The rapid fall in oil prices which began on March 9 sparked fears of existential threats to the Russian economy, which remains heavily dependent on hydrocarbons. Observers were quick to remember similar sequences of events which have befallen Russia in the past: a fall in oil prices leading to a weakening ruble and decline in exports, in turn leading to increased inflation, declining real incomes and GDP, and the need to burn through financial reserves. But this time, things are a little different: surprisingly, Russia itself provoked the collapse in oil prices by refusing further reductions in oil production under the auspices of OPEC+. Naturally, Russian President Vladimir Putin does not look like a person about to commit “economic suicide.”
A week and a half on from the oil peak, the ruble has declined significantly in value, but its drop has not been as precipitous as oil prices. From March 6 to March 19, the price of Brent fell by 41.6% (to $26 per barrel) while the ruble weakened against the US dollar by 15%. This means an end to the widely accepted rough exchange rate of 80 rubles to the dollar, the maximum since early 2016.
Over the weeks to come, the Russian market will remain volatile. I cannot even predict what oil prices or the ruble exchange rate will be by the time this article is published. But what I can say with more confidence is that the system of economic protection against external shocks devised by the Russian authorities in recent years has functioned quite effectively.
The financial bodies responsible for macroeconomic stability (such as the Central Bank of Russia and Ministry of Finance) were fully prepared for the recent market shock. Already by the morning of March 9, the Ministry of Finance had issued two detailed reports about currency interventions due to commence next month: the sale of foreign currencies from the Russian National Wealth Fund and the purchase of rubles in accordance with budgetary rules (i.e. the sale of foreign currency from state reserves begins if the price of Russian Urals oil in 2020 falls below $42 per barrel), as well as the suspension of public debt auctions during periods of volatility. The Central Bank, without waiting for the Ministry of Finance, began to sell currency from its own reserves in order to support the ruble: to the tune of about $50 million per day. That may be a relatively small amount in market terms, but has a profound psychological effect.
On March 17, the government and Central Bank issued an unprecedented joint statement assuring that they were taking operational measures against the crisis and that they would do everything to ensure financial stability and a steady economy. The Central Bank has also launched a webpage providing regular updates about the stabilisation measures it is taking, which is undoubtedly a constructive approach to public communications in times of crisis.
How long will Russia’s reserves last?
The Ministry of Finance has attempted to reassure the market with its announcement that even if oil prices permanently hover at between $25 and $30 per barrel at 2017 prices (or $27 to $32 at 2020 prices), Russia’s total foreign exchange reserves would be enough to finance all planned budgetary obligations for the next six to ten years. During the previous cycle of low oil prices, the government quickly burnt through its reserves between 2015 and 2017, after which it amended its budgetary constraints and began again to increase its foreign exchange reserves thanks to newly increased oil prices.
Economists were surprised by the figures in the Ministry of Finance’s statement. Bloomberg wrote that their estimate was not ten but closer to six years, and S&P’s Global Ratings economist Karen Vartapetov told the news agency that with oil prices at around $35 per barrel, the Russian government might only be able to live off its savings for three years. On March 14, Russian Finance Minister Anton Siluanov said that with prices at around $30 per barrel, the budget would be sufficiently resourced for at least six years.
The Ministry of Finance’s calculations raise some real questions. The ministry’s foreign exchange reserves — resources of the National Wealth Fund — now amount to more than $150 billion, or 11 to 12 trillion rubles by current exchange rates (or ten percent of GDP). And the weaker the ruble, the greater the National Wealth Fund, explaining why a weak ruble suits the Ministry of Finance, as long as it does not escalate into substantial inflation. In the near future, some of these funds will go towards saving Sberbank, as agreed by the Central Bank in February. This amounts to approximately 2.2-2.3 trillion rubles. However, by agreement of the government and the Central Bank, around 1.3 trillion rubles will eventually go towards budget expenditures. This means that overall, the National Wealth Fund’s net expenditure on Sberbank will come to about a trillion rubles. Consequently, the flow of dividends from Sberbank will, in the course of four to five years, allow the National Wealth Fund to fully recoup its investment.
Beyond Sberbank, the Ministry of Finance is unlikely to be able to afford any other investments courtesy of the National Wealth Fund. Nevertheless, in February Siluanov stated that the authorities had not abandoned their plan to use 300 billion rubles from the National Wealth Fund for domestic projects. With protracted low oil prices, the fund’s resources will now have to be directed solely towards covering shortfalls in revenues for the federal budget (and possibly to address the deficit in Russia’s pension fund, an option permitted by the budget rules.)
In this context, the revenue refers to the income from the extraction and export of hydrocarbons, lost due to the fact that the 2020 price for Urals oil has dropped below $42.4 per barrel (the value is indexed by two percent every year). According to budget rules, this means that the budget’s total expenditure must be reduced by an amount corresponding to the lost income, unless that income can be compensated for with savings from the National Reserve Fund.
What are the authorities keeping silent about?
So, estimates vary for how long the National Wealth Fund will suffice for all planned expenses. These discrepancies are partly due to the fact that the Ministry of Finance’s calculations now take into account proceeds from a so-called “shock absorption” mechanism introduced in 2019. This means higher revenues during times of low oil prices. The aforementioned mechanism obliges oil companies to make extra contributions to the budget if domestic prices for vehicle fuel are higher than export prices for Russian oil — that is, when international oil prices are low. Thus oil companies have a share of the excess profits produced from fuel sales in the domestic market.
