Russian government’s new budget, which was approved last week, appears to contain conflicting figures. That is, the ministries plan to lower inflation to the Central Bank’s required level of 4%. At the same time, the value of the rouble is expected to fall around 10% against the dollar by 2019. Yet the Russian currency has hit a record high in recent months. To achieve both of these goals, while maintaining a relatively balanced budget with a small deficit, seems unlikely.
For budget purposes, assumed oil prices will remain more or less stable at around $40 per barrel. The current price is slightly higher and is likely to hover around a similar level at the end of year, which is the time when the 2016 budget will be adjusted according to the cost per barrel (the current budget was set with a base cost of $50). With a barrel of Brent oil currently being sold at $50 (usually two or three dollars more expensive than Russian Urals) the base might be bigger.
Yet it’s not simple to predict the behavior of hydrocarbons for next year. On one hand, major producers have agreed to freeze production, which has lingered for a long period of time at record levels. On the other, the world market is constantly flooded with billions of barrels of oil reserves, stored in supertankers and underground facilities. This fact alone can nudge the price in either direction.
Bank of America expects the annual oil price to fall to $25 per barrel in 2017, while US currency will appreciate 30% versus the rouble. This is the worst case scenario but it is still probable.
Another dilemma facing the budget is how to combine this with the forecast of currency rates. In the past, a widely used formula accurately predicted the dollar-rouble-oil value. The recent exchange rate and price of oil have turned everything upside down.
The Bank of Russia allows the rouble float and does not have a say in the exchange rate. But the government would prefer a weak rouble in order to balance the budget.
To Curb Inflation and Rescue the Budget
But oil is only one part of the problem. The other part is figuring out how to match a relatively weak rouble with a 4% inflation indicator. The dependence on inflation of the rouble is undeniable. Import substitution cannot fully compensate for the losses should the dollar start strengthening sharply, and a weak rouble inevitably translates into substantial inflation (as price on imported goods will rise immediately). Furthermore, despite the rouble’s growth during 2016, the pace of inflation has not fallen in line with the desired four percent.
The previous forecast of the Ministry of Economic Development presumed that with an oil price of $40 and somewhat steady rouble, inflation would only fall to 4.1% in 2019. In 2017, it will be around 4.9%. The lower rate is possible with gradual increases in oil prices and strengthening of the rouble.
Finally, this equation contains another component, that is, the balancing of the budget. The ideal scenario to achieve this is a weak rouble and expensive oil, so that dollar revenue and export duties spelled more roubles for government coffers. But how is it possible to achieve this with the oil price rallying since the Central Bank has sidestepped currency interventions?
“The question of balancing the budget and its ties to a specific rouble rate is still open,” says Evgeny Koryukhin of Alor Broker. If we assume that Russian currency does get stronger, the Central Bank will have to adjust its monetary policy and reduce the interest rate, focusing on rouble liquidity. “Ultimately it will lead to an acceptable currency rate that is good for the budget and economy,” the analyst stated.
According to Sergey Khestanov, an adviser to the general director on macroeconomics at Otkrytie brokerage, balancing Russia's budget without cutting spending and a strong rouble can only be achieved with an increase in oil prices or with a surplus fund. “A moderate weakening of the rouble is less painful than public spending cuts,” the expert believes. There’s no need to try hard, he says, to artificially devalue the rouble. It would suffice to continue lowering the key rate and replenish reserves (with a cheaper dollar the Central Bank will start purchasing the currency on the market; additionally, a law can be introduced requiring excess oil revenues to be directed into the reserve fund).
Elvira Nabiullina now personally sets the course for Russia’s monetary policy. Her main objective is to decrease inflation to 4% by 2017.
Alexander Polyutov, research and analysis manager at Promsvyazbank, believes that balancing the budget and rising oil prices are quite compatible. He does not expect a strong appreciation of the rouble owing to the situation taking place on the commodity markets, as oil will not top $50-55 per barrel in the next year or two. “Moreover, given the budgeting problem, during 2017-2019 the rouble is likely to weaken as the surplus fund shrinks. The Central Bank may as well start propping up gold and foreign currency reserves, which in turn will loosen the national currency. The regulator plans to increase gold and currency reserves to $500 billion,” he says.
But the issue regarding inflation has still not been resolved. In fact, a fall in prices can happen during an internal crisis that is not linked to the price of oil. For instance, it could be linked with income reduction of the population (which we are currently witnessing). The second option is lower consumption and higher savings (inherent to deflationary crises abroad).
Inflation can also be lowered by freezing or very low indexation of tariffs on natural monopolies. This scheme has already proved its effectiveness. Currently, all tariffs are planned to be increased by more than 4%. It is doubtful that the government will change its course. Lobbying efforts by monopolies will be fierce, but the support of the population is guaranteed.
It appears that when the budget was drawn, the government had set overly ambitious goals, given the current economic climate, that in all truth contradict each other. If nothing changes, we will have to choose between inflation or a stable budget with a minimal deficit and a weak rouble.
Author: Dmitry Migunov