Bank Rossii Eases Further As Russia's Economy Contracts At A Record Rate

Russia’s central bank this week lowered its main interest rates for the seventh time since April 24 - lowering the refinancing rate a further quarter percentage point. The decision came hard on the heels of the announcement that the Russian economy suffered a record economic contraction in the second three months of the year and refelect the growing recognition that the country now faces a painfully slow recovery. Just how painful things might become will form the subject matter of this report.

You can also download the full text in PDF if you prefer to print and read - Bank Rossii Eases Further As Russia's Economy Contracts At A Record Rate.

Risks Rising On All Fronts

Bank Rossii cut the refinancing rate to 10.5 percent from 10.75 percent (following a quarter point reduction on August 10), and lowered the repurchase rate charged on central bank loans to 9.5 percent from 9.75 percent, effective from tomorrow. The bank has now cut the rates six times since April 24. Nonetheless Russia’s benchmark refinancing rate is still the second-highest in Europe, after the 12% on offer in Serbia and Iceland - meaning ruble denominated assets remain an attractive carry pair with either Euro or USD, and that with inflation stuck around the 12% mark the problems for central bank monetary policy are legion.





In the report that follows I will argue how the steady and systematic long term mismanagement of Russia's monetary policy has now created a veritable Procrustean bed of problems for Russia's economy and society. Failure to address the underlying inflation problem between 2005 and 2008 meant that large structural distrortions were accumulated in the economy, including a massive problem of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has now arrived, and it is not at all clear just for how long we will all need to get to learn to live with it.

In a more or less reasoned analysis Capital Economics suggest that oil prices could fall back to somewhere around $50 a barrel in 2010. If this forecast proves anywhere near correct, the Russian economy is going to be subject to major downside risks, due to the difficulties posed by:

i) financing the fiscal deficit
ii) rising unemployment
iii) growing bad loans in the banking system
iv) refinancing external debt
v) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee, adding to the risk element on all fronts. The Russian Economy Ministry seem to be getting ahead of themselves at the moment, since following a period when they have tried to get the bad news all out up front, just last week they decided to raise their 2010 forecast to a growth of 1.6 percent - up from the previous 1 percent forecast. This growth, if realised, would follow an anticipated shrinkage of some 8.5 percent this year, based on the September 9 estimate of Economy Minister Elvira Nabiullina that output may grow 3.9 percent to 4.5 percent in the second half of this year compared with the first six months - such strong optimism I find hard to accept, unless the turnround in global economic activity turns out to be much stronger than the one we are currently seeing.

Is The Worst Really Behind Us?

Gross domestic product contracted an annual 10.9 percent in the second quarter, according to the Federal Statistics Service. The headline number represented a worsening in the year on year performance following a 9.8 percent contraction in the first quarter. Evidently the Russian economy has been extremely hard hit by the worst global financial crisis since the Great Depression as demand for Russia’s oil, natural gas and metals (around 80% of total ex-CIS exports), and industrial production plunged as companies depleted stocks and struggled to raise funds during the credit crunch.



Manufacturing contracted an annual 18.7 percent in the quarter compared with a 23.5 percent drop in the first quarter, while construction was down 20.5 percent in the period following a 20.9 percent annual decline in the first three months. Retail sales fell an annual 11.3 percent, more than twice the pace of decline in the first quarter when they shrank by 4.9 percent. Capital investment slumped by an annual 23.1 percent in May, the most since December 1998. The Russian government forecasts that GDP may fall by as much as 8.5 percent for all of 2009, following growth of 5.6 percent in 2008 and 8.1 percent in 2007.

Looking Into The Third Quarter


However the contraction evidently eased in the second three months of the year, and while the Russian Statistics Office do not publish seasonally adjusted estimates of quarterly movements in GDP, Neil Shearing at Capital Economics estimates the economy effectively moved sideways, with roughly zero percent growth (plus or minus a tiny fraction on either side). Moving forward into the thirds quarter, the best measure we have of the current activity level is the GDP Indicator compiled for VTB Capital by Markit Economics on the basis of their Composite PMI.

Interestingly, the Indicator moved back intopositive territory in August, posting above the neutral level of 50.0 for the first time since last September. That said, the latest reading of 52.2 suggested only a moderate rate of expansion in activity, and remained well below the long-run series average, while both the contry's services and manufacturing sectors posted equally modest month-on-month gains in activity. So we could say the economy continued to move more or less sideways on the month with the quarterly rate still standing at the slightly negative minus 0.2%.

Now while the GDP indicator continued to show quite a strong year on year contraction in August of minus 3.9%, this was well down on May’s revised record rate of minus 9.9%. So while the Indicator has now spent nine months in negative territory - a longer sequence than the earlier seven-month record run from September 1998 to March 1999 - as companies produce direct for new demand, and government stimulus spending has its effect, the rate of contraction has eased notably. But it is worth noting that the current average rate of decline - minus 6.4% - is much sharper than that seen in the 1998 downturn, while we should be asking ourselves, absent a clear rebound in energy prices, just how sustainable the current improvement is.



Over the second quarter as a whole, the Indicator averaged a revised annual minus 9.2%, far worse than the annual minus 6.2% posted in Q1. The first two quarters of 2009 have seen steeper contractions than in any previous quarter since the current time series began in June 1998. However,the Indicator does show a slower rate of annual decline for Q3 since the average so far, is minus 5.2% over July-August.

Industrial Output Trending Up

Russian industrial production rose for a second consecutive month in July, and the year-on-year decline eased after the central bank cut rates and the government ramped up spending. Output rose 4.7 percent from June, after a 4.5 percent rise the previous month, and on an annual basis declined 10.8 percent compared with 12.1 percent in June, according to the Federal Statistics Service.




VTB’s Russian Manufacturing Purchasing Managers’ Index also advanced in August to 49.6 from 48.4 July.

“Modest production growth was supported by a second successive monthly increase in new orders, which reflected stronger market activity, particularly at home,” the report said. At the same time, “excess resources remained a key feature,”with “employment, backlogs and inventories all continuing to fall.”

In addition Russia’s services sector returned to growth during August. Both the level of activity and amount of new business rose for the first time since last September, resulting in an overall improvement in the business climate. Employment continued to fall, but the rateof job shedding was at its slowest in ten months. Costpressures intensified again, but remained subdued whencompared against the long-run trend for the survey.

The August services PMI rose by 3.7 points, reaching 52.2, ending a ten-month sequence of decline in the service sector. That said, the survey organisers were at pains to point out that the latest figure still pointed to a relatively muted rate of expansion compared to the survey’s long-run trend.

As Unemployment Rises, And Incomes Fall, Domestic Demand Shrinks

Russia's unemployment rate has been declining recently after reaching its highest level in more than 8 years (8.8%) in April. The unemployment rate continued to decrease in August in all Russia’s 47 regions, according to the latest statement from the Russian Ministry of Health and Social Development. Still, the current 8.2% rate is still very high by Russian standards.



