Exclusive Interview: Alfa Bank’s Chief Economist on the outlook for Russia

The Russian economy returned to growth in 2017 after several years of recession. However, there are still major challenges ahead, including the need for budget reform, a financial sector overhaul, and the risk of sanctions. Natalia Orlova, Chief Economist and Head of Macro Insights at Alfa Bank, offers her expert view on these issues to GRI’s Michael Loginoff – and warns that the market may be incorrectly pricing Russia’s sovereign risks.

With the presidential election next month and a widely expected victory for Vladimir Putin, speculation naturally turns to what this will mean for the Russian economy. Optimists are hoping for wholesale reform via the 2018-24 Economic Strategy proposed by former finance minister Alexei Kudrin. Restructuring cannot be effective without action on several fronts, especially given the depletion of Russia’s Reserve Fund at the end of 2017.

The financial sector is one such area. The Russian government bailed out Okritie Bank, B&N Bank, Promsvyazbank, and Jugra Bank during 2017, and the health of the sector is uncertain. The level of non-performing loans is still rising, calling into question the durability of the recent apparent economic recovery. On the positive side, the inflationary impact of the bailout seems to be minimal, the timing is right for a thorough overhaul of Russia’s banks.

Oil prices are another question mark for Russia in 2018 and beyond.  In 2017, oil still represented over 50% of export revenues and 40% of total federal budget revenues.  Although stable prices can be expected due to supply-side measures such as the recent OPEC deal signed in Moscow and Riyadh, global demand is changing, with advances in electromobility and the potential reduction in Chinese dependence on oil. Russian reliance on commodity exports still leaves its economy vulnerable to price volatility.

Finally, international sanctions are a potential economic agenda item for the Kremlin in 2018.  Despite the US Treasury releasing a list of Putin’s inner circle and the recent indictments of 13 Russian citizens and 3 Russian entities, Congress has yet to introduce new sanctions on Russia, and some in Europe are calling for the easing of sanctions. Nonetheless, the risk of new measures from Washington against major Russian businesses and/or sovereign debt presents major uncertainty for Moscow.

ML: If President Putin is reelected in March, in which direction do you see him taking the Russian economy in his next term?

NO: The ray of hope for 2018 lies in the expectations of the economic reform agenda, which, according to consensus, should be unveiled after the presidential elections or once a new cabinet has been appointed (by May 2018). The market consensus anticipates a new program to be formed on the basis of Kudrin’s 2018-24 Economic Strategy proposals in the best-case scenario, or represented by a mix of Kudrin’s and the Stolypin club’s strategies in the worst case. Should a combined program materialize, it would contain some structural measures in the areas of customs services and the legal system for example, but would also focus on the implementation of industry support programs.

My strong belief, however, is that the president will focus intensively on budget policy instead of prioritizing large-scale reforms. This is because the challenges facing the budget are becoming more acute.

The room for manoeuver on the expenditure side is shrinking: in 2016, some 57% of the consolidated budget expenditure was allocated to social spending (21% of GDP), while the combined expenditure for defense and internal security at the consolidated level amounted to 6.7% of GDP, virtually the same as the 7.3% of GDP allocated for education and healthcare.

Concerns over human capital investment have forced Alexei Kudrin recently to call for an increase in the new budget rule for oil prices – i.e. to raise it from $40/bbl to 45/bbl. At the same time, while Russia is still expected to have run some $80 bn of state savings by end-2017, the Reserve Fund was depleted by end of 2017. Further, this year the two state funds (the now-empty Reserve Fund and the National Welfare Fund) will be unified, signaling an increase of pressure on state savings.

Striking a balance between large social obligations, the need to maintain a certain level of state services, and the desire to avoid an increase in debt is a tough challenge, which will consume the cabinet’s attention. An increase of the tax burden on individuals looks inevitable given these challenges. Yet, a decision to increase the tax burden, however necessary, is still painful and now looks likely to be postponed until 2020.

ML: How do you see energy markets affecting the Russian economy in 2018?

NO: In previous years the increase in oil prices had brought capital inflows to Russia, and through this channel economic activity was boosted – despite the fact that it was associated with the appreciation of the ruble exchange rate. Now the situation is different: higher oil prices stabilize the ruble exchange rate; however, this does not bring more capital to Russia, partially because of the substantial deceleration of the growth rate and partially because of sanctions.

