Russia’s Economic Crisis – Separating the Forest from the Trees – Part I (trees)

Even though I have not posted in a while (exams), it has been exciting to see how much Western media coverage Russia received over the past months and weeks, even if it was almost entirely negative. Just the other day we learned for the umpteenth time that Russia plans on ‘testing’ Obama, according to Undersecretary for Arms Control, John Rood. And earlier this week, yet another Russian ship docked at yet another Latin American/Caribbean country with whom the United States refuses to deal. Meanwhile, Latin American leaders met with that same country and Russia at a summit to which the United States was not invited. These events all raise questions about our Russia policy (and Latin American policy!), but that is a topic for another day.

The really interesting coverage, however, has been on the economic front, and the amount of confusion with regards to what is happening in Russia, and why. On a side note, I’ve been especially surprised at the amount of schadenfreude over Russia’s economic challenges. It baffles me that, as every new U.S. economic indicator is reported with the words most/biggest/worst/lowest/least and the phrase “since the Great Depression,” the coverage of Russia’s crisis is almost gleeful.

The Short-Term, Cyclical Causes of Russia’s Downturn

Clearly, the global financial crisis has hit Russia hard and, as with every other country, has resulted in a dramatic slowdown in economic activity, with industrial production falling 8.7% in November, a steady erosion in the ruble’s value, and a rapid depletion in Russia’s foreign reserve holdings (see graph to left below) [read good coverage of this and other indicators here]. So what is the immediate cause of this downturn? Much of the Western coverage focuses on the incredible declines in the Russian stock market since the summer (see graph to right). Furthermore, many consider the South Ossetian War instrumental in this fall. In reality, while the war certainly did not give investors a reason to stay, the fall started in May, and really took off in September-October (i.e., during the Lehman Bros. collapse and mid-October crash). More important, however, is the issue of the extent to which the Russian stock market is even relevant to the Russian economy (both financial and real). From 2005-07, foreign portfolio investment (FPI) in the form of share purchases constituted only 3% of total foreign investment. Foreign direct investment (FDI) was 24% and ‘other’ portfolio investment 73%. Indeed, to finance their activities, Russian firms are much more reliant on foreign purchases of bonds and other loans, and not on the stock market. As the crisis picked up steam in the United States, more and more financial institutions started to dump these bonds and call in loans. In this way, the stock market crash did contribute by making margin call provisions in the loan packages available to the foreign lenders. In fact, total Russian corporate debt is only 30% of GDP (vs. 65% in the U.S.), as Ben Aris argues in the most recent businessneweurope magazine, “the slowdown came so fast that companies had no chance to restructure their debts to cope with the changes,” which has led to the slowdown in the real economy. Thus, the crash of the Russian stock market did not proximately cause Russia’s financial and subsequent economic crisis, as it is the least common source of capital for Russian firms. Rather, the problems started when demand for bonds dried up and, for certain enterprises, margin calls on loans were made.

The second primary cause of Russia’s problems, which is in fact mentioned in Western coverage, is the collapse in the price of oil and other extractive resources. Oil and gas constitute over 65% of Russia’s total exports, 79% if you add in metals. Also, strong demand for Russian natural resources is a vital source of foreign reserves and key to the ruble’s freely convertible status. Still, even as the price of oil spiked over the past two years, reaching a record-high in May, the role of extractive industries as a source of GDP growth has decreased. In 2003, 11% of GDP growth was attributable to extractive industries, whereas by 2007, that number had dropped to 0.3%. In fact, the leading sources of GDP growth in 2007 were nontradable sectors including construction (16.4%), wholesale/retail trade (12.9%), financial services (11.4%), and transport/communication (7.7%). As for tradable sectors, manufacturing still contributed a respectable 7.4%. Thus, Russia has used high oil prices to finance the growth of other areas of the economy (more on whether they invested wisely later). When demand for oil and other resources collapsed, so did one of the major financial sources of Russia’s GDP growth.

In sum, Russia’s recent economic performance was particularly reliant on two sources of finance – cheap money from foreign financial instiutions and high revenues from skyrocketing oil prices. These two cash machines were shut off so quickly, that the Russian economy had no time to adjust, leading to havoc in the real economy. Luckily, the Russian government appears to have set aside enough cash reserves and a Stabilization Fund that it can prevent what will likely be a recession from transforming into a full-fledged [near-]depression. This will, however, constrain the government’s ability to fund desperately-needed investments in infrastructure and public health.

In Part II of this post, I will cover the ‘forest’ – the long-term, structural economic challenges facing Russia.

(the atm is broken)
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One Response to Russia’s Economic Crisis – Separating the Forest from the Trees – Part I (trees)

  1. Jeff B. says:

    I would tend to agree with your analysis. Russia remains predominantly a commodity price story which started in May. If you compare the stock market fall to that of Brazil, they’re very similar. Georgia didn’t help matters but it’s clearly not the root of the current crisis. In the long-term, lower oil prices will be good for the economy as it will provide incentives for restructuring and improvements in the investment environment. The West should avoid seeing this as a come-uppance and seize this as an opportunity to resurrect a meaningful dialogue with Russia on economic, energy and financial matters. I wouldn’t be surprised if there is a resurrection of Gore-Chernomyrdin in the form of Biden-Putin or something similar in the Obama Administration.

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