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SBERBANK OF RUSSIA External Shocks of 2015: Unpleasant But Not Catastrophic July 20, 2015 2015 was marked by escalation of risks associated with the situation around Greece, reaching an agreement on Iran and more significant and rapid slowdown in China’s growth. Increasing the Federal Reserve System Rate in 2015 will cause capital inflows into the United States. But the appreciation of the dollar has already happened, so we are not expecting a strong decrease in the dollar price of commodities on account of this factor. Although the level of turbulence of the global markets will grow significantly, catastrophic scenarios at the global and regional levels are unlikely to happen. Decline in raw material prices, especially oil, and additional turbulence in the currency market will be the main factors in the impact of these shocks on Russia. As a result, the restoration of the Russian economy and its way out of recession may be delayed. In the current recession conditions, the growth of the negative consequences of the risks will not be dramatic. Risks and Shocks of 2015 New risks of 2015 The level of macroeconomic uncertainty has increased greatly in 2014. The geopolitical crisis in Ukraine and the hostilities in the territory of neighboring state have greatly increased the political risks and led to the present economic shocks, i.e. the consequences of the application of the EU and US economic sanctions. No one expected the halving of oil prices in 2014, but this decrease has made the Russian economic recession and currency crisis inevitable. In 2015, the situation is more calm and predictable (especially in the 2nd quarter of the year). Nevertheless, the significant risks of external shocks on the macroeconomic stability in Russia are already obvious. They may materialize in 2015 and have a significant impact on the fundamental factors for the country. We are going to analyze four major events: 1) Greek withdrawal from the Eurozone 1. Events around Greece, i.e. Grexit: Although market expectations regarding the development of a negative scenario are formed and included in the price of assets, it is difficult to calculate the specific dynamics of the developments and take into account all the risks. The direct effect of Greece on Russia is negligible, but we cannot exclude shocks on the foreign exchange market and the devaluation of the euro as a short-term risk. © Center of Macroeconomic Studies of Sberbank of Russia 1 SBERBANK OF RUSSIA 2) Collapse of economic bubble on China’s stock market 2. China’s stock market bubble has burst: Slowing of economic growth in China has become a fact in the years 2013-14, but the bursting of the bubble of the stock market, which lost 30% of capitalization in the last month, can accelerate this process. For Russia, the result of the slowdown is the raw materials demand shock. Reduction of prices on energy carriers and metals should be expected. 3) Cancellation of sanctions against Iran 3. Agreement on Iran and cancellation of sanctions: For all the positivity of this event, the shock on the supply side of the oil market can be easily predicted. Moreover, this factor takes effect almost immediately. 4) Increase of Federal Reserve System Rate 4. Increase of FRS rate: In 2015, a new cycle of the US Federal Reserve monetary policy will begin. The first stage is expected to take place in September-October 2015 (more likely in October). Raising rates will cause a strengthening of the dollar and, thus, an additional decline in gold and oil prices. Impact of shocks on Influence of these external shocks will be mitigated due to the isolation of the Russia will be mitigated Russian economy from the global capital markets. Under normal due to isolation from circumstances, the global shocks could cause a significant change in capital markets interest rates and the outflow of capital from Russia. The shocks broadcast channel is currently blocked. Nevertheless, the consequences will be severe Thus, with a deep reduction of oil prices and a new spiral of destabilization in the currency market, the macroeconomic situation in Russia may significantly deviate from our baseline scenario: the recession will deepen, the budget will require more funding, the ruble weakening will accelerate, and the exchange rate will get even more volatile. A new acceleration of inflation is a major challenge for the monetary authorities in such a situation. The reduction in real wages and incomes will cause new challenges for banks. Greek Withdrawal from the Eurozone Probability of Greek withdrawal from the Eurozone increased The Greek debt crisis in 2015 reached its peak. The first two programs involving the three creditors could not stop the growth of government debt, so another restructuring was a matter of time. The progression of events accelerated after the relatively radical party, Syriza, came to power in January and advocated for the abandonment of the three creditors program. “Greece in the Eurozone” Scenario New ‘three creditors program’ postpones the state debt problem instead of solving it The least traumatic and most likely scenario for the near term development of the situation around Greece is the postponement of the problem. This exact scenario is now being realized. So far, European lenders have agreed on lending the Greeks only €7 billion euros of bridge financing, €4.2 billion of which will be paid on July 20th by the ECB; 2 billion euros will be paid by the IMF as part of an overdue debt. Further funding (€86 billion) as part of the Greece's third program involving the three debtors is yet to be approved by the national parliaments. In © Center of Macroeconomic