Emerging Economies ProjectCountry Report - RussiaEPGP 2015

Manisha Aithal1514026

Rohan Agarwal1514041

VC Sundar 1514059

Uddipt Mitter1514062

Varun Devgan1514064

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TABLE OF CONTENTSKey Macroeconomic Challenge3Underlying reasons for the Recession in Russia3US Sanctions3Sharp Drop in International Oil Prices4Fiscal Austerity5Other side effects of the negative GDP growth:5Deprecation of Local Currency5High Inflation6Budget Deficit6Reducing Foreign exchange reserves7Policy Prescription8Fiscal Policy8Increase in Government Spending8Monetary Policy9Interest Rates9Currency Controls10Structural Reforms10Focus away from Oil and Gas10Other reforms11Reduce International Sanctions11Look East Policy12Demographics12

Key Macroeconomic Challenge The key macroeconomic challenge facing Russia in the past two years has been stagnant real GDP growth rate of the economy. [footnoteRef:1] [1: http://data.worldbank.org/indicator/NY.GDP.MKTP.CN]

More recently Russias GDP declined 4.6% year-on-year in June 2015.[footnoteRef:2] [2: http://www.ft.com/intl/cms/s/3/8e640b2e-3f71-11e5-b98b-87c7270955cf.html]

The negative growth rate in Russia has in turn caused a lot of other issues including but not limited to high inflation, depreciation of the local currency, reducing foreign exchange reserves and budget deficit. Underlying reasons for the Recession in Russia

US Sanctions The US and EU imposed economic sanctions on Russia in 2014 in response to Russias annexation of Crimea and the ongoing proxy war being fought in Ukraine. The sanctions, although not as severe as ones imposed on Iran, have still led to the Russian economy going into a spiral as it already deals with falling Oil prices. The Russian state banks are not allowed to raise capital from the western world and there are strict visa restrictions for Russian businessmen. Even more hard hitting was the restrictions on sales of dual-use goods and blocking of energy deals, which were a major source of foreign exchange for Russia. Since the companies in US and EU were not allowed to supply goods and parts to companies on the blacklist, the exports to other nations also suffered. All of the above US actions were aimed at the weakening the Russian President Putin, to economically destabilize the country, and fight a proxy war through trade and commerce. The Russian government imposed its own export bans in response to the western sanctions. Counter sanctions are believed to cause further fall in the economy. Sharp Drop in International Oil PricesThe other major reason for Russian economy suffering has been the sharp drop in oil prices during the last 2 years. From a peak of $ 110 in Sep, 2013 to a low of $42 in Aug, 2015 a barrel. [footnoteRef:3] [3: http://in.investing.com/commodities/crude-oil-historical-data]

Russia export in 2012[footnoteRef:4] [4: Harvard Atlas of Economic Complexity]

The above chart from 2012 shows that approx. 66% of Russian exports came from petroleum and gas products. Energy also accounts for 25% of its total GDP. As the case with many commodity rich countries Russia also suffers from over-reliance on its natural resources and has not diversified sufficiently to cushion loss from low commodity prices. The oil market is oversaturated with supply and there is weak demand from China and the developed economies. Fiscal Austerity Russia, similar to other Emerging economies, has been practicing pro-cyclical policies. Russia has been splurging during the commodity booms and cutting spending during the recession. [footnoteRef:5] Except defense, the finance minister proposed cuts in government spending up to 10%.[footnoteRef:6] With private consumption and investment already low, further budget cuts by the government will only exacerbate the situation of an economy in contraction. [5: http://www.economist.com/news/leaders/21638197-why-some-commodity-exporters-are-coping-better-lower-prices-others-what-vlad-can-learn] [6: http://money.cnn.com/2015/01/14/news/economy/russia-spending-cuts/]

Other side effects of the negative GDP growth:

Depreciation of Local Currency

The Russian Rouble has depreciated by more than 50%[footnoteRef:7] in the past one year due the above-discussed issues plaguing the economy. The only good news by some accounts is that in real terms the Rouble is still overvalued[footnoteRef:8] and the cheaper domestic currency can boost the export earning of the Russian firms. [7: http://www.economist.com/news/leaders/21636747-collapse-rouble-caused-vladimir-putins-belligerence-greed-and-paranoia-ye] [8: http://www.economist.com/blogs/freeexchange/2015/05/russian-rouble]

