We continue to forecast growth near 2% over the four quarters of 2012, with a sub-1% reading in 2Q12, assuming expiration of the payroll tax cut. Bear case recession risks remain significant, but it has been encouraging that US growth has slowed but not rolled over in the past two months. And while the crisis in Europe has worsened, there are at least now potentially important plans being formulated to try to support the European banking system and avoid a deepening European credit crunch that would likely have substantial further negative knock-on impacts on the US.
The basic story for the US economy remains relatively straightforward. Growth should be much better in the second half of the year than it was in the first half. But this is largely attributable to special factors - namely, a sharp rebound in motor vehicle production as supply chain disruptions abate and a plunge in gasoline prices. The key to generating a sustained economic recovery at this point is income support tied to the performance of the labor market.
We had been getting increasingly nervous on this front in the wake of some terrible jobs figures during the summer months. However, September's results have talked us down off the ledge. Friday's report showed payrolls rose 103,000 last month - very close to our estimate but well above the consensus of +60,000 (note that the return of striking Verizon workers added 45,000 to September payrolls, as anticipated). Most importantly, there were significant upward revisions to July and August (totaling 99,000) as well as a rebound in the average workweek. The upward revisions were scattered across a number of categories, with the sharpest adjustments coming in government and temp help. Last week, the BLS announced that its preliminary estimate of the annual benchmark revision to payroll would be approximately +200,000 (or +0.1%). This means that when the official figures are released next February, there will be upward revisions averaging about 16,000 per month during the April 2010 to March 2011 benchmark interval.
Meanwhile, the household survey showed a very sharp jump in employment (+398,000) during September. This follows a 331,000 gain in August. However, it's important to recognize that this is a very volatile series based on an extremely small sample size. Moreover, the advances seen in the past two months merely offset the declines posted during the April through July period.
The only negative surprise in Friday's report was some weakness in manufacturing. Still, some technical considerations imply that industrial production will post a modest rise in September.
The September payroll results might have been even better were it not for the impact of Hurricane Irene. We like to use the "Not at work due to bad weather" measure from the household survey as a proxy for weather-related influences on payroll employment. Using an admittedly crude relationship developed over the years, we estimate that Hurricane Irene had about a -20,000 impact on September payroll employment.
The employment data are key at this stage of the economic cycle because productivity growth appears to be experiencing some underlying moderation. This is quite normal a couple of years into economic recovery, but the deceleration now is likely being exacerbated by extremely low net business investment over the past three years. So, we need income support from the labor market in order to sustain domestic demand and output. The employment report showed that aggregate weekly payrolls - a gauge that serves as a proxy for wage income since it captures the impact of changes in employment, hours and wage rates - posted a solid 0.6% rebound in September. This follows on the heels of a 0.5% decline in August, which represented the worst performance since the end of the recession in June 2009.
While this report was much better than consensus expectations, it still points to a weak labor market. Indeed, excluding strike effects, private payroll employment growth has been below 100,000 in four out of the past five months. If this trend continues, we are likely to soon see a slow but steady rise in the unemployment rate - especially after factoring in the ongoing declines in state and local government jobs. Assuming a stable participation rate, the economy needs to generate about 125,000 jobs per month just to keep the unemployment rate steady. Unless job growth starts to improve, we could be back near a 10% unemployment rate in 2012.
We remain concerned that pessimism tied to government economic policy will be revisited in the days leading up to the November 23 deadline for the so-called Super-Committee. This could reinforce the cautiousness that makes employers reluctant to hire. Indeed, recent data showed that sentiment regarding government economic policy registered only a very slight uptick in September on the heels of the all-time record low seen in August.
Continued fiscal gridlock will mean that the problem of dealing with a faltering US economy will be left at the doorstep of the Federal Reserve. The Fed is not out of ammunition but the options that appear to be available at this point are not all that exciting. Friday's employment report was the last one that will be released before the November 1-2 FOMC meeting. The better-than-feared results should - at least temporarily - take some pressure off the Fed to do more.