Studies of Sberbank of Russia 2 SBERBANK OF RUSSIA addition, the ECB has increased the volume of liquidity provision by €990 million (up to €90 billion), so on July 20th the Greek banks may be able to resume work. This is all part of a temporary agreement. Government debt will continue to grow Privatization objects are not specified Firstly, according to the IMF estimates, Greece will not be able to pay off the government debt. Even a complete relief of €53 billion issued in 2010 from the Greek Loan Facility will not be enough to put the debt issue on a steady path. While, according to Germany, the debt relief is impossible in accordance with the Eurozone agreements, the experience of the previous restructuring (private sector involvement in 2012) suggests otherwise. Moreover, without the debt relief, the IMF is likely to stop the participation. Secondly, it is not clear what assets worth €50 billion Greece is going to privatize in the coming years. The agreement merely states that "valuable assets" are going to be transferred to the fund. Obviously, art objects and territories (islands) are not being considered. Shares of Greek banks, which the state will receive as a result of the emergency recapitalization, will cost very cheap. Sale of infrastructure objects for €50 billion is hardly possible. The creditors will return to this issue in the 4th quarter of this year since the unclear privatization plan was one of the most criticized aspects of the Greek proposals to the three creditors. Probability of social unrest has increased Thirdly, the set of measures, for which the Greek Parliament voted almost unanimously (229 out of 300 votes), contradicts the results of the referendum held two weeks ago. Social unrest and protests are inevitable, although their scale is difficult to predict. Grexit is not cancelled, it is postponed In summary, the agreement will stay in effect as long as the Greeks are not convinced that the reform package adopted on July 15 does not help to stop the recession, deflation and rise of the government debt. At this point, the government will decide to loosen the fiscal discipline and creditors will suspend another tranche of the third anti-crisis program. Moreover, if a number of European parliaments rejects the anti-crisis plan or if the ECB's support is not enough to restart the Greek banks and abolish the restrictions on capital flows, or the IMF refuses to participate as a creditor, then the Grexit will become one of the most suitable ways to solve the problem. Chaotic Withdrawal from the Eurozone Grexit can still happen by the end of the year ECB will determine the Grexit's final moment Due to the intermediate agreement with creditors, Grexit is now less likely to happen. In addition, European countries have repeatedly warned about the preparation for Grexit, meaning that technical and legislative solutions will be in a high readiness mode. This will ensure a less chaotic withdrawal. This is how we see the withdrawal progressing if it actually happens this year. A government bonds default will breach the balance sheets of Greek banks worth €46 billion, €13.6 billion of which represent the government debt (according to ECB as of April) and €30 billion represent the instruments with state guarantees. The ECB will stop providing liquidity to Greek © Center of Macroeconomic Studies of Sberbank of Russia 3 SBERBANK OF RUSSIA banks, which is €90 billion as part of the ECB's emergency liquidity program of ELA. Greece does not have enough money to recapitalize the banking system, so we think that the Icelandic option will be chosen. Banks will be divided into an "external one" and several "internal ones" with the external debts moratorium. This will help to preserve the banking system which is vital for the restart of growth after the withdrawal from the Eurozone. This will mark the end of the collapse's acute phase, but the economic contraction will stop only in the middle/end of 2016. Drachma's deprecation is not going to be critical The first key question is how critically will the new Greek currency (drachma) deprecate? The most extreme estimate is the current discount which is applied by the ECB for Greek bonds as part of ELA, namely 45% (according to Bloomberg). This rate may be considered probable in the case of recalculation of foreign debt into national currency. Although we believe that this estimate is too high. Greece's current account positions in the 1st quarter were balanced at the level of +0.2% of GDP (for comparison, the current account positions balance in Iceland in 2008 was 23% of GDP). All the capital that could have been disinvested was already disinvested, and the probability of the complete abolition of the imposed restrictions on the capital outflow is very low. However, the situation is worsening because of the trade balance deficit (€1.3 billion as of May). So far, we believe the potential of drachma depreciation is 15% and increasing with each passing month. ...and the cost of introducing a new currency is low The second question concerns the cost of introducing a new currency. The costs of conversion of all financial reports into the drachma, in our opinion, are small in macroscale. Although the transition will definitely create many legal problems and will take several months. The costs of printing new drachmas will be quite reasonable. Printing banknotes via outside organizations is a widespread practice: almost half of the countries with their own currency uses such services. Price of one note varies from $0.02 to $0.06. According to our calculations, the replacement of the circulating euro bills (approximately 520 million pcs.) will cost Greece $21 million. These costs should