Household income which had begun to strengthen following last winters dramatic fall, began to weaken in late spring and was down 5.4% year on year in August, providing additional evidence that the stimulus spending isn't working out exactly as intended.



And so, not surprisingly Russian retail sales dropped the most in almost ten years in July, sliding for a sixth consecutive month, as households cut back spending in response to falling income and limited consumer borrowing possibilities. Sales slid 8.2 percent from a year earlier after declining 6.5 percent in June, according to the Federal Statistics Service.


Inflation Still The Big Bugbear

The best think that can be said about Russian monetary policy instruments is that they are hopelessly ineffictive. Even though August consumer-price growth was probably much lower than July’s 12 percent pace it is still extremely hard to understand how incompetence can have reached such a level that an economy which has been contracting at more than 10 per cent a year can still have double digit consumer proce inflation. There is no other word for it, this is a mess.



Producer prices at least have been falling, and slid again in July for the eighth consecutive month as industrial production slumped and companies competed by discounting products amid waning demand, according to the press release from the State Statistics Service. The price of goods leaving factories and mines was in fact down a record 12.3 percent compared with July 2008 after sliding an annual 9.4 percent in June. The pressure on wages and incomes is thus easy to see. What is not so easy to see is why domestic prices take so long in responding to these signals and the Economic Development Ministry still expects inflation to range from 12 percent to 12.5 percent in 2009 from last year’s 13.3 percent. Stunning!


Now suprisingly one of the biggest problems Russia faces as a result of this very disorderly contraction is a sharp fall in capital investment, which is dropping steadily almost with no relief. Down 18.9% year on year in July.



So, as the Federal government pounds in stimulus after stimulus, while oil prices however in the $70 dollar a barrel range, the country now risks returning to a period of entrenched budget deficits that may threaten its credit rating and lead directly to further ruble devaluation. The country faces “still-substantial risks to public finances due to the severe economic contraction” and financial risks linked to “stress” in the financial industry and liabilities of state-run companies, according to Standard & Poor’s analyst Frank Gill.

According to Gill, if the government fails to rein in the budget shortfall, the credit rating may be cut from its current BBB rating. Russia's budget deficit widened in the first eight months of 2009 to the equivalent of 5.9 percent of GDP, according to Finance Minister Alexei Kudrin following a shortfall of 4.3 percent in the first seven months. The expectation now is that the deficit may come in at around 8.9% of GDP on the whole year.

On the other hand the government stimulus plans involve an average outgoing of between 850 billion rubles ($26.8 billion) and 900 billion rubles a month this year following a 1.5 trillion ruble jumpstart in December. In its attempt to plug the gap the government is drawing on its $85.7 billion Reserve Fund and $90.7 billion National Wellbeing fund, which were built on windfall oil revenue, tin order to pay for an “anti-crisis” program that estimated to be worth about 2.5 trillion rubles ($79 billion) you include the tax breaks, central bank lending and all the other multifarious measures.

With the Reserve Fund expected to be drained by the end of next year, Russia will need turn to international debt markets for the first time since 1998, and is seeking to raise $17.8 billion from investors next year, according to Alexander Kudrin. This will mean the country’s debt to GDP ration - which is still very, very low by international comparisons - will more than double by 2012, growing from 6.5 percent of GDP in 2008 to 16.4 percent by 2012 according to Finance Ministry estimates.

How To Get Out Of the Mess

Well, one way not to solve the problem would be a ruble devaluation according to European Bank for Reconstruction and Development Chief Economist Erik Berglof. Even while recognising that the country has a very difficult couple of years in front of it, Berglof argues “this (devaluation) is the wrong way to think about the recovery in Russia”.

As he says, Russia’s failure to wean itself off its reliance on commodity exports has condemned the country struggling to find economic growth in the face of a large drop in demand for its key export products. “If you want to have a flexible exchange rate, you need to get out of this dependence on commodities,” Berglof said. “It’s a major concern that in the last 10 years Russia has become actually more dependent on commodities. Unfortunately, not much progress has been made.”

Well, this is eaxctly the point, and is why I have been arguing over the last two year about how all those wage increases which the Russian administration seemed to rejoice in (since they bought short term popularity) simply fuelled domestic inflation and in the process did untold damage to domestic competitiveness. However it is evident Russia's industries cannot now simply be transformed overnight, and this is where I find a weakness in Berglofs argument, since some remedy is needed to straghten out the distortions and get of commodity export dependence. But what? If it isn't devaluation, then surely we will need to see very substantial wage deflation in order to attract the now much needed inward foreign investment.

Of course not everyone agrees with Berglof, and the Russian Association of Regional Banks, whose 450 members include the Russian units of Barclays and Citigroup, has called for a devaluation of as much as 30 percent. Billionaire Vladimir Potanin, realist and owner of 25 percent of OAO GMK Norilsk Nickel, said in recent interview with the Russian Newspaper Vedomosti that the “interests of the economy” will lead the currency to depreciate in the “mid term,” allowing exporters to cut costs and modernize production.

Nonetheless energy, including oil and natural gas, accounted for 69.1 percent of exports to countries outside the former Soviet Union and the Baltic states during the first seven months of this year, according to the Federal Customs Service, while metals were responsible for another 12%. So the commodities dependency is massive, and this situation can't be turned round easily.

Getting Carried Away By Global Liquidity?

Bank Rossi are also not 100% convinced by Berglof's reasoning, as witnessed by the fact that they facilitated a 35 percent depreciation in the ruble during the second half of last year (see chart below), and as the collapse in raw material prices and the dramatic change in local credit conditions first pushed Russia's economy into recession the ruble’s trading range was widened to between 26 and 41 against the dollar-euro basket.

However the central bank is now locked on the horns of a massive dilemma, since as risk appetite returns, with it comes the enthusiasm for buying the so called "high yield" currencies - like the South African Rand, the Russian ruble and the Hungarian forint. Instruments denominated in all these currencies offer investors substantial returns at the present time thanks to offering some of the highest interest rates among globally traded currencies.

Indeed buying Russian rubles was one of the key recommendations made by Angus Halkett, currency strategist at Deutsche Bank in London, in a research report published back in April, and the market seems to have followed his advice The so-called carry trade works by investors borrowing in currencies with low interest rates and good prospects of continuing depreciation (the USD at the moment, for example) in order to buy higher-yielding assets, in countries with high domestic interest rates and continuing prospects for ongoing appreciation.

In general, engaging in one or other form of the thousand-and-one-varieties carry trade is pretty standard practice during times when returns for real economic activity are low, and central banks hold down rates and supply liquidity. Indeed we may include here the kind of carry practiced by banks in borrowing from the central banks only to then lend - for a small, but very low risk, interest rate commission - to their national government, who at this stage in the business cycle will normally be running a fiscal deficit. So more than funding recovery, the watchword at the moment is very much "carry on carrying".

