13 March 2014 EM Monthly: Limiting Contagion

Russia: macro implications of increased geopolitical risk

Tensions over the situation in Ukraine escalated recently with Russias legislature granting its President the right to send troops to Ukraine, which notably increases the scale of political risks in the near term. The latter are likely to lead to a significant rise in capital outflows, which adversely affects the currency as well as the growth trajectory, most notably on the fixed investment side. We assess the implications of political risks for Russias economy through various scenarios for capital outflows. Our analysis suggests that capital outflows of USD75bn would prompt a surge in the ruble rate to more than RUB/USD36 and prevent Russias economy from staging acceleration this year. We assess only the sensitivities associated with the direct effects of capital outflows on growth and the exchange rate, and do not take into account the effects of sanctions, changes in interest rates and other factors. With respect to sanctions, we believe their overall direct effect is likely to be limited for the economy but may add to capital outflows even if sanctions are not fully applied but simply discussed publicly. All this implies that the estimates of the costs to the ruble and growth resulting from capital outflows should be seen as the lower bound of the total effect, which takes into account other factors, including sanctions.

Capital flight may erode economic outlook In terms of the economic impact, the main implication at the macro level for Russia is likely to be a significant rise in capital outflows, which adversely affects the currency as well as the growth trajectory, most notably on the fixed investment side. The overall impact on the ruble could be moderated in part by the relatively favourable global economic backdrop as well as by the tightening of monetary policy (the CBR already temporarily hiked rates by 150bps at the beginning of March). While in 2008-2009 the global economy was sliding into negative territory, which led to a sharp decline in oil prices, in 2014 the pace of economic growth may accelerate to well beyond 3% yoy, which should sustain oil prices at levels not too far off USD100/bbl (our commodities team projects USD97.5/bbl Brent). On the downside, however, the severity of economic isolation along with the resurgence of political uncertainty may exact costs, with considerations regarding macroeconomic fundamentals likely being overshadowed by negative sentiment. Figure 1: Net private capital outflows, USDbn, 2005-13
100 50 0 -50

Ukraines political turmoil poses risks to Russian economy

Putin authorized to send troops to Ukraine On 1 March, Russias President Vladimir Putin issued a request to the Federation Council for authorization to send troops to the Crimea peninsula, where the Russian fleet is based. This request was swiftly granted, with Russias officialdom noting that the decision to send troops had not yet been taken by Putin and that such a decision would depend on the course of events in Ukraine. These developments were accompanied by demonstrations in the eastern parts of Ukraine as well as in Crimea. Meanwhile, the latter is preparing for a referendum to get more autonomy from Ukraine or even to join Russia. The measures taken by Russia were met with the possibility of sanctions from the West, which may affect Russias economy. These developments notably increase near-term sovereign risks pertaining to Russia and Ukraine, and are fraught with the potential for acceleration in capital outflows.
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USDbn

-100 -150 2005 2006 2007 2008 2009 2010 2011 2012 2013 Banking sector - assets Banking sector - liabilities net errors and omissions
Source: CBR, Deutsche Bank

Non-Financial sector - assets Non-Financial sector - liabilities Net Capital Outflow

2014 vs. 2008: fundamentals are different In terms of domestic economic development, the key difference now compared to 2008 is that the economy is not overheated. Back in 2008, the pre-crisis period was characterized by massive net capital inflows, a booming stock market and real estate segment growth, as well as high growth rates in GDP and lending. This time Russias financial markets are less overheated and growth is approaching zero, with growth in lending decelerating.

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13 March 2014 EM Monthly: Limiting Contagion

Figure 2: Russias external debt profile, % GDP

40 35
11 12 12 13 14 14 14 14 15 16 16 17 21 21 21 19 18 17 17 16 16 15 15 15 14 14 14 14 14 14 14

30 25
% GDP

20 15 10 5 0

(USD17bn in January 2013 and USD16bn in January 2012). According to Economy Minister Ulyukaev, this is related to an increase in FX assets in the banking sector. In addition, the population actively purchased currency in January, which contributed to the outflow. We now proceed to look at the sensitivity of Russias economy to various scenarios of capital outflows. Impact on the ruble We base our sensitivity analysis for the ruble rate on the following capital outflow assumptions. Figure 4: RUB/USD vs. CA surplus and capital flows
80 60 40 20 0
USDbn

General Govt & SOEs - ST

Source: CBR, Deutsche Bank

1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13

3 3 3 4 4 6 6 6 6 5 5 4 4 4 3 3 3 3 3 3 3 3 3 3 3 3 3 3 2 3 2

16 15 11 12 13 14 13 12 12 11 10 10 11 12 13 13 12 12 12 12 11 11 11 11 11 12 13 13 15 16 16

Private sector - ST

General Govt & SOEs - LT

Private sector - LT

-20 -10
% yoy (inverse)

In terms of debt levels, Russias sovereign balance sheet is strong, even though the susceptibility to lower oil prices has remained high, as evidenced by the level of the non-oil budget deficit, which exceeded 10% of GDP last year. On the corporate side, the maturity of debt is less short term than in 2008 and has fewer currency mismatches. Figure 3: RTS Index vs. Moscow Property Prices
1 600 1 400 1 200
1-Jan-2000=100

-20 -40 -60 -80

10 20 30 40 50 2005 2006 2007 2008 2009 2010 2011 2012 2013 CA, USDbn Cap. flow, USDbn RUB/USD, % yoy (RHS)

-100 -120 -140

Source: Rosstat, CBR, Bloomberg Finance LP, Deutsche Bank

1 000 800 600 400 200 0 2000

Scenario 1: Capital outflows moderate to a level of USD30bn from USD62bn in 2013. Scenario 2: Capital outflows intensify to USD60bn, the level of 2011-2013. Scenario 3&4: Capital outflows intensify beyond/significantly beyond the average levels of the past several years, namely to USD75bn and USD100bn, respectively. Scenario 5: Capital outflows resemble 2008 and reach USD130bn.

