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.