Streetwise Professor

November 25, 2008

The Financial Crisis in Russia Begins to Bite

Filed under: Economics,Energy,Politics,Russia — The Professor @ 10:09 pm

I haven’t written anything on Russia lately, being absorbed (obsessed?) with all things clearing, so I need to do something to stir up the natives in SWP-land;-)

There has been little concrete news to write about.   The odd constitutional amendment Kabuki dance continues, but there’s little more to say about it.     The Russian central bank has loosened the ruble band a bit further, but is evidently still defending the ruble–effectively giving speculators a free put that will pay off when the bank cries uncle, as it inevitably must.   This is a foolish economic policy dictated by political considerations; if rapidly deteriorating fundamentals justify a drop in the ruble, let it drop rather than throw away (I cleaned that up) hard won reserves in an ultimately futile defense of an overvalued currency.   The only conceivable reason for engaging in this policy is that Putin has staked his reputation on the ruble and avoiding another 1998-esque collapse, and that relatedly, a rapid drop would give the lie to Putin’s and Medvedev’s public expressions of confidence.   Timothy Post and Da Russophile are sanguine that the Russian people will not turn on the government out of anger over the economic situation, but its actions suggest that Putin and Medvedev are not quite so confident.

Speaking of deteriorating fundamentals, oil sold off sharply today after a nice rally yesterday.   Urals Med was quoted at $45.86 in European trading today.   Brent has sold off some since that price was quoted, so the current price of Urals is probably south of that number.   $45.86 ain’t $40, but it’s a long way from where the price needs to be to stabilize the Russian economy.

The most interesting news is this Reuters report that the government has decided to “delay” electricity pricing reform.   A long article in the Moscow Times last week suggested that such a move was in the offing.   Russia had spun off its electricity generators from state monopoly UES, but prices are still regulated at very low levels that make it completely uneconomical to make desperately needed investments.   The next step of the restructuring plan would have raised these prices to allow grid operators to earn a rate of return sufficient to attract new capital.   Allowing generators to sell at higher prices was essential to attracting desperately needed investment in new capacity.

The suspension of the pricing reform will likely be viewed as the government reneging on a commitment.   This will make it even more difficult to attact the massive amounts of capital necessary to improve Russia’s decrepit power grid.   (Though it should be noted that the financial crisis itself, and the problems in the real economy that will result from it, would undermine the investment case without the government’s piling on.   But the reputational effect of changing the rules will exacerbate the difficulties in attracting capital, and will have effects well after the financial crisis abates.)

The decision making process was typically opaque, but it appears that major industrial interests, especially the big energy and mining companies pressured the government to keep prices low in order to support their suddenly struggling operations.     This will further discourage investors, not just in electricity, but in all sectors, as it provides additional evidence (as if any was needed) that political calculations, rather than economics, drive key policy decisions.   (And, in a pre-emptive exercise of “whataboutism,”   I concur completely that this is going on the US and Europe too.   Any bailout of the auto companies would be similarly egregious.)

The whole affair also shines a light on Russia’s vast investment needs.   Electricity, roads, rails, health care, to name just the largest, are all in need of massive investments.   The politicized capital allocation mechanism was not directing the oil windfall to where it was needed when energy prices were high, and now tens, and perhaps hundreds, of billions prudently accumulated when oil prices were high are being frittered away bailing out oligarchs to keep the stock they have pledged in collateral out of the hands of western banks, and propping up an overvalued ruble.   This will have deleterious effects on Russia’s long term growth prospects.

Due to the closed nature of Russian governance, the silovikis‘ hands are invisible, but that’s not what Adam Smith had in mind.   The hidden hand of the siloviki distorts the allocation of capital and discourages badly needed investment.   Russia will not make the transition beyond Nigeria with snow and missiles until their malign influence is eliminated.

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  1. I am curious as to what you think of Peter Schiff’s assertion that the American dollar may fall? (see What options does the United States have in the long term other than printing more dollars?

    Comment by Michel — November 25, 2008 @ 10:18 pm

  2. The value of the dollar relative to other currencies, or in goods and services? Somewhat different questions. A decline in the value of the dollar in goods and services means inflation. A decline in the value of the dollar relative to other currencies would most likely be due to greater inflation in the US than elsewhere.

