In Focus: Russia Treasury Research Group For private circulation only. Russia: A slow and gradual recovery. April 11, 2018

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1 Russia: A slow and gradual recovery In Focus: Russia Treasury Research Group For private circulation only Chart 1: Retail sales data shows that the economy is rebounding Source: Bloomberg; ICICI Bank research Chart 2: GDP growth seen picking up April 11, 2018 Shivom Chakravorthy shivom.chakravarti@icicibank.com Yash Panjrath yash.panjrath@icicibank.com Ashray Ohri ashray ohri@icicibank.com Please see important disclaimer at the end of this report Even as the sanctions could hit export performance, we do not expect a recession as private demand is likely to remain firm Even though inflation pressures are likely to remain subdued over 2018, the Central Bank of Russia is likely to maintain status quo on concerns about the exchange rate and as output gaps are likely to close slowly over While the Russian fiscal position could improve, the government sector is expected to remain a drag for a growth stand-point We expect the USD/RUB pair moving towards the range by end-2018 In short, the sanctions are likely to reduce growth via lower exports but not derail the recovery underway Growth: An improvement but downside risks have intensified After a weak end to 2017, there were some encouraging signs that the Russian economy was finally turning a corner from the sharp downturn in 2014 that was driven by a combination of sanctions and softness in crude oil prices. Most of the leading indicators that printed in early 2018 such as industrial production, retail lending and rising real wages showed that the economy was rebounding. Our base-case scenario is for growth to pick-up over 2018 driven by stronger private consumption, investments and a possible improvement in export performance. However, downside risks have only increased as the sanctions could curtail export performance. In short, we expect the economy to grow from 1.5% in 2017 to 1.8% in 2018 and 1.9% in The output gap is likely to narrow gradually with the potential rate of growth estimated to be around 1.5%-2%. We watch the performance of leading indicators to see whether the sanctions have had a more adverse impact on growth than we are expecting, particularly on export performance. Were these set of indicators to soften considerably, we could consider revising our growth projections lower. Inflation: to remain low in 2018 but pick-up in 2019 The most recent CPI inflation print for February came in at 2.2% that was well below the central bank s 4% target. A main contributor towards softer inflation prints in recent times has the food price trajectory. Food prices have moderated driven by a combination of investments in agriculture, an increase in its productive capacity and reduce dependence on weather conditions had a restraining influence on food price growth. We expect the subdued level of inflation to persist over most of 2018 with a very gradual uptrend in Q driven by improving private demand and the lagged effect of exchange rate depreciation. In 2019, the uptrend is likely to persist as the output gap narrows. The Central Bank of Russia (CBR) forecasts annual inflation to be in the 3% to 4% range in 2018 and close to 4% in If exchange rate depreciation persists for a prolonged period of time, we see upside risks to these inflation projections. Monetary Policy: Weakness in the exchange rate to result in status quo The (CBR) lowered its benchmark one-week repo rate by 25 basis points to 7.25% on 23 rd March, marking the fifth consecutive cut, citing sustainably low inflation. The bank said it will continue to reduce the key rate, in order to complete the transition to neutral monetary policy this year. Going forward, the CBR has to balance the risk of lower inflation and currency depreciation that might result in an increase in imported inflation pressures. Given that the growth is likely to improve and the exchange rate is likely to remain under pressure, we expect the CBR to remain on hold in 1H2018. The CBR might consider cutting rates in 2H2018 to provide a boost to growth if and only if the exchange shows signs of stabilizing.

2 Chart 3: Inflation within central bank s target range Chart 4: Ruble s biggest single day fall in two-years after sanctions Chart 5: Aluminum prices at a ten-week high Fiscal Policy: An improvement in store In the first eight months of 2017, the general government fiscal stance improved, helped by higher revenues and tight expenditures. The Russian Government adhered to a path of fiscal consolidation and introduced a new fiscal rule that is expected to smoothen the influence of external volatility on the budget and the real exchange rate. The rule comes into effect in 2019 and will require fiscal consolidation over However, the proposals of fiscal consolidation will likely work in ensuring that the government sector is a drag on the economy. Public investment in several big infrastructure projects is expected to decelerate in This is one key reason why we do not expect run-away growth. Sanctions: What was announced? On 6-April-2018, the US Treasury Department imposed a new set of sanctions on seven of Russia s richest men and 17 top government officials for suspected intervention of Russia in the US presidential elections that were held in Effectively, the action prevents the oligarchs from traveling to the United States or doing business or even opening a bank account with any major company or bank in the US. It also restricts foreign individuals from facilitating transactions on their behalf. Additionally, non-u.s. persons could face sanctions for knowingly facilitating significant transactions for or on behalf of the individuals or entities blocked. The U.S. also froze assets from these entities that were under U.S. jurisdiction. Market implications of the sanctions: The local effect: The first round impact is likely to be that exports to the US and to other trading partners are likely to be hit. The sanctions imposed has a disproportional impact on the aluminum sector and the banking sector. One offset is that Russian households have become much less sensitive to currency swings in the last five years. Thus the sanctions are unlikely to derail growth prospects. While the effect of the sanctions on consumption might be limited, Russian assets the RUB and the local stock market could face additional pressure as investors assess the damage to the economy from the sanctions. The USD/RUB pair moved higher by close to 3.5% in an immediate response to the sanction and we expect a further uptrend over the course of We see the pair moving up towards the range by end The Russian Ministry of Finance does have substantial forex reserves that it will use from time to time to curtail volatility and plug the possibility of sharp disorderly depreciation. The global effect: The sanctions that ban US firms in dealing with certain specific Russian companies, includes the United Company Rusal (UCR). The ban on UCR that produces around 6 percent of the world s aluminum and accounts for 14% of the supply outside the top producer China is likely to create disruptions to supply. Going forward, the London metal exchange will be suspending UCR s aluminum from its list of approved brand from April 17 th until further notice. According to the exchange, UCR roughly contributes 36% of the total aluminum stock in the LME warehouse and a fall in these levels could further add pressure on prices ahead. Aluminum prices have been rising sharply following the US sanctions imposed on select Russian officials and their entities on 6 th April Aluminum prices in the LME rose to a 10 week high of USD 2245/tonne and has risen by 11.2% in the past 3 trading sessions. Developments in this space will be crucial in determining the trajectory of aluminium prices going ahead. 2

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