Russia's new model for economic consequences of oil prices

Nov 28, 2001 01:00 AM

by Ben Aris

The per-barrel price of Brent crude dropped out of the OPEC price band and hit $ 18.75 on Monday, November 26, following Russia's promise of a meagre production cut of 50,000 bpd. It is not likely to return to the cartel's preferred price range any time soon.
OPEC has started a price war it can't win. It said that it would not make a proposed 1.5 mm-bpd production cut to bolster prices unless non-members -- namely Norway, Mexico and Russia -- matched it with a cut of their own of at least 500,000 bpd. Norway and Mexico both came on board and announced cuts, but Russia held out, barely upping its previous offer of a 30,000 bpd cut to 50,000 bpd -- still well short of the 100,000-150,000 bpd it would have to cut to keep OPEC happy.

Why is Russia being so stubborn? Isn't it in Moscow's interests to cut production and boost prices? According to an economic model of the Russian economy developed by the Ministry of Economic Development and Trade (EDT) and showcased, Russia needs lower prices. Economists waded through the ministry's numbers on November 26, when the plan was presented at a joint presentation with a TACIS economics team that worked with the EDT to develop the model.
The received wisdom is that President Vladimir Putin wants to up production in order to earn the same amount of cash from lower prices and so break Russia's addiction to oil exports. Russia remains vulnerable to the vagrancies of the international commodity markets.
In the shorter term, bringing Brent crude prices down into the Russian government's stated band of $ 18-25 per barrel actually delivers economic benefits. High prices hurt the economy more than they help. This seems contradictory. Common sense suggests that the higher the oil price the richer Russia ought to be. According to the EDT's model, however, common sense doesn't work in this case.

The problem is the shoddy state of the Russian economy. In a well-developed economy, bringing in more money can fuel consumption and spur production. But in the creaking Russian economy, there are not enough working factories to meet additional demand. If the amount of money in the economy rises, all that happens is that the slack is taken up by imports and money printed to soak up the incoming petrodollars, a situation that stokes inflation.
There are two ways to grow the Russian economy: Making more cash available, meaning there is more money to spend and invest; or depreciating the rouble, which means that the dollar consumers have will buy more. The question is which of these two methods is better. For those who live in stable economies, the knee-jerk answer is that more money is better, but the EDT's model shows that the opposite is true for Russia.
The first scenario took note of the fact that a hypothetical $ 1 increase in the per-barrel price of oil would cause Russia's export revenues to jump by $ 2.4 bn, which in turn increases tax revenues, private investment and consumption. However, such increases are easily offset by increases in inflation and the rapid appreciation of the rouble (both poison to Russian enterprises), leading in turn to a fall in exports and a rise in imports in real terms. The upshot is no net increase in real GDP if oil prices rise.

In the second scenario, the model was run with a hypothetical 1 % devaluation of the rouble. Exports increased again, but by a much more modest $ 400 mm, and again tax revenues, private investment and consumption all rose -- albeit less than in the scenario of rising oil prices. But the crucial difference is that this time, imports fell and exports rose in real terms instead of the other way around, as was the case with rising oil prices. And the upshot was that the real GDP looked set to increase by 0.3 %.
These calculations assume that oil prices and the rouble's value are independent of each other, which is not the case. Thanks to the requirement that Russian companies sell $ 0.50 of every $ 1 they earn from exports to the Central Bank of Russia (CBR), the more oil Russia companies export the higher inflation is -- since the bank prints more roubles to soak up the incoming dollar.
The CBR could choose not to buy the incoming petrodollars and let the rouble depreciate, but so far it has chosen not to do this. Instead, it buys the dollars and builds up the country's hard-currency reserves and tries to hold down inflation in other ways.

The EDT forced a plan on the CBR earlier this year to phase out the mandatory surrender requirement by 2004, but the ministry still has no control over the bank's monetary policy. In the meantime, it is trying to hold down enterprise-suffocating inflation by freezing tariff increases, which by themselves account for at least a quarter of inflation. Taken literally, the model suggests that the lower oil prices fall, the better. But there is a natural cut-off point to how low prices can go.
Thanks to strong oil exports, Russia's current account was running at $ 46 bn in 2000 (and will probably stand at about $ 40 bn this year). Taking out between $ 8 bn and $ 12 bn in capital flight that is impossible to stop and another $ 7 bn and $ 10 bn in debt servicing leaves about $ 20 bn in spare cash, much of which is being pumped into the economy by the CBR.
Given that a $ 1 drop in oil prices will wipe out about $ 2 bn worth of export revenues, oil prices could fall to around $ 13 a barrel before Russia runs out of money in the current account to meet these payments. Then and only then would there be a crisis.

There are still serious flaws with the EDT's model, which is only in its first iteration. It assumes that as oil prices fall, the behaviour of both government and business will remain the same, which clearly wouldn't be the case. It ignores the problem posed by the fact that while tax revenues rise in real terms they still fall in nominal terms, which means that nominal spending has to be cut -- a politically painful thing, as recent Duma debates have shown. And it ignores the fact that the extra money flowing in will be invested and eventually remove the supply restraints that cause the rapid rise in imports and inflation as soon as petrodollars arrive.
However, it does highlight a general principle: Given the current difficulties Russia has constraining inflation, which is threatening to stem the nascent trend toward economic growth, Russia would like to see oil prices come down a bit. After the meeting, Arkady Dvorkovich, the deputy head of the EDT, confirmed this. He said: "We believe that the [OPEC] price band of $ 22-28 is too high, and we would rather see prices in a band of $ 18-25."

Under international pressure to cut oil production, Russia has agreed to trim output. However, it is unlikely to cut production further as the whole point of the exercise is to re-calibrate the oil price band a couple of notches lower.
There is not much that OPEC can do about Russia's intransigence. Even if the cartel unilaterally cuts production in the hope of boosting prices, it will end up watching non-OPEC countries step inwith production hikes to make up the difference. At some point the non-member countries will hit their production ceilings, but taking the fight to this extreme will be extremely painful for OPEC.
Russia still has some way to go before it finds its ceiling. In peak years during the Soviet period, Russia produced about 9 mm bpd compared to the 7 mm bpd it produces today (of which only about 3 mm bpd are actually exported). Following the fall of the Soviet Union, OPEC stepped in to take up the slack -- and Russia is now reclaiming that slack.

The game has changed. As OPEC hegemony over oil production is broken -- or at least weakened -- the cartel will no longer be able to manipulate prices to support its members' economies to the extent it has done in the past. Its only solution is take some of Russia's medicine and restructure its members' economies -- and break its own addiction to high oil prices.

Source: NewsBase
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