Streetwise Professor

A few items re Russia caught my eye over the holidays.  

David Kakabadze writes:

U.S. Ambassador to the Organization for Security and Cooperation in Europe (OSCE) Julie Finley recently told RFE/RL that Russia’s move to prevent the OSCE from extending the mandate of its mission in Georgia came as “a surprise” to her.

Similar sentiments were heard from many Western officials back in August, when Russia’s large-scale military intervention in Georgia seemed totally unexpected to them. A short time later, Moscow again took the West by surprise when — in violation of the UN Charter — it recognized the independence of the breakaway Georgian regions of South Ossetia and Abkhazia.

It seems that only Central and Eastern Europeans — as well as Georgia’s own leaders — have a good sense of what to expect from Vladimir Putin’s Russia. “Russia’s attack on Georgia was not unexpected,” Georgian President Mikheil Saakashvili told a conference in Riga in November at which international experts assessed how the international situation had been altered by the Russia-Georgia war.  

Saakashvili’s counterparts from Poland and the Baltic states — educated by bitter historical experience — have long tried to persuade their Western allies that the world must be prepared for “unexpected” moves from the Kremlin.  

But these warnings have largely fallen on deaf ears, and the West continues to be surprised.

Those in the West who are surprised must be grossly ignorant of history.  Soon after reading Kakabadze’s piece, I came across this in Adam Zamoysky’s Moscow 1812: Napoleon’s Fatal March:  

Many in Europe [in the early 1800s] were alarmed at this seemingly inexorable onward march of russian power.  There was talk of ravening Asiatic hordes and some fear, particularly after the first partition of Poland in 1772, that Russia might engulf the whole of europe as the barbarians had done with ancient Rome.  “Poland was but a breakfast. . . where will they dine?” Edmund Burke wondered, echoing the fears of many.  Diplomats were struck by the single-mindedness and ruthlessness of Russia’s foreign policy: she did not play by the same rules as others.   What few appreciated was the extent to which Russia saw herself as a special case.

The Asiatic hordes are a bogeyman of the past; Russia’s shrinking population, the aging of that which survives, and its economic weakness, mean that its ability to overwhelm any robust resistance is long gone.  But the messianic tendencies, the singlemindedness, the ruthlessness, and the belief that Russia is above the rules, are still manifest today.  There is a huge mismatch between capabilities and intentions, but western Europe’s pussillanimity and America’s distance and strategic distraction permit Russia to achieve results through aggression and bluster that its military and economic capacities should not be able to support.  

For now, anyways.  The tragedy is that if and when Russia’s policy of  derzhavnost  succeeds sufficiently to pose a more serious threat to Western Europe’s immediate interests, its military and economic potential, and that of the United States, will overwhelm Russia’s.  And then, it’s 1991 all over again.  

So, what we have here is a mutual acting out of Satayana’s injunction about forgetting the past, and repeating it.  Or of Talleyrand’s jibe of forgetting nothing and learning nothing.  Or of Marx’s aphorism about the past repeating itself as tragedy then farce.  Europe and the United States are apparently oblivious to Russia’s historical tendencies, and hence are surprised to see these tendencies re-assert themselves in the aftermath of the supposed end of history.  Russia fails to recognize that these historical tendencies have led to shattering defeat on multiple occasions, so plunges ahead on a quixotic quest to reclaim past glories (largely imaginary though they be).  This mutual ignorance will lead to a confrontation of some sort sooner or later.  But given Russia’s enervated economic, demographic, and military condition, this confrontation will be simultaneously farcical and tragic.  And the tragedy will, as it always has, fall most heavily on the Russian people.  

[Zamoyski’s book is quite excellent, by the way.  It provides a very graphic illustration of the old adage that amateurs talk tactics, professionals talk logistics; he shows that Napoleon’s shambolic logistical preparations doomed his campaign to failure, and his soldiers to misery and death.  It also has other interesting tidbits of history that foreshadow current phenomena, such as: “In peacetime [each Russian] platoon functioned as a trading corporation, an artel, leasing their labour to local civilians, with the profits theoretically being shared out between them, though more often going into the pockets of their officers.”  A historical continuity that makes me skeptical about the prospects for Medvedev’s military reforms.]  

In economic news, Finance Minister Alexi Kudrin has apparently dumped Rosie Scenario and started dating Debbie Downer, or else has taken sodium pentathol:  

Year 2009 will be the worst for the Russian economy since the World War-II, with the country’s national budget deficit touching the USD  
$70 billion mark, says the  Finance  Minister.  

“2009 will be the most difficult for the Russian and world economies. I cannot remember a worse year since the end of the Second World War. This will be the worst year for the economy in modern times,” Russian Finance Minister Alexei Kudrin said last night in a TV interview.  

Kudrin, who holds the rank of vice-premier in the cabinet of Prime Minister Vladimir Putin told state-run Vesti TV channel, “In 2009, the budget will have a deficit of 1.5 to two trillion rubles, which we will have to make up from the national Reserve Fund”.  

Kudrin’s statement virtually acknowledges the  bankruptcy  of Putin’s economic model based on high oil prices, with oil windfall fueling the rapid re-emergence of the former Communist country as a global power.  

Earlier, the Kremlin aide Arkady Dvorkovich said that the budget deficit could exceed five per cent of GDP in 2009 if the economy does not begin to recover by the middle of the year.  

“If the situation follows a negative scenario and the economic recession lasts throughout next year, the deficit could exceed five per cent,” he said.  

During eight years of Putin’s rule of consolidation of the state power, the Kremlin had been reluctant to introduce democratic reforms to give economic liberties to the common man, which in the situation of global  economic  crisis  could spark off massive protests and unrest in the country.

Considering that “modern times” “since WWII” includes 1998, that is a pretty sobering prognistication.  The reserve fund will be depleted substantially, by about one-third if Kudrin is correct, just to pay pensioners, bureaucrats, the military, and cover other current expenses.  (Methinks that paying the military will come close to the top of the priority pile.)  For a nation that desperately needs to invest in industry (including in the oil industry that generated the reserve funds in the first place), infrastructure, public health, and human capital, this is bitter medicine indeed.  (But the nation plans to plunge ahead in spending on military hardware, budgeting $140 billion over the next three years.  Not enough, in other words, to seriously improve its military position vis a vis the US, but more than it can afford to spend with dwindling oil revenues and pressing domestic needs.)  

This is a far cry from Medvedev’s or Putin’s standard lines, and is hard to square even with Kudrin’s recent statements that the Russian economy would grow 2.4 percent or so in 2009.  One wonders why, so soon after his more optimistic statements, and the government’s fervent denials that a recession was possible in 2009, that Kudrin would say such things on government television.

Kudrin’s pessimism could well reflect last Wednesday’s steep drop in oil prices (a 10 percent decline in Brent, pushing it well below $40/bbl for February delivery.  Oil regained about half of that on Friday, and in overnight trading on ICE is up about 4 percent today.)   It suggests that the Finance Ministry’s projects that oil prices will remain in the $40-$50 range at best, and perhaps in the $30s, for a good part of 2009.  

The declining oil price and the prospect for a yawning Russian budget gap is putting additional pressure on the ruble, and the Russian Central Bank is slowly turning up the heat on the frog pot:

The ruble fell to a record low against the euro as Russia’s central bank extended six weeks of devaluations to compensate for falling oil prices.