But for those on the receiving end, the consequences of so much carry are far from innocuous, since the process simply funds all sorts of economic distortions, and far from allowing normal market corrections to occur, it simply amplifies the problem. And this is exactly what is starting to happen now in Russia. The ruble had its biggest weekly advance in more than three months last week as risk sentiment rose, following industrial output data from China, which is now the world’s second-largest energy user, which simply showed output increased at a faster pace than forecast.

As a result the ruble tends to rise as risk sentiment does, and in particular as economic data exceeds consensus expectations, and the currency has now been on an upward trend since mid-August (see chart below), gaining 0.7 percent to 30.6629 per dollar last Friday alone. This was the highest close since July 27. Over the week as a whole the ruble appreciated 3.1 percent, the most since the week ending May 22. So things are now becoming very detached from the so called "fundamentals" (whatever those might be in the topsy turvy world in which we now live), since it simply is not plausible that the currency should be rising in this way in a country with 12 percent consumer price inflation and which badly needs to move away from commodity export dependency. The only conclusion which could be drawn is that the Russian economy now needs massive structural reforms, and on any imaginable scenario in the world in which I live these are simply not going to be implemented.


Bad Loans About To Surge?

We also need to consider what is going on in the banking system. According to the lastest report from Standard and Poor's Russian banks currently face “increasing system-wide risks” as loan quality deteriorates and borrowers struggle to keeps their heads above water during the record economic contraction.

S&P last week downgraded Bank Vozrozhdenie’s credit rating to B+ from BB- and Alfa Bank, Russia’s biggest private lender, was cut to B+ from BB- as a signal to the industry. As the ratings agency indicated, the inability of Russian companies to continue to make their debt payments will more than likely further stifle lending as banks channel funds into building up their reserves.

“The ratings on Bank Vozrozhdenie broadly reflect the increasing system wide risks in Russia due to the economic recession and deteriorating operating environment,” the S&P analysts said. “The downgrade primarily reflects deteriorating asset quality for Bank Vozrozhdenie, and the entire Russian banking industry, owing to the continuing economic slowdown.”

OAO Sberbank, VTB Group and other lenders are also facing a surge in “troubled assets” that may total $213 billion, according to an earlier Standard & Poor’s report in June - with as much as 38 percent of all assets held by Russian banks possibly becoming problematic by the end of 2011. Russia's banks had already set aside 1.5 trillion rubles ($48.9 billion) in July to cover overdue debt, a monthly increase of 7.6 percent compared to a rise of 6.9 percent in June, according to the last statement from Bank Rossii (Sept. 1).

Sberbank’s provisions for the rising debt reached 388.1 billion rubles, or 7.1 percent of total lending, as of June 30, according to the bank itself. The share of bad loans in the second quarter jumped to 6.4 percent from 3.5 percent in the first quarter, while year-to-date lending by the bank was only up 0.4 percent.

At Bank Vozrozhdenie, S&P's estimate that about 15.7 percent of loans are “under stress,” S&P. The bank, which focuses on lending to small and medium- sized businesses, saw non-performing loans rise to 7.3 percent at the end of the second quarter, compared with 3.4 percent in the first three months of the year.

Overdue bank loans in the system as a whole reached 5.5 percent of total lending in July, compared with 5 percent a month earlier, with overdue corporate loans jumping to 5.3 percent in July from 4.8 percent in June. The bank corporate loan books fell by 0.2 percent in July, while lending to households was down 0.4 percent for the sixth consecutive monthly decline.


Russian Outlook

In this report we have identified how steady and systematic long term mismanagement of Russia's monetary policy how now created a veritable Procrustean bed of problems for Russia's economy and society. Failure to address the underlying inflation problem between 2005 and 2008 meant that large structural distrortions were accumulated in the economy, including a massive problem of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has now arrived, and it is not at all clear just for how long we will all need to get to learn to live with it.

In a more or less reasoned analysis Capital Economics suggest that oil prices could fall back to somewhere around $50 a barrel in 2010. If this forecast proves anywhere near correct, the Russian economy is going to be subject to major downside risks, due to the difficulties posed by:

i) financing the fiscal deficit
ii) rising unemployment
iii) growing bad loans in the banking system
iv) refinancing external debt
v) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee. The Russian Economy Ministry seem to be getting ahead of themselves here, since only last week they raised their 2010 forecast to 1.6 percent growth from 1 percent. This would follow an anticipated shrinkage of some 8.5 percent this year. Economy Minister Elvira Nabiullina said on Sept. 9 output may grow 3.9 percent to 4.5 percent in the second half of this year compared with the first six months - and this I find hard to accept, unless the turnround in global economic activity turns out to be much stronger than the one we are currently seeing. The consequence of this is that it will still be some years before Russian GDP even gets back to the 2008 level, as Capital Economic's Neil Shearing recently argued (see chart below).

I also agree with Neil that while financing the Russian deficit is unlikely to add to the inflation issues (given the substantial output gap under which the economy currently labours) underlying inflation is bound to remain well above any reasonable comfort zone, and this will complicate policy decisions enormously.

Financing the fiscal deficit - which looks set to top 9% of GDP this year and despite some planned fiscal consolidation is unlikely to fall much below 5% of GDP in2011 - is not a major problem for the government, although the issue of which currency to issue the inevitable bonds in will be, since the likelihood of devaluation at some point remains large - Neil Shearing expects the currency to fall by 10% against its dollar/euro basket over the next six months or so, breaching in the process the current lower bound of the trading range, and this it seems to me is a perfectly reasonable expectation.

Of course, talk at this point of a return to the sort of chaos we saw in 1998 is certainly premature, especially with debt to GDP only just breaking the double digit frontier. But serious issues do lie ahead in 2010, not least of them how to recapitalise Russia's badly wounded domestic banking system, and how to refinance all the outstanding forex denominated corporate debt. Of course, if we are living a fairytale version of Alica in Dynamic Global Recovery land, then demand for Russia's commodity exports will surge again in 2010 and 2011. But what is we aren't, and demand remains muted, or more financial problems break out on Europe's perfifery? Perhaps the prudent investor will be able to spare the time to give just a little thought to the likelihood of this second, and definitely less apetising scenario.

Russia's Contraction Eases But Knife-edge Risks Remain For 2010

The Russian ruble strengthened the most in more than three months against the dollar this morning (gaining 1.7 percent to 32.2247 per dollar at one point) as oil rebounded above $60 a barrel and OAO Sberbank reported better-than-expected earnings. Sberbank shares jumped 5.1 percent after first-quarter net income turned out to be above analyst estimates. But the rise was also helped by the fact that Russia’s central bank spent approximately $2 billion from reserves to try to stop the ruble from falling yesterday, taking central bank reserve spending over the two working days since they lowered interest rates half a percantage point on Friday to around $4 billion, according to reports in the newspaper Kommersant.