not pose a big problem. Government bonds interest rates are not influenced by the situation in Greece Source: Bloomberg © Center of Macroeconomic Studies of Sberbank of Russia Major part of the debt is on the Eurosystem’s balance sheet (€323 billion in total) Source: Public sources 4 SBERBANK OF RUSSIA Budget catastrophe in Greece is not expected Exit from the Eurozone will obviously be accompanied by unforeseen expenses. Greece has very little space for budget maneuvers, but there is space nonetheless: in January-May the primary surplus of the central government budget amounted to €1.4 billion, and the primary surplus of the consolidated budget amounted to €0.5 billion. Also, Greece has a plan of further increase in budget income coordinated with the three creditors. Serious budget spending cuts in real terms can not be avoided, but the budget catastrophe is not expected. So, the hardest part of Greece's withdrawal from the Eurozone is already behind. Recession can not be avoided, but we believe that it will be shallow and short. Potential Withdrawal Effect Grexit’s direct effect on Eurozone will be insignificant… Direct damage from Grexit for the Eurozone countries will also be moderate. Since 2008, the private sector has almost gotten rid of the Greek debt, its bigger part (€213 billion) is now on the balance sheet of the Eurosystem (ECB and the EFSF, ESM, GLF fund system). Writing off the debt from the balance sheet of the Eurosystem may require additional capital investments by the ECB. Prior to the start of the quantitative easing program, this could have posed a problem, but now it will just be a part of QE. The direct effect on trade, due to the small size of the Greek economy, will be unable to slow down the growth of the Eurozone. Our conclusions are confirmed by the dynamics of rates on government bonds of the periphery: they did not react to default on the IMF debt or the Greek referendum results. ...while the indirect effect might be the final step towards the Eurozone's collapse But we do not overestimate the current calm on the markets. Paradoxically, the calmer the Greece's withdrawal from the Eurozone is, the worse its effect on the rest of the Eurozone will be. If Grexit turns out to be painless, by the end of the year we will see the growth in the activity of political parties in the countries of the periphery calling for the exit from the Eurozone. Government debt interest rates will increase, expectations will be self-fulfilling. Italy, Spain, Ireland and Portugal are already in the red zone in the IMF reports on debt sustainability. A slight slowdown in growth, growth of rates, weakening of fiscal discipline and preservation of low inflation put their debt to the trajectory of growth. Grexit could be the final trigger of such transition. Global effect: turbulence of currency market and capital outflow from emerging markets If events develop in such a way, eurosceptics will grow in number, the euro could fall in price to parity with the US dollar, and emerging markets will once again face the outflow of capital due to the growth of global risks. We believe this is what poses the main risk and the main channel of influence of the events around Greece on Russia. We estimate the additional capital outflow from Russia in this scenario in 2015 to be worth $5 billion. Agreement on Cancellation of Iran's Sanctions Iran's sanctions will be completely cancelled in a few weeks Negotiations on Iran were very hard, but the compromise was reached. The parties agreed on Iran's commitment to reduce the number of © Center of Macroeconomic Studies of Sberbank of Russia 5 SBERBANK OF RUSSIA centrifuges and the 15-year-old ban on new uranium enrichment facilities. The annexes to the document determine the procedure of sanctions cancellation, including the cancellation of sanctions on Iranian oil exports, supply of oil industry equipment, the lifting of sanctions in relation to banking, insurance and disconnection from SWIFT. Sanctions will be renewed in case of Iran's violation of the agreement. The document comes into force 90 days after its approval by the UN Security Council. It is a positive example of quick termination of sanctions... Agreement between the Six, i.e. the USA, Germany, France, China, Britain and Russia, and Iran is great news, which opens up new prospects to Russia as well. It will make the resumption of a full-fledged nuclear cooperation and work on other joint projects possible. Most importantly, such agreement shows the possibility of cancellation of the toughest economic sanctions 3+ years after their declaration (Cuba wasn't that lucky). ...and a serious shock on However, the lifting of sanctions will give Iran new opportunities in the the raw material production and export of oil, which is taken in consideration by all the market market players. Despite the fact that the country will not be able to immediately increase the supply of oil, market expectations have already caused quite a significant decrease in oil prices. When the supply of oil actually increases, three major trends will manifest more harshly: First, oil prices will go down, and for a short period may even drop below $50/barrel. Second, the price spread between Brent and Urals brand prices will expand and amount to the previous $2/barrel. Third, the price war and the struggle for market shares will exacerbate causing the increase in price volatility in both the amplitude of their oscillations and the frequency of price changes. What Can the Increase in Oil Supply be Like? Recovery of Iran's export deliveries is around the corner In order to answer the main question about the additional volumes of oil supply, let's take a look at the dynamics