How can a country with US$500 billion in foreign reserves get into a crisis? Russia 2008

Since last June Russia has been one of the hardest hit countries in the emerging world. The stock market has plunged, capital has flown out of the country and inflows have stopped. A liquidity crisis in the domestic banking sector emerged and even corporate giants in the energy sector have begun to have difficulties in refinancing or even repaying their debts. One could argue that this is hardly surprising, as the current financial crisis is a global one and thus no country will be spared. However, one needs to explain why Russia is doing much worse than her peers in the emerging world, even worse than countries with huge external imbalances, e.g. Baltic countries and countries in South-Eastern Europe.

When the crisis erupted last year, the perception on Russia’s risks was low, both in the market and in the assessments of international institutions. Russia had a sizable current account surplus, coupled with a sizable budget surplus. Furthermore, having resisted pressures by international financial institutions to appreciate the Rouble, Russia accumulated a huge stock of foreign currency reserves. To provide even stronger safeguards, Russia saved oil revenues in an oil stabilization fund and had created a sovereign wealth fund to invest such surpluses.

By any standards, the stock of foreign reserves was so large that any currency or financial crisis seemed close to impossible. The stock of foreign reserves covered the full stock of broad money: the central bank could withstand even a run on Rouble-denominated deposits in the banks. In terms of coverage of foreign refinancing or repayments, international reserves were extremely safe. Net of short-term foreign debt, foreign reserves still cover the total amount of deposits in the banking sector (Figure 1). Even if we were to add all foreign debt of the country, including private sectors, international reserves would remain almost as large of foreign liabilities.


In summary, are we witnessing a classic self-fulfilling panic, largely unrelated to fundamentals? According to many observers, such panic could have been triggered by the conflict in Georgia and by the increasing tensions between Russia and the Western World, associated with clear authoritarian tendencies in the country and with a “statalist” approach unfriendly to foreign investors. These elements may have played a role, but they have not been the main cause of the crisis. As recently as the Spring of 2008, rating agencies were in fact pointing to the strong state as a main risk-moderating factor.

I believe that the Russian crisis of 2008 is largely grounded in economic factors. The main insight for understanding the Russian crisis comes from a view expressed by Guillermo Calvo and Ernesto Talvi last year on this site “Current account surplus in Latin America: Recipe against capital market crises?” May 18, 2007, thus before the start of the financial turmoil). Calvo and Talvi, in the middle of optimistic assessments about Latin American countries, warned that risks were under-estimated and suggested that aggregate indicators such as the surplus in the current account were misleading. Their main point was that even when the country as a whole is a net lender, there might be large sectors in the economy that have large deficits and large foreign debts. In the event of a sudden stop of foreign financing, these sectors are going to be severely affected. In principle, surplus sectors could support the deficit sectors. However, this would require highly efficient financial markets. Furthermore, this transfer is unlikely to happen because if anything surplus sectors would tend to keep abroad their investment. In fact, capital flights may even increase.

This view is highly relevant for the current Russian crisis. Despite a sizable current account surplus many sectors, especially non-energy sectors and non-tradable sectors, had financed their growth through foreign borrowing, either directly or through the domestic banking sector that sharply increased its foreign indebtedness. Interestingly, despite the large current account surplus, in 2006-2007 Russia had a massive inflow of capital, well above capital outflow from Russia. Such inflows were as high as 15% of GDP in 2007 (Figure 2).


A key additional element of the picture is the high dependence of Russia on energy exports. The large surplus in the current account was due to booming commodity prices. Therefore, Russia benefited simultaneously from booming energy prices and easy access to foreign financing. Both elements turned around abruptly in 2008. The true trigger of the Russian crisis was the drop in oil prices that began in June 2008.  Indeed, it is from that point, well before the war in Georgia, that Russia starts to get into troubles. Starting in June, the stock market plunged, capital started to flow out and a sudden stop on capital flows occurred. The real economy began to be hit very hard. The financial sector appears highly segmented. Since then, the State has intervened heavily and has de facto assumed the debt of several corporations and banks.

