Decoupling from the Unwinding

Three months ago I wrote an extensive analysis of Russia’s economy during the crisis in which I said that although it is going to be damaged by the shutdown of its traditional financing mechanism – cheap credit from the West – sovereign solvency will not be threatened and there will be a strong recovery in the second half. I was too optimistic, mostly because I misunderestimated the sheer severity of the global crash. That said, let us see how well its predictions stack up against reality more than three months on. I will also update my thoughts on the US and world economy, including for the more distant future.

Following the ruble correction, the trade balance was shifting back into positive territory. As of January, although resource exports fell by about a half the decline was less pronounced, with machines / equipment and chemicals falling 30% and consumer goods / agricultural products by 20% – this despite the internal credit crunch, shrinking foreign demand and increasing protectionism. Imports fell severely, especially for the biggest category – cars and equipment. This is not surprising – import tariffs were raised on cars and sales have plummeted, while there’s little need for new physical capital (machine tools, etc) when demand falls for the goods it is used to make.

In my essay, setting oil at 50$ per barrel and making some assumptions resulted in 2009 exports of 245bn $ and imports of 223bn $ – annualizing the January figures gives 204bn $ and 104bn $, respectively. Pretty much what I expected for exports, but imports will probably rise as inventories clear out and the ruble (perhaps) strengthens against the US dollar and the euro, which is quite possible since I expect oil to finish the year between 60$ and 80$ (PS. In the article I guessed that oil will average 50$ for 2009 – looks like its going to be significantly higher, as it is already hovering around 52$). Nonetheless, the current account will remain very much in the black. Keeping our capital account assumptions constant for next year, I stick with the “78bn $ in the medium scenario (50$ oil)” (that assumed a 100bn $ capital outflow in 2009 and higher imports – now, some economists are predicting capital outflow will be less than 83bn $), so really the capital account may turn out to be slightly pink instead of deep red).

Despite the ruble correction inflation has not become a major issue. In fact Bank of America Securities-Merrill Lynch expects inflation in Russia to slow dramatically, to just 9% this year.

I was dead wrong about government spending, taking Kudrin at his word that the budget deficit will be at around -1%. In fact, it’s more like -7.4% as spending is increased in the face of a much worse than expected contraction. Still, this is not threatening. Besides, I suspect it will eventually turn out lower since this budget is predicated on average oil prices of 41$ for 2009, which is already looking outdated.

Industrial production started deteriorating in October and accelerated in January, falling 16% year on year.It recovered slightly in February, marking a fall of 13.2% on the same time last year. This is because many manufacturers simply extended the long January holidays to encompass all off the month so as to allow inventories to come down – for instance, after car production plummeted to below 20% of its equivalent 2008 level, it more than doubled to 40% in February.

Industrial production index relative to same month of last year.

Industrial production index relative to same month of last year.

There are a number of convincing arguments that Russia will emerge out of the crisis sooner than many other G7 countries. As Eric Kraus argued in The Wheels of Heaven Stop and earlier, wages and output correct much quicker in Russia than in the developed world. Once the ruble correction restored balance, the salary arrears and barter that were appearing in October-November retreated, as did the specter of outright financial failure and ruble collapse – as acknowledged in the WSJ.

Although the situation remains grim, there are a number of positive indicators. Firstly, the Russian manufacturing PMI surged to 40.6 in February from a truly dismal 34.4 in January. While it is rather lame to rejoice at improvements in second order differentials, the point stands that a few more such jumps and Russian manufacturing output will have plateaued.

Any value below 50 indicates manufacturing decline; above 50 means growth.

Any value below 50 indicates manufacturing decline; above 50 means growth.

It should be noted that Russia’s performance was no worse than the world average. The industrial crisis started in October, the rate of decline troughed at around 34 in Dec-Jan and rose sharply in February. Edward Hugh helpfully collected these graphs into one post at his blog. In the major European countries the crisis took off in August at the latest, hit troughs between 28 and 35, and is still fully in the doldrums. Japan’s PMI is edging up slowly from a catastrophic performance. The decline was not as steep in Poland, but was more prolonged. The US fall started in August, troughed in December and remained at around 35-36 in January and February. It appears to be somewhat better than the global PMI.