We remain convinced that the best option available to the Fed at this point is to team up with the Treasury Department for a streamlined mortgage refinancing program. We estimate that nearly half of outstanding agency-backed mortgages that are still current do not meet standard qualifications for a refinancing because they have a loan-to-value ratio in excess of 80%. Moreover, the share of mortgages that are blocked from a refi has started to rise quite a bit in recent months. This means that much of the economic stimulus associated with declining mortgage rates is not making its way through the pipeline.
In our view, two things will have to happen to bring about implementation of a streamlined refi program. First, the FHFA will have to take a broader view of its responsibilities in regulating the GSEs. Second, mortgage rates will have to continue to move lower, making the potential benefit of a refi wave more and more obvious. We suspect that these developments will play out over the course of time, but we are probably still months away from outright action.
The Treasury market posted substantial 10-year-led losses over the past week as pessimism about the crisis in Europe eased on news that European leaders were developing plans for a broad-based bank recapitalization supported by the expanded EFSF and a run of key US economic data - manufacturing ISM, construction spending, motor vehicle sales, non-manufacturing ISM, chain store sales, and employment - were all better than expected. Data released since the severe weakening in business and consumer confidence in August, driven by public revulsion with partisan rancor and gridlock in Washington adding to worries about the situation in Europe, have indicated that US growth has been sluggish but not recessionary, in line with our downwardly revised base case outlook published in mid-August. Job growth has slowed in recent months to a pace that will not support any improvement in the unemployment rate but has remained slightly positive, the manufacturing and non-manufacturing ISM surveys have slowed significantly but also remained at levels consistent with modest growth, good upside in early indications of September consumer spending point to okay growth for 3Q consumption of +1.6%, and indications of business investment have actually remained robust so far. Incorporating the past week's strong construction spending report, much better-than-expected motor vehicle and chain store sales results, less negative state and local government job growth in the employment report, and upside in wholesale inventories, with a partial offset from somewhat lower results for 3Q auto assemblies than expected a month ago, we boosted our 3Q GDP estimate to +3.2% from +3.0%. Much of this upside reflects improvement in June and July, when the economy was starting to accelerate and reverse some temporary drags in the first half, and the trajectory since then has been softer as uncertainty has risen after the debt ceiling debate debacle and continued gridlock in Washington and the worsening situation in Europe. But incorporating the better-than-expected initial run of key September economic data, we see 4Q growth only slowing to 2.2%, instead of the perhaps 1.5% we were thinking a week ago, and we continue to forecast growth near 2% over the four quarters of 2012.
Our overall view on the US outlook through 2012 when we initially cut our global growth numbers in mid-August (see Global Economics: Dangerously Close to Recession, August 17, 2011) was that the plunge in sentiment in August and likelihood of continuing high levels of domestic uncertainty at least through the 2012 elections and looming fiscal tightening, assuming failure of the Super-Committee and no extension of expiring stimulus provisions, along with the likelihood of continued stress in Europe would keep US growth sluggish through next year. An internally driven recession seemed unlikely, given unusually strong corporate balance sheets, well advanced consumer deleveraging, low inventory levels, falling energy prices and expected additional monetary policy support to help offset fiscal drag. But a worsening negative feedback loop between markets and sentiment, intensified by a worsening in the situation in Europe that led to a credit crunch with likely unavoidable significant knock-on impacts on the US financial sector, could tilt a sluggish US economy into recession.
Such bear case risks remain significant, but it has been encouraging that US growth seems to have slowed but not rolled over in the past two months, and while the crisis in Europe has clearly worsened since mid-August, there are at least some potentially important plans being formulated to try to support the European banking system and avoid a deepening credit crunch. Press reports the past week, confirmed by European leaders, indicated that plans are being developed to use the expanded EFSF (which is expected to reach approval of all 17 EMU members in the coming week, though there is some uncertainty about the vote in Slovakia) as part of a substantial European bank recapitalization effort, a ‘Euro-TARP'. Our European bank analysts believe that policy-makers are moving towards their proposal for new stress tests including mark-to-market on Greek debt holdings followed by capital injections sufficient to make core EMU country banks recession-proof (Tier 1 capital ratios of 7-8%,) and peripheral banks depression-proof (Tier 1 of 12-13% - see Banks: Euro-TARP intensifies, ECB aids funding: how to play it? by Huw Van Steenis, Francesca Tondi, Adrian Reibert and Alice Timperley, October 7, 2011). While this would be insufficient by itself to end the negative feedback cycle between banks and sovereigns and the economy, they see it as an important component of a program to "address sovereign stress, bank funding stress and bank capital and a new vision of the institutional arrangements of the eurozone". And while investors were disappointed that the ECB didn't cut rates, it did take steps to try to help unfreeze term bank funding, reopening covered bond purchases with €40 billion in buying planned in the year starting in November and announcing two 1-year repo operations to take place in coming months. These developments helped European markets improve, which added to the pressure on Treasuries from better-than-expected economic data, though downgrades of the sovereign ratings of Italy (by Moody's and Fitch) and Spain (by Fitch) tempered the improved outlook on the bank recapitalization news. The Stoxx Europe 600 index gained 2.6% on the week, and the iTraxx Europe credit index tightened 13bp to 189bp, while Germany's 5-year CDS spread tightened 14bp to 98.5bp (after hitting a record 117.5bp Monday), France 7.5bp to 177.5bp, Italy 26bp to 444bp, and Spain 6bp to 369bp.