High Inflation

The annual consumer price index rose to above 16% during the first few months of the year in 2015.[footnoteRef:9] The main contributor to the high inflation rate was the rise in food prices, which was, in turn, caused by weak domestic currency and restriction of imports due to western sanctions. [9: http://www.wsj.com/articles/russian-inflation-accelerates-1425574517]

Russian central bank is facing a particularly tough situation as the economy slides into recession, the interest rates already at record levels, the scope for further rate increases to stem inflation seems to be out of the question. Budget Deficit

Russias budget deficit is expected to go as high as 3.8% of its GDP for the year 2015. At the same time compounding the problem is the ban on borrowing from foreign markets by the government to plug in the gaps left by the shrinking Oil and Gas revenues. This is in stark contrast to the 8 to 9 % budget surpluses that Russia saw during the 2006 2009 period. Reducing Foreign exchange reserves

To soften the impact of the of the falling Rouble, the central bank has used its large forex reserves to buy foreign currency. In recent months the forex reserves have bottomed out to a level of $350 Bn, with the central bank on its way to rebuilding its reserves or maintain it at this level. [footnoteRef:10] This is the lowest the reserves have been since April 2007. [10: http://mg.co.za/article/2015-08-13-rouble-rouser-enters-russias-bank]

What remains to be seen is how will the country cope up if the Oil prices continue its slide from the current $50 / barrel level.

Policy PrescriptionWe Believe that Russia needs varied Fiscal, Monetary and Structural reforms to combat the current crisis it faces. Russia faces stagflation at the moment when real wages are reducing and the inflation is at an all-time high. Some of the crisis is its own creation such as an oil-dependent economy, corruption and regression against its neighbors leading to foreign sanctions. Other reasons, such as a the drop in oil prices and an overall weakening economy, are things which are not under the direct control of Russia. The choice Russia faces is that of lowering the inflation rate while maintaining a stable exchange rate and to pull the economy out of recession.

Fiscal Policy

Increase in Government Spending

[footnoteRef:11] [11: http://www.tradingeconomics.com/russia/government-spending]

Russia in the past few months has been relentlessly cutting government spending, by as much as 10% across the board[footnoteRef:12]. This has led the unemployment to rise from 4.8% in 2014 to 5.4% in June, 2015. We believe that the wasteful government spending should be cut so that the monetary policy can be more effective in improving the investment environment and controlling inflation. But at the same time Russian government should spend more on public works so that the private consumption can increase. [12: http://www.ibtimes.co.in/russian-president-putin-cuts-110000-jobs-save-economy-640491]

The Russian government should also spend on development of alternate sectors, other than Oil and Gas, such as agriculture to improve the productivity in those sectors to manage inflation and improve export earnings.

Monetary Policy

Interest Rates

[footnoteRef:13] [13: http://www.global-rates.com/interest-rates/central-banks/central-bank-russia/cbr-interest-rate.aspx]

Central Bank of the Russian Federation (CBR) tightened the monetary policy in the last year by several interest rate increases. At one point in December, 2014 the CBR raised its rates from 9.5% to 17 %[footnoteRef:14] overnight to fight the plunge in the Rouble exchange rate. This emergency action of raising the rates by 6.5% overnight did little for the recovery of Rouble which has remained at the same level since the crisis started. Beginning January, 2015 the CBR has made 5 rate cuts and brought the rates down to 11 % where it stands currently. This was a clear indication by the central bank of its dovish tone where it economic downturn weighs more heavily than the inflation worries. This move could potentially have an adverse effect on the Rouble as well, which seems to have settled at around 60 RUB/$, down from a low of 73 RUB/$. [14: http://www.theguardian.com/world/2014/dec/15/russia-interest-rate-rise-17pc-rouble-collapse-oil-price]