The least affected country there is India, which only began falling in November and never went below 44. China’s decline started in September, troughed in November and has since recovered to 45 by February. This is not surprising – their indigenous financial systems were relatively unaffected by the global / Western financial crisis (hmmm, remember all the brouhaha over how China’s financial system was supposed to collapse because of bad loans? And it turned out to be by far the more stable one), while Russian companies relied on Western intermediation to access credit. China tanked more sharply than India because it is more reliant on exports to the developed world, but will now presumably work to stoke domestic demand by countercyclical fiscal policies and more social guarantees.

So I suspect what we have is decoupling from the unwinding. There was a popular thesis around 2007 that the BRICs will manage to escape unscathed from any US slowdown – since then, most pundits consigned this theory to the dustbin. But I won’t be so quick. The shock was sudden and unprecedented – nonetheless, most emerging markets that weathered the tsunami (with the exception of those that got sunk by it, like Ukraine and Latvia) declined less – and are beginning to fall less rapidly – than their First World counterparts. Japan and Germany are getting mauled for their export dependence but they too will eventually plateau and start recovering once their now excess capacity is trimmed down.

The real worry, I believe, is primarily for the likes of the US and the UK. Their fiscal policies and imbalances are unsustainable and what they are now doing, with the charades over “quantitative easing” (translation: printing money), transferring toxic “assets” onto the public account (ed: swallow enough toxicity, and even a beast as large as the federal government could get poisoned) and fiscal stimuli (ed: only countries disciplined enough to run surpluses during the fat years should have this benefit), is postponing the Day of Judgment. I suspect that the fiscal stimuli will be relatively ineffective as they are not market-allocated; develeraging will have to continue regardless (e.g. house prices are still significantly above their longterm position relative to incomes); and the planned US budget deficit of 12% of GDP for 2009 will not be significantly reduced in 2010 or 2011. By that time the world will be abandoning US dollar assets in despair over ever getting repaid; the “solution” would be either a huge (read: politically unacceptable) cut in public spending or ever more money creation (which just feeds the spiral). Interest rates on the debt will rocket. It does not help that oil prices will almost certainly soar over the next five years, probably surpassing their 2008 peak because of peaking oil extraction and full recovery and resumption of growth in Asia.

Back to Russia in 2009. According to Finance Minister Kudrin, normal lending levels have now been restored internally. From looking at the news, it is clear that foreign investment in Russia continues – unlike its pariah-like status after the Soviet Union or 1998, they realize that it remains a promising market since it is just an average-affected country by a world crisis. (E.g. – Peugeot Citroen and Mitsubishi, GE and Magna, LG, etc are all starting to build factories there). Nor are things all bad amongst domestic manufacturers even now. Naval-military construction is even looking to hire people while there is a surplus of unemployed labor. Anecdotally, consumer sentiment remains significantly better than in the US or the UK. Nassim Taleb (of black swan fame) is optimistic. Some respected Russian economists think government predictions for the economy are too gloomy and actually expect significant positive growth this year (some like Sergei Guriev are gloomier). I predicted a range of 0-3% – now I expect it be about 1% to -2%, and certainly not less than -4% (on the latter point, a made a symbolic bet on this in late March with commentator “Michel” at SWP).

Thirdly, the stock market is rising. Along with China, the RTS has been one of the world’s best performing stockmarkets in 2009, rising from around 500 to 700 (of course, after an precipitous fall). Nor was the improvement restricted to the oil and gas sector. This might mean that investors finally predicted how tremendously oversold everything was and are beginning to snap up stuff at bargain prices, thus vindicating my predictions.

Finally, I highly recommend reading the two latest articles by Eric Kraus – the aforementioned The Wheels of Heaven Stop and (Yet Another) Year of Living Dangerously. In particular, the second one puts to rest some popular but false conceptions about Russian economic weaknesses. I’ll quote it in extenso, if you don’t mind Eric!

Unlike many of its emerging market peers, Russia is relatively immune to miscellaneous scourges facing the developing economies, and which threaten a number of Latin American (Mexico, Argentina), EMEA (Ukraine, Georgia, the Baltics, Hungary) and Asian (Indonesia, Thailand, Philippines, Korea) countries with economic collapse:

•  Plunging global demand for manufactured goods

Russian exports are primarily in the commodities sector – and the main driver here is likely to be Chinese industrial activity. Manufactured exports are limited to military (a growth sector in troubled times), nuclear power generation, and relatively cost-effective heavy industrial machinery (turbines, power generation, etc.) suitable for the needs of the developing countries – where at least some infrastructure spending is likely to be maintained.