On the week, benchmark Treasury yields rose 3-14bp on four straight down days after a rally Monday, with the intermediate part of the curve lagging. The 2-year yield rose 3bp to 0.29% 3-year 7bp to 0.49%, 5-year 11bp to 1.07%, 7-year 14bp to 1.59%, 10-year 14bp to 2.07%, and 30-year 10bp to 3.02%, highs since early August for the 2-year, 3-year, and 5-year, mid-August for the 7-year, and the beginning of September for the 10-year, with only the 30-year yield still lower since the September 21 FOMC announcement. The sell-off was relatively benign from a monetary policy perspective, with real yields declining moderately and inflation breakevens - from too low levels hit Monday - more than accounting for the rise in nominal yields, with 5-year, 10-year, and 30-year TIPS breakevens up 15-20bp on the week. The 10-year inflation breakeven ended 17bp higher on the week and 21bp higher than Monday's close at 1.94%, in line with the 2% level the Fed would probably like to see. The mortgage market struggled with supply concerns, with lower coupons hit hard late in the week by a sharper acceleration in prepayment speeds in September than expected. For the week, Fannie 3.5s underperformed the Treasury market losses by about two-thirds of a point, lifting current coupon MBS yields toward 3.25% from bit above 3% at the end of the prior week. This is now a bit higher than the 3.20% close ahead of the FOMC announcement. Overall prepay speeds accelerated 27% in September from August, but the distribution among coupons continued to highlight the pressing need to ease refinancing terms for high mortgage borrowers. More recently originated low-coupon MBS, with higher credit quality, lower LTV underlying mortgages, saw faster-than-expected prepays in September, but the cash flow benefit to borrowers of refinancing already lower rate mortgages is relatively small. On the other hand, high coupon MBS, made up of far above market rate mortgages owed by borrowers unable to refinance to current record low rates because of excessively tight lending standards imposed by the FHFA on refinancings, actually saw a decline in prepayment rates from August even as mortgage rates plummeted.
Key economic data released in the past week were all better than expected, with job growth slowing less than consensus expectations feared and underlying details on hours and earnings improving significantly, the manufacturing ISM rising a point to 51.6 and the non-manufacturing index dipping a quarter point to 53.0, both holding in modestly positive territory, auto sales surging and chain store sales showing solid growth to point to a strong retail sales report, and construction spending showing big upside to point to a big further gain in business investment in structures in 3Q and a turn to modest growth in recently very weak government construction spending.
Non-farm payrolls gained 103,000 in September, and there were net upward revisions of 99,000 to August (+57,000 versus 0) and July (+127,000 versus +85,000). Much of the growth in September jobs came from the return of 45,000 striking Verizon workers, and excluding this impact the recent trend in jobs - +127,000 in July, +102,000 in August, and +58,000 in September - looks quite sluggish but not recessionary at this point. Compared to the muted ex strike payroll gain, underlying details in September were quite strong, reversing weak August results. The average workweek rose a tenth to 34.3 hours, which along with the gain in jobs led to a 0.4% jump in aggregate hours worked. Average hourly earnings rose 0.2%, which combined with the gain in total hours worked for a 0.6% surge in the key aggregate weekly payrolls gauge, a measure of total wage income. This reversed a 0.5% decline in aggregate payrolls in August and pointed to solid underlying income support for the surprisingly strong indications for September retail sales. The household survey's more volatile measure of employment spiked 398,000 in September on top of a 331,000 gain in August, which kept the unemployment rate stable at 9.1% for a third month even with similarly strong growth in the labor force in the past couple of months. The most notable negative in the employment report was softness in manufacturing, with manufacturing jobs down 13,000 and the average manufacturing workweek down a tenth to 34.2 hours, pointing to a sluggish industrial production report.
