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RUSSIA. Sanctions will magnify the long term deflationary trend

Economist: ALESSIO CHIESA The ADA team can be reached at: [email protected]

Stress Free Country Monitoring, April 2018

ANALYSE. DEBATE. ACT. 1. OUR HIGHLIGHTS.

GDP. BUSINESS CYCLE.

LONG-TERM STRUCTURAL CONSIDERATIONS.

POLITICS. DISCLAIMER.

ANALYSE. DEBATE. ACT. 2. KEY FORECASTS.

2013 2014 2015 2016 2017E 2018F 2019F Real GDP 1.9% 1.4% -2.5% -0.2% 1.5% 1.3-1.5% 1.2-1.5% Households 4.4% 1.0% -8.6% -2.7% 3.4% 3.8% 2.9% Government 0.8% -1.4% -2.9% 0.8% 0.4% 0.2% -0.5% Investment -3.5% 0.2% -13.5% -1.7% 7.4% 4.3% 3.1% Exports 4.0% 0.8% 3.6% 3.6% 5.1% 5.4% 3.5% Imports 3.6% -8.1% -23.7% -4.3% 17.4% 6.2% 6.1% Nominal GDP (USD bn) 2294 2080 1373 1296 1285 1416 1487 USD/RUB avg 31.09 31.84 38.38 60.94 67.06 65 65 CPI, avg 6.8% 7.8% 15.6% 7.1% 3.7% 4.0% 3.5% Policy rate 5.50% 17.00% 11.00% 10.00% 7.75% 6.25% 4.25% Budget balance % of GDP 0.9% -0.9% -2.3% -2.2% 2.0% -1.7% -1.3% Debt to GDP 11.0% 13.8% 14.1% 13.8% 17.4% 17.7% 18.2%

Sources: : CEIC, MACROBOND, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 3. THE BOTTOM LINE.

• The business cycle: The latest round of sanctions announced by the US surprised us in terms of intensity leading us to modestly reduce our projections for this year and mildly increase the outlook for inflation. That being said, in our view none of the key parties involved: Russia/US/Europe have an interest in fully escalating the situation, so we may have hit the “worst spot”. As a result, whilst in the eurozone we are confident that we have passed the peak of the business cycle, in Russia the best may be ahead. • Monetary policy: The pace of the interest rate easing ahead is likely to be slower given the recent RUB and market weakness but we think there is ample scope for reducing the policy rate and thus retail borrowing costs in Russia in coming years. • Exchange rate: We have lifted our expectation for RUB from 60/USD to 65/USD as a result of the sanctions announcement. Even if the geopolitical tensions were to subside, we think a meaningful recovery of the RUB appears highly unlikely in the coming year. • Long-term considerations: Fundamentally the economy is going through a multi-year period of balance sheet restructuring of the non-financial corporate sector. International experience shows this is a process that lasts around 5 years (in which case Russia has 1-2 more years to go) that depresses the labour market but in the end delivers significant improvement in competitiveness. This process is what allows the CBR to gradually cut interest rates – more than what analysts expect in our view – going forward. Ongoing reduction in the CBR’s policy rate will be a catalyst for improving housing market affordability, this in our view is a structural improvement for Russia. Global rankings on some competitiveness measures show that Russia is falling behind on education.

ANALYSE. DEBATE. ACT. .4. GDP: SANCTIONS DON’T CAHNGE THE TREND.

Growth rebound driven strongly by Contributions to yoy growth by key inventories (and thus oil prices). component.

80% 6.0% 6.0% Crude YoY 5.0% 60% LHS 4.0% GDP 4.0% 2.0% 40% 3.0% 0.0% 20% 2.0% 1.0% -2.0% 0% 0.0% -4.0% -20% -1.0% -6.0% -2.0% -40% -3.0% -8.0% Net exports Investments Gov Households -60% -4.0% -10.0% 2011 2012 2013 2014 2015 2016 2017 2018 2013 2014 2015 2016 2017

Sources: MACROBOND, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 5. INFLATION: SLIGHTLY WORSENING, BUT STILL LOW.

Inflation expectations aligning with the CBR’s Contributions by key component to yoy target. inflation.

CPI model target 35 17%

15% 30 about 4% faster than now

13% 25 11% 20 9% 15 7% 10 5%

3% 5

1% 0 2012 2013 2014 2015 2016 2017 2018 2019 2014 2015 2016 2017

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE.. ACT. 6. INVESTMENT: MODEST, BUT UP.

Capacity utilisation (%, lha) and fixed capital Big-medium enterprises internal funds investment formation growth (yoy, rha).