Russia’s central bank cut its main interest rates for the fourth time in less than three months at the end of last week after the government estimated the economy contracted an annual 10.2 percent in the January-May period. Bank Rossii lowered the refinancing rate to 11 percent from 11.5 percent following on initial reduction on April 24 and two further cuts on May 13 and June 5.

But the striking thing here is that today's ruble surge followed seven consecutive days when it fell - including yesterday when it dropped 0.5 percent against the euro and 0.1 percent against the dollar to hit the lowest close against the central bank's currency basket since May 4. Indeed only last week the ruble posted its steepest slide against the euro and dollar since January as oil prices fell and Russia's budget deficit contined towiden. And to top it all, as I say, the central bank reduced interest rates for the fourth time in less than three months.

Indeed just after the rate cut Alfa Bank’s Chief Economist Natalia Orlova commented that she was seeing a “very fragile trend” in the ruble, with a lot of downside potential: and I completely agree with her. What we have is a lot of volatility and a lot of market nervousness. Just this morning Bloomberg cited a research report from the ING Group warning that "the ruble may drop as much as 5.8 percent to the weakest end of Russia’s target exchange-rate basket as the central bank aims to revive credit by lowering key interest rates by up to 4 percentage points.” (research note here).

My feeling is that a 400 basis-point reduction would have an even bigger impact than even ING expect. Basically central banks in a number of central and east European countries are caught in a kind of trap, where the high level of forex borrowing both households and companies have engaged in makes local monetary policy rather impotent, and worse, this impotence itself becomes a self perpetuating situation. The trap perpetuates itself since people become reluctant to take out local currency denominated loans due to the high interest rate they carry, so they take out either dollar- or euro-denominated ones and thus make matters even worse, making the possibly erroneous assumtion that end game of all this will be either a dollar collapse (the Russian view) or eventual euro membership (in places like Hungary and Romania). Those doing the borrowing thus feel themselves to be completely covered, and fail to take into account the capital loss that could follow a large correction in their own local currency.

Slowly monetary policy makers in the most affected countries are coming to recognise that they need to address the issue, and somehow or other to get rates down, since the problem is not going to simply go away, and the meanwhile the respective economies keep on shrinking, with no positive boost from local monetary policy. But it is just when they start to lower rates that things start to turn nasty on them, since the whole situation is non-linear. Supporting a currency with high interest rates works for as long as it does on the win-win dynamic of yield differential AND a rising currency, but once the so called carry trade "punters" get the idea that political pressures to address the economic contraction may force substantial rate cuts on the government and the monetary authorities, and that the expectation of such rate cuts may lead the other "punters" to sell local instruments and exit the market, then the "thinking punter" finds he or she also needs to sell, and this is how we get to see that "will the last one out of the door please turn the lights off" type of self fulfilling herd behaviour.

I would say Serbia, Ukraine, Hungary, Romania and Russia are all vulnerable to this kind of outcome. Of course, from a macro economic viewpoint they can all start to bring interest rates down as inflation steadily drops, but I'm not sure that the inflation element is an important consideration for the short term carry-trade people, since it is the absolute yield differential, and the currency dynamics that would seem to matter most.


Sharp GDP Contraction

Evidently the background to all this nervousness is last week's announcement from the economy Ministry that Russia’s economy may shrink by as much as 8 to 8.5 percent this year. Gross domestic product probably contracted by an annual 10.2 percent in the first six months and may slump at a 6.8 percent annual rate in the second half, according to the latest Ministry forecast.

Behind this drop in GDP lies the fact that Rusia's exports were down by 47.4 year on year in the January to May period, largely due to falling prices for oil and raw materials. The economy ministry also said it expected capital investment to fall by around 21 percent this year as utility and energy companies, which account for about a third of total investment, cut spending programs. The ministry forecast is based on an oil prices scenario of an average $54 a barrel in 2009.

Further, industrial production is expected to shrink between 11 percent and 13 percent as manufacturing falls by as much as 17 percent. Inflation of between 12 percent and 12.5 percent is forecast, down from last year’s 13.3 percent. And retail sales are expected to suffer an annual contraction of 5.8 percent.


For the 2010 to 2012 period the ministry currently predicts a 1 percent expansion next year, followed by a 2.6 percent one in 2011 and 3.8 percent one in 2012. This “moderately optimistic" scenario would produce a deficit of 6.5 percent in 2010, followed by further deficits of 4 percent and 3 percent over the following two years. Government officials have recently stated they expect Russia to have a budget deficit of around 9% of GDP in 2009, up from an earlier 7.4% estimate.

Short Term Indicators Show Continuing Contraction

Industrial production shrank a record annual pace of 17.1 percent in May, while capital investment fell the most since December 1998, dropping an annual 23.1 percent.

Russian unemployment fell back for the first time in 10 months in May, but despite the positive effect this may produce on confidence the rate is sure to rise further in the months to come.





Retail sales fell the most in almost a decade in May, sliding an annual 5.6 percent, the fourth consecutive decline and the biggest since September 1999. The average monthly wage decreased an annual 3.3 percent in May, while real disposable incomes dropped 1.3 percent.

From Inflation To Deflation?

After all the inflation which seems to have become endemic in Russia, deflation would seem to be the most unlikely of scenarios, and indeed it is not the most likely of out comes, given the capacity of the authorities to allow the value of the ruble to fall. However, downward pressure on producer prices is evident at this point, and the cost of goods leaving Russian factories and mines dropped an annual 6.5 percent in May after falling 4.1 percent in April, according to the Federal Statistics Service. Prices rose 0.6 percent from April.

Russia’s inflation rate - which fell to an 18-month low in June - is still far too high. The rate dropped to 11.9 percent from 12.3 percent in May. Consumer prices rose 0.6 percent in the month, the same rise as registered in May. Russia’s inflation rate has averaged more than 14 percent a year since the country’s 1998 default and is certainly one of the biggest headaches facing the country.

Some Rebound In June

Russia’s manufacturing industry shrank last month at the slowest pace since September, and VTB’s Purchasing Managers’ Index advanced to 47.3 from 45.3 in May. So the rate of contraction is easing.

Further Russia's service industries shrank in June at the slowest pace since the contraction began in October, according to the VTB Capital Purchasing Managers’ Index which rose to 49.7 from 46.6 in May.




As a result the VTB Capital GDP indicator showed an annual 6.4 percent rate of contraction in the second quarter following a 5.4 percent decline in the first three months of the year. But output was shown shrinking at a 4.8 percent rate in June (from a year earlier) as compared with 6.8 percent contraction rate in May.