There were some indications in the September employment report that temporary disruptions from Hurricane Irene hurt job growth, with a somewhat elevated number of people saying bad weather prevented them from working. Our best guess is that perhaps September payrolls saw a temporary 20,000 hit from the hurricane disruptions. Claims data suggest this could be recouped in October. Initial claims in the week of October 1 only rose 6,000 to 401,000 after plunging 33,000 in the prior week. In the two weeks since the survey week for the employment report, claims have averaged 398,000, down from an average 426,000 in the prior three weeks covering the period from the late August hurricane through the mid-September employment report survey week, and Labor Department analysts have said that state employment offices pointed to hurricane disruptions as an explanation for the prior elevation.
The economic calendar is pretty light in the upcoming holiday-shortened week. The retail sales report on Friday is the most important data release, and results should be strong after the sharp rise in auto sales and better-than-expected chain store sales reports. Supply will be in focus for the Treasury market for much of the week, with a $32 billion 3-year auction Tuesday, $21 billion reopening of the 10-year Wednesday, and $13 billion reopening of the 30-year Thursday. On the other side of this issuance will be three rounds of Fed buying, in the 2036-41 maturity range Tuesday, 2017-19 Thursday, and 2019-21 Friday. The Fed will also sell March to October 2013 maturities Wednesday. There was huge demand, $243 billion in bids, to buy the $8.9 billion in January to July 2012 issues the Fed sold Thursday, but longer maturities in this week's selling could be more of a challenge without support from money market funds. The minutes from the September 20-21 meeting will be released Wednesday, and investors will probably be most interested in indications of what additional steps the Fed might consider if more easing is seen as necessary, particularly any discussions on cutting the IOER, given the move to more than two-month highs in the 2-year and 3-year yields. Overseas central banks will be attempting to ease dollar liquidity conditions to some extent on Wednesday at the first round of the three-month dollar liquidity offerings by the ECB, Bank of England, SNB and Bank of Japan. To the extent these facilities are used, and 3-month dollar lending rates in Europe may be high enough to lead to some demand even at a fairly high rate of 100bp over OIS, it will result in an expansion of the Fed's balance sheet and creation of additional excess reserves. Data releases due out in the coming week include the trade balance Thursday and retail sales and business inventories Friday:
* We look for the trade deficit to narrow a further $0.8 billion in August to $44.0 billion on top of the $6.7 billion improvement in July, with exports rising 0.2% and imports declining 0.2%. On the export side, industry data point to a big gain in aircraft and factory shipments results and significant upside in ex aircraft capital goods, but we look for offsetting moderation in autos and industrial materials including petroleum products. On the import side, Japanese data point to a continued rebound in autos, but lower prices should lead to further moderation in oil, and continued slowing in inbound port volumes points to more weakness in other goods, in line with slowing domestic demand.
* We forecast a 0.9% surge in overall retail sales in September, a 0.5% gain ex autos, and a 0.4% increase in the key retail control grouping. September sales at both auto dealers and chain stores came in a good deal higher than anticipated. So, we now look for a sharp jump in overall retail activity. In particular, the apparel and general merchandise categories should show solid gains. Also, we expect some price-related upside at gas stations. Indeed, company reports suggest that pharmacies were the only sector to experience any meaningful softness, attributable to payback from precautionary buying ahead of Hurricane Irene.
* We look for a 0.4% gain in August business inventories. Non-auto retail inventories are expected to be little changed, but an anticipated jump in auto inventories, as production began to normalize, should reinforce the previously reported upside in stockpiles at manufacturers and wholesalers. The I/S ratio should tick up slightly to 1.28, within the range that has prevailed in recent months.
