11 min read

Wanted: Dish best served cold

Wanted: Dish best served cold

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The European Commission has formally decided that there's no basis to claim Russia is manipulating gas markets. Frans Timmermans went on to note that the Commission has nothing against nuclear power and no intentions to interfere in development of nuclear power based on decisions taken by national governments. The statement will be seen as kowtowing from the anti-Nord Stream mob, but there's no evidentiary basis to reach any other conclusion given the existing regulatory framework and principles of the EU's gas market(s). The latter point may suggest no intentions of fighting further projects by Rosatom at the level of EU institutions, instead allowing national governments to do as they please. Angela Merkel, meeting with Charles V in Madrid, warned that realizing a European green deal will be quite complex because so few people are thinking about the expenditures involved. If only she could have made some sort of choice as chancellor to reduce those long-run costs...

The new EU plan calling for all oil, gas, and coal deposits in the Arctic that haven't been developed to be left in the ground is a canny bit of diplomacy that manages to create a political pressure point with Russia without necessarily requiring any substantive action. If the Kremlin hoped that the surge in natural gas prices and current supply shortfall would lead to some sort of negotiation over the carbon border adjustment mechanism (CBAM), it probably wasn't planning on having its counterparts start hinting at economic policy instruments intended to undermine or halt further Arctic investments on their part in exchange for a focus on hydrogen (where Russia's competitive advantage and earnings will likely be weaker over time). Plus any language saying the EU must be an Arctic player by geopolitical necessity remind Moscow of NATO expansion and the language used to justify intervention or meddling, a point Maria Shagina raised on Twitter this morning responding to Kommersant's writeup of the new strategy document. Two graphics from S&P Global Platts cover the basic justification the EU has given for the need for a plan and the main basins being developed in recent years on the Russian side:

The Arctic is warming 2.5-3 times faster than the global average

Sadly for Russian policymakers, linkage as a negotiating strategy works best on matters of security, not economic ties where even a Europe under considerable energy strain has a far larger toolkit and set of policy options to respond than otherwise expected without ever uttering the dreaded word "sanctions." Even relatively toothless measures can add up to something more substantive in time or else create a diplomatic offramp to allow Moscow to save face but still eat it on stuff like CBAM. Entreaties from MinEkonomiki at G-20 events to use the WTO as a forum to reframe the energy transition in political terms more favorable to it, including the use of carbon offsets that are demonstrably a sham speaks to the short-sightedness of Moscow's policy approach. You can't put sovereignty first and foremost for years and actively try to insulate your economy from external price levels and legal/regulatory influence and then turn around expecting others to join you when it's convenient. MinPromTorg's internal discussions about applying further tariffs on imports of agricultural and industrial machinery as well as passenger planes from the EU as a response to ongoing tariffs on Russian steel seems bound to become a climate-related trade action the longer the tit-for-tat approach to trade continues.

The EU has shown it's willing to bear some of the domestic adjustment pain to maintain what it believes should be a consistent rules-based trading system heavily influenced if not led by its norms. Look at EU ETS carbon prices as the logical step necessary to make a trade adjustment for carbon possible in the first place. As of now, the big fight amongst EU institutions and regulators is whether natural gas can be considered part of the bloc's green finance taxonomy. The soon-to-be coalition leading SPD in Germany wants to include natural gas, anyone remotely hawkish on the energy transition basically wants to ensure its exclusion. Germany's politicians are still the best bet Moscow has at watering down the regulatory pressure to come, but the situation's changed. The energy bridge doesn't look so sturdy these days as a moderating influence on long-run policy. If short, sharp economic contractions create low-base effects down the line in the economy, then political reactions to shocks like an energy supply shortfall create low-base effects that can skew how we analyze post-crisis developments. The German government is reportedly now talking with Moscow about gas transit via Ukraine. Let's see how that goes.


What's going on?

