Streetwise Professor

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.