Download PDF: Russia Research 2019
- The Linkage between Oil Price and The Russian Economy
- There is little sign that Russian economy is diversifying from energy production and exports in the last 20 years. The direct link and trickle-down effect of higher/lower oil prices to the economy result in an economy that is highly correlated with the global economic cycle.
- Household and government consumption, comprising 50% and 17% of GDP, are significantly impacted by the movement of oil prices through fluctuation of fiscal revenue and wage growth.
- There is a tendency that in periods of declining oil prices, countries that rely on oil production to support their fiscal revenue will further increase their production to avoid further drastic shock in the government fiscal balance, causing even lower oil prices from the increase in supply. This result in highly volatile economic growth for commodity producer countries, such as Russia
- From production perspective, energy sector accounts for only 10% of Russian GDP. But exports of oil and gas accounts for over 40% of Russian exports. Exports to China, half of which is oil, has been increasing as a share of Russian exports. This reflects the underdeveloped and uncompetitive manufacturing sector, which accounts for only 8% GDP and 14% of total exports.
- Russia has also been strengthening its geopolitical presence through the Nord Stream 2 project that links pipeline from Russia directly to Germany, which has been projected to transport 55 billion cubic meters of gas each year, equivalent to US$ 9 billion in exports or 2% of total exports in 2018. This allows Russia to cut its gas exports through Eastern European countries without angering Germany and French. In 2017, Russia exported 192 billion cubic meters of gas to the EU.
- An oil price war that results in oil price below $40/barrel will be detrimental to the Russian fiscal balance, and as the largest oil exporter in the world, Russia has the incentive to maintain high oil prices.
- It is known that the large footprint of government in the economy usually results in low productivity, low investment and corporate governance issues. IMF estimates the Russian government’s share in the economy to be around 30-35% and greater in the banking and energy sector. The public sector also accounts for 40% of formal sector activity and 50% of formal employment.
- Russian equities have always been cheap post-GFC, due to both geopolitical and governance issue. However, Russian energy sector is increasingly attractive due to its lower valuation and higher profitability compared to world average. Leverage has also decreased significantly from 50% to 30%, in-line with the average energy companies in the world. Higher oil price will be translated to higher EPS and ROE, which should boost the multiple upward. The top 6 largest oil and gas company in Russia accounts for over 90% of the energy sector market cap and is tied to government ownership (Rosneft and Gazprom alone comprise 50% of the sector market cap).
- The Significant Reduction in Russian Risk Profile
- Russian economy is well insulated against external risk as the country became a closed one after rounds of sanction imposed by the U.S. and EU. Deleveraging has occurred throughout banks and the corporate sector in the past three years, especially financing through foreign debt.
- Currently, Russian reserves to foreign debt coverage is above 100%, highlighting the very low risk of BoP crisis in the event of currency depreciation, contrary to its condition in 1999. In fact, among emerging markets countries, Russia is among the top countries with regards to external debt coverage.
- Russian government fiscal has been turning to positive direction as well, running surplus (thanks to high oil price) and shifting its government debt toward Rubble denominated bonds. Government debt is at 11% GDP and only a third of it is denominated in foreign currency.
- On the policy side, Russian government need to increase the coverage of its tax collection to be able to spend on important spending on infrastructure, health and education spending that is projected to be worth 1.1% GDP for the next six years. These spending will be financed through either increase in VAT, savings from pension reform or issuance of debt.
- Russians are also aging rapidly. The need for pension reform is imminent to maintain a healthy fiscal balance. Russia has a new fiscal rule to target zero primary balance by 2019 at benchmark oil price of $40. An excess revenue from oil sales above $40 will be utilized for buying foreign currency and invested in National Welfare Fund.
- Starting in the Q4 2018, investors have also become more constructive on Russian assets: speculative position on the rubble turned to record high and equities are rallying 16% YTD in US$ terms. Property prices and construction activity have also been picking up as of late as a result of a stronger oil prices.
- On the domestic side, inflation starts to roll over due to stronger currency and credit growth is still on the weak side, which should keep monetary policy on the looser side. Historically it has been a bull for Russian government bond.
- Reform in the Russian Banking Sector and Financial Sector Valuation
- The banking sector has become healthier after the bankruptcy of two large private institutions (B&N and Otkritie bank) in 2017. Contrary to common occurrence in emerging markets, Russian state-owned banks have healthier balance sheet than private banks.
- Capital and NPL level are now back to healthy level and the interest rates have been coming down as the whole economy improves and corporate sector debt service ratio decreased from 14% of income in 2015 to 8% currently, which should bode well NPL trend going forward.
- According to the Global Bank Directory, the number of banks in Russia declined from 937 in 2012 to 449 at the end of 2018. With those no complying with the Basel III accord having their license stripped by the Central Bank, weaker institutions closed one by one, leaving the overall banking system safer as a result. The downside is that four of the largest state-owned banks dominates 55% of the banking sector’s total assets.
- Valuation wise, the financial sector is not demanding relative to benchmark, with the Price-to-book value trading at 2015 level although profitability is higher than in the past.
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