Warm, hot, colder

Table 1. Base case scenario of the macroeconomic forecast from 2024 to 2027

¹ Economically active population

KEY ELEMENTS OF THE MEDIUM-TERM FORECAST

The key elements of the base case scenario of ACRA’s updated macroeconomic forecast are:

• Economic growth slowing to 1–2% in 2025–2026 after increasing by just over 3% in 2024;

• Inflation over a two-year horizon gradually declining to a level close to the target;

• Short-term and long-term interest rates falling in 2025–2026 (including the key rate declining to 7–8%);

• Prices of Russian exported goods in foreign currency remaining practically unchanged in nominal terms;

• The ruble weakening against world currencies by 1.5–2% in 2025–2026 in annual average terms and being relatively volatile within the year during the specified period;

• The budget balance remaining negative but approaching the range of -1% to 0% of GDP starting from 2025.

The Russian economy faces many risks, but when formulating the conditions for a macroeconomic forecast, the three qualitative questions discussed below are the most relevant in ACRA’s opinion.

1. How long can the state of economic overheating last? The heating up of domestic demand — its growth outpacing the growth of both capacity and production potential — led to increased tension in the labor market, an acceleration in the rate of wage growth, and stronger inflation dynamics in 2023–2024. The consensus of different forecasts and economic theory state that market forces (as well as monetary policy) are working to overcome such an unstable situation. The question is, how long will this take?

See ACRA’s research from March 5, 2024 Reserves of the Russian Labor Market for more on the condition of the labor market.

Fig. 1 shows the change to the average forecast from the consensus survey of macroeconomists carried out by the Bank of Russia before each scheduled key rate meeting. For example, the first dark green column shows that the forecast for the average annual key rate for 2024 increased by 2.2 pps from January to May.

Figure 1. Changes to macroeconomic forecasts from December 2023 to May 2024*

* Change to key rate expectations: 13.7 -> 15.9 (2024), 8.8 -> 12.5 (2025). For GDP growth: 1.3 -> 2.9 (2024), 1.5 -> 1.8 (2025). For inflation: 7.0 -> 7.1 (2024), 4.4 -> 4.8 (2025). For wages: 8.9 -> 12.3 (2024), 6.7 -> 7.9 (2025).
Sources: Bank of Russia, ACRA

Over the first half of 2024, market expectations regarding the timing of the cooling of the inflationary backdrop and business activity were consistently revised — the start of these processes was postponed. Over the past six months, not only price expectations have increased, but also overall market expectations. Forecasts for real GDP growth for the current year increased by an average of 1.5 pps over the first five months, and for wage growth by 3.3 pps (Fig. 1). Inflation expectations have remained almost unchanged, but the forecasts have logically included a much tighter policy by the Bank of Russia in 2024–2025 (the trajectory of the average annual key rate is 2–3 pps higher than in previous forecasts).

The Bank of Russia, guided by its mandate to control inflation, pushed back 2024 the start date for lowering the key rate, which is used, among other things, as a tool to combat economic overheating. At the previous two meetings (in April and June), the possibility of increasing it was also seriously considered, which led to a noticeable increase in long-term interest rates. And in July, the key rate was increased by 2 pps; it now stands at 18%.

How likely is it that over the next six months to a year forecasts for demand, business activity and prices will again have to be revised upwards (for 2025), followed by interest rates? Is it possible to maintain the current high rates of economic growth in the medium or long term? This is unlikely. In the event of no new external shocks, the growth rate of real GDP will fall in 2024 (growth of 5.4% in Q1 will be replaced by growth of around 2.0–2.5% in Q4², which allows for the possibility of achieving rates comparable to 2023 for the full year), and inflation will also fall, which will allow short-term interest rates to be reduced in 2025.

According to the latest budget plans, the fiscal impulse, one of the current drivers of inflation — will weaken as soon as this year, and as a result, the structural deficit will shrink and real expenditures of the consolidated budget will not grow as much as they did in 2023.  Some preferential lending programs are expected to be curtailed, and the tightening of macroprudential regulations will continue, which will contribute to a cooling of lending overall. In addition, over the past six months, even before the key rate was hiked, monetary conditions tightened — for example, interest rates on medium- and long-term market loans increased. The effect that all these events have on overall demand and inflation is spread out over time, but should become apparent to a significant extent over the next few months rather than years.