Waiting for Mexico to join in cutting interest rates in Latin America? We suspect that you will have to wait a bit longer. Indeed, we expect that Banco de Mexico's next communiqué, to be released on October 14, will highlight a new set of risks on the inflation front and may create some confusion after a dovish statement released in late August. Indeed, the central bank's decision - which we expect to be to keep rates unchanged at 4.50% - along with its rationale may create noise in Mexico's rates market, where short-term interest rates have rallied, signaling increasing chances of a rate cut as early as October.
At first glance, the case for a rate cut in Mexico seems strong. After all, rarely has inflation been lower than at the present in Mexico. Despite facing an adverse shock from soft commodity prices - important core components like tortillas were 17.1% higher in September from a year earlier, while bread was up 9.9% - core inflation is running near the lowest levels in decades, reaching 3.12% last month. The pressure from the processed food component, which is now decelerating, has been fully offset by muted services costs, partly reflecting lingering slack in the economy. Inflation expectations, meanwhile, have remained well anchored in the medium and long term at levels near 3.5%, while expectations for 2011 and 2012 have shifted lower of late. And even as Mexico watchers downgraded their outlook for the exchange rate - to 12.62 for end-2011 and 12.63 for end-2012 - in the latest central bank survey, they also adjusted their inflation expectations lower.
Moreover, Mexico's economy is already showing signs of slowing, and we remain concerned that we will see further weakness in the US and Mexico in the months to come. The first signs of weakness came in the form of a worsening in leading indicators. The IMEF manufacturing diffusion index declined sharply in July to 50.6 points and dipped further to 50.0 in September; the non-manufacturing index, which had held up better through August, fell below the critical 50 threshold in September for the first time since mid-2009. The leading economic indicator from statistical institute INEGI has declined in each of the past four months, pointing to a possible turn in the cycle. The deterioration in leading indicators can also be observed in hard data: excluding the automobile sector, manufacturing contracted in excess of 2% annualized between May and July, according to our calculations, and has gone virtually nowhere in the past six months. Industrial exports declined in August at the fastest sequential pace since late 2008; on the imports front, purchases of capital and consumer goods showed softening at the margin, hinting at some moderation in domestic demand growth (see "Mexico: Cooling Off", This Week in Latin America, October 3, 2011).
Indeed, those are some of the very reasons why we believe that rate cuts are coming in Mexico, and indeed drove our decision to call for at least two rates cuts by early 2012 (see "Mexico: Room to Ease", This Week in Latin America, September 19, 2011). With core inflation running near its lowest rate in decades and signs of a softening economy, it seems like it is only a matter of time before Banco de Mexico acts. And Banco de Mexico's communiqué in late August sent a strong signal that the authorities were ready to act with a rate cut.
Appreciation Concerns...
What, then, has prompted us to warn that the upcoming communiqué runs the risk of creating some confusion among Banco de Mexico watchers? Three words: the exchange rate.
When Banco de Mexico last met, on August 25 (the day before it released its communiqué), the central bank was facing a much different near-term picture. While the concerns then over the US economy, possible additional Fed action and the state of the eurozone remain present today, the immediacy of those concerns has eased. In late August, Mexico's central bank had to issue a communiqué not knowing precisely what the Fed chairman's speech at Jackson Hole would outline. There was significant concern that the downturn in financial markets and in particular in Europe might prompt a forceful and imminent move by the Fed to engineer further stimulus. Meanwhile, at the time many Mexico watchers were still expecting Banco de Mexico to hike interest rates at some point in 2012. We believe that the contrast between potentially much greater accommodative policy abroad and the outlook for rates in Mexico led to concern within Banco de Mexico that the peso could appreciate sharply. Indeed, when the central bank warned on August 26 of the risk of an "unnecessary tightening" in monetary conditions, we believe it was the specter of appreciation in the Mexican peso that prompted this language.
The contrast in the direction of the exchange rate - thanks in part perhaps to the central bank's language suggesting that the next move could be a rate cut - since then has been significant. Rather than face an appreciating currency, the Mexican peso has sold off sharply since the August 26 policy meeting. At its weakest points, the peso had sold off by nearly 18% compared with its average level in July before the recent market turmoil. By October 7, the peso had recovered somewhat but was still trading near 13.5 - a fall of almost 14% from its average level in July.