    The dollar has been rising relative to the Euro, Swiss Franc, Loony, Australian dollar, etc., whenever the the stock markets have tanked. As bad as things are in the US, it is viewed as more secure than elsewhere, so there is a flight to quality whenever fears about the financial crisis weaken.

    The US, like other countries, has been shoving liquidity into the banking system at a furious rate. Normally you would think that this is inflationary, but at present all signs appear to point in the other, deflationary, direction. This is because although the supply of money has exploded, the demand for money has increased too. Banks are hoarding most of the reserves that the Fed has been pumping into the system. This means that rather being spent, and driving up the dollar prices of goods, the dollars are being hoarded, thereby keeping inflation in check. This is sometimes referred to as a “liquidity trap.” Try as it might, the Fed can’t inflate the economy. (My how things have changed. Mere months ago the thought of some inflation was a nightmare. Now it’s a dream.)

    The challenge will be when–or should I say if?–the financial crisis abates, and banks begin to try to unload those reserves. That’s when the prospect for inflation, and a serious inflation, kicks in. Since other central banks (ECB, BofE) are also flooding their economies with reserves, they are in a similar situation and so it is difficult to forecast how the dollar will perform relative to these other currencies. I would imagine that as soon as inflation looks like it is picking up, the Fed will try to sop up all that liquidity it has injected into the system by raising interest rates. That might be politically risky, though, as the Fed is likely to fear that raising rates could abort any recovery, and will be subject to considerable political pressure not to do so.

    So yes, I perceive a considerable risk of high inflation–i.e., a decline in the value of the dollar in goods and services. There is also a risk of a decline in the dollar relative to other currencies, but whether this happens depends primarily on whether monetary policy in the US is more or less restrictive relative to monetary policies in other countries. Since the ECB has an explicit anti-inflation mandate, and thus is more likely to fight inflation aggressively than the Fed, a decline of the dollar-Euro exchange rate is a likely outcome.

    Anyways, those are my thoughts off the top. Note, however, that I am not speed dialing my broker to put my money where my mouth is. (Although I did put a good chunk of change on inflation protected TIPS securities that were yielding 14 percent for 2 months, and 6 percent for a year.)

    The ProfessorComment by The Professor — November 25, 2008 @ 11:47 pm

  3. Well, some of the analysts I have been reading have suggested that the United States is likely to face very high inflation if the worst happens: foreign states (read China) stop buying American treasury bonds and the only recourse the United States will have it to print more money. However, bad inflation in the United States will likely lead to horrible inflation elsewhere.

    Comment by Michel — November 26, 2008 @ 12:57 am

  4. A few thoughts…

    1. Isn’t what the US currently doing, propping up the financial system, simply transferring insolvency from the banks to (potentially) the state? It should also be noted that the first baby boomers are now beginning to retire and Social Security obligations are going to skyrocket.

    2. The US has run budget deficits in the good years financed by cheap loans, and in the next few years will probably soar to well in excess of 7% (ML estimate, and that’s without accounting for the TARP, various bail-outs and skeletons falling out of forgotten closets, etc – and on top of Obama’s planned spending on health and infrastructure, which is vital and overdue, but hampered by the legacy of the reckless spending policies of the Bush regime). Costs of servicing debt for 2008 have soared to 451bn$ for this year, according to two sources I’ve come across (I admit up front I can’t absolutely vouch for its reliability, however – but I’m quite interested in the figure and where to get it). Roubini, who’s been the most accurate forecaster so far, expects US GDP to drop by 10% from peak to trough (

    3. Above implies that from 2009, about half of the budget deficit must be used up simply to pay interest on old debt. It really seems it’s caught between a rock and a hard place. If foreigners stop financing US deficit spending out of their savings, then the above process accelerates into the abyss of insolvency. If not, and US savings rise to compensate, we’ll be seeing a large drop in GDP (as per Roubini above), severe fall in tax revenues, and an even larger deficit…which would cancel out the gains from increasing the savings (paradox of thrift).

    4. I might have been overoptimistic about Russia, but considering the above I’d still much rather be in its shoes. Financing growth out of future savings has been happening in the US since the late 1990’s, in Russia it only really took off around 2006-07. If this situation is as bad as some commentators think the US may have to default by printing press.