According to the Ministry of Finance, annual budget revenues from the “shock absorption” mechanism will be around $700-900 million (or between 0.6 and 0.8 trillion rubles) for oil at $25-30 per barrel, measured in 2017 prices. Spending by the National Reserve Fund can thereby be reduced by the high value of these revenues from oil companies. However, in my opinion there is no 100 percent guarantee that all of this money will indeed end up in the treasury, as there is a risk that these agreements could be revised at the whim of the oil lobby.
Another issue with the Ministry of Finance’s calculations is that its definition of “oil and gas revenues” does not actually take into account all budget revenue from oil and gas companies. Budgetary rules stipulate that only those revenues directly dependent on oil prices can be included in oil and gas revenue (for example export duties, where the price relationship is defined in the conditions of payment.) Furthermore, the collection of income tax from the oil and gas industry, or dividends to the budget provided by state-owned oil and gas producers, are also not strictly considered “oil and gas” revenue for the purposes of the Ministry of Finance.
The RBK news agency estimates that in 2018, the expanded revenue from the oil and gas sector to the budget amounted to around 11 trillion rubles — two trillion rubles more than the understanding of “oil and gas revenues” advanced by the Ministry of Finance. The lesson from this is obvious: a collapse in oil prices could lead to a reduction in other sources of revenue for the budget, even from sources not classified by the Ministry of Finance as “oil and gas.” This scenario was set out on March 16 by Moody’s Investors Service in a review of the risks posed by a significant reduction in the profits of Russia’s oil and gas companies and the consequent decrease in their income tax contributions.
Finally, due to low oil prices the Russian budget may also be deprived of some income from another source: anywhere which directly depends on the rate of economic growth. Former Minister of Finance and head of the Accounts Chamber Alexey Kudrin recently warned that economic growth in Russia could drop to almost zero should low oil prices of around $35 per barrel remain stable. Some economists do indeed predict a recession. Value added tax (VAT) revenues, the main “cash cow” of the Russian budget, depend on GDP growth. When the Russian economy experienced its most recent recession in 2015, GDP fell by 2.5 percent. According to my calculations, the collection of domestic VAT in real terms (at 2018 constant prices) decreased by around 2.9 percent.
Naturally, much revenue will be lost due to the ongoing pandemic. The Russian government’s anti-crisis package for combating the coronavirus includes tax deferrals for badly affected industrial sectors and small businesses. However, due to the drop in oil and gas revenues, the authorities are severely constrained in their ability to offer fiscal stimulus to the economy. The Ministry of Finance’s calculations only take into account losses directly attributable to the fall in oil prices, and do not yet include those resulting from the general slowdown in economic growth and anti-crisis measures to support industry.
All the above leave no doubt that the Ministry of Finance’s assessments are exaggerated. I believe that the ministry might have enough reserves for four to five years, as long as oil prices can be maintained at an average of $30 per barrel. The declared range of six to ten years is overly ambitious. This opinion is also held by economists from the state-owned Gazprombank and analysts from the private investment bank Renaissance Capital.
That said, five years is still a very long time. Few expect that we are facing several years of steadily low oil prices; most believe that prices will eventually recover and climb up to $40-45 per barrel by the end of the year. In that case, Russia’s shortfalls could be brought down to a minimum. As data on oil prices since 1861 from the British oil company BP shows, the last such long-term cycle (in which oil prices stabilised at $20-35) occurred from 1992 to 1999.
A hard landing
If everything is more or less in order with the Russian budget, the same cannot be said for the real incomes of ordinary Russians, which are likely to decrease yet again. The Central Bank’s so-called risk scenario, drawn up in September 2019, offers a glimpse of the most pessimistic scenario. The Central Bank then calculated that with average oil prices of $25 per barrel in 2020, Russia’s GDP would fall by around 1.5 to two percent. Real disposable income would decrease, and consequently domestic consumption levels. This would be due not only to a surge in consumer inflation, but also due to other effects: for example, companies are likely to postpone wage increases in such periods of uncertainty. It is also important to note that consumption levels in Russia were already decreasing before the collapse in oil prices, due new rules for issuing consumer loans which entered force in October 2019. With this law, the Central Bank limited the provision of loans to any borrowers who already spend more than 50 percent of their income on servicing existing loans.
The Russian authorities often talk of the need to wean the economy off its excessive dependence on raw materials. However, episodes such as these yet again reveal that much of the Russian economy is still determined by the health of the oil markets. In 2019, oil, oil products, and natural gas formed 57 percent of all Russian exports. If we assume that the physical volumes of oil and oil products dispatched abroad in 2020 will remain the same as in 2019, and that the average price of oil will drop to, say, $30 per barrel, then export earnings will drop from $188 billion to $89 billion. That’s a drop of almost $100 billion. The most likely scenario is that as international demand for oil decreases, so too will the physical volume of oil supplies. Consequently, Saudi Arabia gains a large share of the market from Russia, by offering its oil at a discount to Urals.
In any case, analysts’ forecasts continue to vary widely, largely due to their different assumptions about the future price of oil. For example, Fitch Ratings believes that Russia’s GDP in 2020 will grow by one percent, while the Bank of America expects zero growth or even a reduction in GDP by one percent.
For its part, the Russian government has only gone so far as to acknowledge that this year’s economic growth will definitely be lower than official forecasts (which put it at 1.9 percent). At the end of 2018, the government planned to accelerate economic growth to 3.1 percent by 2020, but now, it seems, the best case scenario is a meagre 0.5 to one percent. This means that Putin’s goal announced after hiss 2018 election victory — to bring the Russian economy growth rates of three percent — has yet again slipped out of his grasp. It looks set to become nothing more than an illusion.