13 March 2014

EM Monthly: Limiting Contagion

Page 20 Deutsche Bank Securities Inc.

Russia: macro implications of increased geopolitical risk

Tensions over the situation in Ukraine escalated recently with Russia’s legislature granting its President the right to send troops to Ukraine, which notably increases the scale of political risks in the near term. The latter are likely to lead to a significant rise in capital outflows, which adversely affects the currency as well as the growth trajectory, most notably on the fixed investment side.

We assess the implications of political risks for Russia’s economy through various scenarios for capital outflows. Our analysis suggests that capital outflows of USD75bn would prompt a surge in the ruble rate to more than RUB/USD36 and prevent Russia’s economy from staging acceleration this year.

We assess only the sensitivities associated with the direct effects of capital outflows on growth and the exchange rate, and do not take into account the effects of sanctions, changes in interest rates and other factors. With respect to sanctions, we believe their overall direct effect is likely to be limited for the economy but may add to capital outflows even if sanctions are not fully applied but simply discussed publicly. All this implies that the estimates of the costs to the ruble and growth resulting from capital outflows should be seen as the lower bound of the total effect, which takes into account other factors, including sanctions.

Ukraine’s political turmoil poses risks to Russian economy

Putin authorized to send troops to Ukraine On 1 March, Russia’s President Vladimir Putin issued a request to the Federation Council for authorization to send troops to the Crimea peninsula, where the Russian fleet is based. This request was swiftly granted, with Russia’s officialdom noting that the decision to send troops had not yet been taken by Putin and that such a decision would depend on the course of events in Ukraine. These developments were accompanied by demonstrations in the eastern parts of Ukraine as well as in Crimea. Meanwhile, the latter is preparing for a referendum to get more autonomy from Ukraine or even to join Russia. The measures taken by Russia were met with the possibility of sanctions from the West, which may affect Russia’s economy. These developments notably increase near-term sovereign risks pertaining to Russia and Ukraine, and are fraught with the potential for acceleration in capital outflows.

Capital flight may erode economic outlook In terms of the economic impact, the main implication at the macro level for Russia is likely to be a significant rise in capital outflows, which adversely affects the currency as well as the growth trajectory, most notably on the fixed investment side. The overall impact on the ruble could be moderated in part by the relatively favourable global economic backdrop as well as by the tightening of monetary policy (the CBR already ‘temporarily’ hiked rates by 150bps at the beginning of March).

While in 2008-2009 the global economy was sliding into negative territory, which led to a sharp decline in oil prices, in 2014 the pace of economic growth may accelerate to well beyond 3% yoy, which should sustain oil prices at levels not too far off USD100/bbl (our commodities team projects USD97.5/bbl Brent). On the downside, however, the severity of economic isolation along with the resurgence of political uncertainty may exact costs, with considerations regarding macroeconomic fundamentals likely being overshadowed by negative sentiment.

Figure 1: Net private capital outflows, USDbn, 2005-13

-150

-100

-50

0

50

100

2005 2006 2007 2008 2009 2010 2011 2012 2013

US

Dbn

Banking sector - assets Non-Financial sector - assetsBanking sector - liabilities Non-Financial sector - liabilitiesnet errors and omissions Net Capital Outflow

Source: CBR, Deutsche Bank

2014 vs. 2008: fundamentals are different In terms of domestic economic development, the key difference now compared to 2008 is that the economy is not overheated. Back in 2008, the pre-crisis period was characterized by massive net capital inflows, a booming stock market and real estate segment growth, as well as high growth rates in GDP and lending. This time Russia’s financial markets are less overheated and growth is approaching zero, with growth in lending decelerating.

13 March 2014

EM Monthly: Limiting Contagion

Deutsche Bank Securities Inc. Page 21

Figure 2: Russia’s external debt profile, % GDP 3 3 3 4 4 6 6 6 6 5 5 4 4 4 3 3 3 3 3 3 3 3 3 3 3 3 3 3 2 3 2

16 1511 12 13

14 1312 12 11 10

10 11 12 13 13 12 12 12 12 11 11 11 11 11 12 13 13 15 16 16

1112

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1415 16 16 17

21 21 2119 18 17 17 16 16 15 15 15 14 14 14 1414

14 14

0

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30

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40

1Q06

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4Q07

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2Q08

3Q08

4Q08

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2Q09

3Q09

4Q09

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2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

% G

DP

General Govt & SOEs - ST Private sector - ST General Govt & SOEs - LT Private sector - LT

Source: CBR, Deutsche Bank

In terms of debt levels, Russia’s sovereign balance sheet is strong, even though the susceptibility to lower oil prices has remained high, as evidenced by the level of the non-oil budget deficit, which exceeded 10% of GDP last year. On the corporate side, the maturity of debt is less short term than in 2008 and has fewer currency mismatches.

Figure 3: RTS Index vs. Moscow Property Prices

0

200

400

600

800

1 000

1 200

1 400

1 600

2000 2001 2002 2004 2005 2006 2008 2009 2010 2012 2013

1-Ja

n-20

00=1

00

RTS Index Russia Moscow Property prices

Source: Bloomberg Finance LP, Deutsche Bank

At the same time, overall debt levels in the corporate sector remain significant, while the balance sheet of Russia’s households is arguably more problematic now than in 2008 (to the degree that it represents one of the macro risks and concerns for the CBR) after Russia’s household debt grew at a rapid pace over the past several years.

