Economic Research:

Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Credit Market Services: Sophie Tahiri, Economist, Paris 33 1 44 20 67 88; sophie.tahiri@standardandpoors.com

Table Of Contents
Indicators Point To A Steady Slowdown Supply Constraints And Demand Pressures Weigh Monetary And Fiscal Policies Are Tight A Weak Business Climate Will Mute Longer Term Growth Related Research

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Economic Research:

Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Russia's economic growth is softening not just in line with weak global conditions, but also because the economy is reaching the limits of its capacity, in Standard & Poor's view. We forecast that GDP growth in Russia will slow to 2.0% year on year in 2013, down from 3.4% in 2012, and 4.3% in 2011. One reason for this is that the weakness in the eurozone and other economies worldwide is cutting demand for Russian exports, especially oil, gas, and other commodities. However, the Russian economy is also suffering from a lack of investment in new and productive capacity in its vast natural resources extraction sector. Added to this, the country is experiencing large private capital outflows as the business environment deters both domestic and foreign investment. Despite the weakness in the economy, inflation has been edging up since 2012. It remained high in the first half of 2013 at an average 7.1%, which is well above the central bank's target 5%-6% range in 2013. Meanwhile, the unemployment rate, at 5.3% in July, continued to hover at near record lows. These factors, alongside a declining trade balance surplus, suggest that the economy is operating near its current potential. Now that lower worldwide economic growth has curbed increases in the oil revenues that supported Russia's growth in the decade between 1998 and 2008, Russia faces a difficult question: How can it counter the slowing in its economy with less support from growing commodity prices? The government is attempting to accelerate diversification and to introduce incentives to boost growth and encourage private investment in infrastructure. However, we believe sustainable growth will also require an improved business climate. Overview We forecast Russia's GDP growth will slow to 2.0% year on year in 2013. One reason for economic softening is a weak global economy, which is cutting demand for Russian commodity exports. However, insufficient investment in new capacity and an unattractive business climate are also dragging on growth. Tight monetary policies are additionally limiting policymakers' leeway to boost growth.

Indicators Point To A Steady Slowdown

The weak momentum that took hold in Russia's economy in 2012 appears likely to extend through 2013. GDP growth was 4.9% year on year in the first quarter of 2012, but moderated to 4.0% in the second quarter, 2.9% in the third, and just 2.1% in the final quarter, according to the national statistical office. The slide has continued in 2013, with a rate of expansion of 1.6% in first-quarter 2013, and just 1.2% year of year in the second quarter. Other indicators also point to softer growth. The industrial production index (IPI) contracted by 0.7% year on year in

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

July after IPI growth had slowed continuously since 2010 (see chart 1). The manufacturing industry was the main drag, with the annual growth rate sliding to -1.5% year on year, from -1.2% in June. In particular, investment-related industries, such as construction materials, metallurgy, and truck manufacturing, appear to have slowed.
Chart 1

Data from Russia's Purchasing Managers' Index suggest that growth will remain weak in the third quarter of this year. The PMI for August improved only marginally to 49.4, staying well below 50 for two consecutive months for the first time since 2009 (see chart 2; a PMI of more than 50 represents expansion of the manufacturing sector compared with the previous month, while a reading under 50 represents a contraction). These data also suggest that Russia's slowdown reflects not just global conditions, but also specific Russian structural weaknesses, in our view. The economy appears to be underperforming its neighbors. Manufacturing PMIs in countries in the emerging EMEA regions all improved in August on the back of economic improvement in some countries of the eurozone (European Economic and Monetary Union), and all except Russia are above 50 (see chart 2).

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Chart 2

Consumption is fairly resilient

We expect that household consumption will stay the most important driver of growth in Russia this year, as in 2012. Domestic demand remained strong in the first half of last year in spite of slower economic growth, although it eroded somewhat under rising inflation. Retail consumption expanded by 5.9% in 2012 and 3.7% year on year in the first half of 2013. Credit growth and real wage growth have underpinned this increase. Last year, bank lending to households remained rapid throughout the year, rising at an annual average rate of 46%. Real wages rose by an annual 8.6%. This partly reflected continued tightness in the labor market, with the unemployment rate at a low of just above 5% (see chart 3). Nonetheless, employment appears to have declined somewhat in the first half of 2013, suggesting that output weakness may have started to weigh on the labor market. Tighter liquidity and higher lending rates have also led to a slowdown in credit to the private sector, albeit from a very fast pace. Added to this, the central bank has also imposed tighter regulation, specifically with a view to slowing down red-hot retail lending. As a result, lending growth to households slowed to an increase of 37% in the 12 months to May. We therefore think it unlikely that retail consumption in 2013 will expand at the same rate as it did last year, and even less likely that it will reach the double-digit growth rates seen before the 2008-2009 crisis. We nevertheless forecast that consumer spending will expand at an average of 4.0%-4.5% over the next two years. Our expectation that the inflation rate will decelerate in the next few quarters on the back of a better harvest than last year and the central