40% 66 30%

64 5% 20%

62 0% 10%

60 0% -5% 58 -10%

-10% -20% 56

-30% 54 -15%

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT.. 7. INDUSTRIAL PRODUCTION AND CONSTRUCTION SENTIMENT.

Yoy change in Industrial Production. Confidence indicators.

20 15%

10 10%

5% 0

0% -10

-5% -20 -10%

-30 -15%

-20% -40 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014 2016 2017 2002 2004 2006 2007 2009 2011 2012 2014 2016 2017

Sources: MACROBOND, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 8. WAGES: UP LATELY BUT DOWNSIDE RISKS.

In Russia, there are various ways of measuring 30% incomes, and wages include a Real wages Real avg income 25% variable bonus, which can swing significantly from Real retail sales year to year 20% 15% The chart shows that basic wages, deflated by CPI, 10% have improved thanks to the fast drop in inflation 5%

However, the broader measures of incomes, such as 0% disposable income, have shown much slower growth in both nominal -5% and real terms -10%

-15% The low disposable income is a constraint on inflation and ultimately caps the spending recovery -20% 2003 2005 2007 2009 2011 2013 2015 2017

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 9. LABOUR MARKET: SANCTIONS WILL WEAKEN IT.

Job creation and real disposable income. Unemployment rate in historical context.

25 4 Real disposable income Job creation YoY rhs 10 3.5 20 3 9 3 15 2 8 7 2.5 10 1

6 2 5 0

5 In % In 4 1.5 0 -1 3 1 -5 -2 2 Unemployment rate 0.5 1 -10 -3 Unemployment rate ILO mn RHS 0 0 -15 -4 2004 2005 2006 2008 2009 2010 2012 2013 2014 2016 2017 2005 2006 2008 2009 2011 2012 2014 2015 2017

Sources: MACROBOND, BLOOMBERG, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 10. COMPETITIVENESS.

Quality of the education system. Quality of overall infrastructure.

5.5

4.5 5

4.5 4 4

3.5 3.5

3 3 2.5

2.5 2 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Indonesia Poland Romania Indonesia Poland Romania Russian Federation Turkey Russian Federation Turkey

The charts above show the scores for Russia and peer countries on various indicators related to the competitiveness of the economy. The higher the number the better is the performance of the country, as assessed by the World Economic Forum.

Sources: CEIC, WORLD ECONOMIC FORUM, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 11. COMPETITIVENESS.

Availability of latest technologies. Capacity for innovation.

4.8 5.6

5.1 4.3

4.6 3.8 4.1

3.6 3.3

3.1 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2.8 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Indonesia Poland Indonesia Poland Romania Russian Federation Romania Russian Federation Turkey Turkey

The charts above show the scores for Russia and peer countries on various indicators related to the competitiveness of the economy. The higher the number the better is the performance of the country, as assessed by the World Economic Forum.

Sources: CEIC, WORLD ECONOMIC FORUM, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 12. INDEBTEDNESS.

Debt to GDP measures for companies and Retail cost of borrowing%. households.

30,000 200% 17% 20,000 16% 180% 10,000 15% 160% 0 14% 140% -10,000 13% 120% -20,000 12% Non-financial corporations 100% -30,000 Households RHS 11% 80% 10% -40,000 2012 2013 2014 2015 2016 2Q17 -50,000

NFC (lha) passed from 100% in 2012 to a peak of 175% of GDP in 2016, -60,000 while HH (lha) passed from 11% in 2012 to a peak of 16.3% in 2015. 2011 2012 2013 2014 2015 2016 2017 2018

Sources: MACROBOND, CBR, ADA ECONOMICS

ANALYSE. DEBATE. ACT. 13. INTEREST RATES.

Retail cost of borrowing, %.

35

30

25

20

15

10

5

0 01/11 01/12 01/13 01/14 01/15 01/16 01/17 01/18

NFC, RUB under 1yr NFC, USD, under 1yr HH,RUB under 1yr HH, USD under 1yr

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 14. INTEREST RATES.

Inflation expectations aligning with the CBR’s target.

20 18%

Policy rate Real policy rate Inflation RHS 16% 15 14%

10 12%

10% 5 8%

0 6%

4% -5 2%

-10 0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 15. MONEY GROWTH.

M2 and M2 X.

100% M2 is a very good leading indicator for real GDP growth in Russia and it seems stuck stubbornly at 80% M2X 10-12% yoy. 60% M2 Without a significant pick up to 20% ormore, it is hard for us to forecast growth above 1.5% as an average. 40%

20% That said, in the past few quarters, some important dynamics are emerging outside of the 0% M2 definition, which may affect the economy positively – please see the next slide. -20% 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 16. MONEY GROWTH.