Therefore, the causes of the crisis are not so obscure. However, are the markets punishing Russia well beyond what is justified by fundamentals. Why the spreads on CDS went above 1,000 basis points? Is a default on Russia sovereign debt around the corner?

As noted at the beginning of this piece, Russia has a large stock of foreign reserves and thus sufficient ammunition to fend off even a dramatic panic by depositors. Even taking over all foreign short-term debts of enterprises and banks, the Russian government would have enough foreign reserves, either at the central bank or at the oil and sovereign funds, to withstand a run on deposits. Therefore, default on sovereign debt is unlikely.

However, the market may be correctly anticipating a serious country risk in the form of nationalizations and confiscation of assets. Looking forward, government assets do not look so healthy. Not only, with declining oil prices, Russia’s current account will quickly turn into a deficit. In addition, there is a huge implicit liability of the government that is related to the enormous infrastructural investment needed to maintain production of energy (in real terms). As energy is the main asset of the country, the government needs a huge amount of resources to maintain the value of such asset. The resources set aside as foreign reserves and as oil and sovereign funds look small relative to the huge public investment needs. The true underlying fiscal position of an economy that is moving towards an encompassing role of the State in all economic sectors is very weak. Given the bottlenecks in the energy sectors, it is unclear what are alternative sources of growth for the Russian economy.

In sum, the growth displayed by Russia in recent years is not sustainable and the outlook is rather grim. In contrast with the crisis of 1998, Russia may escape default on sovereign debt. However,  the prospects of a fast growing Russia post-crisis looked much better in 1998 than today.

21 Responses to "How can a country with US$500 billion in foreign reserves get into a crisis? Russia 2008"

  1. Anonymous   October 28, 2008 at 8:32 am

    Having been to Russia several times in the last few years and experiencing the political environment there first hand, it is apparent that investing in Russia is no longer an intelligent option for the West unless of course, you want to risk losing your investment due to trumped up charges, risk your life to poison, or find yourself in the stranglehold of unclear regulations and Anti-West sentiment.

    • Anonymous   October 28, 2008 at 12:11 pm

      the property rights and the opaque regulations risk was already factored into the valuations in May. What we are seeing now is the result of oil price dropping and economic warfare by the Bush administration, which has no other immediate means of responding to being humiliated in Georgia.

    • Guest   October 31, 2008 at 9:04 am

      Have you been poisoned?

  2. cscap   October 28, 2008 at 11:07 am

    So much for an open economy! Compare this with the restriction on foreign lending to China and the restriction on raising capital overseas. People, firms and countries go bankrupt because of excess availability of funds. The recent examples are the Asian financial crisis, the “dot-com” crash, and the current “sub-prime” mortgage crisis. Draconian regulations are necessary to protect the average borrowers who have not develop strict discipline in financial affairs.

    • Guest   October 28, 2008 at 12:03 pm

      No, average borrowers need to use discipline. If they can’t understand that the payment can’t be larger than the income, they need to suffer.

  3. Anonymous   October 29, 2008 at 2:42 am

    I want to contradict the two previous commentators. While it is definately true that Russia has neither a western style legal system nor a “real” democracy you can easily make business in Russia as is attested by hundreds of medium sized German companies who have sat up production units in Russia. Don´t believe it? Enter any supermarkat in Russia and look at the brand names and the place of production. What do you need? 1. No involvement in anything that is termed “strategic”. i.e. ressources, armaments a.s.o. These have in fact been the only ones who have been bothered. 2.A russian partner who you can trust. Not that difficult contrary to the usual image of Russia. Just as legal details don´t play such a role in Russia personal relationships tend to be much more reliable there than in the West.3. Shut up about Russia while you´re there. The government has strong support among all segments of the population and the surest way how to get in trouble is to approach the country with a western point of view. Try to view the place from the inside out. Vital for the relationship thing 4. Get into some niche. There´s lot´s of them still there to be taken.5. Always grease the right palms but combine that with a personal attitude.6. Never be stingy because that is not the Russian way. This is a famously exuberant people.6. You´ll make lot´s of money