of oil production in Iran before sanctions were imposed. After all, the extraction and export of Iranian oil was severely affected by the imposition of sanctions by the United States in late 2011 and the support of this imposition by the EU in summer 2012. The country's energy sector was affected by the ban on investment in the Decrease of Iranian oil exports by directions Source: EIA © Center of Macroeconomic Studies of Sberbank of Russia Net exports and consumption of oil by Iran Source: EIA 6 SBERBANK OF RUSSIA oil and gas sector, the closure of access to Western capital markets, the trade embargo on the purchase of Iranian oil, as well as the ban on insurance of Iranian oil tankers. The ban on investment did not have an immediate impact on production, but the deferred effect is expected to last long (it will affect the first half of 2016). Effects of other sanctions manifested quicker, but the recovery after the lifting of sanctions is expected to be quick, it will require only a few months. Thus, the dynamics of the recovery of production in Iran will begin in October 2015 Let's conduct simple estimates of potential production growth. According Iranian oil exports declined due to sanctions to EIA, from 2011 to 2014 the export of oil (crude oil and condensate) fell by 1.2 million barrels per day reaching the 1.4 million barrels per day by 1.2 ml b/d mark. Nearly half of the reduction (0.6 million barrels per day) fell on the decline in exports to the EU. EU replaced the imports of Iranian oil supplies mainly by importing from other OPEC countries. Since 2012, the share of Saudi Arabia in EU imports grew from 5.9% to 8.8%, while the share of Nigeria grew from 4.1% to 8.2%. Russia’s share decreased from 34.7% to 33.7% by 2014. Potential of +1 million barrels/day recovery Now, during several months since October 2015, Iran will be able to ramp up production at 0.5+ million barrels per day, as well as export the accumulated reserves (estimates vary from 7 to 35 million barrels). But the potential for further growth in supply has been limited by low investment in oil and gas sector during the last three years of sanctions and will not exceed 1 million barrels per day in the next 12 months. Iranian oil characteristics are similar to the Urals oil Source: U.S. Energy Information Administration, based on Energy Intelligence Group …although a significant increase in volumes is possible in the long term Iran's reduced exports contributed to the decline of Urals/Brent discount Source: Reuters In the medium term, the production growth could reach an additional 1 million barrels/day, but only with the inflow of investments by international energy companies. It is quite a possible scenario, too: in May this year a number of companies, including Shell and Eni, reported about the resumption of business relations with Tehran and the beginning of the discussion of their return to Iran. Still, it is quite unlikely that the oil and gas complex of the country will reach their investment attractiveness of © Center of Macroeconomic Studies of Sberbank of Russia 7 SBERBANK OF RUSSIA 2010. Today, the oil prices are relatively low and not growing, therefore the profitability of such investments is reducing. Oil price could fall to $48-50 per bbl Brent It is easy to guess what will happen to the oil price if the market receives additional volumes. According to the Rosneft experts, additional supply volumes of 1 million barrels per day reduces the price by about 10%, i.e. in this case by $6-7 per bbl. It's close to a consensus. According to the EIA (US Energy Information Administration), the decline in oil prices from a full package of agreements on Iran will amount to $5-15 per bbl to the baseline scenario of 2016 (the basic forecast of the Administration is $67 per bbl). The effect is partly included in the oil prices as the markets always took into account the likelihood of resolution of the situation around Iran. However, the initial proposal of larger volumes of stocks (from 7 to 35 million barrels) may well cause the markets to react to an agreement aggressively. In other words, we should not exclude a shortterm reduction of Brent price to $50 per bbl and a lower level compared to the baseline of $55-60 per barrel in 2016. Expansion of Spread Between Urals and Brent Iranian oil is similar to the Russian oil Iranian oil is similar in characteristics to the Russian oil grade Urals. Iranian and Russian oils are heavy, sour grades, which under normal conditions of the market provides a price discount relative to the marker grade Brent. This is largely explained by the technological peculiarities of processing, which is easier and cheaper when dealing with light oil grades. Iranian sanctions contributed to the decline of Urals-Brent discount Reduction of Iranian oil supply after the introduction of Western sanctions in 2011-2012 contributed to the reduction of price discount of Urals to Brent. High interchangeability of the Russian and Iranian oil, as well as technological limitations of the refinery to quickly shift to another type of oil, determined the growth in Urals oil demand. Discount is unlikely to rise after sanctions cancellation In this case, the lifting of sanctions will launch a reverse process, i.e. the expansion of Urals-Brent spread, but the discount is unlikely to exceed the ten-year average of $2.5/barrel. Getting an accurate assessment is difficult: the discount size was always characterized by high volatility and depended on many factors, including the seasonal effects (Urals discount is traditionally lower in summer). Today, the Urals price exceeds the Brent price due to interruptions in sour crude supplies from the Iraqi province