    5. “(And, in a pre-emptive exercise of “whataboutism,” I concur completely that this is going on the US and Europe too. Any bailout of the auto companies would be similarly egregious.)” – SWP

    Actually, in this case the whataboutism is unjustified and the statement represents a lot of what is wrong with this country. Why does the Bush junta feel the need to pour down trillions into criminal, and worse, useless, wars and bailing out the overgrown casino that is the financial system, but are unwilling to give just a few tens of billions to reviving American manufacturing, which is the foundation of its economic and military strength and the major source of long-term wealth?

    6. Banks will start unloading those dollar reserves when the crisis turns around, as noted by SWP. That will also coincide with a resumption in inflation due to higher demand for energy, minerals and food, and fewer supplies of them due to the wrong signals that have been coming to investors in commodities since this crisis began. A double wammy?

    7. “Russia will not make the transition beyond Nigeria with snow and missiles until their malign influence is eliminated.” – SWP

    Lol. Even you can’t seriously believe in that comparison.

    Comment by Da Russophile — November 26, 2008 @ 4:48 am

  5. It’s quite possible that SWP’s comparison of Russia to Nigeria is ill-founded. History may well show he’s being far to hard . . . on Nigeria. After all, Nigerians whatever their faults haven’t been so utterly insane as to elect a proud representative of a secret police organization that engaged in mass murder and torture on a scale grand enough to wipe out an entire predecessor nation, nor have they sanctioned massive political assasinations, crazily self-destructive cold war provocation of the world’s only superpower, and Nigerians haven’t applauded as their army wrecks military havoc on a tiny defenseless neighbor.

    Many might argue that Nigeria’s prospects are far brighter than Russia’s — even Africa’s AIDS crisis may well soon be dwarfed by Russia’s.

    Comment by La Russophobe — November 26, 2008 @ 9:01 am

  6. I knew I could get the fur flying again;-)

    Michel–Here’s an article from the WSJ that discusses the potential for a dollar decline. The analysis is pretty much along the lines of what I said in my comment–but remember, you read it here first;-)

    Happy Thanksgiving everybody.

    The ProfessorComment by The Professor — November 26, 2008 @ 12:04 pm

  7. […] Professor discusses how the Russian economy is coping with its challenges in the wake of the global financial crisis. […]

    Pingback by Global Voices Online » Russia: In the wake of financial crisis — November 26, 2008 @ 3:13 pm

  8. Can’t open the link unfortunately 🙁

    Happy Thanksgiving!

    Comment by Michel — November 26, 2008 @ 5:06 pm

  9. Michel–

    Maybe this will work.

    The ProfessorComment by The Professor — November 27, 2008 @ 9:35 am

  10. Managed to open that link. The Economist has a nice piece on the other possible options (and the risks they entail):

    Comment by Michel — November 27, 2008 @ 2:59 pm

  11. Hey, SWP, Michel, Timoty, or heck even you dear penny and LR,

    Come visit Da Russophile 2.0! at

    Comment by Da Russophile — November 29, 2008 @ 2:05 am

  12. I believe it was Da Russophile who believed that OPEC could save Russia by implementing cuts that would bring the price of oil back up. Here is an interesting passage from an article in the Financial Times:

    In a statement following the two-and-half hour meeting, he said: ”Ministers noted with concern the deterioration of the global economic situation and its impact on oil demand, which is now expected to be much lower than estimated a month ago.”

    He said Opec was ”determined to stabilise the market” but also noted that the group was adhering to the 1.5m barrel-a-day cuts announced on October 24. Analysts say Opec is in fact not fully implementing its cuts, estimating 1.2m barrels-a-day of production had so far been cut out of the 2m promised over the past two meetings.

    Saudi Arabia early Saturday indicated the Opec oil cartel would delay a further round of output cuts until December.

    Over the past three months, Opec has already agreed to cut 2m barrels a day of its production and analysts said the group was more than half way there.

    The decision to delay a cut in output is a victory for those who worried the group’s reputation would suffer if it promised more cuts while appearing unwilling to implement them.


    Russia shouldn’t expect OPEC to come to the rescue any time soon.

