Weekly 20 December 2022

Four worrying signs for the Russian economy

Four worrying signs for the Russian economy

The Russian economy is approaching the end of 2022 in a far better state than many had anticipated in the spring following the invasion of Ukraine and ensuing Western sanctions. The fall in GDP has only amounted to about 3% or even less, and the U.S. dollar is still trading at less than 65 rubles. Even the Western ban on high-tech imports, although challenging, has proved manageable. But none of this means that Russia’s economy is out of the woods: many risks still remain. We asked economists from Russia’s leading investment banks to highlight the new warning signs that have emerged in recent months.

  • Oil and gas revenues started to fall sharply due to an embargo on oil sales to Europe and a price cap imposed by the G7. In November, oil and gas revenues contributed 866 billion rubles ($13 billion) to the state budget — down 2.1% year-on-year. This is not a critical fall in revenues. However, in reality, almost half of that sum ($6.4 billion) came from a one-off payment of Gazprom’s mineral extraction taxes. Without that money, oil and gas income was down 48.9% compared with 2021.

There are two possible reasons for this. First is the near-total cessation of pipeline gas exports to Gazprom’s lucrative European market following the closure and subsequent explosions on the Nord Stream gas pipeline. Second is the fall in prices for Russian oil, which led to November’s oil revenues being down 25.4% year-on-year.

  • Russia’s Finance Ministry is printing money to cover this deficit. Part of the hole can be filled using the National Welfare Fund, but this alone will not be enough. Relying solely on the NWF would mean the liquid part of that fund would run out by 2025 according to the projected budget deficit, Central Bank analysts reported.

This fall, the Finance Ministry turned to large-scale borrowing in the federal loan bond market to cover the rest of the deficit. These internal loans raised 1.44 trillion rubles ($22 billion) for the ministry. Of this sum, 77% derives from bonds floating rates, which will ultimately be tied to Central Bank rates. The main buyers of these bonds were leading banks, which previously borrowed 1.39 trillion rubles ($21 billion) through REPO transactions. Therefore, we are effectively looking at hidden money emission, a fact which is increasingly noted by analysts.

This has obvious consequences: it will likely increase inflationary pressure, forcing the Central Bank to raise interest rates and sacrifice economic growth. However, not every economist regards this scheme as inflationary. Economist Viktor Tunev believes that, from the point of view of modern monetary theory, this borrowing algorithm will have no significant economic consequences. He calls these loans “Russian QE”: the Central Bank creates liquidity in the form of federal loan bonds, simultaneously improving standards in assets and enhancing money supplies to the banks’ liability without involving capital.

  • As the year draws to a close, unemployment levels in Russia remains close to historic lows even as foreign companies have left the market and factories have closed. The latest official figures show that 3.9% of the workforce was unemployed in October (the all-time low of 3.8% unemployment was set in August).

There are several possible explanations for this paradox. First, Russia’s labor market always responds to a crisis by cutting salaries first, not jobs. Second, the low level of benefit payments in Russia means that people who do lose their jobs are likely to grab any job they can as soon as possible.

On top of this, Russia launched its military mobilization amid this “compressed” labor market, said Rostislav Kapelyushnikov, deputy director of the Center for Labor Market Studies at Moscow’s Higher School of Economics. The loss of approximately 1-1.5 million people from the labor market due to war-related mobilization and emigration will exacerbate the situation with a growing pool of unfilled vacancies.

This serves as a wake-up call that Russia’s labor resources are limited, says Alexander Isakov, an economist specializing in Russia and Central & Eastern Europe at Bloomberg Economics. Because there are no spare resources in the economy, mobilization requires those working in “productive” industries (such as processing, construction and transport) to be diverted into the state sector. All of this impedes potential economic growth: increased defense and public sector spending have structural side effects that will limit potential annual growth to about 0.5% over the coming five years, Isakov says.

  • Russia’s real estate market is currently experiencing a bubble due to cheap mortgages. The current program of discounted mortgages at a rate of 7% was due to end in Russia at the end of this year. Both the Central Bank and the Accounts Chamber have repeatedly called for the scheme to be canceled. However, President Vladimir Putin recently announced that the program would continue, albeit at a slightly higher rate of 8%. These discounted mortgages are causing Russia’s real estate market to overheat. The primary and secondary housing markets are unbalanced (the price difference between a new apartment and a “maintained” apartment is now 40%).

Subsidies have made housing more affordable for more citizens, who have decided to take out mortgages now rather than wait. Demand has risen sharply — faster than supply can adapt — and prices are soaring. In Moscow, it is now impossible to buy a comfort-class apartment in a new building without taking out a mortgage. However, this bubble is unlikely to burst, according to independent financial analyst Sergei Skatov: developers have already sold more than 51% of the housing due to come onto the market by the end of 2023. They need to sell a further 10-20%, which is entirely achievable even if demand falls to summer levels. Defaults on mortgage portfolios could also burst the bubble, but with a failure rate of just 0.4% (and 0.15% in the primary market), this is also unlikely, Skatov said.

Why the world should care:

None of the examples of imbalances listed here are capable of killing the Russian economy by themselves. However, each one is a serious problem that Russia’s leadership is accustomed to solving with budget money, such as subsidized mortgages. However, budget revenues are declining while expenditures are increasing: in the third quarter alone, spending increased by 16%.

