The Russian Economy Inches Forward: Will That Suffice to Turn the Tide?
No. 36, November 9, 2016
Global growth is weak. It slowed down to 2.2 percent in the first half of 2016. While the Brexit vote has had a limited impact on global growth so far, growth in Advanced Economies (AE) has been disappointing. In the U.S., following a particularly subdued first half of the year, growth recovered in the third quarter but continued to be held back by weak investment. In the Euro area, the economy lost momentum given falling domestic demand and exports.
Growth in Emerging Markets and Developing Economies (EMDE) also remained subdued because of the weak performance of commodity exporters, although many commodity importers showed robust growth; an important exception to this robust growth of commodity importers was China, whose economy continued to decelerate given its rebalancing from manufacturing to services. 2016 has also seen a stagnation in global trade – the slowest it has been since 2013 – although external financing conditions for emerging economies remained strong in general. In terms of oil, there was little change in crude prices in the third quarter of the year, with prices averaging $44.7/ per barrel (bbl).
Amidst external headwinds, the recession continues in Russia, although the pace of GDP decline has slowed down. Russia continued its adjustment to lower oil prices and the environment of economic sanctions imposed in July 2014. Over the last two years, the government’s policy response package of a flexible exchange rate policy, expenditure cuts in real terms, and bank recapitalization – along with tapping the Reserve Fund -- has helped facilitate this adjustment.
A sustained fall in real incomes kept domestic demand depressed, while the recession, which started in the third quarter of 2014, persisted in the first half of 2016. However, supported by the government’s policy response package, the pace of the recession has now declined substantially: real GDP shrank by just 0.9 percent year-on-year (y-o-y) in the first half of 2016 compared to -3.7 percent in 2015.
After a prolonged recessionary period, headline economic and financial trends and indicators are now picking up. Inflation in January - October 2016 was 7.4 percent – less than half of the 15.9 percent in the same period in 2015. The banking sector has also now largely stabilized. The consolidated budget of regional governments even registered a surplus in the first eight months of 2016. And in May, for the first time since 2013, the government successfully issued US$1.75 billion 10-year Eurobonds with an effective rate of 4.75 percent.
The balance of payments remains stable. At 5.6 percent, unemployment is at near minimum levels. Nuances and details matter though: the reduction in inflation, for example, is partly due to the base effect while inflation expectations remain elevated (Figure 4). The banking sector, though stable, remains vulnerable to macroeconomic risks of low growth and weak demand. Low unemployment has been maintained -- not by easy entry or exit in the labor market -- but mostly through flexible wages. Though the regions registered a fiscal surplus, they are expected to be in deficit by the end of 2016.
Moreover, averages mask variations, and over two thirds of the regions have a fiscal deficit and many are experiencing growing debt. And the Reserve Fund, expected to be depleted in 2017, is now under severe pressure. We discuss these important nuances and details in the report but the overall storyline that emerges is, arguably, a positive one -- of Russian institutions dealing ably with multiple shocks, albeit reactively.
The fiscal deficit worsened in 2016. Although expenditure cuts were undertaken since the beginning of 2016, the federal budget deficit widened in the first nine months of 2016. As Table 1 shows, it currently stands at 2.6 percent (compared to 1.1 percent in the first nine months of 2015). This is because expenditure cuts only partly compensated for the revenue shortfall from the oil price shock. And as expenditures outpace revenues even further in the last three months of 2016, the end of the year deficit is expected to grow to 3.7 percent.
Adherence to the proposed medium term fiscal framework envisages fiscal consolidation in the 2017 – 2019 period. A draft law on the federal budget (which assumes a conservative oil price of US$ 40/bbl) and the associated medium-term expenditure framework for 2017 – 2019 are currently with the Duma. This framework envisions consolidation mainly through expenditure cuts and some revenue mobilization efforts (with the exception of changes in most non-oil tax related rates which are postponed until 2019, thereby postponing the uncertainty around the overall tax regime).
Expenditures would decrease by 3.7 percent of GDP over this three year period, with the three biggest cuts to occur in national defence (-1.8 percent of GDP); social policy (-0.5 percent of GDP); and national security (-0.4 percent of GDP). And revenues would be mobilized predominantly from transfer of dividends of the state controlled companies and increasing tax revenue from the energy sector.
