Russian Q3 GDP grew 1.8% yoy which was down from growth of 2.5% yoy in Q2 and slightly weaker than market expectations of 2%. Elvira Nabiullina, the Central Bank Chief, is reported as saying she expects growth to reach 1.8% for 2017 as a whole although the Central bank has been guiding to 1.7-2.2% range, and the Finance Ministry projection has been at the upper end of the range. Moody’s estimate 2017 GDP growth at 1.5%. But all projections represent a significant improvement from GDP growth of -0.2% in 2016.
Inflationary pressures are continuing to ease with October CPI tracking at 2.7% yoy, albeit helped by some transitory factors, comfortably below the central bank’s 4% target, and the rouble has been relatively stable this year, implying the Central Bank still has scope to lower interest rates further. The Central Bank cut rates by 25 basis points to 8.25% in October but market expectations are for a further rate cut at the December 15 meeting as real rates remain high.
While cutting rates will help growth, the Russian economy still faces structural challenges which are constraining growth in the 1.5%-2% range: the population is ageing, international sanctions are a hindrance to FDI and the institutional strength and ease of doing business have room for improvement. Added to this productivity growth has been weak and the economy can be viewed as being overly dependent on commodities with high level of government ownership in key business areas. President Putin acknowledged some of the structural challenges in his 2016 Address to the Federal Assembly, although so far policy initiatives to address this have been limited and appears to be focused on improving the ease of doing business. Interestingly, Russia has improved its position in the World Bank’s Ease of Doing Business Rankings for 2018 to 35th place, a notable improvement on last year and its ranking of 120th in 2011.
The adoption of the fiscal rule (effective from 2018) is a positive development in that it aims to rebuild fiscal buffers in periods where the oil price is trading above a conservative budget assumption of USD40 per barrel (Urals blend). Thus, revenues above the budgeted amount will be converted to US dollars and held in the sovereign wealth fund. Clearly, with the oil price trading above budgeted levels the fiscal position is on an improving trend. Current projections are for the federal government deficit to fall to 0.8% of GDP in 2020 from an expected deficit of 2.1% this year.
As we have seen in the period since mid-2014 and a precipitous fall in the oil price, Russia is fortunate in that its flexible exchange rate can act as a shock absorber, reducing the amount of fiscal adjustment required compared to countries with a fixed exchange rate. Moreover, Russia started from a position of strength with a strong external position helped by sizeable asset buffers and low debt levels. The strong external position and a low dependency on external financing are important as sanction risk remains after the US government’s ‘Countering America’s Adversaries Through Sanctions Act’ has been signed into law in August.
Russia remains one of our favoured countries although we see greater valuation upside by taking exposure through quasi sovereign names. Gazprom, 50.23% owned by the Russian government, remains one of our preferred holdings. This week Gazprom returned to the market raising EUR 750m from a 7 year Eurobond offering at a yield of 2.25% that was more than 2x covered, although we prefer to take exposure through the GBP or USD curves as we believe the markets have moved further to discount moves to start to normalise monetary policy. For example, the GBP denominated Gazprom (Gazprom Capital) 4.25% 2024 issue trades on a yield of 3.5% and is trading over two credit notches cheap on our models.