After surging past their usual levels for 2017-2019, imports in September show signs of decline and demand slowdown. Even with seasonal adjustment, seems they peaked earlier in the summer. But this is also where we'd need much finer-grained data to really understand the dynamics at play. The relative cost of machine imports, for instance, was up 36% in year-on-year terms for August. That declined to 19% in September. That indicator, however, is a monetary one. We know the category of import and overall cost, not the physical volume of units that have moved. Here's the visual from Kommersant so you can get an idea of what the surge looks like relative to 2020 and past years:

Dark Blue = actual volume (US$blns) Lighter Blue = seasonally-adjusted volume (US$blns) Beige = growth % (RHS) 

If we game out the timing of the surge, it largely parallels the huge surge in government spending from late last year into this year and then sustains itself through the summer as businesses were spending more and consumers taking out more and more debt to make purchases. My sense is that the US$ volume is hiding some of what that actually looks like. Supply chain squeezes and massive increases in container rates would pass through to the cost of imported goods themselves. Since a lot of price increases are past the 10-15% range, a decent chunk of the growth in monetary terms doesn't necessarily reflect strong domestic fundamentals. It also reflects different dynamics between imports of capital goods for business and consumer goods for household consumption, I just don't have that data handy and need to spend more time thinking that angle through.

Still, it's interesting to see and the timing of the import peak does logically follow from the manufacturing and consumer slowdown of the last few months. The threat of importing inflation is one of the key concerns for the Bank of Russia and other policymakers in government as everyone in Moscow is now finally recognizing a major slowdown in the Russian economy is being worsened by the current COVID wave. Any production outages in China and Europe will lead to large short-run markups in prices for imports as Russian firms have to compete against bidders elsewhere for scarce supply. That goes on for long enough and the risk switches – suddenly we'll be talking about global deflationary risks in 2022 led by China and to a lesser extent Europe dragging down Russian growth since it corresponds so heavily to commodity demand and price levels, though the oil "boost" to growth via transfers seems to max out at just 1.5-2% growth once the oil price breaks $60 a barrel. If the September import decline presages a much steeper drop in October, then the annual GDP growth forecasts for 2021 might have to be revised downwards in current circumstances.

Russia's still facing problems retaining capital that can be invested in development despite the fact that 3Q export earnings reached $148 billion, nearly matching 2011-2013 highs despite oil standing at $20+ fewer a barrel than in those years. At the end of September, currency reserves reached $614 billion, equivalent to 40% of GDP. Thanks to BOFIT for this chart (and roundup) showing the problem of outflows is getting worse as things improve on the export side:

There's a lot to unpack as to why capital always leaves Russia in greater volumes when times are ostensibly better. My view is that it ultimately comes back to the institutional factor – anyone who can do it wants their money out of the regime's reach – on top of the business factor – foreign firms are shifting profits out – and finally the macroeconomic factor since the record earnings are primarily a windfall for exporters and domestic consumption is too weak. The fact that fixed investment surged upwards past 2011-2013 peaks but is now falling back to earth, I think, supports the assumption that there's a relatively hard ceiling on investment levels without rising real incomes and domestic demand. Setting aside the macroeconomic mismanagement of the shock and refusal to deploy more reserves as a savings transfer from the state, excess mortality is probably an important culprit in the demand-side of the equation as well given a) Russians of younger ages than their OECD counterparts have faced higher mortality risks due to health complications since the pandemic began b) older family members relying on fixed incomes/social transfers or else with savings and property would disrupt some family expenditures and inter-generational transfers c) you'd have increased medical costs and social care costs for anyone seriously ill over a longer-period of time, including more time off work given Russian workplace norms d) the composition of consumption for durable goods and services varies somewhat with age as well:

This excess mortality captures daily deviation from prior forecasts at each day for which data is available

These are calculated per million people. The relative death level in Russia is on pace to reach 3 times that in the US at the current rate of increases, though it may stall out before that and the US is starting to rise again. Today was the first time for the pandemic that over 32,000 cases in Russia were officially recorded. So domestic demand is getting rocked by COVID (still), the attempts to ease labor shortages by granting rights to 300,000+ migrants is a start but far short of the scale of needs from what I've seen, and the current commodity price rally threatens deflation next year. Little point in sticking it out for the long-haul to invest more in Russia when you can get your money out while the getting's good.