The ruble lost as much as 1.6 percent to 40.8931 per euro before trading at 40.8143 at 12:28 p.m. in New York, the weakest level since the European currency was introduced in 1999. It declined as much as 1.2 percent to 29.0577 against the dollar, a four-year low, capping a 19 percent drop since early August.

Russia’s foreign reserves, the world’s third largest, have fallen by a quarter since August to $451 billion as the central bank sought to prop up the currency and export revenue declined. Standard & Poor’s cut Russia’s credit rating this month for the first time in nine years to BBB on concern Russia is wasting reserves defending the ruble.

And speaking of oil, it takes all my will to fight schadenfreude when reading this:

With Prime Minister Vladimir Putin presiding, energy ministers from 12 gas exporting countries, many of them OPEC members, agreed to transform an existing gas forum that they said could benefit consumers and would not control output or prices.

The event, partly meant to increase Russia’s clout in global energy diplomacy, did not go smoothly for Moscow.

Concern about falling prices and flagging demand quickly surfaced as country representatives said Russia should have sacrificed some of its own output to back up President Dmitry Medvedev’s promise to support OPEC oil production cuts.

The Kremlin’s critics said an important way to help gas prices is to bolster the oil price, which they reflect.

“We needed to redress the situation to the market of oil so as to redress the situation in the gas market,” Libya’s top oil official, Shokri Ghanem, told the ministers.

“We are still waiting for a declaration from the Russian Federation that they are cutting their (oil) production not only to support the (oil) market, but also to support the gas market,” Ghanem said.

Russia, the world’s No.2 oil exporter, has said it is considering all options, including joining the Organization of the Petroleum Exporting Countries, to defend its national interests.

However it did not make any firm pledges when OPEC ministers, meeting at Oran in Algeria last week, agreed their deepest production cuts of 2.2 million barrels per day.

OPEC’s President Chekib Khelil told Reuters on the sidelines of the meeting that Russia had enjoyed the benefit of OPEC’s cuts without sharing the pain.

“If there was no OPEC reductions in September and October, I think we would have seen prices today at maybe $20 (per barrel). So it was because of OPEC that revenues for Russia were at $40 now, not at $20,” Khelil said.  

OPEC members were fools to believe that Russia would do anything more than pay lip service to the idea of sharing the pain of output cuts (beyond those dictated by the declining productivity of Russia’s fields).  Putin et al were perfectly content to play footsie with OPEC, then let the cartel bear virtually the entire burden of cutting output.  (Note that OPEC’s announced cut was larger than originally forecast by almost exactly the amount that Russia had suggested that it would cut–then didn’t.)  As I wrote before, there’s no honor among colluders, and Russia’s incentive (given that its exports make up only about 4 percent of non-Russian consumption) is to continue to export as much as possible while others (with a larger collective market share) cut output to prop up prices.  

Russia will gain little from this however, because (a) the global demand crunch is likely to be protracted, (b) burgeoning inventories will suppress prices for an extended period, and (c) it is highly doubtful that OPEC discipline will be robust enough to support prices at much above the competitive level.  

New Years is the biggest holiday in Russia.  It will not be a happy one, and the year that it ushers in is likely to be unhappier still.

The price of oil continues to drop.   Earlier today, February Brent fell below $40/bbl.   It is now at $40.23.   WTI is also down.   This follows a rather steep drop yesterday.   Inventories continue to build in the US Midcontinent, and reports that oil companies are leasing supertankers to store crude are common.   In the Midcontinent, Cushing storage is almost full up.   (This is why WTI delivered in Cushing is selling at a discount to Brent, in contrast to the typical relationship where WTI sells at a premium.)

This accumulation of inventory will have a lasting effect on the price of oil.   Even when demand turns up (and who knows when when is?), much of that demand increase can be met by drawing stocks down to more normal levels, thereby dampening any price recovery.     Inventories may well continue to build, moreover, due to the fact that supply is very inelastic in the short run, and shutting down wells is a costly proposition.

Update: Urals Med (per WSJ) was quoted at $33.87/bbl this PM in Europe.   Ouch!   Or, should I say —ой!

Two subjects of several SWP posts, and considerable discussion, are drawing increasing attention in the wider world.

Regarding the ruble, the World Bank recommends that Russia cease its intervention to prop up the currency:

The World Bank called on Russia to abandon the ruble’s managed exchange-rate policy in order to moderate capital outflow, which is set to reach at least $100 billion this year, and safeguard the country’s massive monetary reserves.

A Russian man stands near a currency exchange point in Moscow earlier this month. Shrinking revenue, which has been falling in lockstep with the more than 70% drop in oil prices since summer, has put enormous downward pressure on the ruble.

The recommendation, the World Bank’s firmest on the subject yet, capped a week of economic data making it seem more likely Russia will fall from robust growth to recession.

Zeljko Bogetic, the World Bank’s lead economist for Russia, said that an average price of $30 a barrel of oil over the next two years would be ruinous for an economy that relies hugely on revenue from crude exports. Shrinking revenue, which has been falling in lockstep with the more than 70% drop in oil prices since summer, has put enormous downward pressure on the ruble, which economists consider a commodity currency. This, in turn has led Moscow to try to keep the currency from sliding and avoid widespread fears that another 1998 crash is looming.

. . . .

Meanwhile, monetary authorities have remained determined to defend the ruble and dip frequently into the country’s amassed oil wealth. As a result, Russia’s gold and foreign reserves have shrunk by more than $160 billion since August.

“We’ve seen the monetary reserves dwindle as a result of the central bank’s policy,” Mr. Bogetic said. “We also see now that the policy is increasingly less sustainable.”

Regarding the potential for civil unrest, from Gideon Rachman at FT:

I was in Ukraine last week – and a Russian economist mentioned to me that there were demonstrations in Vladivostock against the new tariff on car imports. The FT is now reporting that the trouble is spreading.

More broadly, the Russian government is facing a serious economic crisis on several fronts. Just six months ago, its huge pile of almost $600 billion in foreign reserves seemed a symbol of the country’s new-found strength. But they have got through roughly a quarter of that in just three months – mainly through supporting the rouble. At this rate, it will all be gone well before the end of 2009. That is not an entirely implausible scenario, because the fiscal pressures on the Russian government are only likely to grow over the next year. Official projections are still that the economy will grow by about 3%; but private-sector economists in Moscow are talking about a deep recession. With oil down at just over $40 a barrel, the cash-spigot has been turned off.

There is a danger that, as  the government comes under increasing fiscal pressure, it will be tempted to raid the foreign reserves for ordinary budget spending – espescially if the alternative involves cutting social spending and risking further popular unrest. Local governments are also likely to be screaming for financial support from Moscow.

The whole Putin phenomenon has been based on oil wealth and economic growth. So what happens now?

Very good question, Gideon.

And from Vladimir Ryzhkov in the Moscow Times:

The government’s attempts to play down the seriousness of the crisis are becoming increasingly difficult to pull off. There is simply too much bad economic news hitting Russia from all sides. For example, industrial output fell 11 percent in November. The AvtoVAZ, KamAZ and General Motors auto plants have announced temporary halts to their production lines. There have also been major production cuts in the construction, metallurgical and chemical sectors. The crisis has struck hard in regions that had shown strong export-oriented growth over past years, such as Kuzbass, Chelyabinsk, Lipetsk, Belgorod and Cherepovets. After the long New Year’s holiday, hundreds of thousands of employees will learn that they have just been laid off. An even larger number of workers will face cuts in their salaries even though the average salary before the crisis was only $600 per month.