² Quarter vs. the corresponding quarter of the previous year.

2. What will be the full impact of the tax reform? Starting from 2025, the personal income tax scale, corporate income tax rate, tax rebates, and simplified taxation system will change in Russia; exchange rate-tied export duties will be cancelled along with an increase in mineral extraction tax on certain types of resources, and some excise taxes will increase. Thanks to these changes, average annual budget revenues will grow by 1.5 pps of GDP, and the redistributive role of budgets will increase. The tax reform will reshape the structure of aggregate demand: from companies and the population toward the state, from a population prone to saving towards a more consumption-oriented population; investment incentives for companies will also change as a result of the tax reform. Therefore, the reform has the potential to influence economic growth and inflation, however, given the multicomponent nature of the changes, this potential is difficult to quantify. At the qualitative level, it can already be concluded that from a macroeconomic point of view, the effect is unlikely to be strong.

Part of the additional budget revenues from the new personal income tax rates will be redistributed, through wages and social programs, and still spent by consumers. There is a pro-inflationary potential in this regard, because, as noted above, money will go to those individuals who have a relatively low propensity to save and, accordingly, a high propensity to consume. On the backdrop of high inflation, this demand may further affect prices. However, in quantitative terms, the effect should be moderate (probably noticeably less than that from the VAT rate increase in 2019). The impact of this component of the reform on GDP will, apparently, also be relatively weak.

Among all the components of the reform, changes in the corporate income tax rate and related deductions have the greatest potential to affect business activity. They directly impact a significant proportion of taxpayers and a broader flow of payments, so these changes will generate around 60% of the expected additional budget revenues. However, the real effect will largely depend on how the federal deduction will be implemented: the impact of an increase in tax rates on business activity is a priori rather negative, but theoretically, the deduction can contribute to a noticeable strengthening of investment incentives and an increase in investment volumes (including government investments), which compensates for this impact. As a result, the total effect on the medium-term GDP dynamics may turn out to be near zero, whereas the long-term GDP dynamics will be determined by which investments are promoted.

For more details on the international context, budget effect and complications of the reform, see ACRA’s research Increasing progression in the Russian tax system from April 25, 2024.

3. Will the conditions for foreign trade and cross-border payments worsen? The latest restrictions imposed by Western countries in June 2024 include a ban on transactions with Russia’s Financial Messaging System, as well as sanctions against the Moscow Exchange (for details, see page 6).

According to ACRA’s estimates, at the macroeconomic level, the main risks associated with these financial constraints are higher transaction costs in international trade. Routes for export and import payments of Russian companies are becoming more complicated and lengthened due to, for example, stricter compliance requirements of banks from friendly countries. One of the main adjustment mechanisms is the search for financial intermediaries who are less vulnerable to so-called secondary sanctions. In 2022, the first sanctions waves unexpectedly launched the adjustment mechanism, and the adjustment took a relatively long time. At that time, not only the intermediaries were changed, but the directions of trade as well. Therefore, the physical volume of trade significantly decreased (by more than 10%, Fig. 3), which led, among other things, to a very strong ruble, since imports were constrained more significantly than exports, and serious barriers arose for outgoing financial flows.

ACRA assumes that the impact potential of the abovementioned new sanctions packages on foreign trade and the exchange rate is not comparable with that of 2022, and their long-term impact potential is very limited.

Figure 2. Physical volumes of foreign trade in goods and services (indexes)

The main risk for the base case scenario, in ACRA’s opinion, is the failure to hit inflation targets on the forecast horizon (for example, in the event that the fiscal impulse grows again, and the tools and speed of monetary measures are not sufficient to compensate for it). The need for an increase in budget expenditures may be caused by contingent liabilities of the government, financial support for the public sector and quasi-public sector companies, and defense industry needs. In these cases, short-term interest rates will be higher than in the base case scenario. For a short period of time, the physical growth of GDP may also be higher. In addition, according to the Agency’s estimates, conditions remain for relatively rapid exchange rate fluctuations in the domestic foreign exchange market (by 5–10%).

Termination of the exchange trade of dollars and euros. context

The ACRA FSI RU assesses the proximity of the Russian financial system to a crisis. The boundary of the system’s transition to a state of crisis is 2.5 points. For details, see the relevant page of ACRA’s website and the Principles of Calculating the ACRA FSI RU.

