And informed, exhaustive and sober look at the state of Russia's economy and finances and their likely trajectory in 2016

Originally appeared at bne IntelliNews

However, the structure of the budget is also a bet. The military spending is a drain on the economy that cant be sustained for more than a year without change. Likewise, the enshrining of a 3% deficit and the reluctance to increase taxes or reduce subsidies to state-owned enterprises means the government is hoping that oil will recover to an average of $50 in 2016.

If it doesn't (as appears increasingly likely at the time of writing) then more cuts can be made, but this will hurt the blue-collar workers most, which are Putin's core constituency, and comes at a political cost the Kremlin is unwilling to pay at the moment.

The parliamentary elections in 2016 and presidential elections in 2018 are already looming over the agenda and the goal is to get passed these two milestones with as few changes to the current set-up as possible. Only after 2018 is the prospect of radical change and reform possible.

For investors this means there are investment opportunities in the bond market, which has been an outperformer in 2015 thanks to the belief that the high-water mark of the political clash with the West over Ukraine has passed.

A more stable political situation will also improve the equity story, mainly because Russian stocks are so cheap, even by its own low standards. The beneficial effects of steep ruble devaluation in December 2014 are working their way through into some sectors. Many raw material producers with costs in rubles and revenues in dollars have already been winners.

Agriculture has also been a stellar story in 2015 and will continue to improve in 2016. And the crunch is forcing a rapid consolidation in organised retail and banking in particular; the Central Bank of Russia (CBR) closed a record 100 banks in 2015 and will continue until it has reduced the number from the current 700 odd to around 300.

Economic Outlook

The economic outlook in 2016 will be largely determined by what happens to two factors: can the CBR cut rates down into single digits, which is a function of what will happen with inflation, and where will oil prices settle?

While there are grounds for optimism on the first score – largely because inflation was falling steadily in the second half of 2015 (and may be overestimated – see section) – there is less grounds for optimism on the second score, after OPEC effectively abandoned its production quotas in December 2015.

Having said 2016 will almost certainly be better than 2015, as the economy appears to have bottomed out in the summer of 2015 and while no one is expecting strong growth in 2016 - the estimates range from -0.7% to the most optimistic forecast from Sberbank of 2.5% - growth is expected to build as the year wears on.

In addition to the economic variables, the other big uncertainty is politics. There has always been a specific "Russia risk" to investing here, but this political factor has taken on global proportions since the conflict with Ukraine started and more recently the military campaign in Syria. This factor is entirely unpredictable.

On the one side is the implacable opposition of the United States to President Vladimir Putin and Russia's attempt to increase its say at the geopolitical high table. On the other is European business's desire to trade with Russia and their countries' dependence on Russian energy and raw material exports.

However, the biggest change to doing business in Russia is the apparent new policy of the government to keep the ruble weak and so encourage the development of local production. Russian wages are now already less than Chinese wages and a start to import substitution has been made (most noticeably in cheese production). But the jury remains out on the question whether a weak ruble will be enough to counteract the endemic problems of corruption, red tape and aged infrastructure.

In the medium-term, business should win out over politics as money speaks louder than guns. But the path between here and there is fraught with problems, none of which will necessarily be solved quickly or easily. In the meantime, sanctions on Russia will remain in place and coupled with low oil prices this will have a negative impact on Russia's development. Politics means things could get worse even if the underlying economics are improving.

Sanctions Outlook

At the end of 2015, it was clear that sanctions against Russia will be extended by at least another six months. Despite some opposition from Italy, Luxembourg and some other EU members, ambassadors representing the 28 EU states decided on December 18 to prolong the measures from January for six months for Russia's support of the pro-Moscow separatist conflict in Ukraine's eastern Donbas region.

EU sanctions automatically expire after the end of each six months, but for them to be lifted the Minsk II accord has to be fulfilled. This requires several steps to be taken by both sides. At the time of writing, Ukraine had failed to meet many of the conditions including: given general amnesty to rebels fighting in Donbas and to change the constitution to give the region "special status".

For their part, Russia has not withdrawn its support for rebels nor removed its military personnel "holidaying" in the region. It is unlikely to do so until Kyiv meets its obligations, which are politically difficult for Ukraine's embattled President Petro Poroshenko to fulfil. The upshot is a stalemate that will continue for the foreseeable future.

Putin was hoping that his "pivot to Syria" by launching airstrikes there would do more to break the EU-US resolve in perpetuating sanctions. While the launch of military operations in the Middle East has introduced cracks in the alliance – noticeably France has also called for closer cooperation with Russia – these have not been sufficient to break EU unity.

Putin is now faced with a problem in that Russia cannot afford an extended military campaign in a foreign country that is costing $3mn a day. That is probably the US strategy: "Go ahead, knock yourself out. We can wait."

Still, the sanctions regime could be lifted in 2016 due to the resistance by Italy and several other southern European states to its continuation. Russia's economy is now large enough that the economic pain it is suffering is infecting the rest of Europe.

The measures and Russia's retaliatory ban on EU food has hit European businesses hard. Farming groups say the two-way sanctions led to the loss of some €5.5bn of agri-food exports. The European Commission offered a €500mn relief package in September as protests against continuing the sanctions grew, but farmers said the package was not enough.