of Kirkuk controlled by the Kurds. But this is a temporary phenomenon. It is not clear how long the expansion of the spread might take. It should happen in 2016, so the price of Urals crude oil, due to the increase in Iranian supplies, is unlikely to exceed an average of $54-59 per barrel in 2016. Economic Slowdown in China © Center of Macroeconomic Studies of Sberbank of Russia 8 SBERBANK OF RUSSIA Bubble is deflating; the consequences are unclear The collapse of the stock market in China was so rapid and profound that it shaped the expectations of further uncontrolled reduction. The Shanghai stock exchange index has lost about 30% from mid-June to early July. Given the starting level of stock indices at the beginning of 2014, the decline could continue, as in the previous eight months the market grew by 117%. Reduction of market capitalization now amounts to about $2 trillion (from $10 to $8 trillion, i.e. from 100% to 80% GDP). Many analysts fear the negative effects on economic growth, especially in case the reduction continues. Although, the market has stabilized in the last 2 weeks. During the collapse of China's stock market, the authorities were actively discussing the possibility of banning the IPO and the creation of stabilization fund to support the stock market. All 28 companies with an allocation permission in 2015 decided to postpone it. The last action of the authorities was the introduction of a six-month moratorium on the sale of shares by majority owners (over 5%). Nevertheless, in spite of the stabilization of the market, we think that this is not the end of the story. Currently, about a third of companies listed on the Shanghai Stock Exchange, took a wait and are not trading in the market. Their entry into the market could lead to a new increase in volatility. Economic slowdown is possible Yet, we are not expecting a catastrophic scenario regarding the market; the negative consequences for the real economy in the short term will be limited. The state has a sufficient amount of reserves and supervision over the financial system in order to avoid the escalation of the stock market crash into the economic crisis. Although, the economic slowdown can not be avoided, which carries the risks of raw materials price reduction. China has had an Experience with Bubbles China's stock market has already experienced bubbles Classic dynamic of stock market bubble deflation is not new to China. Previous bubble appeared in 2007 and deflated in 2008 before the onset of the acute phase of the global financial crisis. Particularly strong growth of stock indices happened in 2007: at the beginning of the year, the Shanghai Composite Index was at 2,600 and by October 2007 rose to 6,100 Shanghai Composite stock index suffered even worse times Source: Haver Analytics, calculations of the Center of Macroeconomic Studies © Center of Macroeconomic Studies of Sberbank of Russia 9 SBERBANK OF RUSSIA points (a record of 5150 points in June 2015). The volume of China's stock market capitalization at its peak time was 131% of GDP (the peak of June 2015 - just 100% of GDP). Although, the situations are somewhat different People's Bank of China at that time followed a restraining monetary policy. Key rate of the annual loan was raised from 5.58% to 7.47% during 20062007. However, these restrictions were not enough, so the market was still growing. The stock market access of foreign capital was very limited then, although today the share of foreign investors remains low and does not exceed 10%. Another important difference of this bubble from the 2007 bubble is the margin trading. During the 2007 bubble the margin trading, i.e. trading with borrowed money, was banned. It is permitted now, which creates additional risks for the banking system. China’s economic slowdown… Growth Slowdown: Plans and Reality China has been the most dynamic economy in the world in the last 15 years, but a couple of years ago the slowdown in its growth became noticeable. Even the Chinese government, which is not prone to public recognition of problems in the country, is using the "new normality" term more and more often. The recognition of the fact that the economic slowdown is structural was the main breakthrough. Aggressive investment increase (up to 48% of GDP) did not lead to the maintenance of high growth figures. Exhaustion of possibilities of export and investment growth model made it necessary to rely on a new growth driver, i.e. consumption. However, consumption growth was not sufficient to sustain high rates of economic growth in general. At present, the Chinese economy is experiencing a slowdown that threatens to cause a hard landing. In 2014, GDP grew by 7.4%, which is the lowest figure in the modern history of China. The slowdown continues; the opinion that the growth target of 7.0% in 2015 will not be achieved has become widespread. If Chinese administration chooses the path of economic liberalization, the growth in the second half of the year will slow down to 6.0-6.5%, and the slowdown will continue in 2016. Trying to maintain the economy using the familiar measures of strict state regulation can support growth in 2015 and 2016, but in the future this may lead to full-fledged economic crisis. Consumption should become the new incentive of China's growth Source: Haver Analytics, calculations of the CMS © Center of Macroeconomic Studies of Sberbank of Russia Investment growth did not sustain the Chinese economy Source: IMF 10 SBERBANK OF RUSSIA … will significantly influence the world economy China is not the only country interested in the stability of Chinese economy, the developed countries are as well. The share of export to China is gradually increasing: