Russia: crisis may make it a better place – eventually

19 Dec

But the immediate adjustment will be painful…Russia suffered a huge terms-of trade shock (oil prices down by 40%+ and a Western embargo). That led, by now, to a full-blown confidence crisis and capital flight. Investors (including Russian domestic retail investors) wonder how it could not end in a debasement of the currency/default.

2743355206_8f1b75bb13[1]Sobering up after the go-go years. Source: ucl.blogs

Not all of the investors have sophisticated models, but they are essentially right. This crisis is not just about a depreciating ruble and increasing inflation. Those are symptoms. The Russian government is under serious fiscal strains, and the banking sector is suffering a run, making it a likely candidate for either mass default or a huge quasi-fiscal problem.

First, the fiscal problem. About 50% of Russia’s revenues were from oil and gas before this crisis, and the price of those has dropped by more than 40%. Russia certainly needs to cut real expenditures by a large amount. The exact number depends on what happens with non-oil GDP, and whether Russia wants to maintain military spending at previously planned levels. The necessary non-military real spending cut is at least 20%. Some of this cut is happening through accelerating inflation. But nominal expenditure levels will needed to be cut as well, in the face of accelerating inflation, which is officially only at around 10%. This is not going to be popular, and in the longer run may undermine Putin’s standing, but still it may be doable.

The ongoing bank run is potentially a more significant issue. Broad money, M2, is about 40% of GDP. Right now most of that is trying to leave the banking sector, and practically no level of interest rate is high enough to stop it. The Russian public understands partially reserve banking better than in most countries: if everybody is trying to take out money, you should be the first one. The last ones in line will get nothing. This means that the banks are broke if the central bank, the Bank of Russia is not bailing them out. If it does, it can only do that by printing serious amount of money, which would be putting further pressure on the exchange rate. It would be de facto fiscal spending financed by printing money.

So far, policymakers in Russia only used the “traditional” tools of hiking interest rates and FX intervention. Given the quantities involved, these are likely to be inadequate. The confidence crisis will pass (we would not use the word “solved”) through some combination of the usual channels: high inflation, default (on bank deposits/foreign corporate borrowing) and capital controls.

Interest rates at 17% and a collapsing ruble means that investment and consumption is collapsing in Russia. Fiscal tightening (real fiscal spending cut) is aggravating the demand collapse. The only silver lining is that non-commodity exporters are getting a boost to their competitiveness because of the weaker currency. But high inflation in the past meant that the ruble started from a very strong real exchange rate. The depreciation to say around 75 only means restoring real exchange rates to the level of 2003, when already there was very little non-commodity export. So the ruble depreciation so far is probably not enough to give a decent export boost for non-oil sector exports, and more real depreciation would be necessary to achieve that. It is likely that the central bank will eventually bail out the banking sector by printing money. This may well lead to an even weaker currency.

But despite the screaming headlines, Russia will not disappear from the face of the earth. This is going to be a “textbook” adjustment to a terms-of-trade shock. After the dust settles, there will be a substantial financial deleveraging (debt ratios will be lower), real fiscal spending and living standards will be substantially lower, and the real exchange rate permanently weaker. And that also means that the country will be less dependent on oil and gas.

Capital flight could stop or – if the confidence is there – some of the capital may even return. At that point in the future inflation can be gradually reduced, if the government can balance its budget and it does not resort to money financing. The IMF could make this process smoother, but for obvious political reasons this is not going to happen. Also, Russia could use the opportunity to introduce structural reforms (with or without the IMF), reduce corruption and boost competitiveness, at least in the non-commodity sector. But that would amount to the dismantling of its current clientelist state, so we may need to wait for some other shock in the political sphere for that to happen. But the need for these reforms at least would become obvious.

During this adjustment politics will be important and interesting. At the end of the process, the Russian government will have less resources to play with, and that will limit how much it can achieve both at home and abroad. Some fear that in the meantime, the government may try to buy popularity by gambling on being even more aggressive/nationalistic. That is probably too pessimistic: the Russian government is already fighting an economic war, intensifying a real war in addition to that would put a large strain on its management and financial resources.

It is not going to happen overnight or without pain, but the current crisis may end up making Russia a better place.

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