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Russia is over the worst

GDP is picking up, partly thanks to higher oil prices. But reforms are needed to consolidate the gains

Russia's economy is recovering from recession, but is stuck in second gear because growth can't really take off without structural reforms and major investment.

A recovery in oil prices has helped drag Russia out of a two-year downturn-its longest in two decades—while improvements have been detected in the real economy in agriculture, industry, cargo transportation and non-residential construction. But household income, spending habits and consumption remain under severe pressure.

In late March, finance minister Anton Siluanov upgraded the country's growth outlook for 2017 to 1.5-2% from 0.6%. "On the whole, we agree that the economy will be growing faster than initially expected," he said.

The mood music had improved earlier in the month when ratings agency Standard & Poor's raised its outlook on Russian sovereign debt to positive from stable. That's just one step away from restoring the investment grade rating that Russia lost in 2014. The S&P upgrade follows a similar move by Moody's in mid-February.

Russian corporates, as well as the Kremlin, have learnt over the past two years to cope with sanctions—as well as circumvent some of the prohibitions—judging by the pickup in bond deals and recent privatisation transactions.

Government officials have indicated that the budget, which is based on an average oil price of $40 per barrel, is likely to receive extra oil and gas revenues worth up to R2 trillion ($35bn) in 2017. This may help ease the deficit to about 2% of GDP, compared with an initial plan for 3.2%.

Higher prices for energy, which accounts for about 40% of Russia's budget revenues, have already significantly weakened the fiscal argument in favour of boosting the dividend payouts by state companies.

Scepticism about the long-mooted plan to switch to an excess-profits tax-based (EPT) is also rife following opposition from Rosneft, Russia's largest producer.

Russian corporates, as well as the Kremlin, have learnt over the past two years to cope with sanctions

The finance ministry has proposed to set an EPT that would levy 50% of every company's net earnings excluding production and transportation costs, in place of the Mineral Extraction Tax (MET). Instead, Rosneft is in favour of decreasing the MET rate for its massive Samotlor field, claiming that such a promise had been made ahead of its privatisation deal with Glencore and the Qatar Investment Authority (QIA) in January.

Analysts have calculated the potential tax relief for Samotlor to be $1bn-1.4bn. The introduction of an EPT may lead to a lack of incentive among oil companies concerning cost efficiency and the Ministry of Finance has indicated it may only use greenfields as pilot projects if Rosneft's tax break is allowed.

The pace of inflation has slowed faster than had been expected. As of mid-March, the annualised rate was 4.4%. Given the recent trend, and assuming no surprises, the Central Bank of Russia (CBR) may hit its 4% target in the summer, when food prices fall, and well ahead of its year-end target.

That slowing pace of inflation provided the justification for the CBR to make a surprise cut in rates in late February, lopping 25 basis points off the base rate to 9.75%, the lowest since 2014. CBR governor Elvira Nabiullina suggested that the cut was not a one-off, but that further monetary easing would be gradual.

With oil prices rallying, the ruble has strengthened to as much as R57 to the dollar from R68 a year ago—uncomfortably close to the government's target of R60 or less, which it sees as key to attracting foreign investment.

But a competitive currency can only do so much. To unlock further growth, Nabiullina says the country will need to implement reforms. Without them, growth will be capped at 2%, according to Nabiullina. Among the changes up for debate are an increase in income tax, raising the retirement age and, on the political front, the reintroduction of elections for provincial governors.

Indeed, the stabilisation of the economy has sparked new discussions about reform—and the appointment of various teams to drive a new programme. Economy minister Maxim Oreshkin has been summoned to coordinate such efforts while former finance minister Alexei Kudrin is supposed to be drafting a plan.

"The economy has recovered from recession but growth will remain weak without another strong driver," says Chris Weafer, senior partner at Macro Advisory, a Russia-focused consultancy. "That driver cannot be based on the oil model but will have to come with a rise in investment spending and in foreign direct investment in particular."

Putin vs the young

A nationwide wave of protests against state corruption has taken the Kremlin by surprise and could even trouble President Vladimir Putin as he pushes for a fourth term.

Tens of thousands of young Russians took to the streets in Moscow, St Petersburg and 80 cities across the country on 28 March in the biggest opposition rallies in four years. The government reaction was swift: 1,000 were arrested in Moscow alone, including opposition leader Alexei Navalny, who was fined and jailed for two weeks.

The target of the protestors' ire was prime minister Dmitry Medvedev. An exposé by Navalny's foundation presented evidence of Medvedev's enormous wealth, and said it had been accumulated corruptly. Medvedev scorned the claim.

But Navalny has succeeded in resuscitating a protest movement by reaching out to a younger generation who have only ever known Putin as Russia's leader. It remains to be seen whether the movement can be sustained and whether Putin will crack down—or demote Medvedev.

Terror attacks on St Petersburg's metro, on 3 April, which killed at least 14 people, also overshadowed the protests. The opposition's momentum could be tested by the response to the murders.

But with presidential elections looming in March 2018, the government's most significant proposals are likely to be unpopular: a proposal to raise the retirement age is under discussion, as are cuts to state subsidies, higher income taxes, and a system of obligatory personal contributions to pension savings.

Speculation about a replacement for Medvedev is focused on the head of the Central Bank, widely respected Elvira Nabiullina, and the reforming former finance minister Alexei Kudrin.

But talk about new reforms seems a lot like recycled hot air. Seventeen years after Putin came to power, the drive towards ensuring stability still remains the prime policy goal of the Kremlin.

Navalny, a 40-year-old lawyer-turned-agitator, spearheaded protests in 2011-12 in the wake of alleged ballot rigging by United Russia, the ruling party, in elections for the Duma. The protests petered out after a Kremlin crackdown. The difference this time is that while those protests drew mainly from the middle classes in Moscow and Petersburg, these ones have involved a more youthful crowd, spread more widely across the country.

"It is hard to imagine the latest demonstrations being allowed to get out of control to the point of threatening the regime itself—remember therein that a 'coloured' revolution is the one thing that likely keeps Putin awake at night," says Timothy Ash, a senior strategist at Bluebay Asset Management.

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