There's Light at the End of the Tunnel for Russia's Economy
- By Vladimir Kozlov
- Dec. 03 2015 00:00
Since early last year, Russia's economy has been hit by Western sanctions and slumping oil prices. The economy has contracted and the national currency, the ruble, has undergone a sharp devaluation. However, after many difficult months, there might finally be some light at the end of the tunnel.
Oil Prices and Sanctions
"We saw the main impact of the sanctions in the second half of 2014 and earlier this year, when Russia had to start repaying its foreign debt, accumulated earlier, more actively," said Oleg Kuzmin, vice president at Renaissance Capital investment bank.
"That was one of the reasons for the ruble's sharp devaluation and the recession this year, although the decline in oil prices has had a more significant impact," he added.
The Russian economy, which has been heavily reliant on oil and gas exports, suffered a heavy blow when oil prices fell from over $100 per barrel in mid-2014 to under $50 per barrel in early 2015.
Many sectors of the Russian economy have seen declines in production and sales this year, which has led to cuts in investment in longer-term projects.
"The negative trends were triggered by declining prices of raw materials and the ruble's sharp devaluation, rather than the sanctions as such," said Pyotr Dashkevich, an analyst at UFS IC.
"But it wouldn't be correct to say that the ruble devaluation is not at all linked to the sanctions, and, particularly, to the inability of companies to refinance their hard currency-denominated liabilities in foreign capital markets."
"The sanctions led to a situation where Russian companies and banks were unable to completely refinance their foreign debt and they are now cutting their debt burden," agreed Anton Struchenevsky, a senior economist at Sberbank CIB.
He added that, until September 2014, when oil prices were over $100 a barrel and the sanctions had already been in place a few months, their impact on the Russian economy was very insignificant.
"As the 2009 [economic downturn] showed, when oil prices are low, Russia has problems attracting foreign capital, regardless of whether it is under sanctions, like now, or not, as it was six years ago," Struchenevsky said. "In this sense, short-term ramifications of the sanctions are rather insignificant. But in the mid-term perspective, stable growth in portfolio and direct investment is unlikely. Russia, most likely, will have to continue to cut its foreign debt and finance economic growth from its own resources.
According to Kuzmin, in the mid-term, the sanctions' negative effect will subside as the size of Russia's foreign debt payment decreases and next year it will be half of what it was this year.
"Still, [the impact of the sanctions] will remain considerable, limiting the Russian economy's pace of growth," Kuzmin said, adding that cutting foreign debt in today's conditions is a sign of a weak economy.
The World Bank predicted that the Russian economy would likely shrink by 3.8 percent in 2015. Russia's Central Bank came up with a similar figure, expecting the economy to contract by 4 percent this year, and shrink again in 2016.
Analysts cite just about the same number, pointing out, though, that in the wake of the 2008 economic downturn, the slump was much more dramatic.
"Overall, the decline in GDP is going to be around 3.5 to 4 percent this year, which is much better than the 7.8 percent decline back in 2009," Struchenevsky said.
Longer-term prospects don't exactly look rosy, either. Standard & Poor's said in October it expected the Russian economy to expand by about 0.4 percent annually between 2015 and 2018, which is a much lower figure that the average 2.4 percent in previous years.
Industries that relied heavily on foreign capital or markets were hit hardest by the sanctions.
"It is difficult to make conclusions about the defense industry because of its secrecy," Dashkevich said. "Most likely, it wasn't originally oriented toward Western capital markets, so a negative impact is unlikely, apart from the interruption of collaboration with Ukraine. In addition, here import substitution and state support are most noticeable."
The banking industry was also among the casualties, as banks had difficulties borrowing on foreign markets, while their liabilities denominated in foreign currencies became more expensive due to the ruble devaluation.
The Russian Central Bank was forced to dramatically raise its key interest rate a year ago in an effort to stop the decline of the nation's currency.
By now, however, prospects are not as grim for banks as they looked in early 2015.
"Banks nearly lost access to foreign capital markets, which had a negative impact on the value of their funds, margin and ability to attract capital under market conditions," said Dashkevich.
According to Dashkevich, that was partly compensated for by programs of government support, but, coupled with tighter regulation of the sector, the situation has noticeably worsened.
"[The banking industry's] problems can mostly be resolved," Struchenevsky said. "As the Bank of Russia's interest rates go down, the situation will improve."
He added that, in the long term, technology sanctions are set to be more painful.
"Russia's economic growth was based on foreign technology, and the sanctions are making it more problematic," he explained.
"In the oil and gas industry, the sanctions primarily hit companies' plans, as development of tight deposits became either loss-making due to low oil prices, or impossible due to lack of access to technology," said Dashkevich.
"Industries with high financial leverage, especially a high proportion of hard-currency liabilities, such as construction, transport and tourism, also took a serious blow," he added.
Foreign Companies' Exodus
By early 2015, the economic turmoil in Russia reached the point of many foreign investors running for the exit.
Some companies, like General Motors, left the Russian market, while others postponed or cancelled their plans to enter Russia.