2001

2002

2004

2005

2006

2008

2009

2010

2012

2013

RTS Index
Source: Bloomberg Finance LP, Deutsche Bank

Russia Moscow Property prices

At the same time, overall debt levels in the corporate sector remain significant, while the balance sheet of Russias households is arguably more problematic now than in 2008 (to the degree that it represents one of the macro risks and concerns for the CBR) after Russias household debt grew at a rapid pace over the past several years. At this juncture there is scope for capital outflows to be significant this year given that, along with rising risks, oil prices are high and the current account is enjoying a surplus. With respect to January data, the Ministry of Economy estimates net capital outflow from Russia at USD17bn in January 2014. Given the seasonality of this indicator, outflows appear to be in line with previous years
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Our analysis implies that capital outflows of USD75bn would prompt a surge in the RUB/USD rate to a yearaverage of RUB/USD36.5, while much higher outflows of USD130bn could lead to an average of RUB/USD40. Figure 5: Impact of higher capital outflows on RUB/USD, scenarios
2014 Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5
Source: Deutsche Bank

Cap. outflow, USDbn 30 60 75 100 130

Impact on RUB, % 6.9 11.9 14.8 19.8 25.7

RUB/USD, pavg 34.0 35.6 36.5 38.1 40.0

RUB/EUR, pavg 44.2 46.25 47.47 49.52 51.97

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13 March 2014 EM Monthly: Limiting Contagion

Impact on growth In terms of the impact on growth, capital outflows undermine investment activity with the funds taken offshore rather than invested in new production facilities. Figure 6: GDP growth and its components dynamics
15

In the figure below we illustrate the impact of higher capital outflows on GDP growth. The direct impact column illustrates the first-round effect from higher capital flight, while the impact column also accounts for some second-round effects and the resulting improvement in the CA balance. Figure 8: Impact of higher capital outflows on GDP, scenarios
Cap. outflow, USDbn Scenario 1 Scenario 2 30 60 75 100 130 cap flow vs. 2013, USDbn -30 0 15 40 70 % GDP 1.4 2.8 3.5 4.7 6.1 Impact on GDP, % GDP, pp yoy 1.0 0.0 -0.5 -1.3 -2.3 2.3 1.3 0.8 0.0 -1.0

10

-5

Scenario 3 Scenario 4

-10 1996 1998 2000 2002 2004 2006 2008 2010 2012 Household consumption Export Govt consumption Import Fixed asset investment GDP

Scenario 5

Source: Deutsche Bank

Source: CBR, Bloomberg Finance LP, Deutsche Bank

The uncertainty over the political and economic situation in Ukraine as well as concerns over possible sanctions imposed on Russian businesses could further exacerbate costs. Figure 7: GDP, fixed investment vs. capital flows
15 30

Our analysis suggests that capital outflows of USD60bn would prevent the Russian economy from staging a significant acceleration this year, with annual growth of an estimated 1.3% yoy vs. 1.3% yoy in 2013, 3.4% yoy in 2012 and 4.3% yoy in 2011. Second-round effects are skewed to the downside In this report we assess only the sensitivities associated with the direct effects of capital outflows on growth and the exchange rate, and do not take into account the effects of sanctions, changes in interest rates and other factors that may also have a significant effect on the macro outcomes this year. With respect to sanctions, we believe their overall direct effect would likely be limited for the economy but may add to capital outflows even if sanctions are not fully applied. In terms of the effects of interest rate changes, their temporary nature would likely result in a limited effect on lending and growth; however, if the current political uncertainty proves to be persistent, elevated rates could linger and have a greater adverse effect on growth this year. Another factor that may affect Russias outlook for the 2014-2015 period is the risk to the sovereign credit rating, as stated by Moodys earlier this month. All this implies that the estimates of the costs to the ruble and growth resulting from capital outflows should be seen as the lower bound of the total effect. Yaroslav Lissovolik, Moscow, +7 495 933 9247 Artem Zaigrin, Moscow, +7 495 797 5274

10

20

5
% GDP

10
%yoy

-5

-10

-10

-20

-15 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Net capital flow, %GDP GDP, % yoy (RHS)

-30 Fixed asset investment, %yoy (RHS)

Source: Rosstat, CBR, Bloomberg Finance LP, Deutsche Bank

We base our analysis on the same capital outflow assumptions that we used in the previous section.

Scenario 1: Capital outflows moderate to a level of USD30bn from USD62bn in 2013. Scenario 2: Capital outflows intensify to USD60bn, the level of 2011-2013. Scenario 3&4: Capital outflows intensify beyond the average levels of the past several years, to USD100bn. Scenario 5: Capital outflows resemble 2008 and reach USD130bn.

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The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. [Yaroslav Lissovolik, Artem Zaigrin]

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