  4. Hero   October 29, 2008 at 2:14 pm

    Russia will be fine. The reasons follow:Panic and fear are the main cause of the economic disruptions in Russia now though fundamentals are strong. Russians are easy to manipulate given the memory of the financial crisis of 1998. The biggest fundamental problem of Russia is not the banking crisis, fear or the dependence on the raw materials, but the lack of management and low economic illiteracy rate.To give you an example, the Russian government is pouring money (rubles) into the system. The banks do not trust each other and do not use this money to give credits etc but instead convert it into US dollars putting pressure on the ruble and forcing the government to intervene to maintain an exchange rate in order to stop run on banks and the total collapse of the financial system. The banks’ pressure on the national currency helps to weaken it enough to return the percentage on the credit and receive profit. A few articles in the media and panic is helping private banks in this earning effort. It took the government some time and a drop of ruble’s value by some 10% to understand this. The good thing is that they seem to learn. Though devaluation of ruble is immanent it is not going to happen overnight. The government realizes that such a move will collapse the baking system and thus they will do anything to maintain the comfortable slow devaluation. So I wouldn’t worry about the exchange rate until the fall 2009 and depletion of reserves below 100 bln, which will never happen. The reasons for this are obvious. The world is hungry for natural resources. The demand will only increase in the future.There is also one thing, which is missed by many analysts. The small and medium business, which accounts for a significant share of GDP and employs millions of people, is less vulnerable to financial troubles. The Russia’s curse and inefficiency of its financial sector is now its biggest blessing. The lack of banking competition, high percentage on loans was somehow preventive to blow up the loan bubble. Compare an average 9% car loan and 12% home loans in Russia with percentage available in the western countries. Only 20% of new cars were bought via loans, the home loans were also very difficult to afford. Small and medium businesses were also unable to secure credits, because banks were charging too much and required solid financial guaranties, which small businesses lack. They had to relay on their own financial resources and today are in better shape. Large enterprises in contrast had the opportunity to borrow abroad, which they did and are now exposed to financial risk. The foreign money, which flooded the economy, reached mostly large enterprises and consumer sector through emerging banking industry.However, it would be untrue not to mention the impact of the loan bubble, which indeed is also pretty severe in Russia. Over the past years the economy was pumped with foreign money through foreign banks and oil profits brought by state companies. The banking sector emerged and started to grow rapidly focusing on consumer credit. Slowly in the beginning as it went credits began to reach Russian citizens sparking demand for consumer products. This lead to consumer boom and stimulated construction and retail, as well as banking, and car sales, etc. E.,g until recently the construction sector in Moscow was more profitable then drug and weapons sales. To give a perspective a small 60 sq meters apartment in Moscow in a newly build house cost about $300,000. This is a total nonsense if compared with the same quality apartments in other parts of the world. (It should be noted though that construction market in Moscow is a monopoly.) The demand for new cars was so huge that on average people were waiting for ONE YEAR to buy a car worth $25,000. There are numerous other examples of the disproportions in demand and supply and lack of competition. Unfortunately, neither the business nor the citizens were ready for such easy access to credit money. The active promotion of consumerism through mass media has made its devastating job. The mentality of Russians has begun to change from saving to spending. There is nothing wrong about it as long as you understand it. The bad thing about it is that only few people could manage it effectively. You need to understand that credit was difficult or impossible to get a few years ago and suddenly it has changed completely. For many it was a shock. As banks untighten control over risk assessment, credits were given even to bums provided he/she has a passport. The crisis has arrived just in time to stop the moral hazard. It will eventually have a very positive effect on the economy and society as the whole. The ineffective enterprises should die, and those who dependent on credit should learn the lesson.In either way the country’s economy depends on the export of resources and it is not bad at all in the today’s world. The world requires these resources to live in prosperity. Thus, it will be mined, drilled, harvested regardless of the crisis, political risks, prices, wars, etc. Fundamentally, the country can always provide a positive net trading balance if managed effectively. Unfortunately, the world today is oversupplied with raw materials. Until it is consumed the Russian economy will stagnate. It will take about a year for the commodity markets to restart. The sale of assets may reach its peak in spring 2009, and it would be the best time for buying stakes in Russia’s energy and mining companies. These assets will grow many times in the coming years. The fundamental for this is the lack of natural resources available on the planet to support the world’s 6+ billion population. The production of oil is decreasing all over the world. Russia is not an exception. The production of oil in Russia will decrease by at least 1% this year. The oil and other natural resources will only increase in price as there is no other alternative.More then anyone else I do know about waste and inefficiency going on in Russia, but as strange as it may seem, I begin to think in a more positive perspective of the Russian economy in the mid-term and long-term perspective. Russia will be just fine.

