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Russias faltering economy

January 2015

Oil price decline and western sanctions push Russia's economy into free fall
The year 2014 was a forgettable one for Russia. The country was engulfed by serious geopolitical and financial problems that started
with the rising political tensions in Ukraine, leading to the imposition of trade sanctions by western countries on Russia. The country
reacted by imposing counter-sanctions, resulting in its isolation and grave financial troubles. Although Russia tried to fight the problems
related to sanctions, inflation, and currency depreciation, the sudden fall in oil prices has dealt a severe blow to its economy. Russias
economy depends heavily on the production and export of hydrocarbons; and, the recent decline in oil prices has made it inevitable for
the USD2tn economy to slip into recession. Although the central bank and the government have intervened to revive the economy, any
favorable impact of the measures taken remains to be seen.
Russia had a gloomy 2014. The country is staring at a GDP growth rate of less than 1.0% for 2014 for the first time since 2010. Anton
Siluanov, Russias Finance Minister, has already warned against a GDP contraction of 4% in 2015 and a budget deficit of over 3% if oil
prices stay at USD60 per barrel. In view of the weak outlook for oil prices and unabated tensions in Ukraine, even the IMF downgraded
Russias growth projection for 2014 and 2015 to 0.2% and 0.5%, respectively.
Russias economic growth declined from 2% in 4Q 2013 to 0.7% in 3Q 2014. The sanctions imposed by western countries, following
the geopolitical tensions in Ukraine, and the declining oil prices have wrecked the countrys economy. Investor confidence in the
country has been eroded by the recent turn of events, which is evident from the data released by Russias central bank, showing net
capital outflows in excess of USD85bn in the first three quarters of 2014 as against total outflows of USD61bn in 2013. Russias
problems have been further compounded by a plunging currency; the value of Russian ruble has declined over 60% against the US
dollar since the beginning of 2014.

Russias GDP growth and net capital flows


6%

(y oy change)

(USD bn)

60

4%

40

2%

20

0%

-2%

(20)

-4%

(40)

-6%

(60)
1Q

2Q

3Q

4Q

2010

1Q

2Q

3Q

4Q

1Q

2Q

2011

3Q

4Q

1Q

2012
GDP (LHS)

2Q

3Q

2013

4Q

1Q

2Q

3Q

2014

Net capital flows (RHS)

Source: Bloomberg, IMF, World Bank, Central Bank of Russia, Government estimates

Western sanctions derail Russias growth engine


Russias poor run began with the imposition of sanctions by western countries in 2014, following the countrys military intervention to
support the separatists in Ukraine. Condemning this invasion on Ukraines sovereignty and independence, western nations imposed
stiff economic sanctions on major Russian state banks and corporations. Consequently, Russias status as a super power came under
threat and trade in key sectors including energy and defense, and state finances was affected. The financial sector was deprived of the
much needed funds to support critical growth and development projects. Many large state-owned banks, accounting for more than half

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Russias faltering economy


January 2015

of Russias banking assets, were severed from the US and European Unions financing systems, resulting in a credit crunch. Presently,
Russian companies are finding it difficult to borrow money to even finance their own operations. In fact, the Finance Minister expects
that if the sanctions are extended and continue throughout the next year, Russia could stand to lose about USD40bn (about 1.9% of its
GDP) in economic activity.

Counter-sanctions drive up inflation, especially for food commodities


Russias act of imposing counter-sanctions by banning the import of essential food products such as fruits, vegetables, meat, and
various dairy products, including milk, from the US, the EU, Norway, Canada and Australia, has worsened the situation. Every year,
Russia imports about 25% of its meat requirements and about 70% of the fruits consumed in the country. The ban has pushed up the
prices of key food products that constitute nearly two-thirds of the food inflation index, which has caused the food inflation to rise from
8.6% in March to 11.5% in October 2014.

Oil price plunge not only eats into reserves but also brings economy to a standstill
The sharp fall in the oil prices over the past few months has dealt a severe blow to the Russian economy, already reeling under the
effect of sanctions. In September 2014, the Finance Minister stated that in addition to losing USD40bn a year due to the economic
sanctions, the country would lose another USD90100bn due to the ~30% drop in the oil prices since the beginning of the year. With oil
prices having witnessed a decline of ~48% in 2014, we expect the impact on the economy to be even greater.
The Finance Minister has already issued a warning about GDP contraction in 2015 and a swelling budget deficit if oil prices remain at
around USD60 per barrel. Plummeting oil prices have sharply dragged down Russias energy exports, which form nearly 67% of the
total exports and around 15% of the GDP. The current commodity scenario is likely to propel Russian policymakers to seriously rethink
budget strategies as the current budget had reckoned the price of oil to remain around USD100 per barrel of oil, with taxes on oil
contributing nearly 50% to the total fiscal receipts. According to Tatyana Nesterenko, Russias first Deputy Finance Minister, the
continued decline in oil prices is likely to considerably eat into the USD74bn reserve fund created by the government to sustain energy
price fluctuations.

