Russia's Coming Financial Crash
by Anders Aslund, Peterson Institute for International Economics
Op-ed in Project Syndicate
September 24, 2008
© Project Syndicate
Today, the whole world is being hit by a tremendous financial crisis, but Russia is facing a perfect storm. The Russian stock market is in free fall, plummeting by 60 percent since May 19, a loss of $900 billion. And the plunge is accelerating. As a result, Russia's economic growth is likely to fall sharply and suddenly.
One problem is that, after a long period of fiscal prudence, Russia's government has shown extraordinary ineptitude. Russia has enjoyed average annual economic growth of 7 percent since 1999. With huge current account and budget surpluses, it had accumulated international reserves of $600 billion by July. Its public debt was almost eliminated. But the open economy that has bred Russia's economic success requires the maintenance of sensible policies to succeed.
The initial American financial crisis barely touched Russia, but the global economic slowdown brought about a decline in oil and other commodity prices by more than one-third since July, which was a big blow. All the other hits, however, have been self-inflicted. The Russian financial crisis is high drama, best described as a tragedy in five acts.
On July 24, Prime Minister Vladimir Putin initiated the first act by fiercely attacking, without evidence, the timid owner of the giant coal and steel company Mechel for price-gouging and tax evasion. In three days, Mechel's shares lost half their value, triggering the Russian stock market's decline.
Then, on August 8, Putin launched the second act of this Russian tragedy, his long-planned attack on Georgia. Shockingly, Russia argued that it had the right to attack a country that harbored people to whom it had just issued passports, scaring all countries with Russian minorities. By recognizing the "independence" of the two occupied territories, Abkhazia and South Ossetia, Russia turned the whole world against it.
Russia's leaders have earned a reputation for being unreliable, quixotic, and unpredictable, but markets like trustworthiness, stability, and predictability. Not surprisingly, foreign investors no longer favor Putin's Russia.
Within a week of its attack on Georgia, Russia recorded a capital outflow of $16 billion, which has since increased to $30 billion. This is a small sum relative to Russia's currency reserves, but plenty for the underdeveloped banking system, which experienced a severe credit squeeze.
Putin continues to deny that Russia's financial problems were caused by his war in Georgia, and it took the Central Bank more than a month to provide substantial liquidity injections. But it was already too late, as the liquidity problem had become a matter of solidity. Overtly, Russian stock valuations look attractive, but by heaping abuse on foreigners, Putin has scared them away, while Russian investors have no money at hand. With every statement, Putin erodes Russia's political risk profile.
As is customary, many Russian businessmen pledged their shares to borrow money for stock purchases. As the stock market dives, they receive margin calls and are being forced to sell their shares at ever-lower prices, causing the stock market's downward spiral to accelerate. In Soviet fashion, the Moscow stock exchanges closed for four days in a row in the week of September 15, because stocks plunged too fast. By denying the problem, the authorities have aggravated the lack of confidence.
On international financial markets, the war in Georgia has rendered Russian debt and bonds toxic. Interest rates on Russia's bonds have risen by 2–3 percentage points, and many Russian creditors no longer have access to international capital markets.
Russia is just about to enter the third act of this tragedy, a banking crisis. Numerous medium-sized banks, and some large ones, are set to go under in the stock market turmoil. Too many big investors can no longer meet their margin calls, while borrowing costs have risen sharply. The recent appreciation of the dollar adds to their hardship.
In the fourth act, the real estate bubble will burst. A reasonable guess would be that Moscow's astronomic real estate prices will fall by at least two-thirds. That will exacerbate the banking crisis.
In the fifth act, investment will seize up. Why continue building when you can neither finance your investment nor sell real estate? Russian consumers are already scared and will cut their consumption, causing aggregate demand to contract.
In the end, real economic growth will come to a screeching halt, perhaps as early as next year. Other factors are likely to aggravate the situation. High-level corruption is so rampant that Russia appears unable to build major public infrastructure projects. Oil and other commodity prices are likely to fall further, and oil and gas production have already stagnated. Putin has turned his back on the World Trade Organization and is promoting protectionism, which will also harm growth.
Strangely, the most solid parts of the Russian financial system are the state budget and the currency reserves, but it is too late for them to prevent this tragedy. Neither arbitrary state intervention nor brutality will restore investor confidence.
The villain in this drama is Vladimir Putin, who has thrived on eight years of rapid growth generated by the market reforms of his predecessor, Boris Yeltsin. Russia had a good chance to escape this international financial crisis, but, through his ruthlessness and ineptitude, Putin has rendered his poor country a prime victim. How long Russia can afford such an expensive prime minister?