    • Guest   October 29, 2008 at 11:37 pm

      Russia was never fine, is not fine now and will never be in the future. Just because you have seen Moscow it doesn’t mean you have seen the rest of Russia. Russia might still be around 50 years from now but Slavs are going to be just a minority, which hopefully will peacefully recoincile with it’s decline… .

      • Eric Kraus   November 2, 2008 at 8:13 am

        I have seen the rest of Russia – repeatedly, both for business and pleasure, and more importantly, the same places repeatedly oveer the years. The provinces have seen more impressive growth over the past five years then even Moscow. Samara, Nizny, Irkusk, Petersburg have all been enjoying a belated boom – which completely passed them by in the 1990s. This is why Vladimir Putin remains overwhelmingly popular.

      • Guest   May 7, 2009 at 10:25 pm

        Absolute bullshit – you only looked at the surface from Western eyes. Sounds very much like a USA type.

  5. Kevin   October 30, 2008 at 3:26 am

    Well, what has the historical trend been in other countries with similar political situations?

  6. Anonymous   October 30, 2008 at 11:33 am

    Clearly, Russia is now under a concentrated attack, both financial and informational, with the likelihood of a large-scale military provocation in the summer of 2009 via Ukraine or/and the Caucasus. Western cabals will sooner let the Small Britain sink than loose these beachheads against Russia. So they will keep Ukraine, Georgia, and the Baltic dwarfs afloat by any price. Coricelli’s piece is nothing else but a cover up job for this attack. The ratings for Russia by the US-controlled entities are just too scandalous, especially if compared with those for the bankrupt Small Britain, Poles, Baltic dwarfs and the like. So there is a need in somehow explaining out something that cannot be explained by economic rationality but only as a part of the operation to crush Russia. To make sure they won’t succeed the Russian government must nationalize the banking sector. Russian capitalists are less disciplined and more treasonous than their US counterparts. So they must be harnessed ruthlessly. A la guerre comme a la guerre.

    • Guest   May 7, 2009 at 10:52 pm

      I AGREE. Australian. Time the USA and Europe lets up on China also.A delightfull Country and people.BUT – How dare they do things a bit differently to the West and see some things differently. They should know all wisdom originates in the West. They are just primitive heathens with no real Coulture etc. Who really is fooling who?? Don’t we just fool ourselves with our set Western Dogma and self righteous attitudes???

  7. Anonymous   October 30, 2008 at 2:55 pm

    The good thing is that Putin hasn’t cashed out and left for Switzerland. Whatever motives he may have, he will do his best now to protect stability of his little empire. It is very unlikely that he will confront with the US in the real conflict. Forget that horrific stories about NATO in the news etc. It is all fabricated for public. In reality Russia doesn’t really care much if they accept Ukraine or Georgia or even Russia to NATO or even start building their radar stations everywhere including Moscow, etc. These are just bargaining tools the real value of which is zero, but they are trying to make it look valuable in order to get something out of it. He and his fellow oligarchs are business people first. They only care about money and profits. Russia now is like the US the only difference is that they don’t have good PR, GR, IR, and other Rs.I would rather watch closely Iran and Israel. It is more probable that Israel will attack Iran in the begging of 2009.