Exacerbating the problem is the fact that the economies of about 700 Russian cities are dependent on a single major local industry or factory. If those factories shut down, the majority of the people in those cities will have no way to make a living. Kremlin leaders do not have a clear strategy for coping with this looming disaster.

As the crisis is spilling over into the real economy, the people’s tolerance level for government policies is reaching its breaking point. Even before the crisis, the people’s anger over runaway inflation and their eroding purchasing power had been building up over the past few years. In addition, corruption has gotten markedly worse as the level of monopolization in the economy and bureaucratization of government has increased. All of this is pushing people’s discontent to the surface.

Prime Minister Vladimir Putin’s decision to raise import duties on used foreign cars in an attempt to support the country’s struggling automakers unleashed a wave of demonstrations by drivers who will now be forced to pay through the nose for their favorite foreign models. In essence, the government is trying to force new car purchasers to buy far more inferior Russian models — something they would have never done absent the import duties. Drivers protested all across the country — from Kaliningrad to Vladivostok. Riot police brutally dispersed demonstrators at protests in Vladivostok during the past two weekends — a rare example of police using force against ordinary citizens defending their everyday interests. This marks an escalation in the government crackdown on dissent, which up to now was limited largely to breaking up Dissenters’ Marches and roughing up and arresting their members.

The anger over increased import duties is particularly strong among residents of the Far East, the majority of which — perhaps as high as 80 percent — make a living either directly or indirectly connected with the sale or servicing of imported automobiles. The government’s decision only exacerbates the region’s sense of alienation from Moscow. It also strengthens the region’s separatist tendencies and increases the already high rate of emigration from that area.

In Alapayevsk in the Sverdlovsk region, 17 miners are staging a hunger strike to protest unpaid wages. In Magnitogorsk, people have held rallies against layoffs at the city’s iron and steel works and against price hikes for utilities and public transportation. People are also staging rallies in the city of Senezh in the Karelia region where the local pulp and paper mill is on the verge of closing, and the cost of heating and water have shot up by 20 percent and 27 percent respectively.

Moreover, hundreds of banks across the country might go bankrupt in January and February. That could lead to protests by depositors who are unable to retrieve their money, despite the limited government guarantees on bank deposits. In addition, people are upset with the government’s decision to increase utility prices for all homeowners in 2009. This might have been tolerable during a time of steady economic growth and rising standards of living, but it is unacceptable in the midst of a crisis.

For the first time in eight years, demonstrators not affiliated with marginal opposition parties are making harsh political demands. Drivers in Vladivostok demanded that Putin step down, that media censorship cease, that the government reverses its decision to amend the Constitution on increasing presidential and State Duma deputy terms, that the proposed changes to the Criminal Code broadening the definition of treason be annulled and that popular elections for governors be reinstated.

Despite the increasing number of protests against the government, Putin is still maintaining a 83 percent approval rating. But this won’t last for long as the crisis spreads and the protests intensify next year. When Putin gathers with his friends and family on New Year’s Eve, he should forget about raising his glass of champagne and toasting to his eternal popularity. Instead, he should make a wish for a lot of good luck in 2009 — the only thing that can get him out of this terrible mess.

Translated, “Good luck” means “a miraculous recovery in the world (esp. American and European) economy that causes a serious rebound in the price of oil.” So much for that island-of-stability-unconnected-to-the-world’s-economic-trouble thing.

By the way, how could anybody possibly buy the line that an economy largely dependent on energy exports be immune from a world economic slowdown?

Sorry to say, but good luck as defined above seems unlikely any time soon.   Given the fundamental dependence of the Russian economy on the price of oil, and the dependence of the price of oil on world economic activity, the drumbeat of bad economic news sounding in the Americas, Europe, and Asia bodes ill indeed for Russia’s economic prospects.

In light of these facts, it is distressing to see Finance Minister Kudrin dating Rosie Scenario: “Russia is not in recession ‘yet’ and the economy will grow by as much as 3 percent next year, Finance Minister Alexei Kudrin said yesterday.”   The “yet” reminds me of the joke about the guy who jumped off the roof of a fifty story building.   As he passed the 25th floor, he yelled to horrified people watching from the windows: “So far, so good!”

I see 3 percent as a huge stretch.   The most recent data show a 1.6 percent year-on-year growth November-to-November.   The previous 12 months showed a 6.5 percent year-on-year growth rate.   That means that growth in November was roughly -4.5 percent–and that’s NOT an annualized number.   Given that (a) the situation appears to be worsening, especially in the manufacturing sector (which is exacerbated by the ruble policy), and (b) the oil price continues to decline, worse is likely to come.

Kudrin is evidently in a very weak position, beset by myriad enemies earned over the years.   (And, since you can often judge a man by his enemies, the number and identity of his speaks highly of him.)   Thus, he may be echoing the party line out of self-preservation.   I am therefore willing to cut him some slack.   But I cannot credit his optimism as a realistic forecast.

Today’s title selection was inspired by Led Zeppelin, and Russia’s zig-zag policy on electricity price reform.   First it was reported that Russia would slow the reform.   Then Putin said it wouldn’t be slowed.   Then Kudrin said it would be.   Now?   Well, for what it’s worth:

Russia’s economy minister said on Wednesday the government is sticking to its 2009 plans for the power sector and will not be moved to amend them by the global financial crisis, Russia news agencies reported.

Her statements seemed to conflict with previous comments from top officials, who have said plans to raise electricity prices will have to be corrected.

But the growth in gas prices will be made more gradual, Minister Elvira Nabiullina was quoted as saying. The move would ease the cost for consumers already suffering from desiccated credit markets and falling stocks.

The price of gas will grow 5 percent in the first quarter, 7 percent in both the second and third quarters and 6.2 in the fourth quarter, the agencies reported her as saying.

This compares to earlier plans to raise the prices by around 25 percent as of Jan. 1, part of a plan to gradually bring domestic gas prices to parity with with Europe by 2011.

Nabiullina made the statements while presenting the government’s revised macro-economic forecasts [ID:nLH161149].

“We have factored decisions (into the forecasts) on revising the rate of price growth for natural monopolies,” she said, Interfax reported.

Officials generally use the phrase natural monopolies to refer to electricity, gas and railway service.

“For gas it has been decided that prices will rise at a smoother quarterly rate for all consumers, including households,” she said, the news agency reported.

But her comments on electricity contradicted other top officials, including Finance Minister Alexei Kudrin, who said on Monday that price growth for power, rail and gas services List of stories in basket would be significantly cut due to the crisis [ID:NLF154185].

As Casey Stengel once said: “Does anybody know how to play this game?”   This erratic, contradictory policymaking is hardly conducive to restoring confidence in the Russian economy, the Russian government’s management acumen, or the reliability of its promises and the credibility of its policies.   In a country where the government plays such a dominant economic role, lack of policy credibility is a major impediment to attracting investment, especially in sectors like power.

So what’s the real policy?   Who knows?   I mean literally–who knows?   Putin? Medvedev? Kudrin?   This ongoing to-ing and fro-ing seems to suggest that there is a major fight going on behind the scenes.   The only conclusion that investors can draw is that one can draw no conclusions.   So it is best to stay away.   Very far away.

