Russia’s two-year recession is over. Since 2016, a steady recovery has taken hold. If it weren’t for the geopolitics, Russia could easily turn into a boring story of macroeconomic adjustment after a large external shock and an agenda of structural reforms still to be completed.

The potential for new U.S.-imposed sanctions could change this outlook, at least for a time, and delay the recovery. Nonetheless, we consider Russia’s local currency debt a good yield play for our portfolio now, while we see downside risks to the ruble for the rest of the year.

Economic Adjustment

The collapse of oil prices and the imposition of international sanctions in the aftermath of the Russian intervention in Ukraine in 2014 precipitated a two-year recession. The macroeconomic policy response was to let the ruble float, which caused inflation to surge to 15.6% at its peak.

In an attempt to stabilize the currency, the Central Bank of Russia (CBR) hiked interest rates to 17% from 5.5% in 2014. In the process, domestic consumption and investment collapsed, and the country was forced to deleverage massively. Since the sanctions, Russian external debt declined by about $215 billion – about 16% of its 2016 GDP. Most of the deleveraging was forced on corporate issuers, as they were cut off from refinancing their debt. A bank recapitalization program and temporary regulatory forbearance quickly stabilized the financial system.

On the fiscal front, the government responded to the collapse of oil revenues with a combination of spending cuts and a drawdown of the country’s two reserve funds, which at their peak had accumulated about $177 billion. From 2014 to 2016, the reserve funds shrank to $91 billion. In the same period, about $197 billion of the CBR’s ample reserves were also used to ease the shortage of dollar liquidity.

In the process, the country’s real GDP declined by a cumulative 3% since 2014, much less than it had in previous crises, while unemployment peaked at only 5.8% (Exhibit 1).

Russia Local Currency Debt

The brunt of the adjustment fell on real wages and consumption; both of which declined sharply. At the same time, the collapse of domestic demand increased the current account surplus to its highest level since the 2008 crisis.

Recovery and Potential New Sanctions

A slow but steady economic recovery has been underway since 2016, and consumption and investment are gradually picking up. Since its 2015 peak, inflation has decelerated as a result of weak domestic demand and a strengthening of the ruble. The inflation rate is now approaching the central bank’s target of 4%. This has allowed the CBR to cut policy rates by a cumulative 800 basis points (bps) since the end of 2014.

In addition to these macroeconomic policies, Russia has begun a long overdue and massive cleanup of its banking system. Past policies led to a proliferation of banking licenses, most of which were used by banks to lend to their own owners or similarly connected businesses. The CBR has been withdrawing these licenses quickly without any spillover effects. This cleanup would eventually help credit to flow to the real economy to support investment.

Before the U.S. Senate’s recent resolution to codify existing sanctions into law and extend them to additional strategic sectors, Russia’s fundamentals were pointing to an almost boring recovery. GDP growth of 1.4% to 1.7% was expected in 2017, along with additional CBR rate cuts of about 200 bps in the next 12-18 months.

It is unclear at this point what final form a sanctions law would take in the U.S. House of Representatives and if and when President Trump would sign it. However, considering the current mood in Washington, D.C. about Russia, it is very likely that some form of the draft bill will become law.

More so than expanding U.S. sanctions to additional sectors, vague language in the Senate bill about also subjecting some businesses and individuals to sanctions is creating greater uncertainty. A proposed 180-day review to consider the extension of the sanctions to the government is also a key concern.

The potential impact is difficult to assess at this stage, but the ruble would likely take the first hit. In the midst of a nascent economic recovery, the pass-through impact on inflation is likely to be much less than what we saw in 2014. Three years ago, sanctions fueled capital outflows on top of the oil price shock. The additional forced deleveraging is not likely to be substantial either, considering the scale of the adjustment that occurred after the original sanctions. Nonetheless, the impact of any additional sanctions may be sufficient for the CBR to refrain from any further interest rate cuts for the rest of the year.

Structural Reforms Wait for 2018 Elections

The list of structural issues is long. First and foremost is the dependence of the economy and state finances on oil, which has been a curse for Russia. When oil prices were high, fiscal spending would surge at the same time the broader economy was also benefiting from the oil boom, pushing up domestic demand and inflation.

With the collapse of oil prices since 2014, fiscal revenues contracted by more than 3 percentage points of GDP and government expenditures had to be pared down despite the extensive use of reserve funds. The government has taken steps to reduce this pro-cyclical nature of its spending by saving oil-related revenues when oil prices are above $40 per barrel. This enforces a fiscal discipline on non-oil budget deficits and puts into focus the need to improve non-oil revenues and streamline expenditures.

However, the economy’s dependence on oil is little changed, despite the massive adjustment in real exchange rates. The only exception has been some green shoots in the agricultural sector, which has actually benefited from the import ban that was imposed as a countermeasure to sanctions.

The same top-10 corporations of the past decade, which are mostly state-owned enterprises in the energy sector, remain the champions of industry. This is a reflection of state dominance, as well as a weak investment environment, where concerns about weaknesses in the rule of law limit investor appetite, especially in a pre-election year and under the cloud of sanctions.

Going forward, the structural headwinds to growth will likely take over the economic narrative. Make no mistake: despite the political headlines, Russia has already introduced substantial reforms, at least on paper. For instance, there has been considerable improvement in its ratings on ease-of-doing-business indices compiled by the World Bank. Russia jumped from 92 in 2013 to 40 in 2017, out of 189 countries, and now ranks above Thailand, Mexico, South Africa, China, and even Belgium.1

But clearly that is not how it feels on the ground. Enforcement and implementation of reforms have yet to make a clear difference, while state dominance of the economy has actually increased since 2014.

On a recent visit to Russia, I found a wide recognition of the need for reforms in various areas. One area of focus is rightly on increasing spending on health and education to improve human capital and productivity growth. Improvements in these areas would help address the declining work force, the legacy of low fertility rates during the 1990s following a period of intense social, political and economic transition after the collapse of the Soviet Union. Another area is pension reform to bring spending under control.

These reform proposals will have to wait until the March 2018 presidential elections, when President Putin is expected to be re-elected for his fourth term, since they will need to involve tax revisions. That is a hard call for an economy in which the social contract is at best delicate and paying for social services through taxation has not been the historical norm.

Portfolio Implications

Despite the cloud of potential new sanctions, we believe it would not be wise to write off Russia and the potential for investment opportunities it offers. In the recent past, economic hardship has been effectively directed to bring about useful policy changes. In our view, there is no reason to think that will not happen again in the post-election period.

For now, the local currency debt markets provide a good source of additional yield for our portfolio, while we remain neutral-to-underweight with our ruble exposure. In the credit market, we are adopting a more cautious stance on Russian corporate bonds, given the potential risk that new sanctions could negatively impact a broader array of companies. The 2014 round of sanctions focused on state-owned enterprises, while the current proposals being considered may add sanctions on other sectors of the Russian economy, including railways, shipping and metals and mining.

Regardless of which sectors may be ultimately affected by potential new sanctions, we favor companies that have strong cash flows, ample liquidity, and low external debt levels. We believe corporate debt issuers that meet these criteria should be able to manage their way through another round of sanctions.

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  1. ^Source: World Bank Doing Business Project, 7/12/17 (