Author: Laurence Neville
RUNNING ON EMPTY
Russia is facing some tough decisions as it adjusts to a far more challenging economic and political environment.
Just over a decade after Russia’s forced devaluation of the ruble and default on its debt—which followed a commodity price collapse in the wake of the Asian crisis—the country appears to be following a scarily similar trajectory. Russia is now financially more robust than in 1998, and its political leadership is undoubtedly stronger. But the parallels between the two crises are profoundly unsettling.
“The crisis in Russia has two origins,” explains Alfred Kokh, who was deputy prime minister under former president Boris Yeltsin. “The first is that Russia is part of the global financial system and is inevitably exposed to global problems. The second is the sharp drop in the price of oil and metals on which the country is heavily dependent. Consequently, this drop has been felt more strongly than by other countries.”
Certainly, the global tightening of credit has exacerbated Russia’s problems; the difficulty of refinancing the almost $500 billion of outstanding borrowing by private sector corporates and banks could yet break the country. Similarly, it is clearly true that any country dependent on commodities will suffer when prices fall. But that dependence begs the question of whether Russia has achieved anything in the past decade or merely been the lucky beneficiary of a global commodities boom.
“In the past 15 years the growth rate of the service sector has been high; the bank system, for example, has been created from virtually zero during Soviet times,” says Kokh. Paul Biszko, senior emerging markets strategist at RBC Dominion Securities in Toronto, agrees that from a structural perspective there have been some improvements during the boom years in Russia’s financial system and the small and medium-size corporate sector. However, Biszko believes the country could have done a lot more with the windfall it enjoyed from the commodities boom and the easy availability of credit globally. “The manufacturing sector has continued to struggle, and there has been little effort to diversify away from commodities,” he notes. “Overall, there has been limited banking, judicial and … administration reform.”
Indeed, the origins of Russia’s recent problems predate the subprime crisis. Russia has increasingly sought to leverage its energy resources into raw political power—a path that led to pariah status following the invasion of Georgia. In addition, a succession of events—including the expropriation of oil company Yukos’s assets and pressure placed on foreign companies in Russia such as Shell—have increased concerns over corporate governance and government intervention in private companies.
Gavrilenkov: Russia's dependence on commodities may have a silver lining
Being locked into an artificially high exchange rate was one of the key causes of Russia’s economic collapse in 1998. Yet despite the unrelenting fall in the price of oil, its primary export, the Russian government refused to devalue the ruble until nearly the end of 2008. The result has been a massive reduction in Russia’s previously formidable foreign currency reserves as the central bank spent its reserves defending the ruble. In mid-2008 Russia had foreign exchange reserves of $598 billion; now they are around $385 billion. “Of this, we estimate around $120 billion is already committed in capital injections or supporting significant corporates—leaving $260 billion in actual usable FX reserves,” says Biszko.
Some observers believe there was more than hubris behind the Kremlin’s reluctance to allow devaluation. Biszko says that the gradual devaluation was designed to allow corporates to refinance some of their debt before it was inflated further by a collapse of the currency. Evgeny Gavrilenkov, chief economist at Troika Dialog in Moscow, believes the government resisted devaluation because it did not want strategic assets held by oligarchs to fall into the hands of foreign banks as a result of margin calls.
The Looming Debt Crisis
The liability of private sector corporates and banks grew from $30 billion in 1998 to almost $500 billion in 2008, of which more than $100 billion is due this year. With the ruble almost 50% weaker, it has become twice as costly for corporates to service their debt. Given the opaqueness of the syndicated loan market, it is unclear to what extent borrowers were able to make use of the slowed devaluation to lessen the blow by refinancing. But Biszko at RBC says it seems inevitable that “a lot of second- and third-tier corporates are going to fail.”
Gavrilenkov at Troika Dialog believes the situation is not as dire as it might first appear—for a number of reasons. “On an aggregate level, the debt owed by private corporations and banks is at a manageable level,” he says. “Russia repaid $72 billion of foreign debt and margin calls in the fourth quarter of 2008 without any problems, and the $100 billion due this year should therefore not present a serious problem. Moreover, the depletion of foreign exchange reserves of $210 billion in recent months (to around $385 billion) is not money that has disappeared. Much of it has been used by domestic banks to help corporates refinance themselves.”
Furthermore, should major companies not be able to pay their debt, it seems certain that the government will step in. Consequently, the most likely outcome is that the sovereign will assume much of the private sector debt relating to corporates it deems strategic or that could trigger systemic problems—something it is able to do as debt-to-GDP is currently a very low 6%. Of course, there are risks associated with such a strategy. As Kokh notes, in the worst-case scenario a rerun of the 1998 default is even possible.
Kokh: The bank system has been created from virtually zero in the past 15 years
The risks for Russia in 2009 are great. What does that mean in terms of likely growth? Biszko at RBC believes that Russia is one of the most vulnerable major emerging market economies. “While it has strengths such as the education of its population relative to other emerging markets, almost all of the FDI coming to Russia has focused on commodities, in contrast to China and Brazil, for example,” he says. “There is simply not enough economic activity outside of commodities to offset the expected prolonged weakness in the sector.”
Yet Gavrilenkov believes that Russia’s dependence on commodities may have a silver lining. “China is dependent on exports of finished goods and consumer durables to the US, while Ukraine depends on the export of metals,” he notes. “While Russia is dependent on the export of oil and gas, the elasticity of demand for those commodities is limited. Therefore, the primary impact on the Russian economy will be as a result of lower prices for energy resources.”
The implications of this argument are that growth is possible if the economy adjusts to the new oil price. “If you consider that the Russian economy grew at around 7% a year when the oil price was at $30 a barrel, it is conceivable that growth can be resumed—though not at that sort of level,” says Gavrilenkov. However, in order to achieve such growth and to adjust the economy, the role of the government is crucial. First, it must continue to allow the further slow devaluation of the ruble while normalizing central bank policy. “The recent move by the central bank away from targeting the exchange rate toward a more normal interest rate policy to constrain inflation—currently 13.3%—is a welcome development,” says Gavrilenkov.
Most important, the government must reduce its own dependence on high oil prices. Eight years ago the break-even point of the government budget was around $18 a barrel. This year the break-even point was supposed to reach $70 a barrel. Even though the devaluation has brought this benchmark down, it still remains high: The government currently expects a fiscal deficit of around 8% of GDP.
The massive hike in the break-even point is primarily a result of a change in government policy. “The government needs to move away from the trend in recent years of massively expanding spending on state corporations and on infrastructure projects,” says Gavrilenkov.
This huge increase in state spending has been a major contributor to the worsening perception of Russia as a safe place in which to do business—a problem that began well before the credit crisis. “The change [in government policy regarding state corporations] is reflected in the corruption perception index,” notes Gavrilenkov. “Russia effectively became more corrupt as the oil price increased.”
One can only hope that the fall in the oil price will be used as an opportunity by the government to put its economy—and society—on a firmer footing.
By Laurence Neville