We believe that this trend of easing interest rates should continue, where by the end of the year 2015 it should come down to the pre-crisis level of 8 to 9 %. This will allow the Russian businesses to borrow money at lower rates. Local financial markets will open up and bond sales will also start happening again. More active lending will lead to an active growth phase in the coming months. Source of current Inflation is not monetary or overly relaxed policy rates policy by the CBR, but the drop in Rouble in relation to the foreign exchange basket. The short-term effects of this depreciation have been seen in the high inflation rate facing Russia. At present the inflation rate stands at 15% and the CBR expects the rates to fall to 7% by mid next year. Currency Controls

The current policy of the CBR to not implement capital control unless the situation is dire enough to demand it for the financial stability of the country. The capital flight in 2014 was $150 B as compared to $ 60 B. In the year 2015, the figure is estimated to be around $ 100 B which, most of which will include paying the foreign debts. CBR should continue to maintain the policy of limited capital controls for the time being. It should be implemented only if Oil prices fall even further and the western sanctions are not relaxed in the coming months. Such developments will lead to an erosion of investor confidence and further capital flight.

Structural Reforms[footnoteRef:15] [15: http://www.economist.com/news/finance-and-economics/21650188-dont-mistake-stronger-rouble-russian-economic-recovery-worst-yet]

Focus away from Oil and Gas

As mentioned earlier in the report the Russian economy is largely dependent on Oil and Gas exports and still is the 2nd largest crude exporter in the world. [footnoteRef:16] [16: http://www.irishtimes.com/news/russian-fiscal-policy-not-tight-enough-imf-1.989949]

[footnoteRef:17] [17: Source: U.S. Energy Information Administration, Russia Federal Customs Service http://www.eia.gov/todayinenergy/detail.cfm?id=17231]

Russia would need to diversify away from Oil into sectors such as manufacturing, mining and agriculture. Oil exporting nations like Canada and Australia have successfully managed to do that, making them more resilient to low international Oil prices. Lower currency value would also help the above sectors negate some of the impacts of lower oil prices through higher export earning on these products.

Other reforms

Reduce International Sanctions[footnoteRef:18] [18: http://europa.eu/newsroom/highlights/special-coverage/eu_sanctions/index_en.htm]

It would be in Russias best interest to de-escalate the situation in Ukraine so that the embargo imposed on it can be lifted by the western countries. The sanctions include asset freezes and visa bans, buying or selling financial instruments, trading in defense and Oil exploration equipment. All of the above actions would lead Russian economy sliding further into recession as domestic spending is also weak. Russia itself would be in a better position to control inflation if it could remove its counter sanctions on the import of food products from the west[footnoteRef:19]. [19: https://www.washingtonpost.com/world/europe/a-year-into-a-conflict-with-russia-are-sanctions-working/2015/03/26/45ec04b2-c73c-11e4-bea5-b893e7ac3fb3_story.html]

Look East Policy

Russia which is mainly been exporting Oil and Gas to its European neighbors has started to look towards China in a bid to hedge its exports market. Due to geopolitical reasons EU and US have always moved in tandem, while China has emerged an upcoming superpower capable of taking on the US. China also has the money and the population that can support a large amount of imports of Russian Oil & Gas and other commodities such as iron ore. The 2800 km Altai gas pipeline would also help Russia diversify its export markets[footnoteRef:20]. [20: https://en.wikipedia.org/wiki/Altai_gas_pipeline]

Demographics

Age dependency ratio (% of working-age population) in Russia[footnoteRef:21] [21: http://www.tradingeconomics.com/russia/age-dependency-ratio-percent-of-working-age-population-wb-data.html]

Russian population is declining from 149 Mn to 141 Mn[footnoteRef:22], which in turn leads to the reduction of the scale of the working age population in Russia to decrease. At times of recession though this leads to real wages not declining as much as it would in times of inflation. This has helped the Russian population did not feel as much financial strain as a factor driven economy like India would have. [22: http://www.forbes.com/sites/markadomanis/2015/01/23/russias-population-is-still-growing-but-trouble-lies-ahead/]

In the long term however the Russia needs to tackle the problem of falling population if wants the economy to get on an upward trajectory. One of the solutions to this problem would be easing the immigration policy and get more workers from developing Asian economies to fill in the gap.