Japan's export exceeds 20%, the US - 12%, Germany - 8%. The slowdown in China could undermine the already slow recovery in the developed countries which also faced the problem of low rates of consumption growth. China is important for Russia as the world's largest consumer of raw materials and energy, affecting the world prices. Further Easing of the Monetary Policy PBC has Scope for easing monetary policy In 2007, in order to fight the stock market bubble and the possible overheating of the economy, the People's Bank of China tightened the monetary policy and introduced additional measures of stock market regulation. Today, the situation is opposite. The bubble is deflating under the influence of non-monetary factors, and the economy is slowing down. From the perspective of monetary policy, the current situation creates more incentives for mitigation. Chinese banking sector is still one of the most regulated in the world. Reserve requirements are extremely high (18.5% for large banks), the ratio of loans to deposits should not exceed 75%, but is, in fact, less than 70% (cancellation of this limitation is planned for 2016), the key rate is gradually declining, but still remains relatively high. Since autumn 2014 the PBC has lowered the key interest rate from 6% to 4.85%. Reserve requirements were reduced from 20% to 18.5%. PBC has the opportunity to free up a significant amount of liquidity; estimated reduction of reserve requirements by 50bp will release about $80 billion from reserve bank accounts. There is space for further monetary stimulus as the inflation stays at a low level (1.0-1.5% yoy). Therefore, there is every reason to believe that several rounds of rate cuts and reserve requirements will be held in 2015. Effects of 2015 Bubble Collapse Role of the stock market in the economy is not as great as in the developed countries The effect on the banking system and crediting is expected to be limited, provided that the state employs leverages that support lending to the real sector. It is known that Chinese commercial banks are controlled by the state one way or another. According to the World Bank estimates, the direct state presence in the capital of the banking system is 67%. But at the same time, the effective control is even wider, because the state/party can appoint senior managers and board members. In addition, the presence of the state is also large in other financial sectors coupled with the banking system: in insurance (80%+ control), trust companies (85%+), companies that operate on the stock market (60%+). For example, an indicator of the degree of influence of the state in the brokerage segment was the recent collective promise of the largest brokers not to sell the shares on the market when the Shanghai Composite Index is below 4,500 points (it reduced to 3,500 points on Wednesday, July 8). Banking system is out of the risk zone Thanks to state control over the financial system, classic spiral of falling asset values during the crisis will not be able to unwind to its fullest. © Center of Macroeconomic Studies of Sberbank of Russia 11 SBERBANK OF RUSSIA Market-based indicators suggest that banks feel safe enough, i.e. interbank rates remain at a low level, despite the panic in the stock market. But in the long run, government intervention in the operation of the banks will aggravate the problem of hidden bad debts. Well-being of the population will decrease only slightly The effect on household welfare does not seem significant either. The number of individual investors in China is less than 90 million. According to HSBC estimates, the shares represent less than 15% of household assets, meanwhile less than 10% of households are involved in the stock market trade. The previous stock market drop in 2008, a significantly larger one, had almost no effect on the rate of growth of household wealth. Financing of businesses The effect on the financing of enterprises will also be negligible. The amount of funding through the issuance of shares in China is 10-20 times will remain on the less than traditional bank lending. In 2015, new bank loans were issued at same level an average of $170 billion per month, while the issue of shares brought companies $9.5 billion per month. Although, reforming will slow down The effect on the financial sector reforms seems to us as one of the most significant negative impacts: Measures that are currently applied by the Government to stabilize the stock markets reduce the investor confidence in the declared intentions of the liberalization Growth of bad debts in the banking system and the stress in the asset management sector will force to suspend the process of increasing the transparency of the financial sector and reducing the role of the state The undesirability of capital outflows from the country is expressed in slowing down of the process of liberalization of the external capital account. Accordingly, the convertibility of the Yuan will be PBC has room for easing monetary policy Source: Haver Analytics, Bloomberg, calculations of the Center of Macroeconomic Studies © Center of Macroeconomic Studies of Sberbank of Russia 12 SBERBANK OF RUSSIA postponed Oil demand from China will continue to grow, albeit slower Copper and Nickel can lose up to 25% of the price The effect on world oil prices will be negative in the short term due to increase of uncertainty. However, market analysts believe that the demand from the transport sector (65% of China's oil demand) will not slow down, but rather accelerate. International Energy Agency expects China's oil demand to increase by 3.8% in 2015 (3.0% in 2014) with the economic growth of 6-7%. British Petroleum expects the growth in oil demand