“The GDP indicator suggests that the economic decline in the second quarter of 2009 is likely to be similar to, or slightly worse, than in the first quarter,” Aleksandra Evtifyeva, an economist at VTB Capital, said in the report. “However, the prospects for the second half look brighter.” The pace of Russia's economic contraction eased to a 5-month high of 4.8 percent year-on-year in June, compared with a 6.8 percent shrinkage in the previous month, VTB bank's GDP indicator showed on Monday. The June reading "suggests that the economic decline in the second quarter is likely to be similar to or slightly worse than in the first one," VTB Capital senior economist Aleksandra Yevtifyeva said in the report.

2009 Contraction In Double Figures?

According to the latest report from the World Bank collapsing industrial production, rising unemployment and ongoing capital flight will reduce Russia’s gross domestic product by 7.5 percent this year and restrain “intraregional trade flows and transfers,”. The Bank also highlighted that “Remittances to the broader CIS region are expected to decline for the first time in a decade, by 25 percent”.

Neil Shearing of Capital Economics forecasts a contraction of 10% this year, zero growth in 2010 and fears that Russia may be facing a kind of "lost decade", since it may well not recover the 2008 level of output till 2014, and there are still clear downside risks attaced even to this estimate.


Shearing identifies three main factors which may contribute to the lost decade. First and foremost, he notes, the banking sector remains under enormous strain. While official estimates put bad debt at around 12% of total loans this year, Shearing thinks the true figure is likely to hit something closer to 20%. On this basis, he estimates that the banking sector could require up to $60bn in additional capital – far more than the $30bn that has so far been allocated by the government.

Second, by using so much ammunition this year, authorities leave little scope for further policy stimulus. Monetary policy is somewhat hamstrung as we have seen earlier, and fiscal policy will have to be tightened over the coming years in order to rein in a ballooning budget deficit. Indeed, Laura Solanko of the Finnish Central Bank's Transition Economies Centre calls this "the largest fiscal stimulus ever" in the Russian context.

As Solanko points out, the current crisis has hit oil and gas exports particularly hard, leading to a 47% decline in export duties and a 53% decline in proceeds from taxes on natural resource extraction during the first four months of 2009. The drop in general economic activity has further reduced proceeds from all revenue sources. General government revenues in January–April were 20% lower than a year earlier. If current trends continue, Solanko estimates that general government revenues may drop to close to 35% of GDP this year - down from around 50% in 2008.

Meanwhile, government expenditure has increased dramatically at all levels. In January–April this year, enlarged government expenditure increased by 23% to RUB 4,140 billion. The expenditure at the core of the Russian fiscal system, the federal budget, increased by an astonishing 37% compared with the same period a year earlier. Even taking the fairly high inflation into account, this equals a 20% increase in federal expenditure in real terms. Relative to GDP, general government expenditure has risen to 37% and federal expenditure to 23% of GDP, against 28% and 16%, respectively, a year earlier.

To sum up, public sector expenditure has nominally increased by 23%, and relative to GDP by a whopping 9 percentage points compared with the first four months of 2008. The sheer magnitude of such a fiscal stimulus is huge. During the 1990s, Russia’s public sector shrank dramatically, its GDP share decreasing by 12 percen-tage points to 26% of GDP in 1999. The current fiscal stimulus has shot public expenditure back to the level of the early 1990s.

As the automatic stabilisers in the Russian fiscal system are small, the expenditure increase largely reflects expenditure on anti-crisis measures and advance transfers to the regions by the federal government. The government’s anti-crisis measures announced by mid-March 2008 alone would increase federal expenditure by some RUB 2,000 billion, or 15%, in 2009. Roughly half of that is directed to strengthening the financial system, and the other half to supporting the real sector.

The current federal budget foresees a deficit of 7% of GDP, a figure only slightly larger than last year’s surplus – and only slightly smaller than the total assets of the Reserve Fund. This im-plies that most of the Reserve Fund will be exhausted by year end and the Russian government will have to reenter the domestic and external bond markets in 2010 at the latest.

And we should never forget that Russia remains in the grip of a pretty vicious credit squeeze. Bank lending to companies fell 1.5 percent in May compared with April, while retail loans dropped 1.9 percent. Overdue bank loans reached 4.6 percent of the total in May, versus 4.2 percent a month earlier. And while many Russian corporates may be restructuring their debt, the only deepening their longer term exposure to currency correction risk. As in the case of Moscow-based steelmaker OAO Mechel, who, according to Bloomberg, just agreed to refinance $2.6 billion of loans in the biggest foreign-debt restructuring by a Russian company since the credit crisis began. Such refinancing is not coming cheap - the rate was 6 percentage points over the London interbank offered rate - but even more to the point this type of restructuring may only to a certain extent postpone the inevitable, since the new debt now becomes due in December 2012. This is fine if everything is all hunky-dory come 2012, but if it isn't.....

As the OECD put it in their latest report on Russia

“The main threat to credit growth now appears to be solvency problems, arising from the declining capacity of borrowers to repay bank loans,” the bank said in an economic report released today. “The challenge is to maintain capital adequacy and prevent a sharp curtailing of lending flows.”

Lastly, Neil Shearing points out there remains little external support for the economy. With the global recovery likely to disappoint, export demand will remain weak. Oil could fall to $50pb by early-2010. As ING say:

"Oil price dynamics pose additional risks to RUB. Last week, oil prices plunged below the technically important EMA-200 level of US$63/bbl, indicating a potential further drop to US$47-54/bbl. If this happens, the RUB looks destined to weaken as well, given its greatly strengthened correlation with oil prices over the past two quarters".

And if oil does drop back to this range, and the ruble does weaken, and non performing loans rise above the 20% mark (pushed by that very same ruble weakening, and the rising unemployment), and the Russian Federal Government has to start issuing bonds in 2010, well watch out, is all I can say, since trouble will surely be in store. This is very much knife edge touch and go stuff from here on in. Grit your teeth everyone.

Facebook Links

Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.

Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't fit any mould, and Iam hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

The New Orthodoxy Is Upon Us

We seem to be witnessing the arrival of some kind of new financial orthodoxy. The IMF put it like this in the Hungary Standby Loan Report (which by chance I was reading last night):

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

So from Tallinin, to Riga, to Budapest, to Bucharest, the same sonata on a single note is being played, and the message is cut spending and you will expand. Funny how people are not very convinced about this idea in Berlin, London, or Washington. Sounds like they haven't heard about the paradox of thrift either.

Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.

And today we learn that Dmitry Medevdevis is getting the gospel (via the evangelist Alexei Kudrin)and planning his own package of "expansionary" fiscal cuts for 2010.

Dmitry Medevdev, Russia’s president, on Monday ordered the government to prepare for a continuation of the economic crisis into 2010, delivering a markedly pessimistic view of the country’s economy and mandating wide-ranging budget cuts until now put on hold.

