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Commentary | 19 January 2015

Wither Russia: collapse and default on the cards for 2015?

There is no question that Russia will go into a deep recession this year. But there is no consensus over just how bad it will be. How the two main factors compressing Russia’s economy, the oil price and international sanctions imposed by the US and Europe, both external forces beyond the Kremlin’s control, will develop, are unknown.

Oil prices collapsed in December causing a full-blown currency crisis, but so far this is a currency crisis and not a broader economic or financial crisis like those Russia has endured in the past.

On December 15 oil fell to $50 driving the ruble from RUB53 to the dollar to a low of RUB80. The ruble has since recovered to around RUB65, but the value of Russia’s money remains about half of the RUB32 it started 2014 with. Oil taxes account for about half of the state’s federal budget revenues so the fall in oil hits Russia hard. With the Central Bank of Russia (CBR) forced to make huge interventions on the currency market coupled with accelerating capital flight, will Russia run out money this year?

There is no consensus over where GDP growth will come in this year. Russian hawk and Peterson Institute professor Anders Aslund has the most extreme prediction, forecasting that Russia’s economy will contract by 10% in 2015. Fitch Ratings recently issued a forecast for a 4% contraction (assuming average oil prices of $70). And the World Bank had a milder forecast of a 2.9% contraction in 2015 before returning to growth in 2016. Acknowledging the unknowns, most economists, and the Russian government, believe that growth will come in with a 4%-5% contraction, which is still well down on just under 1% growth in 2014.

The spread is so wide because oil prices have become a wild card. For the last several years oil prices have been remarkably stable and in excess of $100 per barrel. That changed in December when the price fell precipitously, dropping by about $10 a month to hit a low of under $45 per barrel on January 15. At the time of writing it was hovering around $50 per barrel. Oil prices fell in 2008 as well to a low of $32, but that didn’t cause much damage as they quickly recovered. The problem this time round is commentators believe that oil will remain below $100 for several years, which will undermine the whole Russia story.

As with the GDP predictions, the spread on where oil prices will settle is enormous ranging from the $20s last seen in 1998 to those that believe prices will recover to at least $70 in the second half of this year and back to $100 in 2016.

Forecasting oil prices is a mug’s game, but some of factors are clear. The crash in 1998 was precipitated by oil falling to $10 on the back of the Asian crisis in 1997. Like then, today’s global economy is slowing as Japan and many European countries are slipping back into recession, compounded by a sharp slowdown in the Chinese economy, all of which is weighing on demand for oil. The problem has been exacerbated by the booming shale oil production in the US that has rising to about 9m barrels of oil a day (mbd), only a little less than Russia’s own world beating output which is currently at a record 10.6mbd level.

Adding to the pressure is the apparent attack on US shale producers by the OPEC cartel, which refused to cut production in November, and probably precipitated the recent collapse in prices. OPEC’s next meeting is not due to the summer and even then it seems unlikely it will decide to cut production if its goal is to put the marginal US shale producers out of business and reclaim some its market share.

On the positive side, none of the world’s oil producers can tolerate oil prices at current levels for long. Russia’s budget break- even point for oil was $100.1 a barrel in 2014 but this is middle of the range amongst the world’s biggest producers. Countries like Venezuela need a whopping $162 a barrel and the least anyone needs is Qatar with $71.3 for its budget to break even. Without a massive restructuring of public finances, sustained low prices will cause chaos in these countries soon, which suggests that oil prices will inevitably rise again resulting from lack of investment into the oil industry caused by these problems. Certainly that is what happened in 1997-1998, when it took two years for oil prices to recover from $10 to $25 just as Russian President Vladimir Putin took the helm as president.


Fourth crisis

The Kremlin is clearly betting that like 1998 the oil prices will recover in the next two years. Putin said in his annual meet the press conference in the midst of the ruble’s plunge on December 17 that he believes the current instability (he has pointedly refused to use the word “crisis” and state media have been ordered to avoid the word) will only last two years.

And he has some reason to be optimistic. This is Russia’s fourth big crisis, but each one does less damage than the previous.

The first was in 1991, which saw 100% devaluation of the ruble, the entire economy destroyed and it took a decade for Russia to get back on its feet. In 1998 there was a 75% devaluation of the currency, the entire top tier of the banking sector was annihilated and it took about five years for growth to return. In 2008 the ruble devalued by about 30%, one bank went bust (but was bailed out by lunchtime the same day) and economic growth returned after about three years.

Putin is right that this is not a “crisis” in the sense of Russia’s previous big crises. There have been no bank runs, no bond defaults, and no notable bankruptcies (other than Russian travel agencies). Moreover, the population has not been panicked by the collapse of the ruble, which had been falling all year in 2014, although they are glum. Russians have been converting their rubles into euros and dollars, but not on the scale seen in previous crisis, preferring to put it into fixed assets instead.

“In the previous crises people were buying up things like washing machines and microwaves to protect their savings. This time round we are buying apartments and luxury cars. It shows how far we have come,” a Russian friend explained to me this week, trends borne out by rising sales of cars and residential real estate throughout 2014, spiking in December.

