Russia’s GDP may drop moderately by 2.7% in 2015 with crude near $40 per barrel

Having discontinued the government guided exchange rate regime in favor of inflation targeting policy, Russia's Central Bank may change the way crude oil prices influence the dynamics of economy.

With a floating exchange rate and inflation targeting, the effect of long-run fall of crude oil prices on the GDP annual growth rates weakens steadily 2–4 times that with the government guided exchange rate regime. With a floating exchange rate in place, the ruble is facing more rapid devaluation while real wages and prices of domestically manufactured goods are swiftly lowering compared to the global market. As a result, the decline in domestic demand is more reflected in contracted imports than in lower demand for domestically manufactured goods, while exports are growing.
Supposing a scenario with a long-run fall of crude oil prices down to $40 per barrel. The central bank is carrying out a targeting inflation policy in the mid run, allowing for deviations from the target level in the short run. We fed into the model that in response to an oil shock the central bank will temporarily lift the CBR key rate by 5 p.p. (this is the starting point for estimations, we have no intention to describe the central bank's actual policy). A higher increase in the CBR key rate in reality results from response to the ruble depreciation shock driven by not only falling crude prices, but also higher risks of investment in domestic assets and weakened confidence in the ruble.

In the scenario, the fall of crude oil prices leads to a 25% weakening of the ruble exchange rate, ramp-up inflation in the short run. In the mid run, inflation slows down in response to lower growth in prices of domestically manufactured goods (by 2 p.p., but no sooner than in a year). The fall in crude oil prices to $40 per barrel leads to a 3.7% decline in GDP in constant prices, a 14% fall in household consumption, a 33% loss in gross savings (including investment in inventory), a 8% growth in exports.

The structural component of GDP growth has recently slumped to some 1% annually. The sum of falling crude oil prices and potential growth makes a 2.7% lower forecast for GDP. This means that even with a very pessimistic scenario with oil prices down to $40 per barrel, GDP may appear to decline moderately in 2015.

The current situation is distinguished from the crisis 2008–2009 by the decline of physical volumes of exports because of global business contraction and weaker external demand that were seen in the latter case. In the current situation, the fall in crude oil prices is basically driven by increased production and a lower forecast for crude oil demand because of slower growth in the global economy and the replacement of crude oil with alternative sources of energy. However, these factors don't imply lower external demand for domestic goods, except for energy resources. The current crude price shock differs completely in its nature compared to that in 2008, and there is a great potential for increasing physical volumes of exports by virtue of the ruble devaluation.

A depth of economic contraction in 2015 will also be determined by the gravity of adverse effects of geopolitical tensions and economic sanctions. The effects might be severe in the case of decreased exports of hydrocarbons to the European countries decreases, limits on investment financing with foreign capital, a higher premium for the risk of investment in Russian assets, restrictions on imports of technologies, etc., whereas the downturn may be less painful if sanctions are slightly relaxed (or the existing sanctions are not renewed), bypassed by entering new (Asian) commodity markets and capital markets.

To avoid further stagnation in production while potential output growth slows down, more emphasis should be placed on the promotion of supply growth factors, namely improving institutional environment and making the country be more attractive for investment, developing the infrastructure, making markets less monopolized, increasing the mobility of production factors, promoting innovations and enhancing the human capital. An economic policy aimed at promoting aggregate demand will have a very short-term effect and not allow the domestic barriers to be overcome in order to achieve steady economic growth and welfare of economic agents.

Andrey Polbin, a senior researcher

The comments are based on article Денежная политика: Нестрашный спад published in Vedomosti newspaper.