Russia's Economic Situation Is Worse than It May Appear

Op-ed in Capital, Hamburg, Germany

December 1, 2014

The Russian economic situation has long looked stable, although growth has been slow. The budget has been close to balance, with a public debt of only 11 percent of GDP, and Russia has had persistent current account surpluses. In 2014, however, the Russian economy has taken a turn for the worse, and if policies do not change radically, a serious downturn may occur in the second half of 2015.

The Russian economy suffers from three severe blows: ever worsening structural policies, financial sanctions from the West, and a falling oil price. Since the confiscation of the Yukos oil company in 2004, the Kremlin has promoted state and crony capitalism. These tendencies were aggravated during the global financial crisis in 2008–09, and the Russian economy today is no larger than in 2008. Ironically, as Russian joined the World Trade Organization in 2012, its trade policy has become much more protectionist. President Vladimir Putin wants to proceed further with import substitution. These policies assure Russia of no more than 1 percent growth in the foreseeable future.

The Russian economy suffers from three severe blows: ever worsening structural policies, financial sanctions from the West, and a falling oil price.

This year Russia is experiencing large capital outflows, expected to reach $120 billion. Because of Western financial sanctions, they are set to continue. The large outflows erupted in March as investors anticipated financial sanctions, which hit in July and in effect have closed financial markets to Russia. No significant international financial institution dares to take the legal risk of lending Russia money today. All are afraid of international financial regulators. At the beginning of 2014, the consensus forecast for Russia was a GDP growth of 2.5 percent. Now it is zero, suggesting that the cost of financial sanctions to Russia will be 2.5 percent of GDP or $50 billion this year.

On September 30, Russia had a total external debt of $678 billion, while its international reserves appeared solid at $421 billion on November 14, but that is not quite true. Of this amount, $45 billion is held in gold, and $172 billion in the two sovereign wealth funds, the Reserve Fund and the National Wealth Fund. The Ministry of Finance controls those two funds, much of which is deposited in state banks or invested, so these funds are not liquid reserves. If we deduct gold and sovereign wealth funds, the official reserves shrink to $200 billion. In the last year, Russia's international reserves have declined by $103 billion. In the coming year, they are likely to fall by another $100 billion, because Russia has to pay back about $150 billion a year, while its current account surplus is about $60 billion a year. When the market realizes that Russia's reserves are running short, capital outflows will accelerate in anticipation of capital controls and the exchange rate will fall further.

Recently, the Central Bank of Russia let the ruble exchange rate float freely, and this year it is down by about 30 percent in relation to the US dollar. As a result, Russia is not losing reserves to defend its exchange rate any longer, but the capital outflows are a serious concern when no alternative sources of external financing are available.

The third big blow to the Russian economy is the falling oil price, which has also slumped this year by 30 percent to $80 per barrel. The US revolution of shale oil and gas is a major supply shock, while slow global economic development restrains demand. Markets usually overshoot, so the oil price could fall much more. Since the Russian exchange rate falls with the oil price, the budget is likely to remain close to balance. Similarly, the current account surplus will probably remain approximately the same, because imports decline with the exchange rate. The big problems are economic growth and the standard of living, which will deteriorate. Moreover, the low exchange rate and protectionism will hardly stimulate the Russian economy, because full employment prevails, while inflation is 8.5 percent and rising. The central bank will be compelled to hike interest rates further, depressing investment.

Observers tend to focus on one or the other of these three big blows, when discussing Russia's economic growth in 2015, but they all come together. Furthermore, the falls in reserves and in the oil price are likely to have nonlinear effects, that is, the more they slump the greater the negative impact will be. Therefore, a prediction of a decline in Russia's GDP of 1 percent next year sounds optimistic. Without making any exact forecast, conditions are in place for a downward spiral in the second half of 2015 with falling reserves, exchange rates, and oil prices, but rising inflation and interest rates. Then, a GDP fall of 4 to 6 percent during the second half of 2015 becomes quite possible, though not yet likely.