Given Russia’s pressing needs for infrastructure investment, not just in power but in other sectors, the combination of the bleeding of reserves and the policy chaos mean that these needs will not be met for years to come.   Yet another tragedy.

But look on the bright side.   The glorious Russian Navy is visiting Nicaragua and Cuba!   One needs to keep one’s priorities in order!

The Russian Central Bank is increasing the pace of its devaluation of the ruble:

The ruble fell to a record against the euro as Russia devalued the currency for a second time this week amid tumbling oil prices and shrinking reserves.

The ruble weakened to an all-time low of 40.1096 per euro, and was 0.8 percent lower as of 2:39 p.m. in Moscow. Bank Rossii allowed the ruble to decline as much as 1.4 percent against its target basket of dollars and euros, the eighth depreciation since Nov. 11, according to a bank official who declined to be identified. The currency fell 15 percent versus the dollar since August.

This slow motion devaluation is widely recognized to be a major policy error:

“It’s better that they do this quicker rather than slower because everything is looking particularly weak in Russia with the oil price where it is,” said Eugene Belin, head of fixed income, currencies and commodities in Moscow at Citigroup Inc. “The sooner they’re finished with this devaluation process the better for the economy.”

Maintaining the ruble at a level higher than justified by fundamentals bleeds reserves, and weakens the country’s ability to deal with macroeconomic and terms of trade shocks in the future.   Moreover, it damages Russian domestic manufacturing.   Russian industry faces competitiveness problems even absent an inflated currency–propping up the currency only exacerbates that problem. Note that Russia’s recovery from the 1998 disaster was greatly helped by the adjustment of the currency to reflect fundamentals.

So why is Russia boiling the frog by slowly turning up the temperature gradually, rather than allowing the currency float to a level that reflects the dismal fundamentals now facing the country?   The answer is almost certainly domestic politics.   Although several commentors have pooh-poohed my arguments that pronounced and protracted economic difficulties could spark domestic unrest, especially given the fundamentally dishonest way Putin and Medvedev are dealing with the situation, it seems that some people in Russia agree with me about the potential for civil disorder.   People like Putin, Medvedev, and the security forces:

In expectation of uprisingsThe powers have rethought reducing interior troops

Yesterday, the MVD [Ministry of Internal Affairs] decided not to reduce the interior troops (VV), called upon, in part, to disperse demonstrators. The command of the troops justifies this by «tasks that have been set », without specifying them. In the opinion of experts, the siloviki seriously fear unrest among the unemployed, automobilists, discharged military, those dissatisfied with the growth of housing-and-public-utilities tariffs and other victims of the crisis and of the decisions of government officials.

«Reduction of the internal troops of the MVD of Russia will be suspended », — reported, citing a decision of the leadership of the country, commander in chief of the VV general of the army Nikolai Rogozhkin. He in no way connects the decision to maintain the numbers of the VV with the financial crisis, citing the «necessity of fulfilling all tasks that have been set », but which ones specifically, Mr. Rogozhkin does not specify.

«Our troops are designated for the protection of state and industrial facilities, convoying of special cargoes, defense of service lines, suppressing internal unrests and resolving inter-nationality conflicts on the territory of the country, — clarified an RBK daily source in the VV. — Probably, the leadership of the country is assessing the domestic political situation as not very stable, which is why it rethought reducing us ».

The consequences of the crisis and unpopular decisions of the powers have already brought people out on the streets. In Vladivostok a march of protest of several thousand automobilists against the increase in customs duties for used foreign makes went outside the thematic bounds: people started talking about the costliness of fuel, food products and housing-and-public-utilities services, about unemployment, the crisis and property stratification. A protest rally against the growth of housing-and-public-utilities tariffs on 15 December took place in Izhevsk, while on 21 December in the Far east and in Khabarovsk Kray are expected new protests of automobilists. The slogans of the protestors have remained unnoticed by the central telechannels, but have attracted the attention of the siloviki: in the regions are being created anticrisis special groups of the MVD, the heads of the territorial administrations of the FSB are likewise expecting protest actions. MVD analysts are attributing to the risk group reduced military and rotation workers come back from Moscow. Also pouring oil on the fire are growing wage arrears. Thus, according to the data of Rosstat, overdue indebtedness on wages in November increased in Russia by 93% and comprised 7.765 bln rub.

«As much as I know, the power elites are seriously concerned by people’s unrest associated with the financial crisis, — clarified to RBK daily the political scientist Stanislav Belkovsky. — In the situation that has evolved the Kremlin has two ways out: pinpoint financial injections and cracking down on demonstrators with the help of internal troops ». In the opinion of Mr. Belkovsky, the peak of people’s dissatisfaction is going to come in the first quarter of the year 2009: «The ranks of the demonstrators will be augmented as well by people deprived of mortgaged apartments, because for this period is planned their mass repossession ».

The most recent–and most serious–protests occurred in Vladivostok in response to the government’s attempt to protect the imploding domestic car industry (misery loves company) by restricting imports of used cars.

As Russia has experienced numerous times in its history–think 1905, 1917, 1991–protests of this sort can snowball.   Protesters must overcome collective action problems, and isolated protests can be crushed.   When the level of discontent becomes sufficiently great, and a critical mass of protests occurs, it is easier for protestors to coalesce as the security forces become spread more thinly.

The car tariff decision reeks of desperation in the Kremlin–and the White House (on the Moskva).   An ad hoc response taken in haste to defuse one problem creates another.   Putin has few good options.   With the entire economy imploding, everybody is hurting, and moves to help one sector will only aggravate the suffering in others.   Such clumsy moves will quickly undermine the aura of competence surrounding Putin–an aura created by luck (skyrocketing prices for raw materials and a predictable recovery from an inherited economic disaster) rather than by any real economic policy acumen.   Once this aura disappears, the potential for protests and disenchantment grows.   He has only made the ultimate reckoning worse by his failure to level with the Russian people about the seriousness of the situation.   How will Putin likely respond?   I think we all know (and dread) the answer–the answer implicit in the strengthening of the MVD.

Russia’s ruble problem has been eased somewhat by the precipitous drop of the dollar against the Euro and the Yen.   The Fed’s dramatic easing is, in my view, highly unwise.   It appears to be doing little to spark the economy (high powered money is increasing, but velocity is decreasing, meaning that the injection of cash is largely being hoarded.)   Moreover, the huge dollar overhang that is building up will threaten a sharp increase in the price level when the banking crisis eases and financial institutions start lending, rather than holding, this cash hoard.   This will likely lead the Fed to dramatically reverse direction, raise interest rates sharply, and throttle any recovery in the crib.

The continuing fall in the price of oil–January NYMEX WTI closing at $36.25–is particularly remarkable in light of the substantial drop in the dollar in recent days.   Ordinarily, the sharp drop in the dollar would cause an increase in the price of oil.   Not this time.