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

bank's key priority to lower inflation should help underpin this rate of consumer spending growth.
Chart 3

Exports are softening amid weak demand

Fixed investment and exports, meanwhile, are dragging on the economy. Export volumes slowed to 0.4% in the first quarter of 2013 from a year before, amid sluggish foreign demand, especially for oil, gas, and other commodities, which represent about 65% of Russian exports. Commodity prices have fallen--although they remain historically high--amid continued eurozone weakness, a muted U.S. recovery, and faltering in key commodity-importing emerging markets, primarily China and India. Urals crude, the country's main export blend, averaged $106.8 per barrel in the first half of 2013, about 5% down year on year (see chart 4). Growth in fixed investment has also fallen sharply since first-quarter 2012. It was a mere 0.1% year on year in the first quarter of 2013, compared with a 7.8% increase last year as a whole. Slowing external demand, in addition to high borrowing costs, has prompted companies to scale down their investment plans. Still, weak investment cannot solely be put down to cyclical factors caused by the uncertainty related to the situation in the world economy and the eurozone, in our view. Structural factors, including weak political and economic institutions that impede the economy's competitiveness and business environment have also weighed on investment. In the long run, we believe that sustainable investment will not be possible without an improved business environment.

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Chart 4

Supply Constraints And Demand Pressures Weigh

We believe that the Russian economy is facing capacity constraints because of an extended period of insufficient investment in new capacity. The country grew rapidly in the decade between 1998 and 2008, largely by resuming use of capacity constructed before the fall of the Soviet Union. Capacity utilization, which fell sharply during the earlier years of transition, rose from 55% in 1998 to a peak of nearly 80% in 2008. This pace fell temporarily during the crisis, but capacity utilization has since stabilized at around 79%. Nevertheless, investment as a proportion of Russia's GDP, at 22% in 2012, is well below that of China (44%), India (30%,) or other emerging economies in EMEA. Large capital outflows since 2008 are exacerbating this lack of investment. The negative financial account balance persisted in the first quarter of 2013, resulting in a fifth consecutive year of net capital outflow. The Central Bank of Russia (CBR) estimates net private sector capital outflow was $54 billion in 2012 and $38 billion for the first half of 2013 (see chart 5). With the CBR largely refraining from intervening in the foreign exchange market, large net private capital outflows broadly mirrored the current account surplus in 2012. Funds generated by Russian exports are not fully invested at home, which we suspect arises from a perceived lack of investment opportunities in the domestic economy.

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Between 2004 and 2008, Russia benefited from large capital inflows boosted by high returns on investment, owing to a scarcity of capital and room for gains in productivity. The combination of rising oil prices and the central bank's policy of controlled ruble appreciation stimulated carry-trade. Now, however, faltering oil prices, diminished investment opportunities, and the switch toward a more flexible exchange rate have triggered the outflows. Investment contraction also reflects a loss of competitiveness resulting from a rise in wage costs-these have increased by an average of 5.5% in real terms in the first seven months of 2013 on a year earlier.
Chart 5

Russia's private sector outflow is at odds with the other emerging markets, which have experienced sizable private sector inflows since the central banks of developed markets, and especially the U.S. Federal Reserve, have used quantitative easing (QE) in an attempt to stimulate their economies. QE policies have created massive global liquidity and caused an acceleration of capital flows to emerging markets. More recently, however, the Federal Reserve's recent talk of a plan to taper its monetary stimulus prompted investors to shun emerging market economies that had over the past few years appeared attractive to them. The sizable outflow of private sector capital makes Russia less sensitive to the tensions caused by QE. The Russian ruble has only weakened by 4% against the U.S. dollar over the past three months, while the Indian rupee and the Indonesian rupiah have experienced more serious weakness (down by 17% and 15%, respectively, against the dollar).