Composition of exports (2013)

Composition of imports (2013)

Others
20%
Crude oil
33%

Fertilizers &
chemicals
2%

Others
32%
Machinery
49%

Machinery
5%

USD 314.9bn

USD 527.3bn

Metals
6%

Energy
1%
Clothing
3%
Gas
13%

Oil Products
21%

Medicines
Food
4%
5%

Automobiles
6%

Source: Bloomberg

The turn of events has unearthed a structural weakness in Russias economy, stemming from the over-dependence on hydrocarbons.
The debt crisis of 1998, when oil prices plunged to USD10 per barrel, seems to have returned to haunt them. Back then, large fiscal

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Russias faltering economy


January 2015

deficits and low foreign reserves had forced Russia to default on the dollar-denominated public and private debt. Further, the country
suffered from hyper-inflation, which led to a lot of wealth being wiped out.

Ruble reaches its nadir, pushing Russia into a downward spiral


Russias problems do not end here. The rubles fall on account of the decline in oil prices and the western sanctions has led to a
sudden spike in inflation. The ruble has fallen consistently since the beginning of the year, reaching a historic low of almost 68 to a US
dollar in mid-December. This has triggered a sharp rise in the prices of imports. The resultant inflation has seriously damaged the
purchasing power of the ruble. Adding to the woes, the OPEC recently decided to maintain its oil production rate steady at 30 million
barrels per day, thereby keeping supply greater than the present demand. The country has entered a vicious cycle where on one hand
the falling currency has made imports more expensive and on the other, the stagnant demand for oil has made it tougher to earn
foreign revenues. The problems at hand threaten to destabilize not only the countrys economic system but also the political system.

Brent crude oil prices and ruble in 2014


120

Russias monthly consumer and food inflation in 2014


14%

(Indexed = 100)

(y-o-y change)

12%

100

10%

80

8%
60
6%
40
4%
20

2%

0%
Jan Feb Mar Apr May Jun
Oil price

Jul Aug Sep Oct Nov Dec


USD per RUB

Jan Feb Mar Apr May Jun


Consumer Inflation

Jul

Aug Sep Oct Nov


Food Inflation

Source: Bloomberg, OECD

Russia forges stronger ties with China


In the aftermath of the western sanctions and a declining domestic currency, the Russian government sprung into action to counter the
negative impact on the economy. After being denied financial support from western nations in the face of the crisis, Russia strategically
strengthened its economic ties with China. The country turned to Chinese banks for support to maintain a sustainable level of economic
activity. In April 2014, Novatek, Russias second-largest natural gas producer, secured financial support of USD27bn for its Yamal liquid
natural gas project from Chinese banks after losing the financial support of the Export-Import Bank of the United States. Additionally,
Russia is looking to strike important deals with China to support various infrastructure projects such as bridges and transport corridors
in the country.

Central bank intervenes to support currency


Russias central bank has intervened from time to time to prop up the falling domestic currency. The central bank spent USD29.3bn in
October alone to support the ruble. Over the past three months, such interventions have eroded 10% of Russia's foreign exchange
reserves, pushing them to their lowest level since October 2009. However, the positive effects of the intervention have been negated by
falling oil prices. As of December 1, 2014, Russias foreign reserves stood at USD419bn, but it would have to retire more than
USD400bn worth of external debts in 2016 and afterward. Additionally, the central bank has been consistently raising interest rates over
the past one year to counter inflation and support a depreciating ruble. In fact, the central bank has raised the benchmark interest rate

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Russias faltering economy


January 2015

from 7% in March 2014 to 10.5% in December 2014. Also, on December 15, the central bank hiked the interest rate to 17% from
10.5%, which is the largest increase since the economic crisis of 1998. However, these interventions are yet to show any substantial
results. On a separate note, President Vladimir Putin has passed a new law to double the deposit guarantee for deposits in bank
accounts to USD25,370 in order to protect the interests of common citizens. Steps are also being taken to recapitalize local banks if
they face any financial crisis.

Russias foreign exchange reserves


600

Russia central bank interest rates in 2014


20%

(USD bn)

17%
550

16%

500
12%
450

419

8%

400
4%

350

300

0%
2010

2011

2012

2013

1Q

2Q

3Q

4Q*

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2014
Source: Bloomberg

Uncertainly looms large


The slump in oil prices has pushed the worlds largest energy exporter to the verge of recession. Even a positive contribution from the
exports cannot offset the effect of contraction in domestic demand and the damage to the banking system and consumer sentiment. It
is felt that the fall in oil prices and the economic sanctions would weigh heavily on Russias prospects, going forward. Due to its heavy
dependence on food imports, the countrys ability to curb inflation through a tight monetary policy is limited. The country faces political
isolation from its western counterparts, which makes Russias dependence on China for its recovery all the more important.

Research Note by: Rahul Kumar and Akanksha Kumar

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Russias faltering economy


January 2015

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