In Russia, the worst droughts and wildfires in nearly a century have intensified the adverse trends of slowing economic growth and rebounding inflation, as well as all but eliminating most upside risks of a stronger economic recovery in 2010. Rising inflation is also expected to undermine economic growth in 2011 and trigger a cumulative 150 basis point rate hike starting from 1Q11. Meanwhile, the Russian ruble (RUB) is likely to remain weak in 4Q10 on deteriorating fundamental support, whereas rates should start to recover on rising public borrowing.
Key Russian Economic Strengths and Weaknesses
- Strong balance of payments.
- Low public debt and significant fiscal reserves.
- Low leverage of the economy in general.
- Dependence on commodities prices.
- Structural inefficiencies, lack of domestic investment resources.
- High non-performing loan (NPL) ratios.
Drought dries up risks of stronger recovery
Summer has added natural disasters to a list of factors constraining economic recovery. The worst droughts and wildfires in nearly a century triggered a drastic drop in domestic agricultural production, a strong rise of food prices, the introduction of an export ban on wheat, and ultimately seems to have undermined the recovery of both consumer and investment demand. However, we believe the impact of the weather only intensified an already existing trend of broader economic slowdown, rather than launch it, although it also eliminated most of the remaining upside risk for a robust economic recovery in 2010.
Inflation is likely to continue to accelerate well into 2011
We recently hiked our inflation outlook to 8.3% year-on-year for 2010, and 8.2% year-on-year for 2011 eop, in order to reflect the impact of the drought. However, we reiterate our view that the weather only triggered the start of price increases, while the rising money supply – the growth of which accelerated to over 30% year-on-year in 2Q10 – remains the key fundamental driver of broader inflation. Moreover, we think that the delayed effect of the accumulated money supply increase, as well as a strengthening low base effect, should push inflation up to nearly 10% by next summer, and to 9% on average for 2011.
Ruble under pressure
The drought also supports our forecast of RUB35.5/basket for 2010, which we keep unchanged at the moment. In fact, the rouble recently dipped below our year-end forecasts on a combination of technical and speculative factors. Even though this sharp weakness is likely to be short-lived, we think that the currency is likely to remain weak in 4Q10, due to a continued deterioration of fundamental support. As a result of the wheat export ban and very modest 10% increase of food imports due to decline of domestic production, we estimate the Russian trade surplus for the remaining four months of the year should shrink by about US$6-8bn, or by 10-15% at the very least. As a result, the current account surplus, which has already shrunk to less than US$8.7bn – down from some US$33.5bn in 1Q10 – could continue to narrow even further, even with stable oil prices.
Rising imports contribute to general economic slowdown
Rising imports and accelerating inflation also support our expectations for a further slowdown of economic growth in 2010. Therefore, we keep our conservative outlook for 3.4% real gross domestic product (GDP) growth in 2010 unchanged. According to government estimates, real GDP growth has already slowed to just 2.4% year-on-year in August, down from some 5.2% year-on-year in 2Q10. We reiterate that adverse weather has only intensified the slowdown due to the persistent weakness of investment demand, the rapid expansion of imports, the expected reversal of fiscal stimulus in late 2010, and a rapidly fading low base effect. We also note that Federal Statistics Service has revised 1Q10 data only marginally, 2.9% year-on-year growth to 3.1%, and kept its 2Q10 estimate unchanged at a rather modest 5.2% year-on-year, effectively eliminating the last major upside risk to our conservative growth outlook.
2011 outlook cut to 4.3% on rising inflation
We cut our real GDP outlook for 2011 to 4.3% year-on-year growth, down from the previous 5.0%, mostly because of the 2.3% hike in our forecast for inflation, which should constrain the recovery of consumer demand and undermine the real growth of public spending (despite slightly more aggressive spending targets). However, we slightly increased our outlook for investment to a more optimistic 7%, due to restart of public infrastructure spending.
We reiterate our expectations for higher local interest rates due to rising fixed income supply and accelerating inflation. We expect the three-month Mosprime rate to creep above 4% by 2010, and up to 6% as of 2011, because of a planned massive expansion of public borrowing in 4Q10 and 2011. However, the weakening economic recovery might pressure rates in 4Q10. We note that the government has already cut its borrowing outlook for 4Q10 nearly four times to just RUB300bn, partly to prevent rate increases. We also expect the CBR to keep rates unchanged in 4Q10, despite rising inflation, in an attempt to aid recovery, but expect a 150 basis point cumulative hike in 2011, starting with 75 basis points in 1Q11.
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