The Russian Economy Explained – A 3-Part Series (Part 3)
Originally posted in November 2015. Updated in November 2016.
The final installment of our three-part series on Russia consists of an examination of their current monetary policy, exchange rate policy, and fiscal policy.
Before you start on part 3, don’t forget to check out the first two parts in our three-part series on Russia. Part 1 gives an overview of the economy with an analysis on their economy beginning in 1991 after the fall of the Soviet Union, up to present day, including information on assets and risks to their long-term growth as well as forecasts on GDP and inflation. Part 2 details Russia’s Balance of payments, current account, exports and imports.
In the third and final part of a three-part series on Russia, we look at the Central Bank of Russia’s monetary policy, detailing their responsibilities to the Russian Federation and their attempts to stop inflation after the weakening of the ruble in late 2014. It will also delve into Bank Rossii’s exchange rate policy and their attempts to stabilize the quickly depreciating ruble as well as cover the government’s fiscal policy as they attempted to curb the increase of the budget deficit going into 2016.
Monetary Policy in Russia
The Central Bank of Russia (Bank Rossii), founded in 1990, has several responsibilities in compliance with the Russian Constitution and Russian Federal Law: maintaining the value and stability of the ruble, overseeing Russian financial institutions (including acting as a lender of last resort), managing Russia’s foreign reserves and foreign exchange, and setting short-term interest rates, which is one of the main instruments of the bank’s monetary policy implementation.
Low oil prices and sanctions shocks to the Russian economy resulted in the ruble losing 46% of its value against the U.S. dollar in 2014, prompting policies from the Bank Rossii aimed at stabilizing the financial system. Bank Rossii raised its key interest rate in December 2014 by 650 basis points to a lofty 17% to curb runaway inflation caused by the weakened ruble (core inflation reached 11.2% in December 2014, year-on-year). Bank Rossii spent USD 27.2 billion in October 2014 and USD 11.9 billion in December of the same year on interventions to support the ruble.
Russia’s Central Bank gradually reduced interest rates over the course of 2015, starting the year at 17.00% and reduced to 11.00% by July. Interest rates were kept steady for nearly a year until June 2016 when they were cut by 50 basis points to 11.50%. In making the decision to cut interest rates, the Central Bank indicated that authorities were more confident about the evolution of inflation and noted the positive results of a drop in inflation expectations and decreased inflation risks against a backdrop of their slowly but surely recovering economy.
Since then there has been a noticeable drop in inflation, which drove the Bank to cut rates in September 2016 from 11.50% to 11.00%. Authorities did however state that in order to cement a sustainable fall in inflation, “the current value of the key rate needs to be maintained till end-2016 with its further possible cuts in 2017 Q1-Q2.” Considering its decision, the Bank remains confident that with a still relatively-tight monetary policy, inflation will fall to 4.5% in Q3 2017 and decrease further toward its 4.0% target at the end of 2017. The bank also indicated that it will hold off from further monetary easing until the first or second quarters of 2017.
Exchange Rate Policy
On 11 November 2014, Bank Rossii un-pegged the ruble from a dual-currency (U.S. dollar and euro) basket band, ending two decades of exchange rate controls and moving Russia to a free-float exchange rate system. The Central Bank also ended the regular interventions with the ruble, but signaled that it remained committed to intervening in support of the Russian currency in case there were risks to financial stability. As the ruble continued to slide against the greenback because of falling oil prices and higher uncertainty among investors, the Central Bank decided to continue intervening in the foreign exchange market, costing the Central Bank hundreds of millions per day.
The value of the ruble first began to fall in early 2014 after several years of an exchange rate of roughly 30 RUB per USD, as the country was acutely affected by weak economic growth, high geopolitical risks following the annexation of Crimea and the outbreak of war in Ukraine. However, it was with the collapse of oil prices at the end of 2014 when the ruble’s value could not defy gravity and thus began its free fall against the U.S. dollar, with the currency bottoming out at 68.5 RUB per USD on 16 December. Throughout 2015, the Russian ruble has been on a roller coaster. High volatility and strong fluctuations in oil prices have weighed heavily on the country’s currency. The beginning of 2015 saw strong volatility in the foreign exchange market, but the Russian currency stabilized within a corridor of 50 to 60 RUB per USD at the end of the first half of the year. There was another episode of strong volatility at the outset of second half of the year and, on 24 August, the Russian currency closed the trading day at 70.9 RUB per USD, which was even lower than the aforementioned low point of the December 2014 ruble crash and represented a new all-time low. The sharp drop in August was primarily a response to falling oil prices and rising fears regarding the effects that the shockwave caused by China’s stock-market crash could have on the global economy. The ruble closed 2015 at 72.9 RUB per USD—a 30% loss in value compared to the end of 2014.