Doubly remarkable, in fact, in light of OPEC’s record cut.   Or should I say, intended cut.   As I’ve said ad nauseum, these are pie crust promises (to quote Mary Poppins), easily made, easily broken.   The market’s sell-off in the aftermath of the OPEC meeting reflects (a) widespread skepticism about the willingness of OPEC members to adhere to the cuts, especially in the face of pressing budgetary needs and excess capacity, (b) continuing economic weakness and plummeting demand, as indicated by ballooning inventories, and (c) (drum roll please) Russia’s Lucy-and-the-football move of promising cooperation with OPEC, and even intimating joining the organization, and then refusing to cut output:

Russia is not in talks over joining OPEC and has not pledged any oil output cuts in its memo to the oil producers’ group this week, deputy energy minister Anatoliy Yanovsky said on Wednesday.

“There is no talk of Russia joining OPEC,” Yanovsky told reporters, adding that Russia has given a memorandum of cooperation to the Organization of the Petroleum Exporting Countries.

Asked if the document contained any output cut pledges on Russia’s part, he said: “Of course not.”

“Of course not.”   How sweet.   Especially mere days after this:

President Dmitry Medvedev said Russia may join the Organization of Petroleum Exporting Countries and reduce production to support the oil price.

“We have to defend ourselves,” Medvedev said in the Ural Mountains city of Kurgan today. “This is our revenue base, both from oil and from gas,” he said. “I believe that we mustn’t rule out any options.”

Defensive measures may include “cutting the volume of oil production and participating in existing organizations of suppliers, and in new organizations, if we can reach such an agreement,” Medvedev said in comments broadcast on state television.

So, the options are: (a) Medvedev was lying, and Russia had no intention of cooperating with OPEC let alone joining it, or (b) Medvedev gave his honest opinion, and was sandbagged by the real powers in Russia.   Regardless of the truth–and neither is especially flattering to Medvedev or the Russian government generally–there is no doubt that OPEC feels betrayed.   Not that I’m crying or anything, mind you.   As I’ve said before, there’s no honor among colluders.

Although some in the Russian government may feel that they’ve played OPEC like a fiddle, the fact of the matter is that Russia is in a world of hurt.   (Again, much company in this department, but Russia’s economic straits are more acute than Europe’s or the US’s.   Far more acute.)   With Urals blend well below $40/bbl again, domestic manufacturing cratering (with the slo-mo devaluation exacerbating the damage), and reserves ebbing, a hard but brittle political system faces an existential challenge.   The risks of a cataclysm increase by the day.   The probability is not yet 1, but it is rising.   And remember that these processes tend to be “jumpy” and exhibit positive feedback–meaning that once the dynamic of protest and repression begins, it often feeds on itself and spins out of control, and does so discontinuously and rapidly.

Exactly 11 months ago I wrote a post about Russia’s use of “vaporware” and threats to seize control of Serbia’s national oil company NIS at a bargain basement price:

To make the deal look a little less like an abject surrender, Gazprom has also dangled the prospect of giving Serbia a stake in a future gas venture. Word of advice, guys-DON’T BELIEVE IT, and DON’T TAKE IT. Gazprom is the master of what Bob Amsterdam calls “premature contractualization.” That is, announcing deals just in time to forestall projects that are adverse to Gazprom’s interest, and then fading the deal when the threatening competing projects are shelved in response to the Gazprom announcement. Gazprom will whisper sweet promises in anybody’s ear to get what they want, and then renege when it suits them. (Nigeria-you should take note of this, as Gazprom has been wooing you too.)

Gazprom’s stratagem is analogous to a common ploy in the software business. In the 80s and 90s “vaporware” was a commonly employed competitive strategy. A software company would announce a new, improved software product in order to forestall entry by a competitor. Once the potential entrant was scared away, the new software would just fade away into the mists, never to be seen. Gazprom is essentially following this playbook-constantly announcing vaporpipelines, vaporwells, vaporinvestments, vaporstorage, vapor-you-name-it whenever a threatening project is mooted.

So, what Gazprom is offering Serbia is: a pittance in cash plus a pig in a poke in exchange for hard assets right now. Given Gazprom’s record of delivering on its big talk, the Serbs would be well advised to take cash on the barrelhead and take the promises for what they are worth-a little more than nothing.

“A little more than nothing” seems to be a gross overvaluation, based on this piece from Eurasia Daily Monitor:

Serbia’s coalition government has removed Economics Minister Mladan Dinkic from his concurrent assignment as head of the negotiating team on energy agreements with Russia. The impending oil and gas deals involve essentially a Russian takeover of Serbia’s energy sector. Dinkic and his colleagues who were also ousted from the team—State Secretary Nebojsa Ciric and Privatization Agency Chief Branislav Zec—stand accused of holding “unconstructive positions in the negotiations” (Radio B-92 cited by Interfax, December 11; RTS Radio Belgrade, December 12). The government’s Russophile elements have prevailed without apparent difficulty on their pro-European colleagues to precipitate the energy deals on Russian-imposed terms.

One major contentious issue is Gazprom’s promise to build a section of the South Stream pipeline through Serbia. The Russian side is avoiding a clear commitment to a construction schedule and gas supply volumes and is even stalling for time on submission of a feasibility study. This evasive attitude can only reinforce the growing international doubts about South Stream’s plausibility.

Nevertheless, the agreements on oil and gas are now expected to be signed in Belgrade before Christmas by a high-level Russian delegation. Moscow is throwing in some sweeteners outside the energy sector. These would, however, only lead to greater Russian economic penetration of Serbia, correspondingly influencing its political system, and raising questions about Serbia’s European integration, the goal of President Boris Tadic and parts of the body politic.

. . . .

Now, however, Moscow suddenly insists that NIS be separated from the package. It wants to sign the NIS purchase contract immediately and postpone the signing for South Stream for a few years. Officially, Moscow claims that the oil deal and the gas deal remain packaged together, but that this does not preclude separating the time-frames for implementation of each. For Serbia, however, this means no guarantee and indeed no leverage to ensure that the South Stream pipeline and storage site would be built in Serbia. Thus, the disadvantageous handover of NIS to Russia as an incentive for South Stream would have been in vain and a total net economic loss to Serbia (BETA, December 11; RTS Radio Belgrade, December 12).

Vaporware, indeed.   Serbia originally–and grudgingly–acquiesced to the sale of NIJ in return for promises regarding South Stream.   Now, Gazprom/Russia is telling Serbia those promises are no longer operative.   Beware any deal that involves asynchronous performance.   Especially if the party promising to perform later is Gazprom.   You can take their promises to the bank–and be met with stares of disbelief for having been such a sucker.

This discarding of even the pretense of proceeding with part of the South Stream project also speaks to its viability, and the effect of the ongoing financial crisis on that viability.   And if there’s not the money for South Stream–what about Nord Stream?   And if neither is an immediate prospect, what does that say about European gas supplies, and the prospects for Nabucco?   (There’s also an interesting article in EDM about Hungary’s MOL and Nabucco, but that will have to wait for another post.)

Today’s WSJ ran an extensive article on BP’s misadventures in Russia over BP-TNK.   It is titled “Misreading the Kremlin.”   Yes, truly an understatement.

This quote stands out:

“The mistake was believing that there was consensus among all the guys that make these decisions,” said one person close to BP.

Repeat that quote to yourself a few times.   Then ask yourself: who in their right mind could possibly think that there was consensus “among all the guys that make these decisions”?   Anyone who follows this at all knows–knows–that there are battling clans in Russia, and that the most prominent and the most powerful and the most adversarial center on Rosneft and Gazprom.   There is never consensus among these guys.   At best there is a truce, like that between the Five Families of the New York mafia.   Putin’s main job is to balance these factions and keep things from breaking into outright warfare.     There is an uneasy peace, and one faction is not going to do anything to help the other.   Indeed, each will try to torpedo the other whenever possible.