Putin’s pet liberal enters the power struggle at “Russia’s Google”

Alexei Kudrin, a former finance minister who then took charge of the state Audit Chamber, was regarded as the biggest liberal in Vladimir Putin’s inner circle. Now he has officially started working at Yandex, which is known in the West as “Russia’s Google.” However, a power struggle is underway inside this Russian IT giant — and Kudrin is now its key figure.

Kudrin’s term at the Audit Chamber was not due to end until 2024. He only learned of the invasion of Ukraine from the television and was shocked by the news, but had no intention of quitting his post ahead of schedule. Instead, Kudrin wanted to use all available means to demonstrate to Putin how this war was a devastating blow for the Russian economy. Kudrin also urged other influential economists to follow suit. However, by the summer they stopped reporting to Putin about the problems his war was creating for Russia — the president would get angry, and respond by talking about Russia’s historical mission.

Yandex co-founder Arkady Volozh spent a long time unsuccessfully trying to transfer several of the company’s assets abroad. After the war broke out, it became clear that this was now essential: one by one, business partners in the West backed away, members of the board of directors left the company and shareholders lost money.

Withdrawing parts of Yandex from Russia required the Kremlin’s approval — first, Volozh needed to be replaced with an owner more in tune with the authorities; second, this involved moving important technologies abroad. The idea of inviting Kudrin to negotiate with the Kremlin might have been proposed to Volozh by Charles Ryan, who remained on the board of directors. In the summer, Yandex’s board invited Kudrin to “become part of the team.”

It was assumed that Kudrin would take over Volozh’s role at the company and receive 5% of its shares (worth more than $500 million at current rates). But a source told The Bell that the former official is moving to a full-time job and will receive share options at a fixed price. “It’s a complicated remuneration package: salary, bonuses and options,” the source explained.

The big unanswered question is who exactly will take control of Yandex after Volozh leaves (the company is currently controlled by Volozh’s family trust and the company’s management via the Dutch-registered Yandex N.V.). So far, all parties in the negotiations have adopted the following scheme: the largest voting shareholder will be a special fund represented by Kudrin and three senior managers.

“They will be in control of Yandex, not the government or some kind of oligarch group,” said a source close to the company.

Kudrin’s voting share will be greater than that of the other senior managers. The current dispute is about how the decision-making process within the fund will function and how much power Kudrin will have over the other managers and new Yandex shareholders, two sources told The Bell.

Why the world should care:

On one hand, control over a major Russian IT company used by millions of people every day is an important issue in itself. And control over the “Russian Google” could fall to a man who comes directly from the public sector and who has no business experience. However, according to Yandex managers, Kudrin is genuinely engaging with every detail of his work.

On the other hand, Kudrin has in the past actively demonstrated his political position and has given every indication that he could pursue his own political ambitions. But now, all his interests are tied up with Yandex.

“If you imagine that Putin calls him tomorrow and invites him to be the next president, of course [Kudrin] will leave Yandex and take over the presidency,” a source told The Bell. “However, if he is offered the Prime Minister’s position, he would need to think about it. Most likely, he would take the job, but he might hesitate — whereas six months ago he would have agreed instantly. Of course, Kudrin has ambitions, but now he wants to earn money doing an interesting job.”

The Kremlin sends a signal – Putin is directly involved with the war like never before

Last week, Vladimir Putin visited the coordinating headquarters for Russia’s forces in Ukraine and Defense Minister Sergei Shoigu inspected the deployment of troops in southern Russia.

These unexpected events, which were not previously announced, took place against the backdrop of increased Russian missile strikes on Ukraine and warnings from Ukrainian generals of an impending Russian offensive on Kyiv.

On Dec. 15, the Russian Defense Ministry reported Shoigu’s visit to “the forward positions of Russian units in the zone of the special military operation.” The next day, the Kremlin said that Putin had visited the military headquarters and that he worked there “all day long.” In addition to Putin, the meetings were attended by Shoigu, the head of Russia’s frontline forces Sergei Surovikin, and Chief of the General Staff Valery Gerasimov.

The precise location of these headquarters is not known. Journalist Dmitry Kolezev pointed out to the fact that the rooms where Putin was seen resembled those where Surovikin has given interviews in the past.

Putin visited the headquarters on a day of massive missile strikes on Ukraine’s energy infrastructure. Russia is systematically targeting the Ukrainian power grid with its missiles, leaving much of the country without electricity, heating or water. A few days before Putin’s visit, Valeriy Zaluzhny, the commander-in-chief of Ukraine’s military, told The Economist that he expects Russia to make a renewed assault on Kyiv next year, either via Belarus or from the south.

Since the war broke out, Putin has neither traveled to the combat zone nor set foot in the occupied territories. The closest the president has physically come to the war was when he visited a training camp for conscripts in central Russia. Throughout this time, Putin’s speeches have made no reference to the retreat of Russian forces from Kherson, nor their retreat from the Kharkiv region. The Kremlin now wishes to portray Putin as a competent wartime leader, wrote analysts at the Institute for the Study of War.

Another possible reason for this display could be an attempt to rehabilitate the Defense Ministry’s reputation. The ministry has faced intense criticism from supporters of the war as it has suffered a string of setbacks on the battlefield.

Why the world should care:

Putin believes in the “historical justice” of the war in Ukraine — but he has not been directly involved in it until now. All the key decisions in the public sphere were taken exclusively by the military. Now, the president has brought the war under his personal direction. We can only speculate whether this is the first stage of a renewed assault on Kyiv or another PR stunt to appease supporters of the war.

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