Italy's position on delaying the vote on extending sanctions was supported by Luxembourge, Hungary, Greece, Cyprus and several other countries. Poland, the Baltic states, and some other Eastern European nations have been implacable and remain firmly against lifting the sanctions.

#GDP

• Outlook: first half tough, second half better

The outlook for growth in 2016 is confused as it depends heavily on oil prices, which are in a period of flux. International financial institutions (IFIs) are almost universally predicting another year of recession with a 0.7% contraction.

The government's official position is more optimistic, based on its assumption of an average oil price of $50 in 2016, forecasting 0.7% of growth. Putin added at his annual press conference in December that he is expecting growth of 1.9% in 2017 and 2.4% in 2018 based on $50 oil. But he also conceded that a review of the budget was likely due to over-optimism on the oil price.

However, there is more upside than downside this year. The most optimistic is Sberbank's chief economist Evgeny Gavrilenkov, who says several surprises could produce 2.5% of growth in 2016. The main factors are based on consumer deleveraging coming to an end; if borrowing restarts, that will drive consumption faster than expected (many Russian banks are forecasting 0% growth in the retail sector). And Gavrilenkov believes inflation is overstated, so once the CBR switches to a new basket in January, inflation will fall fast, allowing rapid cuts that will in turn lead to more corporate borrowing and growth.

Goldman Sachs also has a rosy prediction, as it believes Russia could see the biggest disinflation of all the emerging markets, with inflation falling from 15.6% at the end of 2015 to only 4% a year later with 500bp interest rate cuts to an overnight rate of 6%. If this holds true, then Russia could bounce back strongly.

• Recession is over!

"The recession is over!" declared Minister of Economic Development Alexei Ulyukayev in November. Whichever scenario manifests itself, the economy probably passed bottom in the middle of 2015 with a 4.1% y/y contraction in the third quarter of 2015 before ending the year with an estimated 3.7% y/y contraction.

More economists were coming round to the official prediction of growth at the end of 2015. Fitch Ratings expects the Russian economy to stabilise in 2016, forecasting 0.5% growth after an expected contraction of 4% in 2015, the agency said in its "2016 Outlook: Emerging Europe Sovereigns" report published on December 14. "The whole of Emerging Europe will benefit from a stabilisation in the Russian economy and stronger growth prospects in central and eastern Europe (CEE) in 2016, although political, policy and external challenges remain," Fitch says in the report.

That still doesn't mean 2016 will be a return to any sort of "feel good" factor. Alfa Bank's predictions for the main parameters are typical and make for fairly gloomy reading.

• #Oil prices

Oil prices dynamics remains the wild card and fell to a seven-year low in the middle of December, crashing through the psychologically important $40 mark. Russia has enough reserves to weather $50 oil for several years, but analysts were starting to ask if Putin can maintain his "fortress Russia" stance with oil under $40, which will play havoc with the budget and exhaust Russia's considerable reserves very quickly.

The 2016 budget assumes a price of $50, and the Ministry of Economic Development is predicting oil could return to $65 by the end of 2016. That would be a comfortable level, as following the devaluation of the ruble the break-even price of oil for the budget dropped from $115 to about $70.

However, at the start of December, Opec failed to agree on an oil production ceiling for the group, which means that producers will probably pump as much oil as they can to make up for revenue lost from the low prices. Russia has already been playing this game for most of 2015.

A significant gap still exists between production and demand, not helped by global soggy growth, especially in China. Opec says it expects demand to increase in the second half of 2016 as most markets recover, but as previous years have shown, even making six-month forecasts has been a largely fruitless occupation.

Russian Finance Minister Anton Siluanov warned on December 12 that Russia should be prepared for the price of oil in 2016 to dip below $30 per barrel. "The International Monetary Fund has downgraded the forecast of the world economy for the fourth time over the last year, this suggests that the demand for oil will also fall," Siluanov said.

"We are seeing now the large volumes of oil reserves and will see the large oil output from the new players in the next year – I mean Iran with 1.0mn-1.5mn barrels per day – all this suggests that the low oil prices will dominate next year … There is no defined [oil production] policy among OPEC countries, everyone works for himself, everyone fights for markets, and it leads to a further decline in oil prices."

• Russia's consumption growth model is exhausted

In previous years, Russia had domestic consumption to fall back on to bolster growth. But falling real incomes already led to retail turnover contracting more quickly than other parts of the economy. This is a trend that is likely to continue, unless there is a recovery in consumer borrowing (see below).

Russia's 2000-2008 consumption growth boom was based on income growth of about 10% a year in real terms – far ahead of both inflation and productivity gains, and super-charged by retail lending. But that came at the expense of squeezing corporate profits and companies have run out of space to keep increasing pay at above-inflation rates.

A variety of factors is weighing on consumption. Inflation is high (albeit falling slowly), held up specifically by sanctions-induced high food prices.

Real income growth has reversed and gone into the red (see section), which has depressed retail shopping and undermined that growth driver. The combination of high food prices and falling income means the share of food in the average shopping basket has risen from a low of 25% in 2007 to 50-55% in 2015, according to VTB Capital.