In an address to top government officials on the budget priorities until 2012, the president sided with the fiscal conservatives in an economic debate that has been raging within the Russian government since last autumn, over how much to cut spending in the face of the crisis.

One of the 10 priorities he announced was “transfer to a strict regime of saving budget resources”. This year Russia will run its first budget deficit in the decade, projected at 7.4 per cent of GDP, which is to be funded almost entirely out of official reserves. Monday’s forecasts, which assume a price of oil of $50 per barrel in 2010, put the budget deficit of 5 per cent of GDP in 2010, falling to 3 per cent in 2011.

Mr Medvedev’s remarks indicate the consensus view on the economy has been getting more bearish, in line with that of Alexei Kudrin, finance minister, who sees the crisis lasting longer than initial forecasts, which saw growth returning by the end of 2009.

Mr Kudrin said lower budgets deficits could only be achieved if the whole system of budget spending was reviewed. “A review of spending, a transition to targeted spending and saving – these are the key words in the next three years,” he said.

Aleksander Auzan, an economist and director of the Social Contract Institute in Moscow, said the projections delivered by Mr Medvedev meant that the fiscal conservatives such as Mr Kudrin had won the debate for now.

Of course, as Krugman points out, the paradox of thrift normally operates in circumstances where monetary policy has been eased so far that interest rates are starting to get stuck around the zero bound, while Bank Rossii has been busy promoting ruble liquidity by pushing interest rates steadily up, although they have been eased slightly of late to 12%, still offering a yield which is very attractive in comparative terms and drawing in a growing crowd of carry traders who are systematically pushing the ruble to ever higher levels and weakening the export potential of Russia's non-oil manufacturing sector in the process.

Russia’s ruble climbed to a four- month high against the dollar, headed for its longest run of weekly gains in almost two years, as surging oil prices and higher interest rates lured investors to the country.

The ruble jumped to as strong as 31.1607 per dollar today, the most since Jan. 14, and is poised for a 2.8 percent gain in the week, its sixth weekly advance and the longest rally since September 2007. The central bank bought the most foreign currency on the market in almost a year this week as it sought to control the advance, said Mikhail Galkin, head of fixed- income and credit research at Moscow’s MDM Bank.

The ruble has climbed 16 percent since the end of January amid a 39 percent jump in Urals crude, the country’s chief export blend, and central bank efforts to deter bets against the managed currency. The ruble depreciated 35 percent in the six months to Jan. 31, spurred by Urals crude’s more than $100 slump from a record high and the worst global financial crisis since the Great Depression.

Bank Rossii, has been buying foreign currency on the market in a bid to limit the ruble’s volatility, the central bank’s First Deputy Chairman Alexei Ulyukayev said in an interview last week.

Deustche Bank last week specifically recommended buying Hungarian forint denominated assets - according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among the most interesting trades at present. At the start of April Goldman Sachs also recommended investors to take advantage of the unique opportunity and use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles.

But we need to be careful here. Kudrin is undoubtedly right, Russia does need to dig herself in for a longish winter. There may well be no global 'V' shaped recovery, and the Russian economy may well have to learn to cut its coat according to its cloth in order to live with oil at prices below the critical levels for Russian stability. But please, oh please, don't let's start fooling ourselves into thinking that applying fiscal and monetary tightening is expansionary!

The Russian Government Forecasts A Possible 8% GDP Contraction For 2009

Of course, with all these large negative numbers doing the rounds at the moment, we are all in danger of going rapidly dizzy, but some pieces of data still have the power to shock, like this morning's announcement from Russia's Economy Minister Elvira Nabiullina that the economy may shrink as much as 8 percent this year.

“The specific contraction numbers could be 4 percent or 6 percent or 8 percent,” Nabiullina said in an interview with Bloomberg Television in Moscow today. “We’re doing various calculations, pessimistic and optimistic. We believe much depends on how efficient we are.”

So the Russian Government is still running through the scenarios, and the ministry now promises to submit new growth forecasts by the end of the month, but it is worth bearing in mind that, as recently as last January, the most probable estimate stood at minus 2.2 percent. And the Economy Ministry aren't the only ones with the excel sheets and calculators out - Alfa Bank, Russia's largest private bank, Goldman Sachs, Citigroup and the International Monetary Fund have all revised their 2009 growth forecasts down recently, with Alfa this week cutting its outlook to minus 5.7 percent from an earlier anticipated drop of 3 percent. Nabiullina's deputy, Andrei Klepach, recently described the International Monetary Fund’s estimate for a 6 percent annual drop as “realistic.”

Russia's Economy Contracts By 7% In Q1 2009

According to Deputy Economic Development Minister Andrei Klepach last week, Russia's economy shrank by 7 percent year on year in the first quarter of 2009, a staggering turnaround for an economy which has just enjoyed eight years of solid oil-fueled growth.

"These figures are worse than we expected," Klepach said at a press conference in Kiev,citing preliminary figures. Klepach also stated that net capital outflows reached $33 billion in the first quarter of 2009, following record outflows of $130 billion in the second half of last year.

The Russian State Statistics Service have also released official gross domestic product figures for the fourth quarter of 2008. GDP was up 1.2 percent year on year, the worst reading for any quarter since the first quarter of 1999, and down from a revised 6 percent in the previous three months. The World bank are now suggesting that the present slump may be deeper than the one that followed the government debt default and ruble devaluation in 1998.

Certainly the data are bleak. Industrial production contracted for a fourth consecutive month in February - falling by 13.2% year on year - as the credit squeeze and falling incomes eroded demand for metals, cars and consumer goods. Retail sales contracted in February for the first time since February 1999. Unemployment was also up, at 8.5 percent in February, the highest level since January 2005.

Manufacturing output plunged with the collapse in demand in the last two months of 2008, and it is likely to contract further in 2009. According to Rosstat five of 14 major manufacturing industries reported outright output declines in 2008, with electronics, electrical, and optical equipment hardest hit (-7.9 percent), followed by textile and sewing (-4.5 percent) and by chemicals (-4.2 percent). Most of the dislocation took place in November and December 2008, when total manufacturing output respectively fell 10.3 and 13.2 percent (year-on-year). As credit continues to tighten and demand to fall, manufacturing is likely to contract further in 2009. According to recent statistics, manufacturing output dropped 24.1 percent in January 2009, compared with January 2008, and 18.3 percent in February 2009, compared with February 2008. In February 2009 the most significant declines were registered in the production of electro-technical and optical equipment (-46.6%), other non-metal products (-33.3%), and transport and transportation equipment (-31%).