At this juncture there is scope for capital outflows to be significant this year given that, along with rising risks, oil prices are high and the current account is enjoying a surplus.

With respect to January data, the Ministry of Economy estimates net capital outflow from Russia at USD17bn in January 2014. Given the seasonality of this indicator, outflows appear to be in line with previous years

(USD17bn in January 2013 and USD16bn in January 2012). According to Economy Minister Ulyukaev, this is related to an increase in FX assets in the banking sector. In addition, the population actively purchased currency in January, which contributed to the outflow. We now proceed to look at the sensitivity of Russia’s economy to various scenarios of capital outflows.

Impact on the ruble We base our sensitivity analysis for the ruble rate on the following capital outflow assumptions.

Figure 4: RUB/USD vs. CA surplus and capital flows

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0

10

20

30

40

50-140-120-100

-80-60-40-20

020406080

2005 2006 2007 2008 2009 2010 2011 2012 2013

% y

oy (

inve

rse)

US

Dbn

CA, USDbn

Cap. flow,USDbn

RUB/USD,% yoy (RHS)

Source: Rosstat, CBR, Bloomberg Finance LP, Deutsche Bank

Scenario 1: Capital outflows moderate to a level of USD30bn from USD62bn in 2013.

Scenario 2: Capital outflows intensify to USD60bn, the level of 2011-2013.

Scenario 3&4: Capital outflows intensify beyond/significantly beyond the average levels of the past several years, namely to USD75bn and USD100bn, respectively.

Scenario 5: Capital outflows resemble 2008 and reach USD130bn.

Our analysis implies that capital outflows of USD75bn would prompt a surge in the RUB/USD rate to a year-average of RUB/USD36.5, while much higher outflows of USD130bn could lead to an average of RUB/USD40.

Figure 5: Impact of higher capital outflows on

RUB/USD, scenarios 2014 Cap. outflow,

USDbn Impact on RUB, %

RUB/USD, pavg

RUB/EUR, pavg

Scenario 1 30 6.9 34.0 44.2

Scenario 2 60 11.9 35.6 46.25

Scenario 3 75 14.8 36.5 47.47

Scenario 4 100 19.8 38.1 49.52

Scenario 5 130 25.7 40.0 51.97 Source: Deutsche Bank

13 March 2014

EM Monthly: Limiting Contagion

Page 22 Deutsche Bank Securities Inc.

Impact on growth In terms of the impact on growth, capital outflows undermine investment activity with the funds taken off-shore rather than invested in new production facilities.

Figure 6: GDP growth and its components’ dynamics

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-5

0

5

10

15

1996 1998 2000 2002 2004 2006 2008 2010 2012Household consumption Govt consumption Fixed asset investmentExport Import GDP

Source: CBR, Bloomberg Finance LP, Deutsche Bank

The uncertainty over the political and economic situation in Ukraine as well as concerns over possible sanctions imposed on Russian businesses could further exacerbate costs.

Figure 7: GDP, fixed investment vs. capital flows

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

%yo

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Net capital flow, %GDP GDP, % yoy (RHS) Fixed asset investment, %yoy (RHS)

Source: Rosstat, CBR, Bloomberg Finance LP, Deutsche Bank

We base our analysis on the same capital outflow assumptions that we used in the previous section.

Scenario 1: Capital outflows moderate to a level of USD30bn from USD62bn in 2013.

Scenario 2: Capital outflows intensify to USD60bn, the level of 2011-2013.

Scenario 3&4: Capital outflows intensify beyond the average levels of the past several years, to USD100bn.

Scenario 5: Capital outflows resemble 2008 and reach USD130bn.

In the figure below we illustrate the impact of higher capital outflows on GDP growth. The ‘direct impact’ column illustrates the first-round effect from higher capital flight, while the ‘impact’ column also accounts for some second-round effects and the resulting improvement in the CA balance.

Figure 8: Impact of higher capital outflows on GDP,

scenarios Cap.

outflow, USDbn

cap flow vs. 2013, Impact on GDP, pp

GDP, % yoy USDbn % GDP

Scenario 1 30 -30 1.4 1.0 2.3

Scenario 2 60 0 2.8 0.0 1.3

Scenario 3 75 15 3.5 -0.5 0.8

Scenario 4 100 40 4.7 -1.3 0.0

Scenario 5 130 70 6.1 -2.3 -1.0 Source: Deutsche Bank

Our analysis suggests that capital outflows of USD60bn would prevent the Russian economy from staging a significant acceleration this year, with annual growth of an estimated 1.3% yoy vs. 1.3% yoy in 2013, 3.4% yoy in 2012 and 4.3% yoy in 2011.

Second-round effects are skewed to the downside In this report we assess only the sensitivities associated with the direct effects of capital outflows on growth and the exchange rate, and do not take into account the effects of sanctions, changes in interest rates and other factors that may also have a significant effect on the macro outcomes this year. With respect to sanctions, we believe their overall direct effect would likely be limited for the economy but may add to capital outflows even if sanctions are not fully applied. In terms of the effects of interest rate changes, their temporary nature would likely result in a limited effect on lending and growth; however, if the current political uncertainty proves to be persistent, elevated rates could linger and have a greater adverse effect on growth this year. Another factor that may affect Russia’s outlook for the 2014-2015 period is the risk to the sovereign credit rating, as stated by Moody’s earlier this month. All this implies that the estimates of the costs to the ruble and growth resulting from capital outflows should be seen as the lower bound of the total effect.

Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. [Yaroslav Lissovolik, Artem Zaigrin]

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