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Meanwhile, the sustained decline in current account surpluses also reflects demand pressures in Russia. The current account balance shrank to 3.0% of GDP in 2012 from 5.3% in 2011. The rate of decline was even greater than in 2005-2006, when the current account surplus was averaging 11% of GDP. Imports last year rose strongly despite falling investment and slower manufacturing export growth, suggesting that the increase was entirely centred in consumer goods. Households' consumption was underpinned by recycling rising energy export revenues. Hence, the population expects rising living standards.

Monetary And Fiscal Policies Are Tight

The current patch of slow growth is producing more calls for the Russian government to react. Yet, the discussions appear to center more on the scope for macroeconomic policies to support growth rather than on structural reforms. We think that the largely structural character of the slowdown suggests that the available policy options are likely to be quite limited. Russian president Vladimir Putin recently called for a strategy to revive growth after his economy minister warned of the threat of recession as companies cut investment and export demand wanes. Mr. Putin is reported to have said that the 1.8% GDP growth for 2013 that his government recently estimated is below the level necessary for sustainable development and to resolve social and other problems. Constrained by the government's recently adopted fiscal rule that bases spending plans on the long-term average oil price, the Russian leader suggested the government could stimulate investments by using the assets of the National Welfare Fund to fund infrastructure projects. Private investment would also be invited into these projects, and government guarantees would minimize risk. This would certainly boost growth temporarily, in our view, although questions remain about the implementation and accountability of the plan. However, sustainable growth will not be possible without a better business environment, in our view. Russia has made some progress in improving its business climate, moving up in the World Bank's Doing Business 2013 rating to 112 from 120 in 2012 (the ranking covers 185 countries). Still, we believe the government will need to do more to reach officially stated goals to move Russia to 20th position by 2020. Tighter monetary policies have also reinforced the slowdown in growth. The CBR has come under intense pressure from ministers to ease monetary policy to stimulate growth. The central bank has so far ignored their requests because, while it admits the risks of a deeper economic slowdown, its key priority is to lower inflation rather than to stimulate economic activity. The CBR is committed to completing its transition to inflation-targeting by 2015 after adjusting its monetary policy priorities post 2008. In the period 1999-2008 its stated monetary policy was to achieve stable economic growth in a low-inflation environment. Since 2008, however, the CBR has declared in its guidelines that lowering and subsequently maintaining low inflation was its main monetary policy objective. In in the process, has gradually and continuously increased the flexibility of the previously fixed exchange rate regime to move to full inflation-targeting. The adjustment to an inflation-targeting regime with a monetary policy horizon of three years aims to lower consumer price growth rates to 5%-6% in 2013 and to 4%-5% in 2014 and 2015. After hiking key interest rates by 25 basis points in September 2012 in reaction to concerns about rising inflation and the weak ruble, the central bank has since kept the official refinancing rate unchanged at 8.25%. Despite the weakness in the economy, inflation has been edging upward since 2012, and remained high in the first half of 2013. Headline

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

inflation reached 7.4% year on year in May this year, compared with 3.6% in May 2012 (see chart 6). This rise was the result of an increase in food inflation triggered by a poor harvest and an increase in administered prices--mostly regulated tariff hikes on electricity and gas prices--in July 2012, September 2012, and January 2013. Inflation ebbed somewhat to 6.5% in July this year as the effects of administrated price rises fade and as a result of a better harvest. Inflation nevertheless remains above the central bank's target range of 5%-6% in 2013. For the same reasons, we expect inflation to average 6.0% in 2013, making a CBR rate cut possible. We also believe that scope for larger cuts is likely to be limited by continued ruble weakness, which will persist amid a diminishing current account surplus and sustained capital outflows.
Chart 6

A Weak Business Climate Will Mute Longer Term Growth

For 2013, we forecast GDP growth of 2.0% on the back of a less restrictive fiscal policy in the second half of the year. Exports will likely pick up as the situation in the euro area improves and commodity prices recover. Inflation should slow down toward the central bank target range, owing a better 2013 harvest and as the effects of administration price increases fade. This will likely increase growth of real household incomes and consumption.

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Economic Research: Growth In Russia Is Faltering On Domestic As Well As Global Weaknesses

Over the longer term, however, we believe Russia's prospects of easing the capacity constraints in its natural resource extraction sector are slim given the extended period of insufficient investment in it. Activity in the non-energy sector is also likely to remain muted until the country's business climate and competitiveness improve markedly.

Related Research
Ratings On Russian Federation Affirmed On Solid Fiscal And External Balance Sheets; Outlook Stable, June 28, 2013
Additional Contact: Jean-Michel Six, EMEA Chief Economist, Paris (33) 1-4420-6705; jean-michel.six@standardandpoors.com

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