Anyone following Russian energy also knows that Igor Sechin is the godfather of the Rosneft clan.   So what does BP do?   It goes to Sechin–the engine of Yukos’s destruction–to talk about its plans to cooperate with Gazprom:

In April, Mr. Hayward visited Igor Sechin, a powerful Putin confidant. According to people familiar with the meeting, Mr. Hayward laid out BP’s efforts to reach a deal with Gazprom.

Un-freaking-believable.

This is a runner-up in the understatement derby:

Mr. Sechin was in an interesting position: He also serves as chairman of state oil company Rosneft, and is generally opposed to further expansion of Gazprom, especially into the oil business, say several people who’ve discussed these issues with him.

“Generally opposed to further expansion of Gazprom.”   You don’t say.

I can only imagine the derisive laughter echoing off the walls of Sechin’s office after Hayward left the room.

In other words, if this article is to be believed, BP was unaware of the most basic contours of the Russian political landscape.   It assumed that “the Kremlin” was a monolithic body at odds with the AAR oligarchs.   Certainly the oligarchs were in a tenuous position, but their very survival was–and is–almost certainly attributable to the fact that the “Kremlin” is anything but monolithic.   The balance of power between the Rosneft-Sechin and Gazprom factions would have been disrupted by ousting the oligarchs, and putting one of the factions in control of BP-TNK.   Hence, these oligarchs survived.

Given the history of Yukos, it should have been readily apparent if the powers that be wanted to destroy these oligarchs, they would have already been destroyed–and BP would not have been the beneficiary.   Their very existence should have raised questions in the mind of BP CEO Tony Hayward.   No doubt Gazprom was feeding Hayward and other BP people a line that “the Kremlin” was looking to boot the oligarchs.   But one must take any representation from Gazprom with all the grains of salt from all the mines in Siberia.   And one must also base all strategies on an understanding of the fundamental Gazprom-Rosneft rift, and an analysis of how one’s proposed moves would play into that battle.

Any strategy involving the Russian energy business must start from a recognition that   there is bitter division and intense rivalry within the Russian hierarchy, especially in anything involving energy.   Basing a strategy on an assumption of “consensus” was a blunder of the first order.   Dealing with Sechin to advance a transaction that would benefit Gazprom is an even worse blunder.

In short, this article makes Tony Hayward and the rest of BP’s upper management look like complete incompetents.   This quote pretty much sums it up:

“There’s a group of people who know what’s going on and know what to expect,” said one person close to BP. “And then there’s the London office.”

Well put.

This is not to say that there is any right way to navigate the Russian energy labyrinth.   Or, to mix classical metaphors, in attempting to do business in Russian energy one must steer between Scylla and Charybdis–a virtually impossible task.   But blundering along as if these dangers do not exist is inexcusable.

Oil rallied this week (but still finished well below $50/bbl) primarily on reports that Russia would cooperate on output cuts with OPEC.   Dmitri Medvedev has hinted that Russia might actually join the organization.

There are several reasons for skepticism.   First, Russia has dramatically reduced its oil export duty, and is contemplating a further cut:

Russia cut oil export duties to $287 per tonne from November 1, from $372.2 in October, in response to calls by producers who feared making losses on overseas shipments. Russia’s senior energy official, Deputy Prime Minister Igor Sechin, had lobbied for an even lower November tariff of $195.20.

. . . .

RIA Novosti reported that Russia could reduce oil export duty to USD 117 per tonne to USD 119 per tonne from the current USD 192.1.

Mr Alexander Sakovich deputy head of the customs payments department at the ministry said the average price for Urals crude on world markets in the monitoring period from November 15 to December 9 inclusive was USD 44.5 per barrel. He said the price could continue to change until December 15 given high volatility on the market.

Mr Sakovich said duty on light petroleum products could be cut to $91-$93 per ton against the current USD 141.8 and on heavy petroleum products to USD 49 per tonne to USD 50 per tonne from the current USD 76.4.

The Russian government decided to set export duties on oil and oil products on a monthly basis from December 1st and abandon the previously accepted bimonthly practice.

The most effective way for Russia to curtail oil exports (which is the only way it would have an impact on world prices) is to keep its export tax relatively high.   Lowering the export tax encourages exports, and is contrary to statements that it will cut output.   Sechin’s support for lower duties is especially important in this regard.

It is possible to both cut export duties and cut exports, but this would require the imposition of export quotas.   Just keeping the taxes higher would be a more sensible and straightforward approach.   Although higher export taxes would hurt Russian oil exporting companies–most importantly, Sechin’s Rosneft–this effect could be mitigated by some sort of compensation to these firms.   (To work, though, this would require that the compensation not be linked to current exports or output in any way, as that would just offset the effect of the tax.)

The fundamental inconsistency between promising to cut output/exports in collaboration with OPEC on the one hand, and cutting oil export duties on the other makes me question the credibility of Russia’s statements.     Moreover, formal monitoring and enforcement of members’ adherence to quotas within OPEC are doubtful enough, and informal promises from Moscow with no prospect of enforcement seem a very weak reed to lean on.   Indeed, if I were OPEC I would be very leery of Russia’s representations.   Russia has every incentive to encourage an OPEC output cut–and then to produce as much as possible to exploit the higher prices.   If Medvedev and Putin think that attending the OPEC meeting and promising cooperation make it more likely that OPEC will indeed cut, they’ll do those things.   The intent to adhere to those promises is highly doubtful, however.

Liam Denning expresses different reasons for skepticism in the WSJ:

Look at an atlas, and you will see that all of the members of OPEC sit within or very close to the Tropics.

That Siberia lies far to the north is one reason why Russian President Dmitry Medvedev’s hints about joining the oil group amount to mere posturing. The Organization of Petroleum Exporting Countries’ primary lever for influencing oil prices is raising or lowering members’ output — sometimes several times a year.

Try doing that when the Siberian winter freezes dormant wells closed, meaning they have to be drilled again. Meanwhile, summer thaws churn up the ground, bogging down maintenance equipment. In Russia, once you drill a well, it pays to keep it pumping.

In theory, the Kremlin could stockpile reserves to adjust export volumes. But this would take time and incur big costs in an economic crisis.

It also isn’t clear why Saudi Arabia, OPEC’s de facto leader, would want Russia to join the quota system. In 2007, the Saudis exported 7.9 million barrels a day, according to the U.S. Energy Information Administration. Russia exported seven million barrels. Saudi Arabia would risk seriously diluting its influence in an already fractious group. And for what? Does anyone think Moscow would abide by OPEC policies if it didn’t suit it?

In reality, Mr. Medvedev is dressing up Russia’s inevitable output decline — largely resulting from the state’s tightened grip on the energy sector — as a planned move co-ordinated with OPEC. Second, with the economy still a leveraged play on energy prices, and a possibly destabilizing ruble devaluation on the horizon, he is trying to talk up the oil market.

Far from hinting at increased Russian influence, the president’s words carry more than a hint of desperation.