from China to amount to average of 3% per year over the next 20 years. However, these projections were formed before the stock market collapse. We expect that a stronger slowdown in economic growth will reduce, in turn, the growth in oil demand. Although it is unlikely that the latter will be lower than last year which means that the effect on the price of oil during 6-12 months will not exceed $2-3/barrel, but it can persist for quite a long time (up to a new acceleration of growth). The effect on world prices of metals will probably be strong. China is the largest consumer of copper and iron ore. In the last year, amid the slowing Chinese economy, the talk about the likely collapse in prices in the metals market was widespread. Stock market collapse will endanger one of the key sectors of China's economy, i.e. the construction sector, which will have a negative impact on copper and steel prices. But steel prices are already low: they are only 7-10% higher than the historic lows, and they have already fallen by 15% since January, 2014. Aluminum prices, which fell one level lower since the beginning of 2014, are unlikely to be severely corrected. A sharp drop in copper and nickel prices is expected, whereas China produces more than half of the demand (construction of skyscrapers will suffer more than the industry as a whole). Copper and nickel can lose up to 25% of the price. This will result in a loss of up to $4 billion a year for Russia. Hidden Threat: Lack of Transparency As in any other analysis of the stability of the Chinese economy, there are blind spots associated with the lack of transparency of the banking system. Quality of banks balance sheets is not clear, additional stress carries risks The problem of bad debts of regional and local governments, accumulated in 2009-10 during the period of credit and investment stimulation of the economy, remains unresolved. State, or rather, the banks it controls, prefer to extend and refinance bad regional debts. Additional problems due to the falling stock market are non-critical by themselves, they bear the risk of further deterioration of banks balance sheets, and can lead to a credit crunch. Increase of Federal Reserve System Rate CMS predicts the first rate increase at the FRS meeting in October The rate of the US Federal Reserve was technically on the lowest level during the last 6 years, and the beginning of its increase, which is expected in the second half of the year, will definitely affect the financial markets. In 2013, the news of the FRS discussion of the rate increase prospects alone triggered a significant increase in market dollar rates and the outflow of capital from emerging markets. The exact time and trajectory of © Center of Macroeconomic Studies of Sberbank of Russia 13 SBERBANK OF RUSSIA Increase of FRS rate is expected in the 4th quarter of 2015 Reduction of stock exchange dollar prices will be insignificant improvement of the Federal Funds Rate is still unclear and are significantly dependent on the US economic growth prospects. It is now clear that the increase will be gradual; for now, the FRS management predicts the FFR rate of about 0.8% by the end of 2015, and less than 2% by the end of 2016, but the negative risks for the US growth, mainly external, exceed the positive ones. CMS predicts the first rate hike at the FRS October meeting and the FFR rate of 0.5% by the end of 2015. Increase of the FRS rate could lead to some rise in the dollar price compared to other currencies of developed countries. Central Banks of the Eurozone and Japan will not raise their rates in the short term, and return on assets in dollars will increase in comparison with the assets in euros and yen. Thus, all things being equal, stock prices could fall, denominated in US dollars. Simple calculations show that the strengthening of the dollar by 1% causes a decrease in gold prices by 1.4% and the decline in oil prices by 2.9%. However, in 2015, this effect on the prices of oil/gold/metals is likely to be negligible, since the future increase of rates in the US is mostly taken into account by the market. You could even say that the markets, and the FRS itself, were too optimistic in the first half of 2015 and overestimated the speed of rate hikes. Accordingly, the dollar may be overvalued now as its nominal effective exchange rate has appreciated by 12% since August 2014. This means that a possible correction of the gold price will not exceed 1-2%, and oil - 2-4%, which is within the ordinary market volatility. Russian Economy after the Shocks Worsening of conditions can be harsh: If all the shocks described above are implemented, the external conditions of the Russian economy will worsen. The main blow will fall on the export volumes due to the high proportion of metal and energy. However, a slowdown in China will not affect the volumes of supplies, but the prices. Decomposition of Russian Exports © Center of Macroeconomic Studies of Sberbank of Russia 14 SBERBANK OF RUSSIA Petroleum and petroleum products account for 70% of Russian exports Commodity structure is well-known. Energy carriers (oil, gas and oil products) account for 70% of Russian exports, so the drop in oil prices is critical to its dollar value. But the directions of export flows are such that we do not expect further reduction of export volumes. Indeed, the main markets for oil and oil products for Russia are the EU countries with the Netherlands at the top, from which the Russian energy carriers are reexported to third countries via the port of Rotterdam. Metals occupy a smaller share Ferrous metals occupy a small but important share - 4.1% of the exports, non-ferrous metals - 3.1% and precious metals - 