These trends are likely to persist in 2016, all else being equal.

• Hope for return of consumer borrowing in 2016

That said, the massive deleveraging amongst consumers, who were so over-borrowed in 2014 that it forced the CBR to hike prudential rules to cool lending, has probably come to an end and should lead to some recovery in borrowing in 2016.

The CBR cracked down on retail borrowing several years ago to nip a consumer borrowing bubble in the bud. That led to a massive deleveraging by the population which is now coming to an end.

According to Sberbank, the level of consumer indebtedness is now less than at the start of the bubble and borrowing could restart in the New Year, supporting retail trade. That has opened up the possibility of a resumption of borrowing in 2016 and better-than-expected retail numbers.

"It is likely that at some point next year, deleveraging will stop and households will start to borrow again, but at a lower rate," Sberbank's chief economist Gavrilenkov said in a note in November. "The debt servicing burden on households will diminish in 2016 (regardless of the scenario, our base case assumes 12% nominal wage growth, our higher and lower cases assume 17% and 0%, respectively)."

The size of this effect will depend on how fast the CBR can continue its policy of cutting interest rates. "The CBR could easily cut its key policy rate by at least 300bp between now and year end. Whether the regulator will slash rates further will depend on actual inflation in 2016," Gavrilenkov added.

At the end of 2015, commercial bank rates for consumer loans were exceptionally high: around 26% for loans up to a year and 19% for loans longer than that, including mortgages.

The consumer debt/GDP ratio reached just 15% in 2014 and fell to around 14% in 2015, which is low by international standards. This will rise going forward, but only if the CBR can radically reduce inflation and cut rates.

• Productivity is improving

Another slow-moving driver that underpins growth is Russia's ongoing improvement in labour productivity. Russia remains the least productive country in Europe; its productivity is half the European average and below even the embattled Greek level.

However, the slowdown of 2015 has refocused Russia's leading companies from growth and grabbing market share, to cutting costs and improving profits by being more productive.

Russian productivity gains passed their Soviet peak in 2003 and have grown steadily since then, largely unperturbed by the various crises in between. Currently, Russia's productivity is at an all-time high and continues to grow at twice the rate of the rest of Europe, according to the Vienna Institute for International Economic Research (WIIW).

If the government follows through on any of its promises for structural reforms, then significant growth could come from simply improving the way companies work, without investing a kopeck: various studies from McKinsey & Co and the World Bank concluded that Russia's economy could double in size just from bringing a relatively small share of workers up to international productivity standards or better management techniques.

While a revolution in productivity is highly unlikely (the government has consistently failed to deliver on structural reforms for two decades and there is no reason to expect anything else in 2016), the organic improvement in productivity driven by progressive sectors like telecommunications and mass retail means Russia's growth is more robust than first seems and so less dependent on external factors; indeed, the worse the headlines get, the more focused on productivity gains Russian companies are.

#REFORMS

The Kremlin is fully focused on modernising the military and so little or no attention is being paid to deep structural reforms to the economy. Instead, the government is tinkering with the tax system to squeeze more cash out of the budget and that will have an indirect effect on inefficient companies and regions as subsidies become smaller and harder to get.

Given the political calendar of elections in 2016 and 2018, don't expect any major economic reform initiatives to start until after then.

#BUDGET POLICY & DEFICITS

Is the Russian 2016 budget wildly over optimistic about conditions in the upcoming year?

In December, the Duma approved a budget that assumes $50 oil and a modest 3% deficit at most. However, on the same day, Opec announced it was abandoning production ceilings and within a week oil was trading below $40.

Another crucial assumption in the budget is that a third (32%) of spending will go to the military with few cuts (and $1.2bn for the Syria campaign). The other really big spending item is the 27.6% that will go on social payments, which apart from a lowering of the index rate for pensioners to 4%, way below inflation, also remains largely untouched. Spending under the heading of 'national economy' will rise from 14.7% to almost 16.0% – mainly support for state-owned enterprises. The state is even going to maintain its spending on state-controlled media (international broadcaster RT and its pet news agency Sputnik) at 0.5% of GDP.

However, economists say that the state can't afford to do any of these things. Even the CBR tried to reduce the military spending (former finance minister Alexei Kudrin lost his job from taking the same stand), but it got shot down.

Clearly, Putin is putting geopolitical goals ahead of macroeconomic recovery. And while the numbers look bad, thanks to Russia's reserves and the Kremlin's policy of not touching things like personal income tax or retirement ages for nearly 15 years, the state actually has a lot of wiggle room to raise more money from the people and debt, and make more cuts if it has to.

In effect, the 2016 budget boils down to a "do the obvious things and hope for the best on oil". The upside is that Putin will maintain his support amongst his core constituency (the main beneficiaries of that social spending), as well as being able continue his geopolitical goals. The downside is not pleasant, but Russia could cope even with even $35 oil for a while. The beauty of this plan is that if things do go badly, the geopolitics provides a ready-made scapegoat with which to blame the increased burdens that the population will ultimately carry.