Denning’s point about the inherently less flexible nature of Russian oil production is of great interest.   It means that actual Russian cuts in the short run are more credible in the longer run than cuts in, say, Kuwait. Kuwait can cut today, and increase output relatively easily in the near future.   If Russia cuts today, it is effectively committing itself to cut for a considerably longer period.   Knowing this, it is less likely that Russia will choose to cut.   It would be in a real jam if it cut in conjunction with OPEC, only to have the latter’s members (predictably) renege on their commitments weeks later.   In that case, Russia would have the worst of all worlds–lower output and low prices.

So, I concur with Denning’s basic argument that Medvedev is just talking his book (as traders say), and that he is trying to get some price action in exchange for cheap talk.

Rather than listening to Medvedev, or Putin for that matter, I would pay attention to the export duty.   That is the primary lever that Russia can pull to affect exports and hence world prices.   If Russia raises the duty, it means it is serious about cutting output.   If it keeps the tax low, or cuts it further as the Novosti article suggests, all the talk about cutting output in conjunction with OPEC is just that–talk.

Much news on the Russian economic front.

One of my favorite Russian commentors, Vladimir Milov, said this on Ekho Moskvy:

According to Kiselev’s next guest, Vladimir Milov, president of the Energy Policy Institute, compared with his previous annual question and answer sessions with the nation, this year “the president did not look confident”. Milov continued: “I would put it this way: there was less of the aplomb which we could observe in the previous years and more apologies and attempts to explain the situation.” “It was as if he (Putin) was apologizing for what is happening and, in my view, he was not very successful in this,” he said.

According to Milov, Putin is not suitable for the role of a crisis manager: “Putin is so used to the idea that everything is growing, that mentally it is very difficult for him to adjust.   One can see that he has a very inertial mentality and hence it is very difficult for him, in the conditions of the crisis, to respond to the current major and sweeping changes. He is definitely not suitable for the role of a crisis manager.”

Asked whether he approved of the government’s current strategy of “ensuring economic growth and GDP growth at any cost”, Milov replied: “To be honest with you, I can’t see the government acting in a coordinated manner, not to mention having a clear strategy or aim.” “It is evident that they (the government) have got into a muddle and are not ready to get together as a single team and draw up a coordinated anticrisis plan,” Milov said.

He went back to elaborate on the idea of the “inertia” prevailing in Putin’s and other leaders’ approach: “They are used to the situation of the past few years when everything was improving all the time owing to various external factors which they had nothing to do with, and they are simply not ready, they simply do not know and do not understand what to do in a situation when the economy is functioning in entirely different mode and when very difficult problems have emerged and the essence of which they do not understand either.”

“It is a question of fundamental incompetence and inability to assess the scale of the problems that have appeared very suddenly and are of rather an unexpected nature,” he added.

Asked how he would have dealt with the current crisis, Milov replied: “There are ways, but first of all we still need a competent leadership that would indeed understand the essence of the economic problems we are facing. Judging by what Putin said yesterday (4 December), he is a long way from having even a basic understanding of the nature of these crisis phenomena. He was still blaming America for everything. But soon, incidentally, most people will realize that America is America but jobs are being cut here, in Russia.”

Asked about the possible political consequences of the current economic crisis, Milov said: “It is a very difficult question because there are two opposite theories. According to one, the growing economic difficulties will undoubtedly start affecting a wider circle of people and very quickly push these people towards a realization that something needs to change in the political system and they (these people) will demand this.”

“But there is another theory”, Milov continued, “which says society can be rather adaptable –
people will be getting used to having slightly worse living standards and will start saying, as Putin did yesterday, that in its one-thousand-year history Russia has been through much worse times. At present it is very difficult to say what will happen in society and how this will affect the political system.”

And, in conclusion, he added: “Even if they want to, these authorities, which have only the most primitive tools at their disposal, will not be able to respond because they can’t provide any serious crisis management. Hence, if there is a significant public protest, I think they will simply have to go. There are no other options here.”

It’s easy to look like a genius when the prices of your main products go through the roof.   When oil was $140/bbl, Putin strutted about like the cock who thought his crowing made the sun rise.   Too often, people confuse luck for skill.   Happens with traders all the time.   Now, things are a little bit more difficult, and Vlad is not looking quite so good. Maybe Time should reconsider that Man of the Year thing.

The main issue is the ruble.   Due to concerns about the ruble, S&P has downgraded Russia’s sovereign debt rating, with a negative outlook (meaning that further downgrades are likely.)     Another first! (Russia is the first emerging market to have its rating cut by S&P.) S&P emphasized both macroeconomic and political risks in making its judgment. The political risks are especially important in my view.

In one rather (black) humorous moment, A S&P analyst opined:

“On the other hand, passage of measures to improve the legal and institutional framework for foreign direct investment and enhance competitiveness of the broader economy, as well as implementation of monetary policies to preserve the government’s still substantial liquid assets, could lay the foundations for greater resistance of the balance of payments to external shocks, and lead to a stabilization of the sovereign rating,” S&P’s Frank Gill was quoted as saying.

Good luck with the “passage of measures to improve the legal and institutional framework,” Frank.   That’s a very weak reed upon which to lean. In fact, if that’s the key to creating a firm foundation for future investment and growth–and I believe it is–then going short the ruble is a very good trade.

The increasing consensus is that (a) Russia is making a serious mistake by delaying the adjustment of the ruble to reflect the new bearish fundamentals (most notably the oil price), and (b) political considerations are driving this policy error.   Nouriel Roubini has an excellent analysis:

Given this sudden change in the Russian fortunes there are several key policy issues that the policy authorities need to deal with: of course given the external shocks (terms of trade worsening and sudden stop of capital and credit) it was important to use the buffer of foreign reserves to avoid a bank run by providing liquidity and capital to banks and by providing a fiscal stimulus to a country that is sharply slowing down. But the key unresolved policy issue is what to do with the exchange rate. Until recently Russia was on an effective basket peg (with 55% for the dollar and 45% weight for the euro). But with oil prices now down over 60% from the peak of the summer and with incipient current account deficits and fiscal deficits and a likely recession in 2009 the currency is obviously overvalued. A reasonable estimate of the needed exchange rate depreciation – with oil at about $50 a barrel in 2009 – is 25%. But until recently the authorities resisted the needed depreciation through aggressive forex intervention.

The reasons for resisting such necessary depreciation were varied: the banks and the corporate sector had massive foreign currency liabilities and a sharp movement of the currency would have led to nasty balance sheet effects and severe financial distress; the incipient bank run of retail depositors could accelerate if the currency were to fall sharply (Russian depositors were wiped out already twice in the transition period in the early 1990s and again in 1998 and they tend to be trigger happy); Putin staked part of his reputation and his view of a strong Russia on maintaining a strong rouble.

But the forex intervention that financed the capital flight out of Russia (a flight initially triggered by the increase in political risk given the Georgia conflict and then exacerbated by the global sudden stop of capital given the US financial turmoil in October-November) exacerbated the flight. Indeed, a good part of the forex intervention was sterilized thus preventing a significant stabilizing increase in domestic interest rates that an unsterilized intervention would have triggered. But, as a perfect case study of Triffin’s “inconsistent trinity”, a country cannot maintain a peg, have no capital controls and, at the same time, maintain monetary independence and avoid an increase in domestic interest rates that an expected depreciation triggers. The sterilized intervention thus led to a persistent bleeding of forex reserves that could continue unless such intervention is allowed to be unsterilized and thus force a rise in interest rates that would however be seriously costly in growth terms.