...Replaced with Pass-Through Risks
This has prompted a new set of concerns at Banco de Mexico surrounding possible pass-through from the weaker currency. Given those concerns, we expect the central bank to remain at hold in October. In late August, the authorities were envisioning a scenario in which Mexico's exchange rate might strengthen and lead to a tightening in monetary conditions that would require central bank action to offset. Now with the real exchange rate having weakened, this has led to an easing in monetary conditions without requiring action by Banco de Mexico on the rates front.
Ultimately, we expect pass-through to be limited, and that should open the door for rate cuts. But we expect that the central bank will want to wait for additional evidence before easing. After all, the magnitude of the depreciation in the real exchange rate as well as the persistence of the weakness matter for the inflation outlook.
To get a sense of the potential pressures from the weaker peso, we looked closely at the groups that are most sensitive to exchange rate swings, namely tradable goods such as electronics, appliances and personal care items. These groups, indeed, became an important source of price pressure during the last episode of significant peso weakness that began in late 2008. The good news is that our seasonally adjusted estimates do not show any meaningful acceleration in the pace of price changes for most tradable goods in August and September, unlike the rapid pick-up observed in late 2008. For example, electronics declined at a sequential clip of almost 6% annualized in the past two months, virtually unchanged from the pace of the first half of the year. Personal care products, which were flat in the first half of the year, declined almost 4% annualized in August-September, while the pace of hikes in appliance prices picked up slightly to around 0.5% annualized. Though it is too early to assess the ultimate impact of the recent peso weakness, at least our results seem consistent with anecdotal evidence from retailers that appear to have continued discounting imported items even after the currency sell-off. Indeed, we have heard that there has been an increase in discounting in some cases despite the currency's move, suggesting perhaps concerns over current inventory levels in a context of moderate consumption growth. In addition, today's initial conditions for inflation are quite benign - characterized by muted services costs and decelerating food prices - which should play a role going forward in limiting currency pass-through.
Staying Put
While there is a risk of further volatility in the currency, the first signs from August and September suggest that the currency's move has not been associated with worrisome outflows from foreigners. The central bank has been explicit about the challenge to monetary policy from the large foreign presence in the local bond market. And some money has already left: after reaching a high of US$18 billion in early July, about a third of the foreign holdings of short-term paper (Cetes) has been liquidated. By contrast, holdings in longer-term bonds (MBonos) have been exceptionally resilient, with only about US$1 billion decamping since mid-September out of a stock of almost US$50 billion at current exchange rates. Considering the growing uncertainty about the global economy - including concerns about the strength of the US and Mexican economies as well as mounting European woes - the central bank is likely to be comfortable with recent trends in the local bond market.
Bottom Line
When the prospects for the US economy and particularly the Fed's response appeared to change, Banco de Mexico quickly warned that its policy direction could change as well. That message was heard loud and clear in the central bank's communiqué in late August. And perhaps thanks in part to the central bank's communication, the currency is weaker than before that statement, and yet near-term interest rates are lower and inflation expectations have remained contained.
In many ways, this is precisely what the authorities wanted: if indeed the prospects for US demand and the Mexican economy have deteriorated, the currency needed to suffer an adjustment. But Banco de Mexico remains anxious to limit that currency move to an adjustment in relative prices and not the beginning of a generalized uptick in prices. We think that the risk of the latter is limited and hence there will be scope for some easing, but the central bank is rightly likely to warn this week that the verdict on the pass-through risk - given how recent the currency's move has been - is still out.
In this focus piece, we review the macro impact of the recent change in the Russian petroleum fiscal regime - the so-called 60/66 reform (for more background and industry detail, see Russian Oil & Gas: 60-66: Well flagged...but still underappreciated, August 25, 2011). The reform targets an expensive and distortionary tax loophole, and by increasing upstream returns by ~20% protects the budget and balance of payments from the risk of falling oil production. Among a complex set of impacts, we estimate a US$18 billion cut in energy subsidies, a US$3.7 billion loss to the budget, a US$4 billion increase in investment, a +0.3pp impact on inflation, and a potential 4Q11 surge in crude exports. Looking ahead, the government faces a complex trade-off between maximising budget revenues in the short term and providing incentives to the industry to invest and meet the declared goal of maintaining oil production at over 10 mmbpd for the next decade. In making this trade-off, we expect the government to prefer adjustment to the current familiar petroleum fiscal regime to wholesale reform.
