9 min read

Made ya Luk(ashenka)

Made ya Luk(ashenka)

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Say what you will about the limits of rhetoric or what his largely conservative haters perceive as fecklessness, but the Biden administration's communications about the buildup of Russian troops that could be mobilized for operations in Ukraine sent the Moscow Exchange down 2.16%. Investors still get spooked whenever a US administration raises the specter of further sanctions and policy risks. It's worth flagging, though, that on a capitalization basis, Russia has been outperforming the broader MSCI emerging markets index bigly since last year:

The commodities rally has done the lifting in what's been a novel environment. Some of that can also be chalked up to the stability afforded by the government opting for deflationary policies that benefit asset owners, some can also be chalked up to the specific firms and sectors that have benefited from their ability to borrow using the sovereign to back their credit and operating as oligopolies or quasi-monopolies effectively arbitraging the gap between their export earnings, relatively controlled domestic sales costs, and cheaper inputs. We can see from MOEX's monthly reports that futures activity have rotated from being more heavily weighted towards currency risks earlier in the year when Biden's first sanctions hit and worried people towards commodities and broader indices:

Higher prices power through, stabilize the current account, and also help with the ruble given import demand is lagging now. Blinken's main comment was as follows:

“Our concern is that Russia may make the serious mistake of attempting to rehash what it undertook back in 2014, when it amassed forces along the border, crossed into sovereign Ukrainian territory and did so claiming falsely that it was provoked."

That the market reacted now might also be influenced by events on the Belarus-Poland border, and could also be interpreting wholly unrelated economic data that's just timed to coincide with these comments. But it's noteworthy that investors are watching when prior tough talk didn't really affect stock market capitalizations.

What's going on?

The Chamber of Commerce is looking to help businesses by setting some regulations to control the tax services' ability to use informal discussions and meetings with businesses. President of the chamber, Sergei Katyrin, is fighting the good fight. At present, the tax services can use informal communications to pressure businessowners and negotiate from a position of strength to cow them into paying up what's demanded. At present, tax inspectors send letters to businesses laying out their tax obligations and risks and offering them the chance to come before a commission to voluntarily pay before an on-site inspection is declared. On-site inspections always lead to higher tax bills, but the sums of money extracted at the commissions are high as well. The process is clearly designed to convince businesses they have no way out and no viable means of contesting tax bills, less a problem when you're a large firm with friends and access to ample legal resources but terrible for smaller firms. Businesses end up agreeing to terms that arne't legally required out of panic, fear, or else the desire to get the FNS off their back. So long as there are national goals to increase small and medium-sized businesses' (SME) share of the economy and state procurements, that's untenable. Central Bank financial surveys show that inflows and outflows of money in consumer-facing industries are reflecting the underlying weaknesses we've seen broadly given growth rates, with October-November an important additional data point once that comes through:

Inflows – Dark Blue Bar = quarterly average
Outflows – Dark Blue Bar = quarterly average

Outflows look lower for October and that means lower profits. SMEs in the services sector are probably going to struggle more for 4Q-1Q 2022. What's worse, state company procurements from SMEs have flatlined year on year in nominal ruble terms – 2.8 trillion rubles for 1-3Q 2021 vs. 2.7 trillion rubles for the same period last year. Companies may have pared back spending, but the bigger problem is that a flat change in nominal terms is more akin to a 25% reduction in procurements in real terms because of inflation levels seen in the manufacturing sector. SMEs can't get no respect, to cite the great Rodney Dangerfield. All of this comes on top of a broadly observed deficit of labor across the economy, which almost always disproportionately benefits large firms that have more financial room to adapt wage levels and benefits while maintaining higher margins to retain or attract workers. The tax service is adamant that existing regulations stop excesses from taking place as written into the legal codex, but we all know how informal rules of the game differ widely from what's written on the page. Not much in the pipeline looking positive for SMEs in the year ahead.

The Ministry of Finance has amended the incoming tax hike on the metallurgical sector now working its way through the Duma with an altered approach for electric steel manufacturers. Electric steel is produced to maintain magnetic properties useful for motors, hence why they're used for stators and rotors and why they matter so much for manufacturing when it comes to transport. MinFin doesn't want to exempt them entirely from new excise taxes, but instead work out a separate formula to calculate them for electric steel. The bill already adopted on first reading introduces an excise tax on steel at 2.7% and changes the tax formula applied to iron ore and coking coal, including doubling the "rent" coefficient for several phosphate minerals and an 85 ruble per ton tax levied on potassium for any ore that's mined. Taxes would also not be levied on steel smelted in furnaces with capacities under 1.5 tons and steel used for an enterprise's own needs and a tax deduction be offered for steel sent to be resmelted. Electric steel excises will be calculated at 30% of the difference between export prices for steel billets – as yet unrefined/unshaped bars of steel at the intermediate stage of production – and the price of scrap. Scrap accounts for about 80% of the inputs for electric steel. As usual, the compromise is just as complicated as the original tax change. Something like 14-16 billion rubles of revenues will be foregone vs. 23 billion rubles foregone if the excise was lifted entirely, enough to nudge up capacity investments potentially but that'll hinge on domestic procurements and export demand.