It was also enabling a high level of cabinet spending in past, however now the cabinet plans to keep nominal expenditures under control at the level of RUB16.4-16.5 tn a year. Therefore, because of the changed dynamics, even an environment of higher oil prices will have very little favourable impact on economic growth.

While a positive and stable trend in oil prices is assured by supply-side measures, i.e. OPEC deal, another important angle of the oil discussion is of course what is happening with the global demand for oil. On this side there are mounting concerns about the effect of the technological changes on the automobile market and strength of the economic growth in China, which are both making Russia very vulnerable to the oil prices downside risks. Oil still represents around 55% of total export revenues in 2017 and represented 40% of the federal budget revenues last year.

ML: As the numbers show, the Russian economy has recovered from its recession and the impact of sanctions.  What effect will sanctions have on the economy in 2018?

NO: Until recently, sanctions have had a limited effect on the Russian economy – they have reduced the appetites of banks and companies for foreign debt, but this has not really prevented foreign investors from making portfolio investments in the Russian bond or equity markets.

What is also important is that after triggering a response to the sanctions in the form of food-import restrictions (as a result of which, the share of imports in Russia’s food consumption declined from 30-35% prior to 2014 to 23% currently), counter-sanctions were not actually used as a policy response. Instead, the Russian authorities were actually signaling their intention to open the road to dialogue.

This equilibrium is, however, fragile and could be damaged if sanctions pressure is escalated to a new level. The agenda for 2018 includes two risks:

1. the introduction of sanctions against major Russian business groups, and/or
2. the introduction of sanctions on sovereign debt.

The second would clearly be a very negative development, and we do not believe this scenario is priced-in by the market.

Our major concern is related not so much to the pure economic effect of such a measure – after all, the Russian government is running debt of only 13% of GDP, which is 70% locally funded – but to the unclear response, which sovereign sanctions could trigger from the Russian side.

ML: What role will FDI play in Russia this year? What in your view are the key political and regulatory decisions – elections aside – that may affect the investment climate in 2018?

NO: In Russia, FDI has only historically existed at the very low level of around 1% of GDP – the country instead has mainly relied on foreign debt as a source of its growth rather than on FDI inflows. Additionally, the current sanctions environment complicates any change of this strategy and will keep the Russian economy closed from the viewpoint of external long-term investors.

That said, from an economic point of view, a number of steps were executed in order to improve the investment climate in the previous year. The main achievement was in Russia’s inflation targeting strategy.

Last year was exceptionally successful for the CBR – inflation reached its 4.0% target in July and has decelerated to 2.5% y/y by end-2017. That reflects a combination of food deflation and weak monetary transmission; however, the deceleration in inflation was faster than expected, which raises concerns for 2018, when inflation could return. I expect inflation to stay around 2.0% y/y by the end of spring 2018, largely reflecting the 2017 deflationary trends; however, I still expect inflation to reach around 4.0% for the end of 2018. This is an additional argument to expect tax reforms to be delayed until 2020.

Inflation risks justify the view that the CBR is likely to pause its cycle of policy rate cuts from 2Q18; we expect it to have cut the key policy rate to 7.5% by that time. The appointment of a new cabinet and the debate over budget policy priorities set an ideal framework for the CBR to communicate the pause at that level, above the nominal equilibrium rate of 6.5-7.0%.

There are two strong reasons behind this monetary policy decision. First, we have always considered the CBR’s ability to raise the policy rate as limited; this rings even truer now that the CBR has been burdened with number of large banks that need to be restructured. Second, the external environment carries risks – in the event of new sanctions, Russia’s interest rates should increase and the high real rates currently are a provision against this risk.

However better transparency in the area of monetary policy is counterbalanced by structural issues. For example, on the investment side, growth, which according to our estimates, was 90% driven by activity in Crimea, Moscow City and the Far East in 9M17, is likely to decelerate.

With completion of the Kerch Bridge expected to take place by the March 2018 presidential election and the Moscow City renovation program only expected to gain momentum after 2018, the Far East pipeline looks to be the main driving force of investment growth in 2018.

Continuing corporate sector deleveraging and fears of financial instability will also restrict investment growth – we expect a 2.5% y/y increase in investment growth in 2018. The consumption side looks more positive, however, the obvious risk is a scenario of lower nominal salary growth (a function of low inflation in 2017) combined with an acceleration in the actual inflation rate in 2018 which would damage the purchasing power of the population. This outlook would keep investment growth concentrated on state projects.