Tighter credit, collapsing global demand, huge global uncertainty, and rising unemployment have hurt both investment and consumption growth in Russia. According to Rosstat, total fixed capital investment grew 9.8 percent in 2008, compared with 21.1 percent growth in 2007. More worrisome is the investment decline by 2.3 percent in the fourth quarter of 2008 (year-on-year), largely reflecting escalating liquidity problems in the banking sector and the resulting credit crunch and a deceleration in consumption growth due to rising unemployment and lower growth. (World Bank Report, April 2009)

GDP Indicator Shows 5.4% Contraction in March


The latest data we have to hand confirm the ongoing character of the contraction. The Russian economy is thought to have declined by 5.4 percent in March compared with March 2008, according to the latest GDP indicator estimate provided by VTB Capital. The VTB GDP indicator also registered an average 4.4 percent contraction for the first three months of 2009, which would be the worst decline since the economy shrank 5.1 percent in the fourth quarter of 1998. The difference between the VTB estimate and the 7% estimate put forward by Klepach would lie in the fact that the VTB indicator does not include contstruction, and construction activity has declined sharply in recent months, so the two pieces of data are consistent with one another.



Purchasing power has been reduced by lower wages and less access to credit, togther with rising unemployment rates. 6.4 million Russians, or 8.5 percent of the economically active population, were unemployed in February, a 5 percent increase over January and a 20 percent increase on February 2008. The World Bank forecast recently that unemployment would rise to 12% in 2009.

The weakening in retail sales and other consumption indicators is not that surprising given the strength of the contraction, and especially since there is now growing evidence that Russia's employers, in order to make cost savings while maintaining staff levels during financial crisis, are more and more resorting to salary reductions or part-time working schedules. This approach is thought to be being used widely and appears to have much more legitimacy under Russian law than simply telling employees to go home and take unpaid leave. Employers are being advised to take special care when unilaterally modifying major terms and conditions in employment contracts, since although under the Labour Code, changing the terms and conditions of an employment contract is permitted only by mutual written agreement of both parties, there is an exemption from this rule – Article 74 of the Code - which specifies that in the event of a change in organizational or technical working conditions which make it impossible for the previously agreed terms of an employment contract to be maintained, an employer is entitled to unilaterally change such terms on his or her own initiative.

As a result of this contraction in output and weakening in the labour market real incomes have declined substantially in Russia since the autumn of 2008. Rising unemployment and worsening enterprise finances (wage arrears have increased considerably) have meant that in the fourth quarter of 2008 alone, real disposable income dropped 5.8 percent year on year, and by 10.2 percent in January 2009 (again year-on-year). And unpaid wages as a share of total enterprise turnover tripled to 0.12 percent in December 2008, compared with August 2008. The stock of wage arrears as of March 1, 2009 (8 billion rubles or about USD 240 million) remains small but is likely to increase as the crisis grows. At the present time such arrears are thought to affect up to 450,000 people, significantly less than 1 percent of total employment. Growth in real wages came to a complete halt in January-February 2009, following double-digit increases in previous years.

Russian Services Contract Less Slowly In March

Activity in Russia’s service sector continued to contracted in March, although the seasonally adjusted headline VTB Services Purchasing Managers Index rose to 43.9 in March from 40.0 in February. Since any readings below 50.0 signals contraction, we can see that while Russia's services are still contracting, they are contracting somewhat less rapidly than in earlier months.



Activity and new business both declined for the sixth consecutive month, however the rate of decline in the volume of new business was at its lowest rate since last October. However a survey-record decline in employment was registered in March, with redundancies at their most severe in hotels and restaurants. Firms raised output prices at a weaker rate in March, as input price inflation moderated and pricing power remained weak due to falling demand for services.

“Surging price competition on the back of weak market demand has urged companiesto tighten their cost cutting programs. Among the measures that have been applied are further redundancies that resulted in the fastest rate of employment contraction in the history of the survey. The input price inflation eased slightly, however, the pressure of utilities charges remains significant,” Svetlana Aslanova, an analyst at VTB Capital, commented on the survey.

As Does Manufacturing


Russian manufacturing contracted at the slowest pace for five months in March as companies reduced their stocks of unsold goods and the decline in new business eased, according to the latest PMI report from VTB Capital. The VTB Purchasing Managers’ Index was at 42 last month after a 40.6 reading in February. Stockpiles of unsold goods fell at the fastest rate since December 2005, according to the survey of 300 purchasing executives.



Inflation Rising Again

Russia’s inflation rate rose to a five-month high in March as the weaker ruble boosted import prices. The rate rose to 14 percent from 13.9 percent in February, while consumer prices grew 1.3 percent month on month, compared with 1.7 percent in February.




Inflation was spurred at the start of the year by the weakening ruble, which pushed up import prices, helping the annual rate jump to 13.9 percent in February from 13.4 the month before. The ruble has now lost 29 percent against the dollar since August. The most recent spike in inflation is evidently producing quite a headache for the Central Bank, since chairman Sergei Ignatiev last week that if April's inflation is “significantly less” than it was a year ago, the central bank may consider cutting interest rates for the first time since 2007, giving some kind of monetary relief to an economy which is badly in need of it. Russia’s inflation rate went as high as 15.1 percent last June, and has since come down somewhat from that peak, but really the record of the central bank in containing inflation has been pretty abysmal.

Bank Rossii has been forced to raise its refinancing rate twice since last November, to the current level of 13 percent, in an attempt to limit the amount of rubles available to banks and companies and to slow the decline of the ruble against the dollar. On the other hand the central bank may be in danger of excessive optimism at this point, with Ignatiev telling journalists that his expectation was that the economy may pick up within “several months,” thus trying to offer hope that Russia's banks won’t suffer that “second wave” of crisis that Finance Minister Alexei Kudrin said may hit as bad loans eat up capital. I am of the opinion that Kudrin is right to be cautious here.

Rising delinquency “is a serious problem, but I don’t share the opinion that a second phase of the crisis is unavoidable,” is Ignatiev's view. Overdue retail loans rose to 4.4 percent as of 1 March from 3.2 percent on 1 September. “I believe the most serious phase of the economic crisis is over," Ignatiev told journalists. Would that he were right, unfortunately I think he is wrong, the worst is still ahead.

Obviously the continuing inflation is a problem for Russia's central bank since they would obviously like to offer monetary easing to the economy, just as the U.S. Federal Reserve, the European Central Bank and the Bank of England are doing by bringing their benchmark rates close to zero to bolster banks and pull their economies out of recessions. Bank Rossii last cut the refinancing rate in June 2007, and it has now increased the repurchase rate charged on central bank loans four times since November.


The refinancing rate, seen as a ceiling for borrowing money and a benchmark for calculating tax payments, is currently at 13 percent after being raised in November and December. The central bank increased the repo rate charged on central bank loans twice in February.


