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Russian Lesson

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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.

First, a group of Russian investors in TNK-BP, the Russian oil company 50 percent owned by the U.K. petroleum major, decided to pick a fight with their British partners. When BP invested $2 billion into TNK in 2003, it was hailed as the first of many future deals between Russian and Western companies and it reportedly had the personal blessing of then President Vladimir Putin. This year’s fight was largely about strategy, but it featured ugly harassment of British executives by various government agencies and politically motivated legal suits alleging unfair labor practices.

Then in July Putin viciously dressed down the head of Russia’s largest metals and mining firm, Mechel, whose ADRs are traded in New York. The company’s offense was refusal to play by government rules and keep its domestic prices down. Fearing another Yukos affair, investors promptly pushed the value of the company’s stock down by some 60 percent.

And then in August came Russia’s all-out invasion of its neighbor and former colony, Georgia. Worse, the attack was accompanied by an anti-American hysteria in the state-controlled media and an apparent zest for starting a new Cold War with the West. Not surprisingly, foreign investors began voting with their feet. Russian money, too, started to flow out of the country at the fastest pace since the 1998 financial crisis.

Unready for CrisisAs a result, Russia entered the period of heightened global financial uncertainty in early September already badly weakened. It was not prepared to withstand selling pressures that hit world financial markets. The problem was compounded by the Russian government’s apparent disdain for financial markets and obvious misunderstanding of the role they play in a modern economy. Rather than seeing financial flows as the lifeblood of economic activity, they treat markets as an irrelevant gathering of speculators buying and selling pieces of paper and churning around money, most of it foreign.

Initially, when the Russian stock market fell, Russia’s top government officials just shrugged. They failed to see how it could bear on their country’s ability to produce oil and gas or to buy and sell goods and services.

By mid-September, events were moving out of control rapidly. After the collapse of Lehman and the takeover of Merrill Lynch by Bank of America, selling pressures in the Russian stock market intensified. The RTS index dropped by over 11 percent in a single session. The central bank, which had spent nearly 5 percent of its hard currency reserves defending the ruble in previous sessions, had to step in again and pump liquidity into the financial system. Bank failures began to loom large, and given the fact that depositors suffered huge losses in 1998, the authorities began to worry about a run on deposits.

Large state-owned conglomerates are not immune from a financial debacle, either. Rosneft, the company that grabbed Yukos’ productive assets, is saddled with $24 billion in foreign debt, while Gazprom owes foreign banks and bondholders $21 billion. The government has enough money to save them if need be. However, it suddenly woke up to a major economic crisis on its hands — one for which it had no one but itself to blame.

Perhaps the Kremlin could come away from this experience learning more about the way modern economies and financial markets really work. But there is a lesson for foreign investors here, too. It is as follows: There is no substitute for solid regulation, sound corporate management practices and a business-friendly investment climate. When investors put up with being treated shabbily because they earn a good profit, it is only a matter of time before those profits evaporate and are replaced by major losses.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected]. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past five years, 2004-2008.


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