Stratfor: Russia’s economy burns; they have no good options.

Summary: As Obama’s military requests vast new sums to defend against Russia, Stratfor examines Russia’s crashing economy — and its few options for recovery. Russia is largest casualty of the financial world war begun by the Saudi Princes (bet on them to win). While this great conflict burns the US military dances away to its own delusional but profitable tune.

Stratfor

Russia Has Few Options for Turning Its Economy Around

Stratfor, 5 February 2016

Forecast

  • The Central Bank of Russia will try to reduce high inflation and encourage growth to counter the economy’s rapid deterioration.
  • However, the bank probably will not be able to rely on its biggest tool — the interest rate — to do so, instead turning to less effective means that will have little impact on inflation.
  • While the central bank’s efforts to reform the banking sector will not yield many immediate gains, they could spur growth in the long run by encouraging investment in Russian businesses.
  • Meanwhile, the Kremlin will use its limited resources to prop up Russia’s most important sectors, including agriculture and the military.
  • Still, unrest will likely grow throughout the year as inflation continues to put pressure on the Russian people.

Analysis

Low oil prices have thrown a wrench in many of the world’s economies, but perhaps nowhere more so than Russia. Depressed energy prices have sent the value of the Russian ruble tumbling and inflation soaring, and much of the Russian population is struggling to make ends meet.

The Central Bank of Russia, under pressure to find a solution to the country’s deepening economic crisis, is exploring all of the monetary policy options at its disposal. But the bank will find that its primary tool for combating the inflation wreaking havoc on the Russian economy — adjusting the country’s key interest rate — may be difficult to actually use under the current circumstances. As a result, bank officials will likely be forced to turn to secondary, less effective measures to keep the Russian economy from sliding even further into disrepair.

An Overburdened Welfare System

After years of sanctions and declining oil revenues, the outlook for the average Russian is looking increasingly grim. Unemployment is rising, and average wages — already at their lowest since October 2005 — are still declining. Meanwhile, a growing share of the population (likely as much as 14 percent in 2015) is falling below the poverty line. The dauntingly small budget of Russia’s welfare system, which is meant to provide a robust safety net for the poorest of Russian society, is buckling under the weight of its burden, and the government is having trouble keeping its poorest citizens from sinking into utter impoverishment. Social tension is mounting, and unrest will likely only grow as the year progresses.

Many of these socio-economic problems stem from inflation. Though inflation is expected to fall, first from 12.9 percent in 2015 to around 10.5 percent in 2016 and then again to near 7.1 percent in 2017, it remains high. This, combined with a devalued ruble and lower incomes and employment levels, has substantially reduced the spending power of Russian citizens. Consequently, nearly a quarter of Russians are considered to be “at risk.”

Russia’s central bank is looking for ways to lessen this inflationary pressure and encourage development to improve the country’s economic health. Historically, it has primarily fought inflation by intervening in currency markets to prop up the ruble, as it did during the 1998 ruble crisis and the 2008-2009 global financial crisis.

Stratfor: Russia's monetary policy

Click to enlarge.

However, this approach often requires the bank to draw heavily from Russia’s foreign currency reserves. After the crash in 2008-2009, Moscow drained nearly $200 billion from its reserves to keep the value of the ruble from tanking. Thanks to high oil and natural gas revenues, Russia managed to rebuild its shrinking reserves to $545 billion by August 2011. But yet another attempt to artificially buoy the ruble in 2014 sapped those supplies once again. As of Jan. 21, the country’s foreign currency reserves had dropped to about $368 billion and the ruble had rapidly devalued by over 50 percent, reaching around 80 rubles to the dollar.

Balancing Inflation With Federal Debt

With its foreign currency reserves dwindling, Moscow may have to turn to issuing debt to make up for its budgetary shortfalls. (Issuing debt allows a government to borrow money from lenders with the promise to repay them at some point in the future.) This is especially true since the central bank, in the wake of its massive effort to sustain the ruble in 2014, has vowed to let the ruble float freely rather than again intervening to prevent further devaluation.

But with Russia’s low credit ratings, it would likely have a hard time attracting buyers for its debt unless the central bank raised interest rates — something that would align with the bank’s goals of lowering inflation but would also limit consumer spending and hike up costs for Russian businesses. This would in turn increase their reliance on government subsidies to stay afloat, at a time when low oil prices have already cut into the Kremlin’s funds. Thus, the interest rate tool that is typically a central bank’s greatest policy lever is, in fact, a double-edged sword for the Central Bank of Russia: Raising rates would help manage inflation and attract foreign lenders, but it would slow the economy while expanding the government’s subsidy burdens and future debt.

Central bank chief Elvira Nabiullina has made tightening Russia’s monetary policy a priority, but being unable to adjust interest rates will hamstring her efforts to reach her target of “low deficit, low debt and low inflation.” Still, there are other measures she can resort to, though each has its own problematic consequences.

