Why Russia's Woes Should Worry You
For months now, my attention has focused on Russia. The country is big enough, and its problems serious enough, that it could take the global crisis to a new level of danger.
Let me quickly summarize the last crisis:
- In 1998, a worldwide financial crisis that started in Asia led to a collapse in demand for oil, natural gas and nonferrous metals, which formed the foundation of the Russian economy.
- The prices of oil and other commodities plunged, which left banks that had made huge loans to oil or mining companies (or to investors who had pledged shares of those companies as collateral) teetering on the edge of insolvency.
- Despite government efforts to defend the ruble, the Russian currency went into free fall.
- The Russian stock, bond and currency markets collapsed when domestic and overseas investors delivered a devastating "no confidence" vote by refusing to buy ruble-denominated bonds despite yields of more than 200%. Russian stocks lost 75% of their value from January to August.
- With inflation running at better than 80% and food prices up 100%, Russians took to the streets in protests that eventually brought down the government of Boris Yeltsin.
- Russia then defaulted on its ruble and dollar debts, leading to the failure of the Long-Term Capital Management hedge fund after losses of $4.6 billion in less than four months. To prevent a panic in the financial markets, the Federal Reserve stepped in to organize a bailout of the fund.
So here we are in 2009, and a worldwide financial crisis has led to a collapse in demand for the oil, natural gas and nonferrous metals that still form the basis of the Russian economy. Share prices on Russian stock markets have headed south with a vengeance. Shares of Gazprom (OGZPY, news, msgs), the leader of Russia's oil and gas industry, dropped more than 70% in 2008.
On Sept. 16, the government suspended trading on Russia's stock exchanges for an hour after the worst one-day fall since -- you guessed it -- 1998. Despite words from the finance minister assuring investors that there was no systemic crisis, trading had to be suspended again Sept. 17 and 18. The Russian stock market fell 19% on Oct. 6 and an additional 14% on Oct. 9.
Banks that had made huge loans with shares of energy and mining companies as collateral teetered on the brink of insolvency, as they had in 1998. However, in the 1998 crisis, the Russian government lacked the financial resources to act. As 2009 begins, the country's coffers are full after a decade of climbing energy prices. Russia's reserves stood at $600 billion in August, so the government has been able to move aggressively.
In September, the government lent the country's three biggest banks $44 billion. That same month, the government injected $20 billion into the financial markets and then lent an additional $110 billion to the country's banks. October brought $36 billion more in loans to banks.
To head off runs on those and smaller banks, the government raised the limit for deposit insurance to $25,000. As in the U.S. crisis, even after an injection of liquidity from the government, Russia's banks refused to lend to each other. Interest rates on interbank loans climbed to 23%. Nine banks had failed by the end of November. The government allowed others to keep operating, even though they were insolvent.
War on 3 fronts
But keeping the domestic banking system from insolvency is only one front in the war. At the start of the crisis, Russian companies owed $450 billion to overseas investors. With the Russian stock market falling and the ruble down 20% since August, many of those overseas investors have demanded their money back. The government has authorized state loans of $50 billion to make up for overseas loans that come due and where overseas investors refuse to roll them over. That's clearly a stopgap measure, however.
And let's not forget the ruble. On Dec. 29, the Russian currency traded at 41.6 rubles to the euro: That's the lowest value ever for the ruble against the euro. Against the U.S. dollar, the Russian currency is doing better: At 29.3 rubles to the dollar, the ruble is cheaper against the dollar than it's been since 2005. But the ruble was down almost 40% in 2008 against its official dual currency basket of 45% euros and 55% dollars.
The big worry is that Russia won't have enough in the bank to win a war being fought on these three fronts. Reserves that stood at $600 billion in August were down to $450 billion as of Dec. 19. Spending to control the economic, financial and currency crisis is accelerating. In the week that ended Dec. 19, for example, the central bank spent $7 billion to buy rubles to slow the currency's decline. Reflecting those fears, Standard & Poor's has downgraded the country's long-term sovereign credit rating to negative from stable.
And it looks like spending on social programs is just starting to climb. Failing companies have stopped paying wages. Inflation -- the government hopes for inflation of just 13% in 2009 -- eats away at already meager payments to pensioners. A falling ruble makes anything imported more expensive. Efforts to end domestic subsidies for energy eat into already strained family budgets. The last time around, the government threw money into pensions, subsidies and pay packages to keep protests down to acceptable levels. I don't think it will be different this time.
The good news
Ending Russia's crisis doesn't require a 180-degree turn in the economy, the Russian stock market or the ruble. What's important is the pace of the fall. If the ruble declines in a slow and measured fashion, if the economy looks like it's headed for a recession instead of a deep plunge into panic, and if stocks fall slowly enough that the stock market can stay open, the crisis will be manageable. And Russia will remain one of a very large group of countries coping with a global economic and financial crisis rather than becoming a wild card with problems big enough to threaten the global economy.
Because the speed of the decline is critical, the first quarter of 2009 poses the greatest risk. If the crisis in Russian financial markets, Russian banks and the ruble turns into a rout in the first quarter, then Russia's problems are on the way to becoming the world's problems. Watch the ruble: Some currency experts think there's a chance it could fall 20% to 30% in the first quarter of this year. That would constitute a rout.
I don't think that will happen. Russia's reserves, though not infinite, remain hefty. The country may not be making as much at energy and mining as it did when oil was $147 a barrel, but the country continues to run a trade surplus that adds to reserves. And Prime Minister Vladimir Putin went into this crisis with a far stronger grip on power than Yeltsin had in 1998.
Underinvestment likely to cost
However, even if Russia dodges a bullet, its crisis could have a huge effect on the global economy -- especially on the global energy economy.
Gazprom and Rosneft (RNGZY, news, msgs), Russia's other national energy champion, have underinvested in energy production during the boom years for oil and natural gas. At the beginning of the boom, young fields produced huge amounts of oil and natural gas with relatively small investments. But now many of these fields are aging and need billions of investment dollars to keep production from falling. Gazprom's budget for capital investment is set at $32 billion, which is about five times the company's capital budget in 2004.
It's hard to see how Gazprom and Rosneft, which has its own portfolio of capital projects, will be able to fully fund their ambitious production and pipeline expansion plans if Russia continues to divert billions to stabilizing its banks, supporting its currency, propping up its stock market and increasing social spending to head off a rising tide of protest.
Looking at the silver lining
Before the global financial crisis, projections from organizations such as the International Energy Agency suggested that current underinvestment in energy production would lead to a supply crisis in the next five to 10 years. The global economic slump, which has decreased demand for oil and natural gas, has put off that crisis by at least two years.
But by creating more competition for limited supplies of global capital, by raising the cost of capital, by pricing out some sources of energy and by making it harder for some companies and countries to raise all the capital they need, the current slump all but ensures that the supply crisis, when it finally comes, will be more painful than projected earlier.
And that's the best-case scenario now playing out in Russia.