What is different from the previous big crises is that the ruble has devalued by at least 50% from its value at the start of 2014, making it the worst performing currency in the world last year, worse than the Ukrainian hryvna and Belarusian ruble.

Ironically that is not necessarily a bad thing. The other big change in this crisis is that the CBR decided to let the ruble go in November and make it a freely floating currency for the first time. That will have some big benefits this year that have yet to kick in. In 2008 the ruble exchange rates were fixed inside the exchange rate corridor which forced the CBR to spend $200bn to “defend” the currency. Part of the reason the currency has fallen so far this time is it is simply recalibrating to the realities of the new oil price – as it should – and the CBR has spent about $70bn in 2014 managing the currency lower.

That is important, as the reason why the CBR failed to act to defend the ruble on December 15 during the worst of the collapse was Russia’s hard currency reserves have clearly become a strategic resource and need to be preserved at all costs as Putin is expecting the show-down with the west (and hence the sanctions) to last a while.



Sanctions have inflicted a great deal of pain on Russia and currently the CBR is the only source of funding for the economy. Does that mean Russia is facing a banking crisis, bond defaults and a wider economic crisis this year?

The short answer is almost certainly no. It is difficult to underestimate what a boon the prudential accumulation of petrodollars into the two Reserve Funds (over $170bn) has been. Russia has enough financial firepower to both meet its obligations and direct spending to encourage growth for at least this year and probably all of next year as well.

On top of that, floating the ruble introduces a new dynamic into the economy, which has been suffering from the “Dutch disease” – an over valued currency due to oil exports has killed the development of domestic non-oil industry.

The floating ruble is also a boon for the budget. One of the quirks of the Russian budget is that while spending is denominated in nominal rubles the state earns up to half a trillion dollars from oil export taxes, which makes the state one of the biggest winners from devaluation. The upshot is that Russia is still running a triple surplus – trade, current account and budget – and so has plenty of cash (albeit less valuable) to throw at the problem.

The falling price of oil will reduce the amount the state earns from oil exports this year, but devaluation also drastically reduces imports: in 2014 Russia had a $200bn trade surplus, a $55bn (2.9% GDP) current account surplus and a budget surplus of about 2% of GDP. This year the trade surplus will probably be reduced to $100bn but Fitch is forecasting a rebound in the current account surplus $72bn (5.3% of GDP) in 2015 as imports shrink. The budget will probably go into deficit as the government needs to spend heavily to pick the economy up but unless oil stays at $45 all year the deficit will be a few percent at most.

A banking crisis also seems unlikely. The state has already earmarked RUB1 trillion ($15bn) to support the banking sector and recapitalise the state-owned VTB Bank, Russian Agricultural bank and the privately owned Trust bank. It will probably need another RUB2 trillion ($30bn) to support another 25 large banks, but this remains easily within the state’s means.

Russia’s sovereign debt is not a problem either, currently about 14% of GDP, or $50bn. Corporate debt is larger and will be more of a problem; Russian companies have to refinance up to $150bn this year. However, about half of this debt is owed by the state-owned gas and oil companies Gazprom and Rosneft, both of which earn revenues in hard currency and so should be able to meet their obligations out of their cash flow.

Capital flight will also remain a problem and will peak to an estimated $150bn in 2015, up from $130bn in 2014 and $63bn in 2013. However, at least $50bn of that is Russian companies paying off their international debt, which reduces the pressure on the economy. Anticipating problems, Russian companies were building up currency reserves during 2014 and are thought to have about $80bn in cash to meet debt, but this will remain a significant drain on resources.

Going into the 1998 crisis Russia had $10bn in reserves, in 2008 it had $600bn and at the start of the devaluation process in 2014 it had $450bn. As of January 1 2015, Russia still has $388bn in its war chest hopes to spend as little as $100bn on the currency and debt this year. It could spend $200bn if things go badly. But that would still give it a large cushion going into 2016: when Russia was upgraded to investment grade in 2003 it had only $50bn in reserves.


Outlook for 2015

So the outlook for 2015 is bad, but not disastrous. But the focus on the default and banking crisis misses the real danger Russia faces. In the midst of the December ruble crash, the CBR hiked interest rates to 17% and that will cause the already high level of inflation to rise this year to something on the order of 15% from 11% in 2014.

This is a lethal combination, as inflation will reduce Russian real income for the first time in Putin’s 14-year rule (indeed, real wages dropped by 4.6% in December for the first time in a decade according to preliminary estimates). At the same time investment has been anaemic to negative in all 2014. With the cost of capital effectively doubled, it will collapse in 2015.

Unless the CBR can cut interest rates soon and the Kremlin can successfully boost investment through things like massive infrastructure projects then the real danger for Russia is stagnation, not collapse. The Kremlin has proposed several sensible ad hoc fixes to deal with the current currency crisis, but it has yet to say a word about the kind of large scale reform programme the country now needs if it is to avoid a lost decade.


The opinions articulated above represent the views of the author(s), and do not necessarily reflect the position of the European Leadership Network or any of its members. The ELN’s aim is to encourage debates that will help develop Europe’s capacity to address the pressing foreign, defence, and security challenges of our time.