The central role of oil and gas in Russia: Oil and gas is central to the Russian economy and its international role. It is the largest producer of oil in the world, with over 10 mmbpd of production, and the second-largest producer of gas. Oil and gas account for over 60% of exports. On the restricted official definition of oil and gas revenues, which includes export duty and royalties, but does not include other taxes paid by upstream companies (including profit tax), it accounts for 45% of federal and a third of consolidated government revenues. It accounts for between 17% (official estimate) and 25% (informal estimate by former finance minister Kudrin) of GDP, depending on whether oil and gas are priced at world or domestic prices. In addition, movements in the oil price have driven the economic cycle in Russia, including in 1998 and 2008.
A tax and royalty petroleum fiscal regime... With the exception of a handful of production-sharing agreements, mainly offshore Sakhalin, the Russian petroleum fiscal regime is a tax and royalty system, based in particular on a royalty tax (Mineral Extraction Tax - MET), charged at 22% of every US$1/bbl above US$15/bbl, and an export tax, charged at 60% of every US$1/bbl above US$25/bbl.
...with many exemptions...Within this simple system, there are a wide range of tax breaks for fields in particular regions (such as the reduced export duty rate for the new East Siberian fields, which feed the East-Siberian Pacific Ocean pipeline), or with particular characteristics (such as the reduced royalty for heavy oil or highly depleted fields or the royalty holiday for early production on certain new fields).
...and lower taxes for oil products: In addition, there are lower export duty rates for oil products - typically expressed as a percentage of the crude export duty rate - particularly for ‘mazut', which is low-quality fuel oil, and accounts for about a third of Russian oil products. When introduced in 2003, this preferential export tax on products was partly to encourage more ‘value-added', i.e., refining, in Russia, and partly so that refiners could afford to incur the cost of shipping an unwanted by-product. However, as oil prices rose through the 2000s, a large number of mini-refineries appeared in Russia to take advantage of the fuel oil tax break, and the volume of low-grade fuel oil produced rose by almost a third from 54 million tonnes per annum in 2003 to 70 million in 2010. We estimate that the fiscal cost of this excess fuel oil production over the decade will amount to nearly US$90 billion, while the cost in 2010 was US$12 billion, calculated as 70 mmt of 2010 fuel oil exports multiplied by the difference between the US$274 average export duty per tonne of crude and the US$107 average export duty per tonne of fuel oil.
Background to reform: The royalty and export duty petroleum fiscal regime has been effective in collecting revenues, and preventing avoidance, so the state has captured most of the oil ‘rent' through the high tax rates, which take 75% of the marginal dollar. However, it has also discouraged investment in more expensive oil projects, such as new greenfield projects or brownfield projects requiring more expensive technology.
Investment - the driver for reform: The main driver for reform, in our view, is the growing risk of a decline in production as the key brownfields of West Siberia mature. The impact of a decline on the economy could be dramatic. For instance, suppose that in 2011 there had been a 10% decline in production as a result of declining reservoir productivity (-1 mn bbl), and a repeat of 2010's strong 9.2% increase in domestic consumption of crude (-300,000 bbl). For simplicity, assuming a US$109/bbl average price and no 60-66 reform, this loss of 1.3 mmbbl per day of crude exports would translate into a reduction of US$52 billion in exports (2.8% of GDP), and US$28 billion in federal revenues (1.5%).
The new export duty regime: On October 1, the Russian government introduced the 60-66 export duty regime. The 60 refers to the new export tax rates for crude oil, down from the previous 65, and the 66 refers to the new rate of export duty on refined products as a percentage of the crude export duty, unifying them, with the exception of gasoline, and sharply raising the duty rate for fuel oil from the previous 47%. In summary, the revised export duties are as follows:
• Crude oil: US$4/bbl + 60% of price over US$25/bbl (down from previous 65%);
• Heavy products, including fuel oil: 66% of crude duty (up from previous 47%);
• Light products, apart from gasoline: 66% of crude duty (marginally down from previous 67%);
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