ML: How can Russia promote growth in the SME sector and how can the government encourage entrepreneurialism?

NO: The development of the SMEs sector has always been a focus of economists; however, this does not bring any positive news. The share of revenues, which the Russian population generates from entrepreneurial activity has declined from 15% in 2000 to 7% in 2016. The share of SMEs remains below 20% of GDP since 2000 and not much change is seen in this area.

Russia remains a country of large companies and public services, and according to polls the majority of the population prioritizes a career working for the state. Statistics point to the fact that that the public sectors absorbs up to 25% of the Russian labour force, and combined with state companies this figure could reach as high as 30-35%.

ML: What do the bailouts of Otkritie Bank and B&N say about the state of the financial sector specifically, and what impact if any should we expect on the overall economic outlook?

NO: Despite uncertainty surrounding the cost of the rescue, it looks like now is a perfect opportunity to clean up the banking sector. There are concerns in the market about the inflationary implications of the CBR’s actions, which will provide capital injections into the balance sheets of troubled banks via the Fund for the Consolidation of the Banking Sector (FCBS). However, the reality is that with inflation at levels of 2.5% y/y in 2017, the moment looks good to initiate the restructuring.

In addition to the low inflation rate, the current moderate banking sector growth is containing the inflationary implications of rescuing the banks. Potential inflationary risks in relation to Otkritie’s deposit outflows during July-August (RUB0.7 tn from retail and corporate deposits) would materialize under two scenarios: 1) if deposits are removed from the banking system and are used to directly stimulate consumption, and 2) if they flow to other banks and are used to boost lending activity.

None of these options looks realistic though. Firstly, around 60% of deposit outflows from Otkritie were absorbed by state-owned banks (retail deposits going to VTB and corporate accounts primarily going to Sberbank) and the deposit growth trend remained unchanged in 2H17. Secondly, as the corporate loan book was stagnant in 2017. Moreover, since June, a bank’s average deposits held at the CBR have increased from RUB0.7 tn to RUB1.5 tn by the year-end. Thus, inflationary concerns over the rescue of Otkritie and B&N Bank look exaggerated.

Regardless of the timing, cleaning the balance sheets of relatively large private banks is an appropriate response to dealing with bad loans.

Recent EBRD analysis of 100 countries (both developed and developing) for the period 1997-2014 suggests that ignoring the problem of NPLs could lead to 2 pp GDP growth deceleration per annum until the problem is resolved. Cleaning the banking system has short-term costs, but longer-term benefits. Thus, we laud efforts of the CBR to clean up the banking sector and regardless of inconsistencies in the procedure (the CBR took too long to make a decision on Otkritie), it is a welcome step.

The main concern with the recent developments in the banking sector is linked to Russia’s economic growth story. The acceleration of economic activity usually coincides with a gradual improvement in loan quality and provides support to those banks, which had experienced trouble during crisis years. However, at the moment, this is not the case for Russia: the level of NPLs continued to grow from 2007 in nominal terms and the current amount is higher even in percentage terms than the previous peak of 2009.

Thus, the collapse of two large private banks is not consistent with the recovery in economic activity.

In other words, the recent developments in the banking sector confirm the view that the economic recovery is, firstly, related to one-off factors, and secondly, very unequally spread across segments and regions. The decline of industrial production in 4Q17 confirms our concerns.

ML: Do you see the ruble becoming stronger in 2018?  What are the broader implications domestically and internationally?

NO: The good news for the ruble exchange rate that the recent oil price recovery is helping the ruble to maintain its strong position, which will ensure a higher than expected current account surplus, at least in the beginning of 2018. We target a $50 bn current account surplus for 2018 under a $63/bbl oil-price scenario. However, the main uncertainty is related to the capital account. First, the CBR’s interest rate policy will no longer help to attract capital in 2018 as it did in 2017. Second, sanctions risk is a major threat for the ruble exchange rate. In the event of sanctions on sovereign debt, at least $30-35 bn will exit from the local bond markets, equivalent to RUB5/$ of ruble depreciation. We target a RUB60/$ exchange rate by the end of 2018, owing to the substantial deceleration in inflation: however, the sanctions scenario could dramatically boost volatility at any moment.

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This article was first published by Global Risk Insights.