According to presidential aide Anatoly Yanovsky, record high coal prices won't ease until spring 2022. Despite prices now sitting at or above $200 a ton, the government expects coal exports to rise just 6% to about 225 million tons for 2021.  Turns out it's another story about inadequate infrastructure investment and supply chain bottlenecks. Coal miners in the Kuzbas are currently sitting on 16 million tons of coal in storage worth $3-4 billion and they can't move more product because Russian Railways lacks capacity. West-bound coal exports rose 12% to 66 million tons for Jan.-Sept. this year, largely a function of greater capacity to handle it via multiple ports and rail routes once supplies leave Siberia thus allowing them to compete with seaborne flows from other exporters. Current spending plans for capacity expansion from 2019-2024 come out to about 673 billion rubles overall in spending, a figure that looks all the worse when you consider that the company's net profits most years recently range from 0 rubles to about 20 billion rubles. In other words, only a large expansion of borrowing, large increases in tariff rates, or else a large increase in federal expenditure could have alleviated the financial constraints on necessary upgrades. Underspending on infrastructure then creates a bottleneck leading to a drag effect on growth and future investment.

Vita Spivak wrote a good overview of the paradoxes of the energy shortage and China's energy needs for Carnegie that captures the contradictions of trying to move to green energy sources. But while her argument rests on Russia's coal export strategy as sound economic policy, the truth seems a bit more muddled (though I don't want to ignore the fact that there are plenty of smart people in the policy world in Russia who saw this kind of problem coming). Even if we assume that trying to increase coal exports is more sound economic policy than the inertia of the regime depending on those votes and protecting business interests, that they can't actually do so effectively in a crisis environment on the market now is reflects the inadequate resources and attention paid to public goods and infrastructure development over the last decade. This then creates a persistent issue of timing – if the surge in demand can't be met now, then not only do Russian producers lose out but they can't plan investments to sustain higher export levels effectively per existing plans. In short, a failure to spend more earlier makes it harder to realize marginal gains in terms of market share later. What's so strange is that the regime's relied on an export-led growth model for two decades, yet doesn't seem to understand just how much greater the fiscal multipliers are for the Russian economy when it comes to spending a lot more building this stuff, and in turn creating more resources and revenues to transfer to the defense sector. But it's too late to learn that lesson, at least based on the current macro framework.

MinEnergo now wants to extend the modernization program for thermal power plants past its original 2031 planning horizon. The rework will also place more emphasis on building out cogerenation of heat and electricity where possible as well as combined cycle gas with steam turbines at 50-55% efficiency levels. Under existing guidelines, investors are guaranteed 14% annually return on investment covered by rising energy tariffs – the approach is supposed to drawn in about 1.9 trillion rubles ($26.69 billion) with the aim of modernizing 41 GW of power generating capacity. The ministry is adamant that continued investment into traditional power generating capacity will be necessary to meet Russia's 2060 carbon neutrality goal, and thus modernization will become the infrastructure week of the Russian energy sector until it materially improves and accelerates. Gas remains at the heart of the national energy mix, and that also means that changes for Gazprom's ability to generate significant export earnings in the future will weigh on the ability to manage domestic price levels without risking any investment shortfalls as a result of lower profits. For me, that's the biggest question mark coming out of the current energy crisis in Europe and China and it's the problem Moscow will have to resolve in the next 5-10 years in the form of further market liberalization or else finding other future sources of transfers to the gas sector.


A Note on the EAEU

Russia and Belarus apparently intend to create a truly joint customs system that not only integrates and harmonizes all relevant regulatory/trade practices, but unifies the use of risk indicators for individual goods or classes of goods to increase transparency and track product flows. It comes as Putin as proposed that EAEU members use a unified system of carbon emissions accounting to ease the planning process for net zero and cross-border investment for firms exposed to external risks such as the EU's carbon border adjustment mechanism (CBAM). Most people love to hate the EAEU as inefficient, unwieldy, and far too cosmetic a forum. However, I do think this will be an area where it may serve a useful coordinating role in a hub-and-spoke model: Moscow will adjust to EU demands (and China if they ever get as aggressive) and then disseminate those standards and concerns to other member states over time. Since hydrocarbon rents and the economic activity they support cross borders in many ways across Eurasia, to me it seems inevitable that some sort of franework agreement will be necessary so long as countries running trade surpluses with Europe and/or China feel it's important to maintain their images, access to western capital, and ability to buy influence for other more salient personal and elite agendas. Oh, and then of course for the sake of their countries' respective economic development.


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