President Putin’s economic Achilles heel
by Gavyn Davies
March 30, 2014 4:34 pm
There are some silver linings. Foreign exchange reserves are high, covering two-thirds of external debt, and the labour market has survived the slowdown in growth surprisingly well.
Still, the economy appeared vulnerable to the effects of Fed tapering, even before the Ukraine crisis erupted. The Ukraine crisis has been widely described as the most dangerous confrontation between Russia and the west since the end of the Cold War. Today’s talks between US Secretary of State John Kerry and Russian Foreign Minister Sergei Lavrov offer hope that the crisis might be defused, with the US suggesting what seems like a joint US/Russian demilitarised “protectorate” in the Ukraine, in exchange for Russian withdrawal from the Crimea.
We shall see whether that satisfies President Putin, whose recent rhetoric about Russia being “cornered for centuries” suggests that he might have much wider plans.
So far, the global financial markets, outside Russia, have been almost completely unaffected by events in the Ukraine. Initially, there was some decline in the stock markets of European economies with significant trading and banking links with Russia, including Germany, but recently these losses have been reversed.
The low probability of direct military confrontation between Russia and the west in the Ukraine is obviously key to this. Perhaps the markets also believe that the crisis will blow over without a major outbreak of tit-for-tat sanctions, beyond the limited restrictions on individuals which have been announced so far. Or perhaps they have concluded that, while the west can greatly damage the Russian economy, the same cannot happen in reverse.
What has become obvious is that the Russian economy itself is very vulnerable indeed to a worsening in the crisis. The burgeoning capital outflow since the start of 2014 has, in effect, imposed a form of economic “sanctions” on the Russian economy, without the need for western governments to take much action of their own. Western leaders clearly believe that this could turn out to be President Putin’s Achilles heel, though this reckons without the possibility that he will opt for riskier foreign adventures in an attempt to distract attention from economic weakness at home.
The Russian economy has been in difficulty for several years. After the boom in the last decade, largely based on rocketing energy prices, economic growth has slowed sharply since 2010. (The IMF’s latest medium term economic projections are summarised in the thumbnail graphic on the right.)
The structural reforms needed to boost private sector growth outside the energy sector have been disappointing, and the exchange rate has been over-valued from the point of view of the manufacturing sector. Excluding oil revenues, the budget deficit has been running at around 10 per cent of GDP, so living standards have become heavily dependent on oil prices remaining above $100/barrel. In recent years, the rate of credit expansion to households has been explosive (over 30 per cent per annum), as it has in many other emerging economies. Whether the banking system could survive an economic downturn is an open question.
Since then, capital outflows, both by Russian citizens and by foreigners, have become serious, running at over $60 billion in 2014 Q1, according to Economy Minister Alexei Ulyukayev. These outflows may weaken the banking system, and withdraw funding for many of the capital investment projects that were critical to a recovery in GDP growth. The growth rate had already declined to only 1.3 per cent in 2013, compared to about 7-8 per cent in the miracle years of the last decade. The capital outflows have also forced the CBR to raise interest rates by 1.5 per cent, something which would otherwise have been unnecessary, given the broadly stable outlook for inflation.
As a result of the crisis, the economy now stands on the brink of outright recession, the first in any of the BRIC economies since 2009. Last week, the World Bank published a frank assessment of the impact of the crisis on the economy, and the Economy Minister surprisingly said that he basically agreed with its conclusions, which are summarised here:
The World Bank figures confirm that Russia’s main vulnerability at present stems from the capital account of the balance of payments, working both through lower investment, and through weaker consumption, which had earlier seemed to be the main hope for economic expansion. Consumer sentiment has plummeted since the crisis started, despite the sharp increases in the President’s personal political ratings.
The World Bank suggests that, if the crisis continues, then private capital outflows would reach $133 billion this year, and real GDP would decline by 1.8 per cent. This would surely result in a sharp reversal of recent declines in the unemployment rate, currently at 5.2 per cent of the labour force.
Of course, the Russian government will take steps to alleviate the problems caused by capital outflows. Deputy Prime Minister Igor Shuvalov said last week that there was an “action plan for the roughest scenario”, even though he hoped not to have to use it.
Russia certainly has some financial weapons it can deploy. Its foreign exchange reserves stand at $510 billion at the end of 2013, enough to replace all of the foreign exchange losses from capital outflows.
Furthermore, the government’s overall budget (including oil revenues) is close to balance, implying that it can afford to finance some fiscal easing, as long as oil prices do not fall. And many western companies, including Siemens for example, are obviously very reluctant to cut their historic ties with Russia if they can avoid it.
Nevertheless, the outlook for the Russian economy in a condition of full or partial isolation from the major developed economies in Europe and America would be bleak.
There would also be economic losses incurred in the west, since Russian gas could not quickly be replaced in many European economies, and bank exposures to Russian assets are not entirely negligible in Austria, Italy and France. But exports to Russia represent much less than 1 per cent of GDP in all of the major European economies, including Germany, which is the most exposed.
Whether the global financial markets could turn a blind eye to this crisis if Russian troops enter the eastern Ukraine seems doubtful. But, in any likely eventuality, President Putin must know that the Russia would be the main economic loser.
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