Stratfor: Russia's currency and economy

Russia’s Other Options

The first and most easily accessible measure is to adjust the Russian banking sector’s capital reserve requirements, or the amount of cash banks must keep on hand at all times. After the financial crisis broke out in 2008, the Basel Committee on Banking Supervision — of which Russia is a member — issued guidelines aimed at preventing banks from overexposing themselves to volatility in niche markets such as housing or technology. The Basel III accords suggest requiring banks to maintain higher levels of reserve cash, a move that could lower inflation by taking money out of circulation. Most Russian banks, especially those that are state-owned, are resistant to raising capital reserve requirements because doing so would cut into their profits and their ability to lend money out. That said, Russia’s central bank has already begun to push ahead with this line of reform, though it will take time to fully implement.

In the meantime, central bank officials have started to pursue an alternative strategy to keep inflation in check: lowering liquidity. Under this strategy, the government essentially reduces the amount of money available by printing fewer rubles and absorbing excess cash through deposit auctions, in which the central bank agrees to compensate banks for holding on to money for short periods of time. Hypothetically, the central bank could also reduce liquidity by issuing more debt to soak up investors’ available funds, but with the heavy subsidy obligations it faces, Moscow is hoping to minimize its debt as much as it can. Lowering liquidity also has its risks: It often discourages lending, which can stand in the way of economic development.

Nabiullina’s final option is to raise the lending standards set for Russian banks, which would make it more difficult for them to lend under risky circumstances. This move would result in greater restrictions on banks’ ability to both lend and borrow, as well as on consumers and businesses seeking credit, slowing economic activity overall in the process. However, the Kremlin has an array of subsidy programs in place that are meant to encourage targeted lending to specific, critical industries. This combination of lending standards and targeted subsidies has been successful to some extent over the past five years, but it has also enabled more unprofitable businesses to seek refuge under the growing subsidy umbrella.

Half Measures Will Give Little Relief

As it stands, none of these options will likely be enough to do what adjusting the interest rate would: lower inflation. But unless oil prices change significantly enough, whether up or down, to force the central bank to re-evaluate its course of action, it will have to make do without its primary policy tool. Consequently, the Russian government will use the secondary measures it has to help stabilize the financial sector while funneling the few resources it has to the areas of the economy that matter most, including agriculture, transportation, manufacturing and the military.

Meanwhile, raising capital reserve requirements and continuing to subsidize loans for Russian businesses will do little to make a dent in the high inflation putting strain on the Russian people in the short term. With social unrest already high and expected to escalate throughout 2016, the Kremlin could find itself in a precarious political situation as parliamentary elections at the end of the year draw near.

Lead Analyst: Joe Parson

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Russia Has Few Options for Turning Its Economy Around
is republished with permission of Stratfor.

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For More Information

See “Russia: The End of the Illusion?” by Amy Knight at the New York Review of Books, 23 Feb 2016. Can Putin remain popular amidst revelations of corruption while Russia’s economy crashes?

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11 thoughts on “Stratfor: Russia’s economy burns; they have no good options.

  1. “of the financial world war begun by the Saudi Princes (bet on them to win”

    It’s possible that they might win. The question is, how long might it take? Say fracking in the US halts completely because of low prices. Prices start to rise, have the Saudis won anything? No, as the price rises to >$40 frack sites become viable and start flowing again. At best I can see the price stabilising around $60, way below anything the Saudis or Russians might be hoping for.

    Meanwhile the technology has improved vastly and it’s even cheaper to frack and more efficiently too meaning the US won’t run dry for many decades.

    “With social unrest already high and expected to escalate throughout 2016, the Kremlin could find itself in a precarious political situation as parliamentary elections at the end of the year draw near.”
    Don’t know about the end of the year, but the Saudi regime and that in Russia are more likely to fold before oil hits a high enough price to float their boats…

    1. Steve,

      (1) “as the price rises to >$40 frack sites become viable”

      No, for several reasons.

      First, that’s wrong. Articles about oil economics routinely cite as “costs” what are in fact “project operating costs” — ignoring other costs: capital costs (capex to develop the field), overhead (got to run the company) and the cost of capital.

      Companies relying on fracking produced little free cash flow even with natural gas (Henry Hub) at $3.50 – $4.00 and WTI oil at $90 – $100 — as they were for most of 2013 – 2014. And that was with an absurdly low cost of capital provided by lenders (too low, as will be proven by the bankruptcies that are just starting).

      When prices rise again, exploration & production will increase — but at higher price points than during the past boom.

      (a) Company CFO’s will write checks only for projects that will produce profits at current prices with conservative assumptions — no more “field of dreams” capex.

      (b) Lenders will demand higher interest rates, as the memories of the coming defaults will last a long time. The coal bankruptcies, now starting to become serious, will further entrench the reputation of energy lending as high-risk.

      Second, natural gas prices are more significant than oil for fracking — and for overall US hydrocarbon (in layman’s term, petroleum) production. See this EIA graph for 2014.

      EIA 2014: US energy production

       

      (2) “the US won’t run dry for many decades.”