Domestic politics plays a role here too: income tax and retirement age hikes are specifically on the cards, but neither is likely to happen soon: Duma elections are due to be held in 2016 and presidential elections in 2018, when Putin is widely expected to re-elected to his last (according to the current constitution) term in office. Any meaningful restructuring to these parameters will be delayed until after those elections.

#Deficit

In January-November the budget posted a deficit of RUB897bn ($12.7bn) or 1.3% of GDP, according to preliminary data from the finance ministry. For the same period of 2014, the federal budget ran a surplus of almost RUB1.3 trillion or 1.9% of GDP. Worse, the deficit for the full year is expected to be about 3% of GDP – Putin has said 3% is a "red line" that must not be crossed – on the back of accelerated military spending.

Falling oil prices, even with the ruble devaluation, will result in monthly revenue being about RUB300bn lower than initial expectations, according to Alfa Bank (January-November revenues stood at RUB12.2 trillion).

Russia has started to run federal budget deficits and these will persist for the next few years if oil stays below $70 – the current break-even price of oil for the budget.

The cabinet now favours budget stability over consumer expectations and most of the pain of the fall in oil prices has been passed on to the people in the form of a devalued ruble. Thanks to the beneficial effects of devaluation on the government's dollar earnings from oil duties, its ruble revenues will go up and allow it to meet its nominal spending obligations and keep the deficit to a reasonably small number.

This hands-on approach is clearly seen in the state's decision to abandon the "budget rule" where expenditures are linked to the average price of oil over the last three years and go into "manual mode" of choosing any assumptions for oil they want. In addition, the decision to allow the ruble to freely float in November 2014 was a way to cut the budget break-even level for oil prices from $100 per barrel to the current $70.

The full-year 2015 deficit is expected at RUB1.7 trillion, or 3% of GDP, and the same level is predicted for 2016. If oil were to stay at the current level of $40/barrel for all of 2016, then the budget deficit could be as large as RUB4.1 trillion or 5.2% of GDP, according to the finance ministry.

# Non-oil deficit

The headline deficit is important, as it is the one that needs to be funded. But to get a better sense of the health of the economy it is more useful to look at the non-oil deficit: the deficit Russia would have if you count out the government's oil revenues.

The government uses its oil money to subsidise its spending and in the boom years it ran a surplus even counting out the oil money. But since the middle of the noughties it has used this money to invest. The rule of thumb was the government tried to keep the non-oil deficit to -4% of GDP until 2008 (with a headline surplus including oil money).

That broke down in 2008 when the government started depending heavily on its excess oil revenues to prop up the economy and the non-oil deficit soared to nearly -14% of GDP. While there was some respite in 2011 (and the headline budget was running at a surplus), the situation has deteriorated again steadily since then.

In 2015, for the first time the government finds itself in the extremely uncomfortable position where both the headline and non-oil deficits are negative. The levels are not quite back to the depths of 2009, but if oil stays at $40 in 2016 and adds 2% to the deficit, then the non-oil deficit will again approach the 14% mark, making the current crisis as bad as the 2008 one.

#Reserve funds

The government has considerable reserves funds in the Reserve Fund that can be used to top up budget spending, and the National Welfare Fund, which is supposed to be used for paying pensions in the future. The funds held RUB3.4 trillion and RUB4.6 trillion respectively at the end of 2015. The state has already said it will spend at least RUB2.5 trillion from the Reserve Fund to supplement the 2016 budget spending and the finance ministry says this "rainy day" fund could be exhausted in 2016.

The National Reserve Fund is not supposed to be touched, but clearly it remains available should things get really ugly.

Almost all of the 3% deficit from the end of 2015 will be funded exclusively from the Reserve Fund, leaving about RUB1 trillion in reserve if 2016 also turns out to be another bad year.

In addition, the budget contains a fund of RUB1 trillion "industrial support" money with no fixed purpose. Spending of half of this amount is under Putin's personal control and it will be used to fight fires, be they political (like truckers protesting against new harsh taxes), economic (like worse-than-expected tax receipts) or corporate (the need to bail out state banks).

#Big Ticket items

– Military spending: This is by far the biggest ticket item in the budget and is running at over 4% of GDP – more than double the Nato member average. Military spending increased by 37% year-on-year (y/y) in November compared with 23% y/y growth in the first 10 months of 2015, and will not abate until 2018 at the earliest when the current military modernisation plan expires.

– Re-capitalising banks: Russian banks have already received RUB2.5 trillion in new capital in 2015 and they could well need the same amount again in 2016. Just VEB, the de facto state development bank, needs a RUB1.2 trillion ($20bn) bailout as of the end of 2015. The state is trying to find a way to plug this gap without adding the sum to the public account and so push the federal deficit over 3%.

Again, the liberals in the government (specifically Economic Development Minister Ulyukayev) have argued that there is no way to do this without adding to the public debt burden, but the Kremlin will veto any attempts to do so. And VEB is not alone. The queue amongst state-owned companies for government help is long.

– Overestimating growth: The official prediction in the 2016 budget is for 0.7% growth in 2016, whereas most of the IFIs predict a contraction of the same amount. The Ministry of Finance has pointed out there is a risk of a shortage in revenue of RUB1.2 trillion-1.5 trillion if the government overestimates the rate of growth.