2.4%. Wood and its products occupy only 2.2% of the total volume. Basic supply of ferrous metals and metal products fall on Turkey, the United States and the Customs Union partners. Netherlands lead in the non-ferrous metals supply. China's share is less than 1%. Share of exports to China is small; China's slowdown will insignificantly affect the exports volume China accounts for 7.5% of Russia's exports, which is $37.4 billion. China's share is only high in the export of energy carriers and it continues to grow rapidly. In 2014, China became the Russia's fourth market for oil and refined products sales, which accounted for 74% of total Russian exports to China, which is $27.7 billion. Timber exports (8.8%) holds the second place. Nuclear reactors and ores account for 3.7% and 2.8%, respectively. Thus, the Russian timber exports to China valued at $3.3 billion is only 0.7% of the Russian export. Consequences of Raw Materials Prices Reduction 1) Reduction of Urals price to $55/bbl in 2016 First, the recovery of oil prices to an average of $65/barrel in 2016 should not be expected, given the effect of a larger slowdown in China and the growth in supply of Iranian Urals oil average price may reach only Russian exports structure ($497.8 bln) Source: Federal Customs Service, data for 2014 Non-ferrous metals sales markets ($15.5 bln) Source: Federal Customs Service, data for 2014 © Center of Macroeconomic Studies of Sberbank of Russia Energy carriers sales markets ($346.1 bln) Source: Federal Customs Service, data for 2014 Ferrous metals sales markets ($23.7 bln) Source: Federal Customs Service, data for 2014 15 SBERBANK OF RUSSIA $55/barrel (the subsequent trajectory of prices in 2017-18 will be lower than predicted). 2) Acceleration of capital outflows by $5 billion in the 4th quarter 2015 Second, the shock on the currency market in the 4th quarter 2015 is probable due to the growth of the euro-dollar volatility. The decline of the ruble may exceed the natural rate of decline due to the fall in oil prices. Capital outflow will accelerate by an additional $5 billion in the 4th quarter 2015 (it will fall by the same amount in 2016 when the CBR returns the repo). 3) Reduction of exports Third, the fall in metal prices will cause the export revenues to drop by $4 by $7 billion in billion in 2016 and by $3 billion in 2017. 2016-17 Crisis recovery is postponed The results of our calculations show that under these conditions, the country will face another year without consumption growth: inflation declines slower than in the basic scenario, real wages and incomes continue to fall in 2016. Crisis recovery is delayed until 2017, but the contribution of net exports into growth will remain positive at the beginning of 2016. The transition to the regime of more budgetary expenditure savings will be inevitable. Indexation of pensions will take place in the amounts proposed by the Ministry of Finance, below inflation (5.5% in 2016), which will deliver another blow to the incomes of the population. © Center of Macroeconomic Studies of Sberbank of Russia 16 SBERBANK OF RUSSIA Conclusion Shocks will exacerbate the old issues, however, the scenario is not catastrophic Although the events that are now unfolding may have a truly dramatic effect on the world, they will affect Russia tangentially. Indeed, during the period of economic boom such shocks can expand the growth trends. But changes under the recession conditions at the qualitative level look insignificant. The fact that the country was cut off from international capital markets even before the emergence of new challenges, reduces its vulnerability against new shocks and reduces the number of channels for their transmission. As a result, the negative impact is reduced to a decrease in raw material prices, a slight acceleration of capital outflows and further decline of the ruble. A flexible exchange rate policy helps the economy to adapt to new environmental conditions by reducing the effects of shocks. Old issues (for example, the depletion of the Reserve Fund in the event of a prolonged period of low oil prices) will, of course, worsen. The consumers' situation will get worse again (especially in the first six months after the shock), and the crisis recovery will take longer. However, catastrophic scenarios are not expected. Time Period Macroeconomic Attribute 2015_q1 2015_q2 2015_q3 2015_q4 2015 2016 2017 2018 53 61 58 52 56 60 65 70 Real GDP growth, %yoy -2.2 -3.5 -3.0 -3.2 -3.0 -0.5 2.0 1.3 Industrial production growth, %yoy -0.4 -4.9 -3.7 -3.1 -2.5 0.0 1.5 2.0 Retail trade growth, %yoy -6.4 -9.4 -5.8 -6.5 -7.0 0.5 3.5 3.0 Growth of consumer prices rate, %yoy (end of the period) 16.9 15.3 15.3 10.9 10.9 7.8 7.5 7.5 Key rate (%, end of the period) 14.0 11.5 11.0 10.5 10.5 8.0 7.5 7.5 62.2 52.7 56.0 60.0 57.7 55.6 57.3 60.0 Raw material prices Urals oil, dollar/barrel Economic activity Inflation Currency rates RUB/USD rate, RUB (average) External sector Capital outflow, bln USD -33 -11 -13 -18.0 -75 -50 -60 -45 Current account positions, bln USD 28.9 19.2 14.5 16.4 79 55.0 61.0 46.0 -9.0 -9.4 -8.4 -9.0 -9.0 -0.0 1.6 1.0 Household income Real average wages, %yoy © Center of Macroeconomic Studies of Sberbank of Russia 17 SBERBANK OF RUSSIA Overview prepared by Yulia Tseplyaeva [email protected] Danir Zulkarnaev [email protected] Aleksey Kiselew [email protected] Konstantin Kozlov [email protected] Kirill Mavrin [email protected] Vasily Nosov [email protected] Aleksandra Filippova [email protected] Nikolay Frolov [email protected] You can direct your questions to the CMS via phone number (495) 747–38–79 or one of the Emails of the overview authors. 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