Streetwise Professor

I have often noted that Russia is a high beta economy.  This reflects, primarily, its extreme dependence on raw materials generally, and energy particularly.  Economic contraction reduces the demand for, and prices of, these commodities, and this hits Russia hard.

Witness the events of recent days.  Europe is re-entering crisis mode, with Greece teetering again, and Spain-a much bigger problem-also in extremis.  China is exhibiting serious signs of weakness.  As a result, commodity prices are down, about 7 percent this month (as measured by the DJ commodity index).

And Russia is down along with commodity prices:

While most countries’ stock markets have been hammered amid Greece’s sovereign-debt woes and its possible exit from the euro, the plunge in Russian stocks—which have dropped from their 2012 highs by nearly twice as much in percentage terms as the MSCI Emerging Markets Index—has been particularly fierce.

“Such is the level of risk-phobia in the world right now, and Russia, despite the generally positive domestic backdrop and very cheap asset base, is viewed as being the most at-risk economy in the world,” said Chris Weafer, chief strategist at Troika Dialog, an investment bank in Moscow.

Moreover, capital outflows are continuing:

Activists who clashed with police before Putin’s May 7 inauguration are protesting non-stop in Moscow, using the Occupy Wall Street movement’s tactics. As the benchmark RTS equity index entered a bear market, Russia-focused equity funds recorded $251 million of outflows in the seven days to May 9, the most this year, while China lost $127 million, India $148 million and Brazil $167 million, EPFR Global data show.

Further:

Russia’s top central banker warned on Wednesday that capital flight is a “serious problem,” as newly released figures showed $42 billion has left the country in the first four months of the year.

“Capital outflow continues to be a serious problem for the Russian economy,” the central bank’s chairman, Sergei Ignatyev, told Russia’s lower house of Parliament.

The ruble is weakening too, down about 5 percent this month.

This follows a first quarter in which Russian growth exceeded expectations.  But that was also a quarter in which oil and commodity prices spiked.

One thing that complicates interpretation of these figures is that multiple things are going on. The first is the economic problems in Europe and Asia.  The second is the ongoing political uncertainty in Russia.  Both are pushing money in the same direction-out of Russia.  The difficulty is trying to determine how much of the outflow is attributable to each of these factors.  It is quite remarkable, however, that the election and the ebbing of the protest movement has quite evidently not staunched the outflow.

With respect to the outflows, Russian officialdom is whistling past the graveyard-and blowing smoke up everybody’s collective rear. Yeah, they say, we’ve had problems-but Happy Days Are Around the Corner!  The flows will reverse manana.

I howled when I read this:

Russian financial officials have assured that Russia would start seeing capital inflows in the second half of the year after the new government is formed. Prime Minister Dmitry Medvedev has submitted candidates for the cabinet to President Vladimir Putin for him to sign on the list of new ministers by the end of the month.

Yeah.  It’s all that uncertainty about the cabinet that is driving money away.

To the extent that the outflows are politically driven, rather than a manifestation of the high beta effect, the exact opposite is true.  It is the realization that the Putin Purgatory, with all its legal nihilism, is here to stay that is the problem.  Investors-including, it should be noted, many rich Russians-have seen the future, and know it won’t work.

When a strong world economy or supply shocks keep commodity and energy prices high, the high beta effect covers a multitude of sins in Russia.  When these factors reverse, things get double ugly.  There is the ugliness of the natural state, Putin’s Purgatory. That is, sadly, arguably a constant.  Then there is the ugliness that comes with a commodity price-crushing world economic contraction.

The thing to watch going forward is how these things interact.  Economic weakness resulting from the high beta effect will impact politics in Russia-and Putin will react to that in ways that will likely exacerbate Russia’s politically-grounded economic difficulties. The populism and promises of government largesse that Putin used to campaign for re-election will not be sustainable.  What will the popular backlash? How will Putin hit back?

Meaning that if the world economic situation continues to deteriorate, the brittleness of the Russian natural state will be tested.