Russian Lesson

Earlier this year, when it became clear that the U.S. economy was at risk of a recession, some economists claimed that the global repercussions of a U.S. downturn could be far weaker than in the past. Gone are the days when emerging economies caught a cold whenever big bad America so much as sneezed, they declared. Now there are such international stalwarts as China, India, Brazil and Russia, all growing rapidly, building their infrastructure and sucking in commodities, consumer products and capital goods.

Their effect would mitigate — even counterbalance — any slowdown in the United States. After all, the combined size of their economies is approaching that of the U.S., while their population measures over 2.5 billion.

Russia in particular was supposed to be a safe haven from global financial troubles. Some 10 years ago, in August 1998, it suffered a crippling debt default and devaluation. But with oil prices going through the roof and other commodities at record levels, Russia in recent years has been running one of the world’s largest current account surpluses, measuring over $100 billion, or 6 percent of GDP. The ruble is backed by a $600 billion reserve cache. Only China and Japan have larger central bank nest eggs.

The RTS index of the Moscow stock market peaked at 2,500 in May, buoyed by foreign investors worried about the impact of rapidly rising oil prices on Western economies. Market capitalization reached $1.5 trillion, roughly equaling the country’s GDP. Earlier this year, daily stock turnover on the Moscow market measured $7 billion, making it one of the busiest in continental Europe.

Lead BalloonBut when these factors were tested by events they all proved worthless. Once financial turmoil hit Wall Street, Russia did much worse than caught a cold. It seemed to come down with some virulent terminal illness.

In the third quarter alone, stocks lost close to 60 percent of their value, vying with China for the title of the worst performing equity market of 2008. By early September, selling turned into an outright panic, with foreign investors withdrawing $35 billion according to BNP-Paribas data.

To be sure, even under the best-case scenario, Russian markets would have sold off in the current international environment. Russia has been posting GDP growth rates of around 8 percent in recent years, but growth was too dependent on high oil prices at a time when a slowing global economy was expected to dampen demand for oil. Merrill Lynch put out a sell recommendation on Russian stocks back in July.

The Russian government has not issued a sovereign Eurobond in over 10 years, but Russian companies have been borrowing abroad with gay abandon. About 25 percent of all domestic financing in the Russian banking system is funding by foreign borrowing. This means, first of all, that Russian banks fund their ruble assets with foreign currency-denominated liabilities and, second, that they could be vulnerable in an international environment of tight credit and counterparty risk aversion.

Besides, looking beyond these international factors, Russia has been over-consuming and under-investing during this period of plentiful, easy money. It has persistently run the highest inflation among major developing economies except for Argentina and Venezuela.

Self-Inflicted WoundsThe international investor community returned to Russia only reluctantly after the 1998 default, in which many Russian debtors left their foreign lenders high and dry. In recent years, they have had cause enough to worry. Yukos Oil, Russia’s largest and most transparent private oil conglomerate, was arbitrarily renationalized and its owner jailed. Then foreign oil companies came under pressure to renegotiate their production sharing agreements or even to give up their businesses in Russia. Royal Dutch Shell, for instance, was harassed by government agencies until it sold its share in the lucrative Sakhalin-2 exploration project to Gazprom, the state-owned natural gas monopoly.

Investors have notoriously short memories. As long as profits were good they were willing to disregard nagging concerns about the business and investment climate in Russia. Instead of using the period of good fortune to improve the country’s investment climate, Russian officials, with an unerring sense of timing, picked this summer to heighten such concerns.