Analytically, these formulas seem to be an increasingly common occurrence in the years ahead. In place of fully rationalized tax systems that are simple, extensive carveouts, concessions, exceptions, and deals will have to be cut sector by sector every time Moscow wants to wring more tax revenues out of non-oil & gas sectors. This isn't to say that these approaches don't make sense – they absolutely do – but rather that they're going to rely on the power of the authorities to effectively match supply, demand, and price information with how they target tax planning in exporting sectors. The same mechanisms used to dictate inflation interventions apply here. While those policy proposals are primarily quotas and tariffs/duties intended to redirect trade flows and affect pricing differentials, excise taxes on the metallurgical sector mirror their logic. All of this is a roundabout way of pointing out, as I have before though without much depth, that the economy is increasingly being governed with a framework intended to manage sectoral balances, stocks of key commodities and/or the attractiveness of exports, and tax takes intended to redirect windfall rents into the hands of the state, a state that has expanded the role and size of subsidies across sectors since 2014. Central planning this ain't, but it's a more recent development that deserves more scrutiny.

The non-working days seemed to have had a bigger effect on the economy than COVID cases. For the first time in two months, Rosstat data recorded a relative slowdown in the rate of price increases for the week. The rate of price increases halved week-on-week to 0.09%. If you're hopeful about the trend, that would push annualized inflation down towards 8.06%:

Some of the slowdown comes from the ruble gaining strength, reducing the relative cost of imports for food in particular. I'm also curious what effects from abroad are visible in the Russian data i.e. Factory gate prices in China are at 26-year highs and half of Japanese firms plan to pass on higher commodity imput prices to consumers. More generally, we should start to see concerns about inflation from consumers in the US and elsewhere affect spending and see a shift in supply chain crunches through the holidays. On the whole, however, these wouldn't have a significant deflationary effect which means that it's likelier the slowdown in Russia has more to do with reduced levels of consumption and more idiosyncratic input price changes – iron ore has fallen 65% on Chinese steel output curbs, which could raise steel prices though Russia doesn't depend on foreign metallurgical imports such that cheaper iron ore more likely lowers domestic prices. If these trends were to continue and price data to enter deflation, it would not indicate a policy success. Rather it'd more likely come with a steady fall in consumer spending and/or purchases and investments across different sectors of the economy. Since the leading causes of price increases in Russia are located in real economy balances, market structures, and exposure to commodity prices, the size of stimulus and other macro measures are poor guides to explain why price levels have risen in the manner they have. Labor shortages will drive up costs for a long time to come and rising interest rates from Central Bank rate hikes will slowly kill investment and consumption. Beating inflation matters a great deal when wages and incomes aren't rising fast enough to match or beat it. Beating it by killing wage, income, and consumption growth, however, tends to just leave everyone worse off than when the crisis started and wipes out a window of time for businesses to lock in investments that would increase productivity and capacity. I'm waiting for next week's print to see if this trend holds or it really is a one-off from people staying home more.

Belarusian president Lukashenka has threatened the EU in his escalating border stand off with the interruption of gas transit via the Yamal pipeline. The pipeline accounts for 32.9 billion cubic meters of export capacity to the EU and anyone reading headlines has seen just how tight the margins are for Europe's natural gas markets at the moment. For now, there's not really a compelling reason to believe the cutoff threat is credible. It would violate commercial agreements Gazprom has signed, affect Russia's budget and balance of payments, and actually give Ukraine and Germany new leverage to demand concessions in exchange for either certifying Nord Stream 2 or else using Ukrainian transit at higher volumes. Rather than being taken as a specific and credible threat, it's a political tool to really emphasize to Moscow how far Lukashenka is willing to take things and also suggests that the window Minsk had to use migrants effectively is closing. Turkey has agreed to monitor flights headed to Belarus after getting pressured by the EU to play this out to its benefit, the Iraqi government has coordinated with its embassy in Moscow to bring asylum seekers back to Iraq, and Polish authorities reportedly stopped two groups of migrants from crossing the border yesterday. Russian paratroopers are apparently now running drills in Belarus which is a low-cost means of signaling Moscow's continued support for Lukashenka even while Putin and Merkel continue phone talks and EU leaders appeal to Russia to intervene. I pulled the Belstat data for Belarus' pre-pandemic growth path to capture just how foolhardy playing with pipelines would be for Lukashenka:

Everything's stagnated since 2014 and the oil tax maneuver Russia has advanced since 2015 has slowly increased the relative refining gate and input costs for petroelum product exports while Minsk remains dependent as ever on low natural gas prices. Even a brief wobble in the reliability of transit would reduce Lukashenka's leverage to ask for more loans or else address pricing needs across the economy. Whatever Moscow's doing to show support, they aren't going to let Lukashenka dictate terms over a leading strategic export like that.

COVID Status Report

40,123 new cases and 1,235 deaths reported today. Any circuitbreaker effect the non-working days have had on case counts has been minimal, only perhaps heading off a higher peak:

Red = Russia Blue = Russia w/o Moscow Black = Moscow

The tables seem to be turning for the public health messaging (a bit at least). Per health minister Mikhail Murashko, 53% of Russians now say they'd want to get vaccinated. Regional hospitals are falling short of medical supplies, however, which goes to show that the current wave is still straining the healthcare system. The gap in case decline in Moscow vs. the rest of the country really captures the problem.

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