•   Inability to fund the current account deficit due to collapse in remittances/bond markets/exports

Russia has no indispensible import requirements, being self-sufficient in all major commodities and basic foodstuffs. In a worst-case scenario, Russia could survive without Mercedes motorcars and French cheese for an unlimited period. Remittances are a negative item on the balance sheet, and the Federal government has virtually no foreign debt to refinance.

•   Political instability

With due respects, reports of Russian political unrest are laughable. Whilst a number of EMEA governments are breaking under the stress, Russia remains remarkably quiet. We would note that the Western press, always desperate for bad news as regards Russia, has been recycling a single demonstration by Vladivostok used car dealer for nearly three months now…

Those of us who lived through the 1998 crisis were stuck by the total absence of popular protest – as the crisis worsened, people returned to their dachas to plant potatoes. Perhaps the experience of seventy years of collectivist rule durably chilled the popular enthusiasm for revolution.

As regards the international context, the crisis has diminished any Western ardour for confrontational politics, the opening of new military fronts, or expensive missile systems; a substantial improvement in US-Russian relations is thus to be expected. Similarly, some of Russia’s neighbours, previously fixated upon comprehensible but perhaps outmoded historical grievances, will now have far more important matters to attend to – in the current climate, even modest Russian investment capital flows will likely receive a warm welcome.

•   Economic fragility

Despite claims by the western kommentariat that the Russian politico-economic system lacks flexibility, in fact, it is far more flexible than that of most developed economies. Downward adjustment of wages and staffing levels can occur virtually overnight, with production simply halted until inventories are reduced to the desired level – as indeed happened during the January 2009 period (resulting in industrial production numbers which were dramatic but quite misleading).

In summary, while our readers are undoubtedly familiar with the inefficiencies of the Russian economy, this does have a silver lining: no manufacturer in his right mind would attempt to set up a just-in-time supply chain in Russia. After 20 very eventful years, like an old Lada automobile, much of the local industrial fabric is relatively inefficient, but at least, admirably fault-tolerant.

Although we would expect to see further discouraging numbers through the first half of 2009, the period of maximal stress was apparently reached in October-November 2008; after a sharp rouble devaluation, successful support for the banking sector, and the recycling of official Forex reserves into the corporate sector, the increase in non-payments which mushroomed out in Q4 2008 has been almost entirely reabsorbed.

Although our view is temporarily unfashionable, we continue to expect a gradual differentiation between the potentially high-growth BRICs countries and the old economies of the West. Those wishing to predict the timing of a Russian rebound would do well to keep a close eye on Chinese growth trends. Whilst the financial disruption in Russia has been severe, the financial system has survived the stress test, and policy of both the Central Bank and the finance ministry are broadly appropriate. Over the next couple of years the opportunities in financial markets will likely match those enjoyed by investors in the 1998 post-crisis period.

As for the foreign currency reserves, unsurprisingly the media has largely fallen silent on it – mainly because nothing’s happened here in the past few months. They stood at 385.3bn $ as of March 20, unchanged from 386.5bn $ in January 23. I stand by my conclusions in the article.

Prediction: “A wave of consolidation will occur in the Russian banking industry”.

This is the context in which headlines such as Hundreds of small Russian banks close to failure need to be viewed in. The opportunity to prune Russia’s 1400 banks (far too many, plus a lot aren’t proper banks at all) that was missed in 1998 arises anew.

Prediction: “The oligarchs, Moscow and the middle classes bear the brunt of the crisis, while the provinces, agriculture and domestic manufacturing benefit, thereby reinforcing already latent tendencies in national development.”

The number of Russian billionaires has been more than halved and they’ve been warned subtly and not so subtly that there would be no more bailouts and that their future survival depends on how they behave themselves during the crisis. The rest needs more time to make itself evident, I believe – but with the ruble devalued, industrial diversification in the form of import substitution should if anything speed up.

Prediction: “All vital demographic statistics, with the exception of the total fertility rate, improve during this period ­ the expanding social safety net checks mortality increases, but the confidence crisis temporarily dents the former.”

According to January figures, births declined by 2.7% and deaths by 7.5% in comparison with the corresponding month a year ago. Infant mortality fell, marriage rates increased and divorce rates decreased. However, I will not draw anything from this yet since the monthly fluctuations tend to be pretty big.

