There is a common perception that Russia’s move on Crimea shows its strength. A closer examination suggests it is more complicated that it may seem. Like the bully at the school yard, the aggressiveness conceals weaknesses.
Simply put, Russia felt threatened and for good reason. The democratic coup in the Ukraine threatened a potentially strategic loss for Russia. For months, it had been using both carrot and stick to pressure Ukraine, Moldova and Georgia from shifting more to the EU. Reports indicate that Putin had drawn his own line on Ukraine and made it clear to the EU and US that Russia would not accept a Ukraine in unfriendly hands.
Yanukovych was brought to heel and at the last minute embarrassed and frustrated the EU (and by extension, the US) and struck a deal with Russia. A democratic coup toppled Yanukovych, and there are reasons to suspect that Europe and/or the US may have helped facilitate the political uprising. Among the first acts, the new government abolished Russian as the second official language.
There was a realistic fear (on the part of Russia) that the new government would move to retract the 2010 agreement that arguably was struck under duress, to renew and extend the Russia’s lease on the Sevastopol naval base. The lease, first struck by Yeltsin was to expire in 2017. Fisticuffs broke out in the Ukrainian parliament over the issue that eventually led to a 25-year extension of the lease.
The annexation of Crimea will make this issue moot, though at a cost. Prior to the annexation, Putin claims the mantel of the status quo power and forces the US and Europe to be the revisionists. Annexation puts the shoe on the other foot. It is a less defendable position in legal and diplomatic terms.
Leaving aside potential Western military options, such as resuming the ballistic missile defense programs, moving NATO troops to Ukraine’s western border, and even sending new weapons to Ukraine, there will likely be economic consequences.
The consequences we have in mind are not sanctions by government, but punishment by impersonal market forces. Ironically, despite some claims that the US military buildup under Reagan led to the bankruptcy of the Soviet Union, arguably more robust analysis would give a more decisive role to the collapse in oil prices in the mid-1980s (e.g., WTI fell below $10 a barrel).
With the exception of Singapore and Hungary, Russia has the highest amount of foreign currency debt at about 12% of GDP. Ruble depreciation boosts the cost of servicing the debt, some of which is in corporate, not government hands. The dollar rose 8.25% against the from rouble the start of the year through early February. It has gained another 7% since then. It is the second worst performing currency against the dollar this year, behind the Argentine peso.
The currency depreciation, in the context of political and economic uncertainty, has seen Russian yields soar. The rouble denominated 10-year yield has risen more than 100 bp, thus far this year, to 8.85%, eclipsing the yield of South Africa. The dollar denominated bond yield has risen 55 bp to 5.11%.
The cost of insuring Russian (rouble) exposure via the credit default swap market has risen about 50% this year to more than 230 basis points. This puts it within spitting distance of Turkey (233 bp), Hungary (242 bp) and Croatia (318 bp).
Russian equities are among the worst performing equity markets in the world so far this year. MICEX is off 13% so far this year, with a 17% slide since February 18.
Even before the recent developments, capital outflows frustrated Russian officials. Outflows have typically exceeded forecasts by the central bank and government. Last year, the central bank forecast $10 bln of outflows. Figures released in mid-January showed that the capital outflows were six times greater. At the same time, the current account surplus was more than halved to $33 bln.
Putin, who claims to be a student of history, may be repeating some of the same mistakes of the Soviet Union with an apparent disregard of market forces; poor domestic investment opportunities, high inflation and high cost of capital weigh on growth. Last year, Russia recorded growth of a 1.3%, the lowest since 2009 and well below the government’s target of 5%.
Russia has accumulated a stockpile of foreign currency reserves. However, after peaking in 2011, near $544 bln, they have been trending lower, especially since the end of 2012. They stood just below $495 bln at the end of February. Reports of recent intervention warn of a further drawdown in reserves. At the same time, its current account surplus is trending lower, with last year’s the smallest in a decade.
Russia is more integrated into the world economy than the Soviet Union ever was. This is a source of non-statist pressure on Russia. A decline in oil prices would be particularly helpful in this regard. There are calls for the US to relax export restrictions on crude oil and natural gas. Such efforts may prove more important symbolically than substantively as it would take a few years to deliver LNG. Despite the increase in US output, the world’s largest economy is still importing some 5.5 mln barrels of oil a day.
This piece is cross-posted from Marc to Market with permission.