    Comment by Michel — November 29, 2008 @ 12:37 pm

  13. Hey, the Saudis have been masters of the oil game for a long time and they aren’t stupid. They are major players with a vested interest in the outcome in Iranian, their Shiite nemesis, agendas. Watching Russia help the Iranians go nuclear isn’t something they want. My guess is they’ll be very happy to undermine Russian oil revenues.

    Russians being pathetically tone deaf to any semblance of political reality have for laughs Medvedev in Cuba doing photo-ops with the saddest of cliched communist hacks, Raoul Castro, this week. It doesn’t get any dumber than that.

    Comment by penny — November 29, 2008 @ 10:32 pm

  14. Followng up on my observation that the Saudis won’t be supporting oil prices to help Russia, Spengler in the Asia Times has an opinion as to where this is going:

    Iran’s ultimate target will be Saudi Arabia, whose largest oil fields are found inconveniently in Shi’ite-majority areas just across the Persian Gulf from Iran. The Saudis will not sit quietly while Iran gains the upper hand in Iraq. Pakistan and Turkey, Sunni powers with large armies, will be loath to allow Iran to dominate the region, and they also will be all the more dependent on Saudi generosity.

    A whole generation of Western analysts looked approving on Turkey’s turn to Islamism, as I reported last summer (Turkey in the throes of Islamic revolution, Asia Times Online, July 22). Now Turkey will be Islamist – and broke. Turkey paid more than 20% for local currency deposits in order to attract the funds to finance a current account deficit amounting to 7% of gross domestic product. The Islamist government of Prime Minister Recep Tayyip Erdogan now faces the worst of all possible worlds. The Turkish lira has lost a third of its value in the past month, and almost all of the devaluation will turn up in higher domestic prices. Credit availability for Turkish businesses will vanish, and Turkey will enter a profound economic crisis.

    A belt of ungovernability now stretches from Lebanon to Pakistan, with incalculable political and military consequences. I believe that a Shi’ite-Sunni version of Europe’s 17th-century Thirty Years’ War will engulf the region.

    Comment by penny — November 30, 2008 @ 9:05 pm

  15. Anyway it’s been nice chatting to you lot but I’ve got a shiny new blog to run. Adios.

    Comment by Da Russophile — December 1, 2008 @ 2:22 am

  16. Penny, you are right. The International Herald Tribune writes: “But there were signs of tensions. The Gulf states, led by Saudi Arabia, are unwilling to approve further supply reductions before other members of the cartel – particularly Iran and Venezuela – follow through on previous commitments to cut output.” In other words, the Saudis will not cut unless Iran does, and Iran, Venezuela (and Russia) can’t cut because they need the money to finance their larger political aspirations to be regional/global power players. Also, they are desperate as they need the money to keep the social peace in their own country, or at least keep a lid on popular unrest. Looks like oil prices will be going down farther.


    Comment by Michel — December 1, 2008 @ 11:20 am

  17. The WSJ also have a very telling piece entitled An “Ode to Oil.” They highlight one common problem faced by a number of countries such as Russia and Iran that rely on petrodollars: in spite of all their bluster, they need foreign investments and foreign technology to maintain production. A few excerpts:

    Today the markets know that Russia needs at least $1 trillion in investment if it is to maintain, let alone increase, its oil production. Just five years ago, output was increasing so fast — energy giants Yukos and Sibneft were posting annual production gains of 20% — that even the Saudis were worried about their own global dominance. But in the past year Russian oil production has started to wane. Leonid Fedun, a top official at Lukoil, Russia’s No. 2 oil producer, admitted back in April that national output had peaked and was unlikely to return to 2007 levels “in my lifetime” and that “the period of intense oil production [growth] is over.” Without foreign money and expertise to extract offshore oil and prolong the lifespan of existing wells, Russian production will fall dramatically.

    Oil could also help the outside world frustrate the nuclear ambitions of Iran, whose output is likely to steadily decline over the coming years unless it has access to the latest Western technology. Many wells are aging rapidly and the Iranians cannot improve recovery rates, or exploit their new discoveries, unless Washington lifts sanctions, which have been highly successful in deterring international investment.


    Comment by Michel — December 1, 2008 @ 6:07 pm

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