Emerging Economies Project

Country Report - Russia

EPGP 2015

Manisha Aithal

1514026

Rohan Agarwal

1514041

VC Sundar

1514059

Uddipt Mitter

1514062

Varun Devgan

1514064
Submitted by -

TABLE OF CONTENT

KEY MACROECONOMIC CHALLENGE....................................................................................3

UNDERLYING REASONS FOR THE RECESSION IN RUSSIA...............................................3
US SANCTIONS.................................................................................................................. 3
SHARP DROP IN INTERNATIONAL OIL PRICES...............................................................4
FISCAL AUSTERITY............................................................................................................ 5
OTHER SIDE EFFECTS OF THE NEGATIVE GDP GROWTH:................................................5
DEPRECATION OF LOCAL CURRENCY.............................................................................5
HIGH INFLATION................................................................................................................. 6
BUDGET DEFICIT............................................................................................................... 6
REDUCING FOREIGN EXCHANGE RESERVES................................................................7
POLICY PRESCRIPTION............................................................................................................ 8
FISCAL POLICY........................................................................................................................8
INCREASE IN GOVERNMENT SPENDING.........................................................................8
MONETARY POLICY.................................................................................................................9
INTEREST RATES............................................................................................................... 9
CURRENCY CONTROLS..................................................................................................10
STRUCTURAL REFORMS......................................................................................................10
FOCUS AWAY FROM OIL AND GAS.................................................................................10
OTHER REFORMS................................................................................................................ 11
REDUCE INTERNATIONAL SANCTIONS..........................................................................11
LOOK EAST POLICY.........................................................................................................12
DEMOGRAPHICS..............................................................................................................12

Key Macroeconomic Challenge

The key macroeconomic challenge facing Russia in the past two years has been
stagnant real GDP growth rate of the economy.

GDP (constant 2005 US$)

764

2005

826

2006

897

2007

944

2008

948

980

993

1000

870

909

2009

2010

2011

2012

2013

2014

More recently Russias GDP declined 4.6% year-on-year in June 2015. 2

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
1 http://data.worldbank.org/indicator/NY.GDP.MKTP.CN
2 http://www.ft.com/intl/cms/s/3/8e640b2e-3f71-11e5-b98b-87c7270955cf.html

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 dualuse 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 PRICES
The 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.

3 http://in.investing.com/commodities/crude-oil-historical-data

Russia export in 20124

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.

Except defense, the finance minister

proposed cuts in government spending up to 10%. 6 With private consumption

4

Harvard Atlas of Economic Complexity

5 http://www.economist.com/news/leaders/21638197-why-some-commodity-exporters-are-coping-better-lower-prices-others-what-vlad-can-learn

and investment already low, further budget cuts by the government will only
exacerbate the situation of an economy in contraction.

OTHER SIDE EFFECTS OF THE NEGATIVE GDP GROWTH:

DEPRECIATION OF LOCAL CURRENCY

The Russian Rouble has depreciated by more than 50% 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 8 and the cheaper domestic currency
can boost the export earning of the Russian firms.

6 http://money.cnn.com/2015/01/14/news/economy/russia-spending-cuts/
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 2015.9 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.
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.

9 http://www.wsj.com/articles/russian-inflation-accelerates-1425574517

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.

10

This is the lowest the reserves have been since

April 2007.
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.

10 http://mg.co.za/article/2015-08-13-rouble-rouser-enters-russias-bank

Policy Prescription
We 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

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 board12. 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.
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

13

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
12 http://www.ibtimes.co.in/russian-president-putin-cuts-110000-jobs-save-economy-640491
13 http://www.global-rates.com/interest-rates/central-banks/central-bank-russia/cbr-interest-rate.aspx

9.5% to 17 %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/$, down from a low of 73 RUB/$.
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.

14 http://www.theguardian.com/world/2014/dec/15/russia-interest-rate-rise-17pc-rouble-collapse-oil-price

STRUCTURAL REFORMS15
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. 16

17

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

15 http://www.economist.com/news/finance-and-economics/21650188-dont-mistake-stronger-rouble-russian-economic-recovery-worst-yet
16 http://www.irishtimes.com/news/russian-fiscal-policy-not-tight-enough-imf-1.989949
17 Source: U.S. Energy Information Administration, Russia Federal Customs Service http://www.eia.gov/todayinenergy/detail.cfm?id=17231

REDUCE INTERNATIONAL SANCTIONS18

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 west19.

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 markets20.

DEMOGRAPHICS

18 http://europa.eu/newsroom/highlights/special-coverage/eu_sanctions/index_en.htm
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
20 https://en.wikipedia.org/wiki/Altai_gas_pipeline

Age dependency ratio (% of working-age population) in Russia21

Russian population is declining from 149 Mn to 141 Mn22, 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.
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.

21 http://www.tradingeconomics.com/russia/age-dependency-ratio-percent-of-working-age-population-wb-data.html
22 http://www.forbes.com/sites/markadomanis/2015/01/23/russias-population-is-still-growing-but-trouble-lies-ahead/