Prediction: “Since Russia is still a rock of stability amidst dangerously overextended east ­central  European countries, it is likely that its position and influence in the region will rise  following the crisis…Relations with Ukraine greatly improve after the
generous aid Russia bestowed upon its cold, starving multitudes following the utter economic apocalypse that precipitated the peaceful protests that overthrew its Orange regime and replaced it with a friendly administration seeking integration into Eurasian economic and security structures.”

Yep, it is now obvious that Ukraine is already for all purposes insolvent – lots of reports about people unable to withdraw money from banks. More than a third have difficulties getting food (i.e. same as Russia in 1998). Not surprisingly, then:

We are in a pre-default situation, and it looks like Ukraine has already lost its chances to reform its economy and industry,” says Vadim Karasyov, director of the independent Global Strategies Institute in Kiev. “The worst thing is, people are starting to feel disillusionment in the idea of democracy itself. The demand for a strong hand, to fix this mess, is growing.

With the nation on the brink of bankruptcy, the market pricing in the likelihood of sovereign default at nearly 90% and its politicians more interested in controlling the lucrative gas transit “business” than providing leadership, I will not be surprised to see revolution in Ukraine over the next few months.


  1. So… can we call the bottom on Russia’s recession yet? What do you think?

    My gut feeling is yes. March will probably be better than January in terms of economic decline compared to the same period last year. If it’s better than February, then it’s certainly a recovery. Only severe external shocks would be able to derail it.

  2. I would say we can call the bottom on Russia’s rate of decline. The industrial/economic bottom is I’d say a few months off (I predicted recovery in H2 and stick by it).

    I think the March figures will be worse than February, but better than January. This is because the January downturn was artificially severe due to holidays being extended, and I know that quite a lot of car production lines, etc, were halted through half of February too, to let inventories fall. So this will be a positive force. But that said, even though the manufacturing PMI was at more than 40 for February, it still indicates a fairly rapid fall which will have a negative impact.

  3. Are you sure the oil price is going to rise? I think there is a lot of negative economic news in the future that might keep the oil price at its current level.

  4. This is one of the things I’m surest about. The price stabilized at 40$ and has since risen to 50$ despite the barrage of bad news. It is now becoming increasingly clear that China is lifting itself out of industrial recession so there’s nowhere for the oil price to go but back up.

    (PS. Also there is currently a tendency towards $ weakening as investors take fright at the size of the bailouts and stimuli. Oil prices are of course denominated in US dollars.)

  5. If March figures are better than January, it still means that the bottom was reached in January (at least for the current leg of the downturn).

    Well, anyway, the economy rose Jan to Feb. Let’s see if it manages to rise Feb to Mar.

  6. I’m afraid that is now totally impossible, Fedia (for March to be better than February).

    <a href=""March manufacturing PMI improved to 42 from 40.6, but that still indicates quite a fast rate of decline.

    Still, Russia is “converging” to China’s rate of decline (down to 44.8 from 45.1) and away from much of the developed world which is stuck in the low to mid 30’s. India is almost out of recession at 49.5.

  7. What is PMI measurement relative to? Previous month, or same period a year ago? If it’s the latter, any increase in PMI indicates economic growth compared to the previous month. E.g., in Feb PMI was 40.6, and yet the economy expanded compared to Jan. If PMI is relative month to month, then I can’t explain this phenomenon.

  8. Somehow, finding a clear definition of PMI proved to be more difficult than one would expect. But it does look like PMI can serve as a slighly leading indicator of *year on year* changes in IP. Therefore, PMI rising compared to the previous month (regardless of which side of 50 it’s on) should predict a rise in y-on-y IP.

    In our case, Mar PMI of 42 compared to Feb 40.6 should predict Mar IP y-on-y change to be above -13.2% registered in Feb. In effect, Mar IP is higher than Feb IP, which means the economy is growing once again, even if it hasn’t reached the pre-crisis level.

    Please correct me if you know more about PMI than I do.

  9. Fedia,

    PMI refers to change compared to the previous month. The reason Feb was better than Jan, was presumably because in Jan many manufacturers simply extended their holidays instead of formally decreasing output.


    An indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment.

    Investopedia Says:
    A PMI of more than 50 represents expansion of the manufacturing sector, compared to the previous month. A reading under 50 represents a contraction, while a reading at 50 indicates no change.

  10. Right, but if Feb was better than Jan, how is it possible for Feb PMI to be so far in the negative territory? It’s an anomaly. (How can you not work and at the same time not formally decrease output?)