#Safety cushion

But the news is not all bad, as the state still has some wiggle room left to raise extra cash by increasing the debt; making manoeuvres with the tax system and reducing the scale of tax breaks; a moderate reduction of subsidies for state-owned enterprises and some of the regions; tightening the criteria for receiving social assistance, or putting investment plans on hold. However, all this comes at cost of delaying the eventual economic recovery.

Debt is one place where Russia has the most room to move. The budget contains provisions for RUB300bn ($4.27bn) and $1.5bn of borrowing in 2016, which are extremely modest levels compared to previous years when RUB800bn was typical for the domestic market; prior to the sanctions, Russia would issue $7bn in Eurobonds every year as much as a benchmarking process for corporate issues as anything else.

#INFLATION & INTEREST RATES

The rate of inflation will be one of the key determining factors for the speed of growth (or not) in 2016. High inflation is depressing consumption and it is preventing the CBR from cutting interest rates, which is in turn killing investment and hence growth.

The 6.8% assumption in the 2016 federal budget also looks extremely optimistic. Russia ended 2015 with headline inflation on the order of 15.6%. While the rate had been falling, fresh drops in the oil price have led to more devaluation, sending the ruble through the RUB70 mark against the dollar, which will increase inflationary pressures. These forces were already in evidence in December when the CBR decided not to cut rates from the still high 11%.

Policy rate

The CBR's imposition of an emergence interest rate hike to 17% in December 2014 killed off virtually all economic growth in 2015.

After oil prices settled and the meltdown of the current was over, the CBR cut rates five times to the current 11%, but this is still too high. "The companies that want to borrow from us, we don't want to lend to, and the companies we want to lend to don't want to borrow at these rates," Herbert Moos, the CFO of VTB told bne IntelliNews in an interview, summing up the dilemma everyone finds themselves in.

Investment, and hence growth, won't resume until rates are cut to a more "sensible" level. The CBR is hoping to get rates down to 8.5% in 2016, at which point enough investment projects become viable that investment will start to have a visible affect on growth. But with the ongoing fall in oil prices and associated ruble devaluation this is not a given.

Inflation is the accelerator on the speed of rate cuts: in the last half of 2015 inflation clearly started to moderate as the worst of the devaluation effects worked their way through the system. The hope is that inflation will continue to moderate in 2016, allowing for another round of policy rate cuts.

Is Russia's inflation overstated?

Is inflation really as high as official data suggest? That was the question posed by Sberbank's Gavrilenkov in a paper in November. His argument is the basket of goods used by the CBR to measure price changes is no longer relevant, as it was full of expensive imported goods that no one is buying any more. If he is right, then inflation could come down faster than expected in 2016.

Gavrilenkov pointed out that according to official statistics food purchases have contracted very sharply, while non-food sales soared, which looks strange. At the same time, VTB Capital reported that the share of food in Russia's spending has increased from an all-time low of 25% of total income in 2007 to 50-55% now. So food spending should have at least stayed the same, or gone up. Indeed, poultry sales have rocketed this year, a largely domestically produced agricultural product that is cheap and filling.

"We think these peculiar developments can be explained by the fact that the consumption basket has changed significantly this year as consumers have been shifting toward cheaper products," Gavrilenkov said. "Perceived inflation may have been lower than the officially calculated statistic, as the official data are based on last year's consumption basket, which contains a higher proportion of more expensive foodstuffs."

Overall, official statistics will report a deep contraction in consumer demand this year amid a decline in retail sales over the full year. The state statistics service Rosstat seems to have conceded the inflation point, as it will introduce a new basket of goods in January and the new methodology could result in a rapid fall in the headline inflation rate, which would be good news for economic prospects in 2016.

"The numbers may look different next year due to the State Statistics Service switching to a 'fresher' basket more appropriate for 2016, which will reflect the shift in the structure of consumer demand. As a result, inflation may fall more than the consensus expects, as there will be fewer imported items in the basket and movements in the exchange rate will have a less significant impact on aggregate CPI. As a result, lower inflation should have a positive impact on real consumption next year," says Gavrilenkov.

IP & #INVESTMENT

Industrial production contracted by an estimated 3.5% in 2015, but began to recover in the second half of 2015 and is likely to continue to expand in 2016, albeit at a modest pace. Alfa Bank predicts a 0.5% expansion in 2016.

The impact on industry has been very mixed and depends on how exposed to FX companies are. However, by the end of 2015 after being negative for almost two years, the Purchasing Managers' Index for manufacturing turned positive for the first time (anything over 50 points means growth), as it seems the majority of Russian companies had adjusted to the new post-devaluation reality.

The agricultural segment fared best, output increasing 7.7% y/y during the month to bring growth to 3.0% y/y over the January-October period, and Russia was on track to bring in a bumper harvest of 104mn tonnes of grain in 2015.

Corporate profits

The collapse of the ruble has not been bad news for everyone and corporate earnings are set to grow faster than GDP in 2016.

In the past, real incomes had been growing much faster than real GDP. At the same time, a strong ruble and climbing wages dragged on the competitiveness of the tradable sector. As a result of both these factors, corporate earnings lagged as a share of GDP. Now that oil prices have plummeted, and will seemingly not reverse to their previous heights anytime soon, this imbalance should unwind. The normalisation of corporate earnings as a share of GDP is worth a 10% increase in aggregate profits.