"Certainly, the decline in oil prices and the need to repay foreign debt have led to a substantial fall in domestic demand," Struchenevsky said. "This has made foreign companies reconsider their policies toward Russia."
"After a substantial decline — by 8 to 9 percent — in domestic consumer demand, we expect a rather weak recovery of internal consumer demand (under 1 percent) and investment demand (just over 2 percent), which may also prompt foreign business to leave Russia," said Kuzmin.
"However, wages in Russia's processing industry are now estimated to be lower than in China, in dollar terms, which creates new opportunities for foreign business," he said.
"We are seeing serious declines in many sectors, particularly in the automotive industry," said Dashkevich. "Companies that have been unable to ensure profitable operation in new conditions are exiting the market, while others are trying to step up localization and cut costs."
As the Russian economy continues to adapt to new conditions, examples of foreign companies canceling plans to enter the Russian market or pulling out of Russia will continue, said Kuzmin.
However, the financial crisis in Russia has a positive side to it for some foreign companies. As the ruble took a plunge against the U.S. dollar and euro, production costs in Russia became considerably cheaper, and some companies are now looking at ways to capitalize on that by manufacturing products in Russia to be exported to other countries.
Manufacturers working in the lower price segment, such as Chinese automotive companies, have become interested in entering the Russian market as consumers have been shifting to the lower price segment, and sales in that segment are on the rise, said Dashkevich.
Several major companies, mostly in the automotive sector, announced plans for stepping up their presence in Russia this year.
China's Fuyao Glass Industry Group recently built an automotive glass plant in Kaluga and said it is planning to export about two-thirds of its output.
Volkswagen reportedly plans to build a third plant in Russia to make chassis for cars produced for the local market, while there are also plans to export some of locally made car engines to Europe.
The Finnish tire manufacturer Nokian Tyres said it increased investment in its plant in the Leningrad region to 100 million euros this year, with the same figure slated for 2016 with a view to increasing exports to other countries.
In the summer of 2014, Moscow responded to Western sanctions by banning many food imports from Europe and the United States.
Simultaneously, the government has been promoting an "import substitution" policy aimed at boosting production and consumption of locally produced foods and other items, which have become less pricey than imported goods.
According to Struchenevsky, the policy of import substitution has been most successful in the consumer goods sector.
"The ruble devaluation and ban on import [of food from a number of countries] helped the local food and agricultural sectors, the petrochemical industry, and it improved the exporters' situation not just in oil and gas, but also in metals, fertilizers and wood processing," he said.
"In retail turnover, the share of imported goods declined from 45 percent to 35 percent," agreed Kuzmin, warning, though, that stepping up import substitution any further won't be easy.
"It will require cheaper credit and the rebound of domestic demand, which will also take time," he explained.
"If the government can maintain conditions that are beneficial for domestic manufacturers, the situation might improve in the long run," agreed Dashkevich. "A complete import substitution in agriculture and the meat and dairy industries is impossible to achieve in one year. Probably, in three to five years, Russian producers will be able to strengthen their positions considerably."
"Most of products that used to be exported from Ukraine, including components for the defense industry, pipes and come food items, were substituted relatively effectively," added Dashkevich.
While the Russian economy's prospects looked grim at the beginning of 2015, the situation stabilized somewhat in the year's first months and later began to improve.
The ruble, after losing nearly half of its value against the dollar over 2014, partially rebounded, and interest rates came down from their post-sanctions peak and are projected to go down further.
At the same time, exports — boosted by the still weak ruble — were up more than 50 percent year-on-year in the first months of 2015, which, to some degree, compensated for the decline in domestic consumption.
Analysts say that, most likely, the crisis has already hit bottom, and they are pointing to positive developments.
"The main positive development is that, this year, despite the economic downturn, the economy has remained sustainable, which will lead to an overall stabilization next year," said Kuzmin, adding that, in 2016, small growth can be expected, along with a halved inflation rate, a cut in capital flight to a $60 billion figure, which is "normal" for Russia, and stability of the national currency.
Other experts are even more optimistic.
"The economy has rather successfully adapted to new conditions caused by lower oil prices and problems with refinancing foreign debts," said Struchenevsky. "What is most important is that there is no longer a feeling of panic."
"The decline seems to be over," he went on to say. "Government finances are in order. The exchange rate has stabilized. The inflation rate and interest rates have begun to go down."
"Apparently, in the eternal contest of fear and greed, the latter is beginning to win," Struchenevsky concluded. "Business has begun to think about how to make money in the current conditions. I believe that the cheap ruble, alongside relatively high productivity — compared with other developing countries — will allow Russia to move from the import substitution model, which helped to stabilize the economic dynamic, to growth supported by increasing exports."
The financial crisis has also made companies and private individuals more careful when it comes to spending money.
"State-run companies have finally begun spending in a reasonable way," said Dashkevich. "Consumers are also becoming more literate, trying to find ways of keeping their consumption standards against the backdrop of declining incomes. Of course, all that is painful, but, in the long run, the economy should benefit from it."