On June 13, 2024, the Moscow Exchange, which fell under blocking sanctions of Western countries, stopped the trading the US dollar, Hong Kong dollar, and euro. This did not come as a surprise to the financial market and regulators. In the week after the termination of dollar and euro trading, ACRA’s financial stress index grew by fewer than 0.1 points, while the Agency considers changes of more than 0.1 and 0.3 points on the daily and weekly horizons, respectively, to be significant when interpreting its dynamics. 

Figure 3. Share of exchange trade in the internal forex market turnover

In this section, all calculations for Russia are based on data from the Bank of Russia: “Key indicators of foreign exchange market of the Russian Federation (according to BIS methodology)”. Calculations for the world are based on the Triennial Central Bank Survey of foreign exchange and OTC derivatives markets (BIS

The yuan has become the main foreign currency traded on the exchange: in May 2024, it occupied around half of the turnover of the Russian domestic foreign exchange market and little more than 50% of the stock exchange currency market. In the second half of June, its share in the exchange market, according to preliminary estimates, exceeded 95%. The official USD and EUR exchange rates are now set by the Bank of Russia based on its own data about prices in the over-the-counter market. At the same time, indicative market rates for the EUR and USD can be obtained on the basis of the exchange rate of the CNY and cross-rates from other markets, and not only from OTC transaction statistics. This is a less streamlined but more expeditious option for market participants to calculate the exchange rate.

The OTC market provides for the bulk of foreign exchange turnover in Russia. This is true for transactions in currencies and derivatives in most of the world’s local currency markets. In Russia, the exchange accounted for about 30–40% of turnover before 2022 and about 55% after 2022 (see Fig. 3). With the departure of the EUR and the USD from the exchange, the relative role of OTC transactions will increase, and the share of exchange turnover will decrease to 20–25%³. At the same time, ACRA does not expect a significant decrease (by more than 10%) in the turnover of the foreign exchange market for the sum of the segments (exchange and over-the-counter) relative to the indicators at the beginning of 2024. In total, all the instruments of all the segments of the foreign exchange market generated a foreign exchange turnover of about 8x the volume of foreign trade turnover each month, and cash transactions (SPOT, TOM, TOD) — about 4x (Fig. 4). These ratios are likely to remain in the foreseeable future.

³ This forecast is based on the expectations that USD and EUR trade turnover will migrate from the foreign exchange market to OTC market, while the total turnover for all currencies in all segments will decline by no more than 10%.

Figure 4. Total turnover of Russia’s foreign exchange market compared to foreign trade turnover (times of exceedance)

For details on the mandatory sale of foreign currency earnings, see the section “Mandatory sale of foreign currency earnings by exporters. Context” in ACRA’s research Charting a course from November 28, 2023.

The role of non-financial companies in the Russian OTC foreign exchange market is fairly strong. The main players in the OTC foreign exchange markets in different countries are usually commercial banks. The share of interbank foreign exchange turnover generally accounts for 50–75% of the total OTC turnover of currency and currency instruments. Non-financial companies directly generate 5–20% of transactions, being party to foreign exchange transactions (the other party is most often a bank). In Russia, the share of turnover attributable to non-financial companies has grown significantly to more than half since 2022. It remained almost unaffected by the mandatory sale of foreign exchange earnings by exporters introduced at the end of 2023. Apparently, sanctions against the Moscow Exchange and the easing of the currency selling regime will also not affect the importance of non-financial companies for the market, as well as the ways and means of mediation in the foreign exchange market.

The macroeconomic effect of the sanctions imposed on the Moscow Exchange is likely to be insignificant. ACRA does not expect fundamental changes in the equilibrium exchange rate due to the transfer of part of currency trading to the OTC segment. The transaction costs associated with exchange transactions in the entire economy may increase somewhat — both the price of mediation in the foreign exchange market and the spreads between currency offer and bid prices will increase. However, as the new structure of this highly competitive market stabilizes, we can expect them to gradually decline.

The open currency positions that banks have acquired as a result of making payments in rubles on swaps previously traded on the exchange are likely to be closed relatively slowly (possibly, needs regulatory easing). Consequently, closure of these positions will not create liquidity flows able to significantly move the ruble exchange rate in the medium or long term.