  8. Anonymous   October 31, 2008 at 6:30 am

    It’s interesting that 6 of the 10 posts here (7 of 11 if you count mine) are “anonymous.” While I haven’t made similar tallies of comments on other articles on this web site, it does seem that there is a disproportionately high number of anonymous posts here. I wonder what that says about the state of Russia.

    • Klim   October 31, 2008 at 6:48 am

      I wonder what that says about the state of Russia.Why Russia? It’s a US website and server. If anything it might say something about the US security state rather than Russia.

    • KF   October 31, 2008 at 8:57 am

      “It’s interesting that 6 of the 10 posts here (7 of 11 if you count mine) are “anonymous”, said Anonymous on 2008-10-31 06:30:41.”what that says about the state of Russia”? Probably nothing.

      • Guest   May 7, 2009 at 10:46 pm

        Yes nothing – I in my first post stayed anonymous I now realise because I do not want to risk being hounded by some narrow Western Dogma driven person. Especially one from the USA. I am Australian.Yes I will stay anonymous. That is the fear I have. Strange I did not feel that Fear in Russia or China recently.What does that mean?? We supposedly have Free Speach in the West ??? Is it just me ???Russia is supposedly not Democratic or China??? or Maybe I found people there in general deal with the FACTS?? We in the West could not be driven by Dogma surely with all the Free Speach and Debate we have ??? Surely not – we are too balanced for that!!!

  9. KF   October 31, 2008 at 8:51 am

    The author started what could be an interesting article and ended up going into fantacizing about coming “nationalization”. I’m sorry, but this is enormously far-fetched. The need to finance infrastructure existed in the early 1990s, in 1998, in 2000s, and will never disappear. If anything, the falling price of oil provides motives for refraining from nationalization, as history, including Russian one, amply demonstrates. The Russian government actually makes a lot of efforts to persuade everybody that it doesn’t have such plans. At the same time, the article’s whole conclusion is based on this fantasy. As a result, the piece makes a very bad analysis.As for the claim that Russia looked more promising in 1998 than now, it is simply an insult to intelligence of anybody who saw 1998.

  10. Guest   October 31, 2008 at 9:12 am

    Regarding Russia being worse-off in comparison to “peers”. Do the “peers” include the ones who are taking money from the IMF now?

  11. Eric Kraus   November 2, 2008 at 8:37 am

    The statement that Russia is one of the “worst hit countries” is patently false.The Russian stock market, primarily the appanage of foreign investors, was indeed hit very hard – as of this writing, it is down about 60%, i.e. slightly less than China and on a par with India. Its integration into the real economy is very tenuous.The rouble has, in fact, not depreciated. It has fallen against the dollar, risen sharply against the Euro.The rouble bond market has become very illiquid, due to problems in the banking sector. This poses a more substantial risk to corporate refinancing, but indications are that money pumped into the top three banks is finally moving into the economy, and there have been no significant defaults to date.The CDS spreads have literally nothing whatsoever to do with perceived sovereign risk – and this not only in Russia. As regards Russia, the grotesque spreads were a reflection of very poor liquidity in the cash bond market, the exit of the hedge funds from the CDS market, as well as panicked US institutional investors buying protection at ridiculous rates under the direct orders of their Risk departments. Those doubting this assertion will need to find an alternative explanation for the 600-point tightening of the 5Y CDS spread over the past 48 hours – this in the absence of any significant news flow.The real financial problem arose from the attempt to adopt the Washington Consensus model, i.e. the opening of the capital account, coupled with the Central Bank investing huge currency reserves in low-yielding G7 assets. The improvement in credit ratings and the US-originated global financial bubble led to a Tsunami of dollar inflow, causing the usual misallocation of resources. The sudden reversal of the flow has proved highly disruptive.The CBR has responded by rapidly sellikng down foreign assets – in particular, US Agency (in-) securities, and is beginning to refinance the debt of the Russian corporate sector.The challenge is to do so without the resources being diverted abroad, or worse still, used to speculate against the Rouble – similar to the situation seen following the 1998 bailout. In this respect, the misnamed KGB-state will need to be rather proactive – and any banker abusing State resources for personal gain should be living in fear.