Ignatiev admitted that problems with dealing with non-performing loans “could arise", and that he did not "think this is just empty talk,” although he stressed Bank Rossii would seek a solution should the banks be forced to increase reserves to deal with possible losses on loans. Bad loans are still a very low proportion of total debt, nut they are rising. NPLs held by OAO Sberbank, Russia’s largest lender, now make up about 2.8 percent of the bank’s loan portfolio, Chief Executive Officer German Gref last week.


Also, on the general economic front the pessimists more or less balance out the optimists. The latest in the pessimist camp, Vladimir Yakunin, head of OAO Russian Railways, said this week that the slowing in the decline of cargo shipments in March doesn’t seem to him to indicate that the country is pulling out of its economic crisis.

“We are only at the beginning of the crisis and we should wait for better and
more solid indications,” Yakunin, chief executive officer at the Russian state
rail monopoly which operates the world’s longest rail network, said in a
Bloomberg Television interview in his Moscow office today. “We didn’t yet pass
the middle point of the crisis.”

Railway cargo turnover fell by 15.8 percent in March from a year earlier, compared with a 32 percent fall in January and a 26 percent decline in February. The data is a “leading indicator of the trend in Russian industry,” according to VTB analysts in their GDP indicator. Yakunin said Russian Railways is “fighting” to limit this year’s cargo turnover drop to 19 percent as it is forced to slow down its development amid falling investment.

We also learn this week that Siberian Services, an oil-drilling company among whose clients are to be found OAO Rosneft, has defaulted on $100 million of bonds, thus becoming the first Russian borrower to fail to repay its foreign debt this year. Siberian Services didn’t redeem the 13.75 percent notes due 2010 by an April 3 deadline after bond holders exercised a so- called put option, according to Bloomberg news, citing some of the investors involved.


State-owned Finance Leasing skipped an interest payment on $250 million of securities in December, according to Bloomberg. Russian borrowers are struggling to refinance about $100 billion in foreign notes maturing this year as banks reduce lending following $1.3 trillion of losses and writedowns since the start of 2007.

Conflicting Futures?

While the Organization for Economic Cooperation and Development and the World Bank are forecasting that the Russian economy will decline by 5.6 percent and a 4.5 percent, respectively, in 2009, the Russian government is still stubbornly holding fast to its official forecast of a 2.2 percent fall. Publicly government officials are sticking to their view, and diiging in around the idea that they expect a recovery in the final quarter. Deputy Economic Development Minister Klepach said that the government forecast takes into account a package of anti-crisis measures currently being debated by lawmakers that should bolster domestic demand and help boost GDP. Without it, the economy could contract by 4 percent to 5 percent, Klepach noted.

The Central Bank, on the other hand, continues to forecast a 4.5 percent contraction for the current year.

The Russian Cabinet approved last month a revised budget containing the first deficit in 10 years. The budget anticipates a deficit of 7.4 percent of projected gross domestic product, but since the current forecast is for a GDP contraction of only 2.2%, the final deficit may be considerably larger. The Finance Ministry is now transfering money from the Reserve Fund to cover the deficit, and anticipates using some 2.7 trillion rubles this year to help fund the budget gap.

The Ministry of Finance has released the main parameters of its revised federal budget for 2009 which is based on lower oil prices (USD 41 a barrel, Urals) and a drop in budget revenues from the original 21.2 percent of GDP (under the old assumption of USD 95 a barrel) to 16.6 percent, or RUB 6.72 trillion. At the same time, expenditures will be increased by RUB 667.3 billion to RUB 9.69 trillion, to produce a deficit of RUB 2.98 trillion (about 7.4 percent of GDP), a massive reversal of the fiscal position from the 4.1 percent surplus in 2008.

The total consolidated general government deficit is expected to be around 8 percent in 2009 deficit and will be financed largely from the Reserve Fund (7 percent of GDP) with modest domestic borrowing (up to 1 percent of GDP). With a large fiscal deficit, however, and the need to preserve some reserve fund resources for the uncertainty likely to extend into 2010, the space for more fiscal stimulus this year appears limited.


So the level of the contraction which the Russian economy undergoes in 2009 really is rather big beer, since it will condition the size of the eventual fiscal deficit, and the percentage of the Reserve Fund which will need to be used this year. If there is no rebound in oil prices in 2010 then Russia's position can complicate on a number of fronts, since the Central Bank Reserves will be significantly depleted, the Reserve fund also, and there may be less room for fiscal easing in the face of potential credit rating downgrades, while monetary easing may also prove difficult given the need to support the currency, and protect Central Bank Reserves. Which brings is back to that “second wave” of crisis that Finance Minister Alexei Kudrin said may hit as bad loans eat up capital. Russian overdue bank loans are increasing by 20 percent a month, according to OAO Sberbank Chief Executive Officer German Gref this week. He also stated that about 3.7 percent of Russian bank loans are currently delinquent, a figure which compares with the 40 percent level hit at the peak of the 1998 crisis. The IMF are already predicting a 10% loan default rate, but at this pace we will hit that level in the autumn, while the 40% rate looms in the spring of 2010, unless there is significant upward movement in oil prices. In fact a Bloomberg survey of 17 bank analysts this week gave a mean estimate that Russian bank bad loans will quadruple to $70 billion this year, with non-performing loans rising to 12.8 percent of the 18.4 trillion rubles ($549 billion) owed by Russian companies and individuals. HSBC Holdings Plc, Europe’s biggest bank, expects delinquencies to reach 23 percent, Europe’s highest rate after Hungary at 25 percent.

All in all then, 2010 could be a very hard year for Russia and its citizens.

Russian Manufacturing Contracts More Slowly In March

Russian manufacturing contracted at the slowest pace for five months in March as companies reduced their stocks of unsold goods and the decline in new business eased, according to the latest PMI report from VTB Capital. The VTB Purchasing Managers’ Index was at 42 last month after a 40.6 reading in February. A figure below 50 means a contraction and above 50 implies growth. Stockpiles of unsold goods fell at the fastest rate since December 2005, according to the survey of 300 purchasing executives.

“Stocks of unsold goods declined which, combined with a sluggish contraction of the new business sub-index, suggest that the headline index may keep rising into the second quarter,” Dmitri Fedotkin, a VTB economist, said in the statement. Still, “no sharp recovery” in the index is to be expected.

The index showed contraction for the eighth straight month, a longer period of decline than the one registered in 1998, when the government devalued the ruble and defaulted on $40 billion of debt.

The manufacturing workforce shed jobs for the 11th month in a row, the longest period of contraction in the survey’s history, VTB said. “Firms reported that the redundancies resulted from lower workloads and the subsequent need to cut spare capacity,” it said in the statement.

OAO Severstal, Russia’s biggest steelmaker, plans to cut as many as 9,500 jobs at its Russian units, Chief Executive Officer Alexei Mordashov said on March 11. The metals industry as a whole could cut as many as 60,000 jobs this year, or 5 percent of the workforce as demand and prices slump, the Industry and trade Ministry said.