    Or maybe, like I mentioned, it’s the slope of the PMI that’s more predictive of y-on-y IP direction. Like in this graph:

    Anyway, let’s wait for a couple of weeks for IP figures to come out. Although econometrics are fun!

  11. That’s intriguing, Fedia, and some searching confirms this.

    1. PMI tends to lead official YoY% growth by 2 months.

    2. VTB – Russian GDP Indicator signaled ongoing economic contraction in February.

    Data Summary
    All Industry GDP GDP
    Index Indicator Indicator
    (50.0 = no change)_ Y/Y% Q/Q%
    Mar 58.8 6.6 1.7
    Apr 57.9 6.7 1.6
    May 59.2 6.9 1.8
    Jun 59.0 7.4 1.8
    Jul 57.5 7.3 1.6
    Aug 54.7 6.8 1.3
    Sep 54.6 6.5 1.3
    Oct 48.0 5.2 0.6
    Nov 36.5 2.6 -0.6
    Dec 32.0 -0.3 -1.0
    2009 Jan 32.1 -2.9 -1.0
    Feb 38.8 -4.7 -0.3

    3. I think the main issue now is what we’re going to see after the October-Jan collapse – a V or U, or an L.

    Recently the World Bank estimated 2009 growth at -4.5% and the OECD at -5.6%. They believe it will be an L, because it is a global crisis and the thinking goes Russia will not be able to export itself out of it as in 1998 (when it was a V shaped collapse with rapid recovery, but output fell by -5.3% then).

    Anyhow, I think it now depends on the external situation. If Russia could attract credit again and if oil prices begin to rise again (incipient signs of both happening), then it will be more like a U, which means growth would be at perhaps around -3% to -2% like the government is now predicting (-2.2%). If not, we’ll plateau and decline by around -5% as predicted by WB / OECD.

    4. The figures here (GPD growth for 2008 breakdown) might be important, but it’s late now and I’m too tired to think about it. Let me know what you make of this.

  12. Anatoly,
    I think you mostly got it right. Russian economy, more or less, will follow the recovery of ruble which, in turn, will recover with oil price.

    It is April 5th, and we know that oil price is already way above the low $40s that the RF government was basing the budget on.

    I am encouraged by your demographic analysis during this crisis. It sounds counter intuitive.

  13. I threw together a quick graph showing PMI/GDP/industrial growth for 2008-early 2009. (PS. 2009 Q1 estimate of -7% based on Klepach).

    Very high correlation between PMI and PMI-based QoQ GDP indicator, as well as YoY GDP indicator but lagging but lagging by 3 months. Fairly high correlation between PMI-based YoY GDP indicator, and real GDP – see this graph. Currently only estimate of Q1 growth was -7.0% by deputy Economy Minister Klepach, which is significantly below what ought to be as indicated by PMI (i.e. around -5%) – that said, during the H2 1998 recession real output fell by -9% for half a year, whereas PMI indicated a trough of around -5%. So even if the recession is V shaped – recovers in H2 as Ed believes above (and I agree), we could still see pretty bad overall annual growth (perhaps -4% or -5%) if it turns out that the real downturn in Q1 and Q2 is around -6% or -7%.

  14. What really matters is for the economy to once again be pointed in the right direction, especially when it comes to the unfortunately lagging indicator of employment.

    If the same IP reading of -13.2% y-on-y remains in effect until Sep, it will at least mean that the real economy is once again growing at the rate it was in 2008, and will reach pre-crisis level in Nov or Dec. If it goes higher, that would imply a rate of growth higher than in 2008. E.g., Jan to Feb growth in 2009 was higher than that in 2008 (even if because of a really low base in Jan due to numerous factors).

    Unless more external shocks are still in store, of course…

  15. I was overly optimistic, unfortunately 🙁

    March IP came in at -13.7% y-on-y. It grew by 11.1% compared to Feb, but it turned out to be a slower rate of growth than in 2008. Considering that March is 10.7% longer than Feb, IP stayed virtually flat.

    But at least it’s not shrinking anymore.

    If this is the end of the crisis, then the recovery is shaping up to be L-like. Not the best scenario.

  16. The Rosstat info
    We should note that March of last year had the 2nd highest level of IP in modern Russia, so there’s a certain “high base effect” (I think its called).
    I agree it indicates an L-shape so far, but the real issue is when the real recovery will start. I stick by my prediction of H2.

  17. PS. I should add that China is continuing to look more promising by the month –

    Coupled with its shift from buying Treasuries to strategic metals, this all bodes quite well for Russia too.