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Given recent developments, we have downgraded our economic outlook for Russia. We now expect the Russian economy to grow by only 0.9% in 2014 (revised from 2.1% in the December 2013 forecast) and by 2% in 2015 (revised from 3.2% in the December 2013 forecast). We have also reduced our  longer run economic growth forecasts, implying an average growth rate of 2% over the remainder of this decade. Even this forecast may be too optimistic. We assign around a 30% probability to a recession in 2014. In a slowdown scenario, Russian GDP would contract by 0.2% in 2014. We assign this scenario a 20% probability. In a severe recession scenario, we see Russian GDP declining by 1.2% in 2014 and by a further 3.3% in 2015. We assign this scenario a 10% probability.

Table 1: GDP Growth Forecasts for Russia

201320142015201620172018
Baseline forecast1.30.92.02.82.72.7
Slowdown scenario1.3-0.21.92.82.42.5
Severe recession scenario1.3-1.2-3.33.53.12.5
Previous baseline forecast (Dec 13)1.42.13.23.43.33.3

Source: Euromonitor International Macro Model

Table 2: Inflation Forecasts for Russia

 201320142015201620172018
Baseline forecast6.86.05.85.14.84.6
Slowdown6.85.85.24.84.64.5
Severe recession scenario6.813.49.04.14.04.2
Previous baseline forecast (Dec 13)6.75.85.55.14.84.6

Source: Euromonitor International Macro Model

The Russian Economy Continues to Disappoint

After growing by 1.3% in 2013, the Russian economy slowed even further in the first quarter of 2014. According to the most recent estimates from the Ministry of Economic Development, year-on-year GDP growth was only 0.1% in January and 0.3% in February. Industrial production in February was actually 0.2% lower than one year ago, while retail sales year-on-year  growth decreased to  to 2.4%. The manufacturing purchasing managers‘ index (PMI), a key leading indicator, has remained below 50 for the fourth consecutive month, suggesting a continuing deterioration in business conditions.

Meanwhile, the likelihood of Russia escaping the middle-income trap and attaining the 5% long run growth target of the government has declined. At the end of 2013, Russia’s Ministry of Economic Development revised down average growth rate forecasts to 2030 to 2.5% with a 3.1% average growth rate to 2020, but this is still probably too optimistic. Given the slow progress on various structural reforms we now forecast an average annual growth rate of 2.5% at the end of this decade.

The fear of worsening political tensions and tighter economic sanctions due to the crisis in the Ukraine, the disappointing economic performance  in 2013 and slow growth at the beginning of 2014 have  led to a large increase in uncertainty for businesses and investors. Since the beginning of this year the stock market has already declined by 9% (as of March 31st) and according to the Ministry of Economic Development capital flight so far this year has been US$65-70 billion (already more than in the whole of 2013). As a result of the heightened uncertainty and growing pessimism about the long term economic outlook, fixed investment should continue to decline this year and GDP growth is likely to be around 0.9% in 2014.

The baseline forecast assumes a containment of the crisis to the seccession of Crima from the Ukraine and the continuation of the current modest sanctions. But even under these conditions, it is possible for the combination of increased capital flight and a large uncertainty shock to hit consumer and business spending much more severely, leading to a small recession. In this slowdown scenario GDP would decline by 0.2% in 2014 and grow by 1.9% in 2015.

Figure 1: Alternative Paths for Annual Russian GDP Growth over 2014-2018

Source: Euromonitor International Macro Model

And Tail Risks Have Worsened

In our worst case severe recession scenario, Russian banks and firms are almost completely locked out of international financial markets and credit growth becomes negative. The Rouble depreciates by 15%, and inflation for 2014 increases to 13.4%. The central bank of Russia (CBR) responds with a 7% increase interest rates in the second quarter of 2014. Consumer and business expenditure plummets, and the Russian economy plunges into recession.GDP at the end of 2014 declines by 5.4% year-on-year relative to our baseline forecast. Eventually inflation declines and the CBR  reverses part of its initial interest rate hikes. GDP falls by 1.2% in 2014 and by 3.3% in 2015, before rebounding by 3.5% in 2016 and 3.1% in 2017. In all our scenarios annual growth towards the end of the decade should be around 2.5%, a far cry from earlier hopes that Russia would continue growing at around 4.5%-5% a year.

Figure 2: Effects of a Severe Recession Scenario on Russia

2.1: Year-on-Year GDP Growth in Russia, Difference from Baseline Forecast

2.2: Year-on-Year Inflation in Russia, Difference from Baseline Forecast

2.3: Central Bank of Russia Refinancing Rate, Difference from Baseline Forecast

Source: Euromonitor International Macro Model

Note: difference from baseline forecasts is the scenario forecast minus the baseline forecast.
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