inflation and weak currency puts the Central Bank in a dilemma. We think that the result will be a mixture of relatively high interest rates and of a benevolent approach to currency depreciation. We already observed the Central Bank s reluctance to intervene heavily when Russia was facing capital outflows and currency markets were close to collapse. However, economic recession should be enough to facilitate further interest rate reductions, although we will see less interest cuts than we previously assumed. This year, we expect the repo rate to be reduced only by 50 bps to 10.5% at year's end and to 8.5% in 2016. Future development depends mainly on oil prices. Assuming oil prices will stabilize at current levels and gradually recover to 50-60 USD in 2016, we expect the real GDP to fall 3.8% in 2015. Sharp currency depreciation should lift the economy from recession, which should result in GDP stabilization in 2016. The subsequent recovery will be muted and the economy will suffer under combination of low growth, relatively high inflation and tight monetary policy for an extended period. It will be difficult for Russia to accelerate above the low 1.5% potential (IMF estimate) unless oil prices recover strongly. The conflict in East Ukraine provides additional risks. Our main scenario is frozen conflict and prolongation of current sanctions. 4
Russian assets suffered in the recent turmoil for being both emerging market and commodity driven economy. In one month, MSCI Russia fell by 12%, 5Y CDS rose by 90 bps to 424 bps, Eurobonds yields widened by almost 100bps (8Y maturity) and local yields rose by 100bps to 11.8% (2-10Y maturities). The environment of cheap commodity prices is not favorable for Russian assets and is hard to see sharp recovery of stock prices or of the currency. Russian equities have a low P/E ratio of 4.3 (MSCI Russia), but offer poor prospects for earnings growth. High yields offered by local bonds may be explored by domestic rather than international investors due to the high costs of hedging. We think that the best risk/reward balance is offered by Russian Eurobonds. The Government s balance sheet remains healthy, external debt manageable, the geopolitical risks are well reflected in the prices and high yields and risk premiums offered by Russian Eurobonds may offer some protection against rising FED funds rates. 5