In some sectors the crisis has been a boon. Supermarkets is the most obvious example, where the strong companies with financial resources in reserve have been opening new stories as fast as possible, leading to an accelerated consolidation in the sector.

Overall, Russian enterprises earned RUB592bn in net income in September, which was a 140% y/y gain, and the nine-month y/y gain was also a positive 29.7% with the trend accelerating as the year came to a close.

Perhaps surprisingly, amongst the biggest winners were manufacturing (55.3%), retail and wholesale (30.3%), and agriculture (46.7%). Worst off were real estate (-6.9%) and construction (-10.3%).

Raw materials and agricultural firms have benefited from the devaluation, as their costs are in rubles, but exports in hard currency. Magnitogorsk Metal Combinat reported record revenues and leading agricultural concern Rusagro has also had a record year. However, other sectors like high-end (imported) retail goods have suffered (there are reports that 17% of stores in Moscow have closed in 2015), while the tourism and automotive industries have been decimated.

In general, most businesses have adjusted to the changes and, as in 1999, the collapse of the ruble has created new opportunities that some are stepping into. While the dollar value of earnings has collapsed, in many sectors the ruble value of revenues continues to climb.

This economic activity will underpin Russia's ongoing development and stave off related problems like social unrest, as people still have jobs and wages, albeit in devalued rubles.

Fixed investment

Russia's Achilles' heel is its lack of investment. The economy will not rebound or return to strong growth until this problem is solved and currently investment is contracting every year.

Investments were recovering in the second half of 2015 and grew 22% m/m in October but fell 5.2% y/y, which was less than the 5.6% fall a month earlier. The full year is expected to see a 5% contraction in investments.

Russia needs to see fixed investment growing by 20-25% a year to fuel strong growth but investment has been contracting adding to the country's economic woes.

Investments in the boom years were made on the presumption of a $2 trillion sized economy, but that has been cut in half to about $1 trillion as of the end of 2015 and consequently a big gap has opened up in investment activity as companies, especially in the investment intensive sectors like car building, have curtailed their expansion plans.

Banks' role in investment

Banks are not participating in driving investment and can't while interest rates are so high. The share of bank lending as a source of investment in production capacity declined to 8.7% of total investments in the first nine months of 2015, compared with 9.8% over the same period a year earlier. However, corporate loans significantly outpaced consumer loans in banks' portfolios, but still remain insignificant as a source of economic growth.

FDI up

Finally, foreign direct investment (FDI) picked up somewhat in 2015, although currently this is almost exclusively foreign companies already working in Russia reinvesting their profits.

FDI remains way off its boom year high and is unlikely to change in 2016, but the residual FDI from existing investors is another long-term slow moving force like the slow productivity gains that will set a base to slow progress and change irrespective of what else happens.

CURRENT ACCOUNT & #TRADE

Current account

Despite the collapse in oil prices Russia has managed to maintain a current account surplus: Russia Inc is still in profit as a whole, albeit earning less than half what it did in the boom times.

The current account surplus widened to $60.8bn in the first eleven months of 2015, compared with $54.2bn a year previously, despite the dramatic contraction in the oil price: oil prices plummeted 46.6% y/y to $54.9/bbl Brent, from $102.8/bbl in the same period. Russia was expected to end 2015 with a $65bn surplus – better than expected at the start of the year.

Imports have obviously been depressed by the devaluation of the ruble, but other factors improving the balance of payments have been the collapse in tourism and corporate foreign debt redemption in 2014- 15 are coming to an end as companies have largely paid off their international debts, which is most visible in the fall in "capital flight" (see section), which is mostly money leaving Russia to pay off external debt.

Capital flight

Having peaked at about $150bn in 2013, capital flight is now falling steadily and finished 2015 with about $60bn of flight capital. The trend is expected to continue in 2016.

Net capital outflow was $53bn in January-November 2015, down from $118.7bn a year earlier. This outflow was associated with foreign debt redemption and took place mostly in 1H15. And in July through November, net capital outflow was only $2.7bn, with a net inflow in September of some $5bn.

The $60bn for 2015 was a surprise and almost half the initially projected outflow figure of more than $110bn, according to Finance Minister Siluanov.

There are no predictions for capital flight in 2016 at the time of writing. But clearly as most capital flight is being driven by corporates paying off debt and the bulk of the deleveraging process is already over, the amount of capital leaving in 2016 will be on the same order as 2015 and probably less, leaving more to bolster reserves.

As an aside, the CBR's campaign to close banks has been directly influencing capital flight as the reduction of "questionable transactions" in the national accounts has fallen in line with number of bank licenses withdrawn. And that pace is increasing: in 2015 the CBR closed a record 100 banks.

Russia's consumer market has expanded from the 21st largest in the world in 2000 to the ninth in 2014. Initially, consumption found support in the sharp personal income tax cut to 13% in 2002, and the subsequent 12% p.a. average real income growth in 2000-2007. The expansion of retail loans from $2bn in 2000 to $140bn in 2008 was the second crucial factor behind the increase.