For a while the Russian authorities tried to skirt this inconsistent trinity inconsistency by introducing capital controls on capital outflows (taking the form of reading the riot act to local and foreign banks and financial institutions and telling them not to speculate against the trouble). But even such controls are leaky as many banks – faced with retail depositors converting roubles into dollars – needed to hedge such currency risk to avoid exacerbating their open currency positions mismatch. So the authorities cannot be too heavy handed against banks that are just hedging rather than speculating”. And unless capital controls are imposed in retail depositors their demand for currency hedging drives the financial institutions need to hedge in turn this currency exposure. So the conundrum of the inconsistent trinity still holds as there are limits to regaining monetary independence under fixed rates when such capital controls are effectively leaky and implemented partially.

The more appropriate way to regain a modicum of monetary independence and prevent a sharp increase in domestic interest rates that expectations of a rouble depreciation trigger is to let the currency peg go and flexibilize the exchange rate regime. Only after the currency has moved down enough expectations of further depreciation would quiet down. So, the right policy move would be one of a one-step large depreciation of the currency value that reduces significantly the amount of actual overvaluation of the currency. Instead, for the time being, the authorities have reacted by allowing only a gradual and modest depreciation, in a series of four 1% downward steps in the last month. But such small step depreciations exacerbate the capital flight incentives (and ensuing bleeding of reserves) as they lead to further expected depreciation expectations that triggers further flight. Only a relatively large unexpected step depreciation can stop such expectations and reduce the amount of the capital flight and forex reserve depletion.

But so far authorities had resisted such large step move for three reasons: losing face politically; worrying about a run on banks by depositors; and the large foreign currency exposure of financial institutions and corporate firms. These three reasons to resist a larger currency move are now becoming less important for several reasons. First, a continued bleeding of a large stock of reserves could cause a much bigger problem down the line – a real currency crash that would be politically even more damaging – if continued sterilized intervention leads to a sharp fall in reserves at the time when the current account and the fiscal account are likely to move into a deficit in 2009. Second, the risk of a bank run can be better managed via a controlled devaluation when reserves are still high rather than when reserves have been mostly depleted via a self-defeating defense of an indefensible peg.

Third, and most important, by now a significant part of the foreign currency exposure of the financial and corporate has been reduced by using the forex reserve intervention to effectively allow banks and corporate firms to reduce their exposure to foreign currency liabilities and thus avoid severe balance sheet effects when the currency moves by a larger amount. Effectively Russia has been doing what Brazil did in 1998-99 – i.e. bailing out ex-ante its banks and corporates by allowing them to cover their forex currency exposure via purchase of a large fraction of the reserves of the central bank.   This Brazilian “ex-ante bail-out” prevented the “ex-post bail-out” that would have been necessary if banks and corporates with a massive amount of foreign currency debt had experienced a large currency depreciation before they had the time to hedge such exposure. So now that the forex reserves of Russia have been run down enough to reduce the foreign currency exposure of the private sector the central bank can allow a faster rate of rouble depreciation without worrying about the banks and corporate going bust via the balance sheet effects of a large currency move on the value of their previous large foreign currency exposure.

All these factors suggests that the Russian authorities are now ready to let the currency fall at a faster rate than it the past. They have already moved in that direction by surprising markets with their weekly 1% moves. But since a much larger depreciation is needed and since further expected 1% moves will trigger even greater amounts of capital flight and reserve depletion a broader and large one-step move is now necessary and viable. The rouble may need to fall by about 25% before reaching a new equilibrium value. It is thus better to make a good chunk of that adjustment faster and in an unexpected way rather than keep on bleeding a large stock of forex reserves if small step movements trigger expectations of further depreciation. Now that banks and corporate firms are more hedged than before and the war chest of reserves has not yet fallen to alarming levels it is time to let the currency level take a larger burden of the necessary adjustment that the country needs to cope with lower oil prices, the sudden stop of capital, the increase in investors’ risk aversion and a global economic outlook that signals a sharp recession in advanced economies and a very likely recession in Russia too.

Roubini does endorse one argument that DR has made–namely, that defending the ruble has effectively bailed out those banks and corporations who have borrowed in foreign currencies. But Roubini argues that the time for that is over. The other deleterious effects of maintaining the peg which I have focused on are becoming too big to ignore. But Russia seems to be ignoring them, and primarily for political reasons, or, as Roubini puts it, “losing political face.” Putin’s ego is a very expensive proposition, indeed.

Roubini’s best point is that by burning through its reserves to prop up the ruble at levels completely inconsistent with the currently low price of oil, Russia is depriving itself of the means to manage the currency at a more realistic level when the real fiscal crunch begins to kick in sometime in 2009.

The incoherence of the Russian policy is becoming more widely acknowledged. One thing I had noted (in a reply to DR in the comments, I think) is that there was a certain dog-chasing-its-tail aspect to Russian policy, with the central bank printing rubles to try to provide liquidity to the domestic economy, and then sopping them up by buying them with dollars and euros. The ruble printing tends to drive the ruble down, so the bank has to sell more dollars to keep up the exchange rate. This can work, after a fashion, if, as Roubini notes, three are effective capital controls that effectively segment the domestic and FX markets, but these controls are not in place. As one Russian economist noted:

Yevgeny Gavrilenkov, economist at Troika Dialog, argues this has accelerated the exodus from the rouble.

“The expectation there will be a devaluation is present and . . delaying this is only making it worse,” he says. “The [central bank] is printing roubles to support liquidity and half of that . . is going to the dollar market. This is a bit absurd.”

Hence, Russia is blowing through its reserves in a thoughtless way that is impeding its adjustment to the new reality of a $40 oil price and depriving itself of the policy flexibility it will need down the road if world economic conditions–and hence the price of oil–continue to be weak well into next year.

All of which just goes to demonstrate the justice of Milov’s rather damning judgment on Russian economic policy and Putin’s crisis management acumen.

This is getting confusing.   First, there were reports that Russia would delay its implementation of electricity tariff reform (specifically, increasing rates to reflect economic realities).   This caused considerable anxiety among investors who had committed capital to build badly needed generation in anticipation of the tariff reform.   Second, a few days later, Putin and the government denied that the reform would be delayed.   Third, today’s Bloomberg reports that Putin’s assurances may no longer be operative:

OAO Gazprom, the world’s biggest natural-gas producer, declined the most in a week in London on concern that possible cutbacks in the Russia’s planned electricity price increases will be extended to gas prices.

Russia may scale back electricity price increases to 5 percent next year from an earlier proposed 19 percent increase, Interfax reported late yesterday.

Cuts in gas prices will probably follow so that thermal power generators, which rely on natural gas, won’t lose money in the first half of the year, according to Matvey Taits, utilities analyst at UralSib Financial Corp. in Moscow.

“If they review the tariffs for the generators, then I suppose they also have to revise them for Gazprom, because gas is the primary fuel for electricity generation in Russia,” Taits said by telephone. Concerns over gas prices are “one of the reasons” the shares are under pressure, he said.

Such policy uncertainty is hardly the way to create (I wouldn’t dare say “restore”) confidence among investors about the security of their investments.   It is particularly dangerous for Prime Ministers to weigh in on such issues, provide assurances, and then have these assurances given the lie within days.