      No energy expert speaks of the US “running dry”. That’s language of peak oil loons and tabloid internet gurus.

    2. FabMax,

      I wasn’t thinking of the US running dry in terms of it being a problem for the US, more that it would be a problem for those who have grown used to the idea that the US was a vast export market for crude that did a lot to keep the price high.

      As for fracking costs, there’s a lot of fields already fracked, so in one sense, the hard work has already been done. Even if companies go bankrupt, someone pick up their fields and their cost options will be different. In any event, fracking became viable at some price point, and probably below $100 per barrel. Russia and Saudi need the price some way above $100 if they’re to stick to their spending plans.

      It’ll be interesting to see how it plays out. There are so many variables. Iran, Iraq, Nigeria, Saudis, Venezuela and Russia all need to pump and the general pressure to limit use of fossil fuels may well mean there’s a glut for many years to come. Perhaps they’ll all reach an agreement and ‘manage’ the price in their best interests. The Iranians would like to see the Saudis fall so they might pump to keep the price low to scupper them.

    3. Steve,

      You are misinformed. I suggest upgrading your information sources, since the ones you use today are not working for you.

      (1) ‘there’s a lot of fields already fracked, ”

      Fields are not “fracked”. Fracking is done to individual wells, which have an effective life of only a few years (i.e., their production curve has a steep drop).

      (2) “Even if companies go bankrupt, someone pick up their fields and their cost options will be different”

      Few oil properties in the US are owned by the E&P companies; they are leased for fixed terms — usually with provisions requiring their production. The cost of the leases is a small factor of crude revenue.

      (3) “fracking became viable at some price point, and probably below $100 per barrel.”

      That was my point. You said “>$40”, which was absurd.

      (4) “I wasn’t thinking of the US running dry in terms of it being a problem for the US, more that it would be a problem for those…”

      As I said, it’s absurd to speak of the US or the world “running dry”. Nobody familiar with oil production or geology says such a thing. It’s terminology popularized by peak oil loons and such.

    4. FabMax,

      1 & 2. Site, field. Doesn’t matter. Once the frack has been done and the gas/oil is able to be extracted anyone taking on the site lease when the frackee goes bust will have different costs to contend with. Lease or not. If the frackee doesn’t go bust they have a choice to sit it out and wait for the price to rise sufficiently or, to take what they can and run. It will depend on the lease I’d imagine and their circumstances.

      3. Viability depends on individual sites. I wasn’t suggesting fracking in general would be viable at any particular price, merely that it’s a *curve*. There are frack sites producing (for whatever reasons) when oil is ~$40, at $70 or $80 there’s plenty of incentive to frack/refrack, and that’s still way below any price that’ll make either Russia or Saudi happy. The technology is always improving, and now, with the price so low there’s even more incentive to develop cheaper ways to frack, and more efficiently too.

      4. Running dry was the wrong phrase to use given recent peak oil hysteria, too emotive. There’s little chance of the US running out of options to frack for many decades. Neither the Russian nor Saudi regimes have that much time. I was just trying to make the point that there’s plenty in the US that’s extractable and that the cosy Saudi ruled oil market may have gone forever.

      I thought the analysis of Russia’s position was spot on, I’m just not so sure that the Saudis really have the grip on things you think they have. There are just too many variables and if the Saudis think they’re in control, they *really* don’t see that the light at the end of the tunnel may just be the oncoming train…

      You’ll be pleased to know you’ve heard the last from me on this subject :-)

  2. “Peak oil loons”.

    Peak oil is a legitimate concept if you restrict it to types of oil and, probably, energy produced/energy consumed ratios.

    Hubbard worked at a time of vertical wells and dominantly primary production. If you look at the resources he was talking about, he was pretty good. These shale gas liquid rich plays were known about but not economic. Today they can be economic but the energy out/in ratios (and grosses) arr worse than in Hubbard’s time.

    Easy oil is running out or perhaps we should say HAS run out. This is extremely important. The future is not cold and dark but it is hard and expensive.

    Technology has helped. But it hasn’t made the hard easy or the expensive cheap. Our petroleum resources have not been replaced with their equivalents.

    We serve out children badly if we think Halliburton has made “peak oil” a silly idea. We can still get a dance in the bar, but it requires a glass of bubbly. A glass of draft beer just won’t do any more.

    1. Doug,

      I am amazed that I need explain this. Yes, everybody who knows anything about geology knows that oil production will peak eventually. There is an inverse relationship between ore quality and quantity, so that once the world is fully explored costs will rise over time — offset by better tech that lowers the cost of extraction and refining (details here). At some unknowable point either the balance will tip so that rising prices force lower production (aka demand destruction) — or new forms of energy replace it.

      As my post 4 days ago explained, people in the “peak oil community” believed in 2005-2013 that either oil production had peaked or that it would do so soon — with catastrophic results. That’s been proven wrong — as production has increased and prices collapsed, but like millenialists predicting the Second Coming, they’ve just moved the due date forward in time. Loons.

      Seriously, did you not know any of this?

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