Russian salaries represent 52% of GDP as of 2014, which is high when compared with other EMs. However, corporate profits have fallen at 32% of GDP, the lowest since 2000, and obviously companies are being increasingly squeeze hence the wage freezes and cuts.

Nominal wages rose 3.0% y/y in October and 5.1% over January-October. As year-on-year inflation was extremely high at over 15%, real wage growth was deeply negative, contracting 10.9% y/y in October and 9.3% in January-October.

However, the slowdown in y/y inflation, which will occur rapidly between November and April, will improve the real wage growth statistics.

The expectations is for either high single-digit or low double-digit growth in nominal wages in 2016, which will bring real wage growth back into positive territory.

Putin raises minimum wage by 4% to $87 a month

Putin threw a sop to falling income levels by signing a law on increasing the minimum wage by 4% from January 1, 2016, the government reported on December 15. This is in line with pension increases, but less than inflation or even the projected levels of inflation in 2016. The minimum salary will be RUB6204 ($87) a month in 2016, up from RUB5965.

Raising of the minimum wage will affect about 700,000 workers, 43% of whom work in state and municipal institutions, while 57% represent the real economy. These are Putin's core voters.

This increase will not reduce the number of Russians who live in poverty, which has been rising in 2015 to reach 20.3mn in January-September, or 14.1% of the total population, the state statistics agency Rosstat reported earlier in December. The subsistence level, which serves as a poverty measure, amounted to RUB9673 ($140), a rise from RUB8086 in 2014 and the poverty level will rise again in 2016.

Pension and state wages

The government's generous pension increases – especially in the run-up to the 2012 presidential election that saw Putin's return as president – have also had a major impact on retail, as have continued above-inflation hikes in the pay of public servants.

The 30% average pension increase in 2007-2010 and sharp jump in public sector salaries in 2012-13 resulted in consumerism prevailing until 2014. As a result, consumption in 2014 was 22% higher than in 2008, while GDP had increased only 6% during the same period.

However, the cash-strapped government has cut the pension hike index to the below-inflation rate of 4% for 2016, and suggested it will stay there indefinitely.

Likewise, public employees have seen their pay frozen at current levels. (One of the unintended consequence of this policy has to seen official corruption come roaring back.)

# BANKS AND BANKING

Russian banks are in a world of pain as the sector is slowly being crushed in the weight of very high interest rates and starved by their lack of access to international capital markets. However, a bank crisis is still a way off thanks to the state's large reserves, which have been used to prop up the sector while the CBR actively closes small banks in an enforced consolidation.

"The model is broken," one senior Russian banker tells bne IntelliNews. "In the old days we could borrow long-term cheap money from abroad, and lend it domestically with shorter maturities and at higher interest. It was easy."

Russian banks – not just those on the sanctions lists – are cut off from the international markets by compliance and risk offices who will not approve loans to any Russian bank in case it winds up on a sanctions list down the line. However, an easing of political tensions has seen some new debt issues by Russian banks in the last quarter of 2015.

The capital of banks has been shrinking after net interest margins (NIMs) were compressed in the last year. However, NIMs were starting to widen towards the end of 2015 and the profitability of banks in 2016 has improved. Net interest margin is expected to fluctuate at 3-3.5% in 2016, while reserves for bad loans will remain at 4.5-5.5% of the sector's total loan portfolio.

Still, Standard & Poor's sees significant increase of risks for capital sufficiency of large Russian banks in 2016 and 2017 due to weak economy, the agency said on December 14.

Liquidity risks and capital erosion are no longer seen as neutral and will be the main factors behind the negative rating actions in the coming quarters, S&P notes.

The agency estimates its own-calculated capital sufficiency of the top 30 Russian banks decreasing to 5% as of end of 2015 compared with 6% a year ago, considerably weakening banks' ability to tackle serious stress situations. Average capital sufficiency is expected to deteriorate further to 4% by the end of 2015 and to stabilise at 3.5-4% in 2016.

At the same time, higher transfers for reserves will undermine the internal capital generation capacity of Russian banks and financial indicators in general in 2015-2016, S&P believes.

For banks actively involved in retail crediting market lower margins and higher reserves might shake the existing business models, S&P warns.

In 2015, Russian banking sector lost an estimated RUB50bn-RUB70bn ($0.7bn-$1bn), the worst result in a decade, compared with RUB220bn net profit in 2014 under IFRS and around RUB1 trillion in "normal" years.

"What we're facing now is a massive crisis. Zero profits, growth of reserves while the Central Bank is involved with financial recovery procedure," the CEO of Russia's largest bank Sberbank Herman Gref said in November. "The next year will not be simple either."

According to Gref, the financial recovery of banks will take several more years due to tightened requirements to capital and from the viewpoint of introducing state-of-the-art technologies, transparency and risk management.

Bank sector enforced consolidation

Russia's largest private banks are consolidating their market share amid the ongoing recession, a credit positive trend likely to carry over to 2016, Moody's Investors Service said in a report published on December 8. This process has been catalysed by the CBR aggressive campaign of closing small banks.