Credit dynamics, yoy. Credit dynamics, yoy.

140% 140% Deposits excluded from M3 Claims on HH 120% 120% Deposits included in M2 Claims on NFCs 100% 100% Debt securities excluded from M3 80% 80%

60% 60%

40% 40%

20% 20%

0% 0%

-20% -20% 12/1/2015 8/1/2016 4/1/2017 12/1/2017 12/1/2015 8/1/2016 4/1/2017 12/1/2017

Sources: CBR, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 17. HOUSING MARKET.

House prices, primary vs. secondary Price evolution in different regions of Russia. market, yoy change.

70% 45% Central & North-Western Districts

60% Primary Sale Southern-North Caucasus-Volga 35% Secondary Sale Federal Districts 50% Ural-Siberial Districs

40% 25% Far East District 30%

20% 15%

10% 5% 0%

-10% -5% -20%

-30% -15% 2001 2002 2004 2006 2007 2009 2011 2012 2014 2016 2017

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 18. HOUSING MARKET: RECOVERING!

Housing affordability relationship with growth Change in mortgages currency during the in mortgages value. 2010-16 period.

95% 4% 120%

90% 4% 100% 85% 3% 80% 80% 3% 75% 2% 60% 70% 2% 65% 40%

60% 1% 20% 55% 1% 50% 0% 0% 2013 2014 2015 2016 2017 2010 2016

Housing affordability (20y loan, 20% downpayment) Mortgages in rubles Mortgages in foreign currency Adjusted MoM growth in Value of total mortgages

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 19. HOUSING MARKET: IMPROVING AFFORDABILITY.

We estimate lower debt-servicing costs in 2018E and 2019E.

100% Housing affordability (rising wages, estimated int rates)

90% Housing affordability (20y loan, 20% downpayment)

80%

70%

60%

50%

40% 2013 2014 2015 2016 2017 2018 2019

For our debt-servicing costs estimates, we assume an average downpayment of 20%, a 20-year mortgage, average mortgage interest rates in RUB, and the average price of a small (50sqm) apartment outside the centre of a major Russian city. For our 2018/2019E forecasts, we derived the change in mortgage rates from the difference in the Central Bank’s key rates easing in past years, which we expect to lead to average mortgage rates down to 8.5% at the end of 2018E, in accordance with our key rate “frozen conflict” estimates. Finally, we assume yearly average sqm prices growth of 3%, consistent with the past five years of the samples we analyzed. Furthermore, we expect real salaries to grow at an average rate of 9% in 2018E and 6% in 2019E.

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 20. BALANCE OF PAYMENTS.

Current Account and Trade Surplus, rolling Funding breakdown. sum.

200 180 115 160 140 65 120 100 15 80 60 -35 40 20 0 -85 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014 2016 2017

Current Account Trade Balance Direct Investment Portfolio Investment Other Investment

Direct investment, a stable source of funding during the past years, has been deteriorating recently.

Sources: CEIC, MACROBOND, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. . 21. BALANCE OF PAYMENTS.

Impact of budget rule of BoP, CA (no rule) – Trend of oil-based exports vs. total CA (rule), % of GDP. exports.

7% 50% 27% Total exports, % of GDP (lha, 6% 48% USD) 25% Oil Based products exports, 5% 46% % of GDP (rha, USD) 23% 4% 44% 42% 3% 21% 40% 2% 19% 38% 1% 36% 17% 0% 34% -1% 15% 32% -2% 30% 13% -3% 30 40 50 60 70

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. . 22. FISCAL POSITION.

Revenue and expenditure growth (RUB Budget balance, % of GDP, monthly rolling bn). average.

1% 18,000 0% 0.0% 16,000 -1% 14,000 -0.2%

12,000 -2% -0.4% 10,000 -3% 8,000 -0.6% 6,000 -4% -0.8% 4,000 -5% 2,000 -6% -1.0% 0 2011 2012 2013 2014 2015 2016 2017 2018 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Primary balance difference (rha) Revenue Expenditure Budget Balance, Percent of GDP, 12-month average (lha)

After 2014 sanctions, differences between primary budget balance and budget balance deteriorated down to -0.8% of the GDP.

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT.. 23. BUDGET RULE EFFECTS.

Fiscal Rule – Budget effect 2018*. Fiscal Rule – Budget effect 2019*.

oil price - 70 oil price - 70 oil price - 60 oil price - 60 oil price - 50 oil price - 50

oil price - 40 oil price - 40

oil price - 30 oil price - 30

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% without fiscal rule fiscal rule without fiscal rule fiscal rule

Estimation completed using MinFin and CBR estimates, following an ideal case of the RUB/USD fixed at 60.