Fiscal tightening at the federal level may also adversely affect the performance of some regions. Fiscal constraints can lead to a cut in transfers to subnational governments, affecting two-thirds of Russian regions where federal transfers constitute 15 to 50 percent of revenue. Concerns about debt levels will make it difficult for many local governments to support expenditures.
In 2016, poverty decreased slightly but vulnerability remains at higher levels than before. Despite a continued contraction of disposable incomes – by 5.8 percent – the poverty rate slightly decreased. In the first half of 2016, 21.4 million people, or 14.6 percent of the population, had incomes below the national poverty line. This was 0.5 percentage points lower than a year ago – a slight decrease. This decrease is because the poor consume more food as a fraction of their income, and food inflation was lower than non-food inflation in the first two quarters of 2016.
However, many people in the bottom 40 percent and in the middle of the income distribution experienced a significant decline of their real incomes in 2015. That led to an 8 percentage points increase in the share of the vulnerable population with per capita incomes below 10 USD/day (in 2005 PPP) – a significant increase, reverting many of shared prosperity gains of recent years. Given tightening budget constraints, it becomes important to ensure such gains are not lost and underscores the progressive role fiscal policy plays in Russia – the focus of the special topic.
Russia’s fiscal policy is more redistributive than the United States’ but less so than the EU’s. Since the crisis in 2009, fiscal transfers—mostly due to increases in pensions—have played a much more critical role than rising labor incomes in sustaining income growth for households.
The good news is that when it comes to reducing inequality, Russia’s fiscal policy performs better than in Brazil, Chile, Colombia, Turkey, and the United States. But with a similar budget size (as measured by government expenditure as share of GDP), many EU countries achieve a much higher reduction in inequality. Russia can achieve more redistribution for its current level of government spending and revenues.
Against these dynamics, we expect the economy to inch towards growth. For 2016, we project growth of the Russian economy at -0.6 percent, an improvement from our earlier June forecast of -1.2 percent. And as oil and gas prices are projected to continue recovering to US$55.2/bbl in 2017 and US$59.9/bbl in 2018 and positively affect domestic demand, we forecast the economy to start inching towards growth of 1.5 percent in 2017 and 1.7 percent in 2018.
This growth upsurge, however, is unlikely to turn the tide in terms of building a more diversified economy. Risks stemming from commodity price volatility and structural constraints remain. All else being equal, a 15 percent increase [decrease] in oil prices changes our 2017 growth forecast of 1.5 percent to 2.1 percent [0.7 percent], underscoring the sensitivity of the economy to fluctuations in commodity prices. Indeed, while exports have expanded in some non-oil sectors, such as textiles, wood processing, metals and metal goods, and agriculture, which grew at 1.5 percent in the first half of 2016, the total value of non-oil exports of goods decreased by 13.4 percent in the first nine months of 2016.
And sectors, constituting slightly more than half of non-oil exports, registered contraction in the first half of 2016. Overall, import substitution seems to have a limited impact on growth and redistribution of production factors so far. The partial cyclical recovery on the back of rising oil prices is unlikely to go hand in hand with a reallocation to higher value added non-oil activities. The diversification process advances slowly due to a relatively low level of spare capacity in most tradable sectors and limited availability of labor, including structural and institutional constraints that need to be lifted first.
What can help turn the tide? While a detailed analyses of structural issues is beyond the scope of this particular report, bolstering investor sentiment towards Russia by reducing policy uncertainty will help. One important step forward, particularly in light of eroding fiscal buffers with the Reserve Fund expected to be depleted in 2017, is a return of the medium-term fiscal framework.
Also, to its credit, over recent years, Russia has accomplished many positive changes across multiple areas of business regulation, helping improve its investment climate. These are necessary though not sufficient – despite the substantial changes in the role of the state in recent decades, the ownership of productive assets has become even more concentrated, reducing competition and impairing corporate governance. And as was analyzed in the thirty fourth edition of the Russia Economic Report, there are complex socio-economic issues of an aging society. Addressing such issues is ultimately what will help turn the tide.