Fluctuations of the Russian ruble are largely driven by the price of oil, which along with gas, is Russia’s main commodity export. The currency took a dramatic fall to an all-time low of 82.4 RUB per USD on 21 January 2016, as oil prices fell to lows not seen in over a decade. It has gradually stabilized between 60 and 70 RUB per USD as the economy has improved and oil prices have crept back up since January 2016.
Since the country’s 1998 debt crisis, a nearly decade-long environment of favorable commodities prices (particular in the energy sector), a relatively weak ruble and tight fiscal policy allowed Russia to run budget surpluses from 2001 to 2008 until the global financial crisis hit.
Russia depends heavily on its energy exports. In fiscal year 2008, oil and gas revenues reached a peak, accounting for half of the Russian federal budget. However, since the global financial crisis hit the country in 2009, the Russian economy began to run fiscal deficits. In 2012, 2013 and 2014 Russia ran budget deficits representing -0.02%, -0.7% and -0.6% of GDP, respectively. The exception was the year 2011, when the Russian budget incurred a 0.8% of GDP surplus.
Low oil prices and a collapse in domestic demand and imports as the economy fell into recession decimated fiscal revenues in 2015. In fact, the impact of low oil prices on Russia’s fiscal revenues raised questions about the country’s long-term economic prospects as well as fiscal sustainability. With the decline of energy prices and the Russian government's dependence on energy revenues to fund its budget—revenues from oil and natural gas represented around 52% of the Russian budget—forced the Russian government to rethink its fiscal policy. The Finance Ministry announced in early September 2015 that it had decided to suspend the fiscal rule—a law designed to limit government spending.
The fiscal rule went into effect in 2013 to prevent the government from wasting windfall oil revenues and instead divert them into rainy-day funds. The rule also aimed to limit government expenditure to projected non-oil revenues, oil revenues calculated using long-term historical oil prices, and a fiscal deficit of at no more than 1.0% of GDP. At the time the rule was created, Russian authorities were concerned that the income generated from rising oil prices would encourage pro-cyclical spending. However, within the context of weak economic growth and oil prices at just half the level observed in 2014, Russia faced the opposite problem.
Because the budget rule limits government spending to long-term historical oil prices, if the law were to continue into 2016, it would have implied a reference price higher than the one that was forecast for 2016—which was an average USD 50 per barrel.
Officially, the fiscal rule was suspended temporarily. Some advisors, among them former-Finance Minister Alexei Kudrin, voiced support for suspending the rule, at least for a year. Moreover, in addition to the suspension of the fiscal rule, the government also announced a transition from a three-year budget plan to one-year budgeting. The three-year budget plan was designed to force the government to take a medium-term approach and avoid making unsustainable pledges. All in all, the changes to the budget process paved the way for a more accommodative fiscal stance in an effort to mitigate the low oil prices and weaker economic growth.
Some analysts suggest that, with sizeable reserves and low public debt, Russia can afford to run a modest fiscal deficit without imperiling fiscal sustainability. The fiscal deficit ended at 2.8% in 2015.
Russia has two fiscal buffers, the Reserve Fund and the National Welfare Fund (NWF), both of which have been under pressure as a result of deteriorating economic conditions. The Ministry of Finance indicated that the budget deficit projected for 2015 (RUB 2.7 trillion, equivalent to 3.8% of GDP) would be covered by the country’s Reserve Fund, rather than by raising debt. Unfortunately, the government was unable to sustain that deficit due to the inability to fund it. Due to international sanctions, the government has been unable to borrow from abroad. The government allowed for increased discretionary use of NWF resources in December of 2014 in order to help stabilize the financial system. The Russian government had no choice but to continue to draw down on the NWF.
What’s next for Russia?
Russia’s ongoing geopolitical concerns involving Ukraine and the resultant sanctions from the west has taken a toll on the economy in the last few years. Their heavily commodity dependent economy, especially the energy sector, has been hit hard as commodity prices have plunged globally. This has heavily impacted Russian exports and a snowball effect has begun to take effect, rolling over and flattening other parts of the economy. Although many downside risks in relation to the Russian economy are evident, it still has a lot going for it.
As was outlined in the conclusion to part 1, Russia is the largest nation in the world in terms of land mass with a little bit of everything in terms of geology - mountain, forest, and coastline. Because of its landmass it has extensive mineral and energy resources available to it, the largest reserves in the world in fact, making it one of the largest and globally. It also plays a prominent role in many global organizations such as the UN, the G20, and the Council of Europe to name just a few, and therefore, it has a lot of reach and power to make things happen on a global scale in its favor.
So, where do they go from here? In 2011, Russia joined the BRICS association, a group of five nations dubbed the five greatest emerging markets, however Russia’s decline in recent times has been mirrored by many of the other members of the group. Questions abound as to whether they are slated to be a potential emerging economy forever or soon rise up to become a world economic super power. Only time will tell.
Anthony Halley and Senior Economist Ricardo Aceves contributed to this piece.
Originally posted in November 2015. Updated in November 2016.
Date: November 4, 2015
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