Sources: CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT.. 24. RESERVE FUNDS.

National Welfare Fund. Reserve Fund.

105 9% 160 14% in billions of US dollars in billions of US dollars (lha) in percent of GDP (rosstat) as a percentage of GDP (rosstat estimate, rha) 95 8% 140 12%

85 7% 120 10% 75 6% 100 8% 65 5% 80 6% 55 4% 60 4% 45 3% 40

35 2% 20 2%

25 1% 0 0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

The reserve fund was completely spent in January 2018, future focus will be on the NWF.

Sources: RUSSIAN MINISTRY OF FINANCE, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 25. EXCHANGE RATE.

MoF FX purchases (lha), oil price and Relationship between RUB and USD Crude USD/RUB. Oil (inverted, 1 barrel, Urals).

300 70 MinFin FX purchases 90 0

250 USD oil price 85 65 10 RUBUSD 80 20 200 75 60 30 MinFin FX purchases 70 150 40 65 55 50 100 60 60 55 50 50 50 70

45 80 0 45 12/2014 06/2015 12/2015 06/2016 12/2016 06/2017 12/2017 Exchange Rate against US$: Monthly Average Average World Price: Crude Oil: Urals: per 1 Barrel

The MinFin FX purchases from 2017 effectively stabilized the ruble against oil price movements.

Sources: : CEIC, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT. 26. POLITICS.

Latest developments. Vladimir Putin-Independent Pavel Grudinin-Communist Party • Presidential elections were held in Russia on March 18, 2018. The Vladimir Zhirinovsky-Liberal Democratic Party current president, Vladimir Putin, won the second consecutive election (fourth overall) term in office with 77% of the vote, Ksenia Sobchak-Civic Initiative increasing its approval rate of 10% in the past 6 years. Grigory Yavlinsky-Yabloko • The government is going to be presented the first week of May, Boris Titov-Party of Growth more focus is expected on productivity and education, along with support for young families Maxim Suraykin-Communists of Russia

• The press supported the idea that, over the next weeks, a Sergey Baburin-Russian All-People's Union significant infrastructure plan will be presented (10 trillion rubles, 162 USD bn). • The expansionary fiscal policies in these areas are expected to be compensated through a spending review and possible tax hikes

Sources: MACROBOND, RT, BLOOMBERG, ADA ECONOMICS LTD

ANALYSE. DEBATE. ACT.. 27. SANCTIONS.

As the latest round of sanctions surprised us in their intensity, we created three scenarios that should be helpful in guiding investors on mapping the impact of future sanctions developments. Our central scenario is that we are in the “frozen” conflict option. 1. A de-escalation of tensions • This would lead to a recovery of the currency to RUB 50 per dollar by late this year/next year, which would turn it to an additional drop in inflation and interest rates. The growth outlook would improve, especially for 2019E, although it would not change materially in terms of pace: fundamentally, the economy would still have to deal with the corporate restructuring that is lurking in the background. 2. Frozen conflict • This would lead to more challenges in financing external liabilities, but not to the point of triggering a solvency or financial crisis risk at the country level. Interest rate would continue declining at a lower pace, and the RUB should remain at around 60 per dollar. Overall, the outlook would not change substantially. 3. One where Iran-magnitude sanctions are put in place • This would probably push the currency to or beyond the previous peak of RUB 80 per dollar, forcing the economy into recession, notwithstanding crude prices assumed at USD 65/bbl. Non-resident holdings of local debt rose to 33% of the total as of February 2018; thus, forced liquidation will pose material challenges for policymakers. Our inflation projections in this scenario jump to 7% on average this year (but to 10% in the near term), delaying the rate cycle mostly to next year.

De-escalation Frozen conflict Maximum sanctions

2018E 2019E 2018E 2019E 2018E 2019E

Real GDP growth 2.00% 2.50% 1.3-1.5% 1.2-1.5% 0.8-1% -1.00% Inflation 4.00% 2.00% 4.00% 3.50% 7.00% 6.00% Policy rate, eop 6.00% 4.00% 6.25% 4.25% 7.00% 6.00% USD/RUB, eop 60 50 65 65 80 80 Source: Macrobond, ADA Economics

ANALYSE. DEBATE. ACT. .2 8. THIS PAGE HAS BEEN LEFT BLANK FOR YOUR CONVENIENCE TO TAKE NOTES.

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ANALYSE. DEBATE. ACT. 29. Disclaimer

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