Beware the wounded bear that is Russia

THE collapse in oil prices since August 2014 has highlighted the extreme correlation between such prices and the exchange rate of the Russian rouble. In addition, there have been geopolitical tensions, with sanctions and counter-sanctions having all but closed the international financial and banking markets to Russian borrowers.

The strongest impact of the oil price collapse and the associated currency depreciation has been an acceleration of inflation, a decline in purchasing power and consumption, adding to a decline in investment spending where energy-related investment is substantial. Together with politically-related trade sanctions, this induced a 3.8 per cent contraction in Russia's 2015 gross domestic product (GDP).

So-called "pass-through effects" from the currency depreciation to inflation were reinforced by trade-related sanctions as well as economic tensions with Turkey (in the form of higher food prices). These factors will keep Russia's inflation durably high, at around 10 per cent this year. This in turn will continue to weigh on real incomes and purchasing power, reducing consumption spending further. With more cuts in investment spending and rising unemployment, Russia's economic activity is likely to continue contracting in the short-run. A positive reversal will have to wait for a pick-up in oil prices (which could happen by the end of the year) and policies to support demand.