Moody's calculated that the share of assets at the top five privately owned banks increased to 12.5% in mid-2015, from 10.8% at the end of 2014 and 8.4% at the end of 2013, according to the agency's assistant vice president Elena Redko. "The share of smaller private banks, on the other hand, fell to 18.9% from 23.4% at end-2013," Redko notes.

The CBR shuttered a record 100 banks in 2015. The number of banks has fallen steadily from over 4,000 in the early 1990s to 923 at the end of 2013, 834 at the end of 2014 and 797 banks at the time of writing.

Yet that is still way too many. The top 50 banks account for well over 80% of the system's assets, while the bottom 700 are largely glorified treasury operations for companies and oligarchs – or what a former Renaissance Capital analyst Kim Iskyan famously dubbed, "bank-like institutions" that are little more than money-making scams.

Putin has suggested that Russia should copy Germany and reduce the number to around 300. And if the current pace of bank closures continues, that goal will be reached sometime around 2025 – although as the number of insignificant banks dwindles the danger of destabalising the system by closing them more quickly recedes, so the process can be expected to accelerate from here.

Russia's CB to double funding deposit insurer amid banking sector clean-up

The pace the CBR can close banks is limited, among other things, by how fast the state's Deposit Insurance Agency (DIA) can refund money on deposit lost during the closure.

The first RUB1.5mn ($21,286) of deposits is guaranteed and the DIA has been burning though its capital in 2015 to the point where it was nearly out of money by the end of the year. The DIA's charter requires it to have a minimum of RUB40bn.

The CBR stepped in in December offering a fresh RUB140bn ($2bn) injection to replenish its funds. The CBR's current credit limit for the DIA is RUB110bn, and the expansion will more than double funds available for compensating guaranteed deposits for failed banks and banks that had their licenses revoked. So it looks like there will be no slow down in bank closure rate in 2016.

The look for the ruble and hard currency reserves are both dictated by what will happen to the oil price and so little can be said at 2015 came to an end. However, most analysts are predicting a ruble dollar exchange rate of RUB70/$1 in 2016 with hard currency reserves remaining flat at about $360bn as Russia Inc more or less breaks even.

US stocks are at highes, while the gap between European quality share valuations and US has never been higher, according to the Financial Times. This suggests when stability returns investors will turn to developed Europe first for returns before they move to more exotic assets such as Russian.

#BONDS

Russia's bond market came back to life in the last quarter of 2015 with the first large benchmark-sized issues in nearly a year: Gazprom, Norilsk Nickel and Lukoil all got Eurobonds away worth more than $1bn.

More borrowing in 2016 is expected as spreads come down. Russia was a star bond market performer in 2015 and could repeat the trick in 2016.

Fitch on October 16 affirmed Russia's long-term foreign and local currency issuer default ratings (IDR) at BBB-, outlook negative, remaining the only one of the "big three" agencies to maintain an investment grade rating on the country, one notch above junk.

Fitch reiterated its stance that the sovereign balance sheet remains a key rating factor supporting Russia's creditworthiness, with lower oil prices and/or stronger demand for foreign currency presenting the main downside risks to the reserves outlook.

Fitch Rating's head of sovereigns James McCormack said in late November that among its emerging market peers, Russia is least likely to have its investment-grade rating revised downwards in 2016.

"In some respects Russia looks the least vulnerable," McCormack said, adding its response to the low oil prices has been better than AA-rated Saudi Arabia's "rather modest" cuts to its budget.

#EQUITY

Russia's equity market remains moribund due to the gamut of risks investors face. The leading RTS index has been range bound between 800 and 1300 for years now and it would take a clear end to the economic and political risks for equities to break out of this range. Sberbank was one of the few investment banks to publish an index target for 2016 and set it at 900.

"Assuming flat oil, we set our RTS target for end 2016 at 900. This target implies 10% EPS growth and a 2016E P/E of 6.0. Risks to this view lie in lower oil and black swan-type geopolitical events. Upside risks include revivals in the oil price, rapprochement with the West and the announcement of a comprehensive reform agenda," Andrei Kuznetsov of Sberbank said.

Despite the volatility, the Russian equity market was one of the best performing in the world in 2015 with the MSCI Russia returning +13.4% at the time of writing with only Japan (+12.5%) and China (+11.4%) also in positive territory. The MSCI EM index by comparison was down -14.9% over the same period.

As in previous years, the dividend paying stocks remain the most attractive for those portfolio investors interested in Russia. Most of these are in the oil and gas and raw material sectors plus telecoms. Russia continues to show a hefty premium of 34% in terms of dividend yield, with the 2016 dividend yield expected at a level of 4.83% compared with the MSCI EM avera­­ge of 3.19%.

The surprise on offer in 2016 is that the government may force more state-owned companies to pay dividends using IFRS calculations. The state has already said that it will stick with its policy of forcing its companies to pay 25% of net profit (under Russian accounting rules) as dividends but if it forces companies to switch to the IFRS accounting standards, these profit and dividend payments could expand sharply.

"Potential positive surprises include Lukoil, Alrosa, Gazprom and Transneft. Meanwhile, discussion regarding the shift of state companies to dividend payouts based on IFRS net income is not fading away. Along these lines, we think that Gazprom and Transneft might raise their dividends," Gazprombank said in a note.