"Happy families are all alike; every unhappy family is unhappy in its own way"
President Dmitry Medvedev’s recent decision to inject $20 billion into Russia’s flagging stock markets – which were down nearly 50% from last May at the time - together with the $60 billion odd dollars of support injected into its groggy banking system served to draw attention to the fact that it wasn't only “over there” on the other side of the Atlantic that the financial turmoil was busy raging. This simple point was further emphasised, if need there was for it, by the fact that both the Russian bourses – the MICEX and the ruble denominated RTS - were only working on a “now you see me now you don't basis” for the best part of a week in mid September. Stealing an idea from Tolstoy’s Anna Karenina, every financial boom is (boringly) the same, but every financial crisis is different in its own special (and intriguing) way. What just happened in Russia merely serves to prove Tolstoy’s point.
Final and Efficient Causes
The immediate cause of the present crisis was an almost random event - a default on commitments by a small and fairly obscure brokerage firm called Kit Finance. This rather anecdotal incident, of limited importance in and of itself - seems to have produced something approaching panic, a panic which extended right across Russia's financial markets, as investors, who had already been growing very nervous about holding Russian assets in the face of the mounting global financial chaos all decided to throw the towel in at once.
Russia seems to have been hit by some sort of "perfect-storm trifecta" in the shape of falling oil prices, a back reaction to Moscow's "go it alone" attitude to Georgia's two separatist regions, and overheating on the back of the oil boom and rising consumer and corporate credit growth in the Russian economy itself. All these factors coalesced to produce what many commentators described as "an especially toxic cocktail" whose effects - despite Russia's substantial oil fund safety net, and the very large quantity of foreign exchange reserves parked at the central bank- are bound to prove very hard indeed for the Russian financial system to simply brush aside.
Long Term Demographic and Institutional Problems
The real point in all this is that while Russia's financial markets are currently taking a pounding for relatively fortuitous reasons, the underlying macroeconomic challenges which Russia is facing were always going to make their presence felt.
Russia's key long term challenge can be succinctly summed up - severe demographic decline coupled with excessive dependence on raw material extraction industries. Basically Russia is suffering from some sort of modern variant of what is known as the "Dutch disease". Revenue generated by the recent sharp oil and commodities boom has served to accelerate the Russian economy way beyond its real short term capacity - bringing home the impact of the underlying demographic challenge in the shape of labour shortages produced by many years of very low fertility and exceptionally poor health among Russia's male over-50 male population. To continue to grow at the present rate the world bank estimates that Russia needs immigration at a rate of 1 million workers a year, and to sustain the assimilation of so many people from so many diverse cultures in the longer term needs a different approach to the whole idea of Russian “ethnic” identity.
Basically this labour supply problem, coupled with the very rapid growth, has lead to a very pronounced spike in short term Russian inflation, and the inflation is, in turn, now having a severe impact on the competitiveness of Russia's domestic industrial sector. Despite the fact that the economy itself is growing at around 7% industrial output actually shrank in July over June. So with the oil sector effectively stationary in terms of output, and manufacturing industry also heading towards stagnation, the Russian economy is becoming seriously unbalanced.
But if demographic difficulties and excessive resource dependence are producing growing problems on one front, poor institutional quality is clearly playing its part in ballooning Russia’s difficulties on the other. Here a comparison with another oil rich emerging economy - Brazil - is instructive, for while Banco Central do Brasil is currently earning a justified reputation for being the new Bundesbank of Latin America (with an inflation rate of 6.2% and interest rates at 13.75%), no one would dream of saying anything of the kind about Bank Rosii, where - despite Russia's roaring 15% inflation rate - the benchmark lending rate is currently set at 11%. This means that far from constraining inflation Russia's domestic interest rates are actually boosting an already overheating economy with an extremely accommodative inflation-adjusted base rate of minus 4 percent.
So one key component in Russia’s current financial crisis is evidently a crisis of confidence in the quality of Russian institutions and in their capacity to handle the very complex problems which present themselves in the context of modern macroeconomic management, and this crsis is now a rather longstanding one and did not simply spring to life when the Russian tanks roared through the Roki tunnel into South Ossetia.
No Financial Melt Down, For Now
So what can we expect to see happening to the Russian economy in the immediate future? Well evidently there is no imminent danger of meltd-down, collapse or short term default, since foreign exchange reserves - which are the third largest globally after those of China and Japan and stood at $560.3 billion on September 12 - are evidently ample and more than sufficient to handle any forseeable short term crisis. In addition Russia has a $163 billion Sovereign Wealth Fund to fall back on to fund any immediate fiscal shortfall which may follow the crisis and the funding injection.
In this sense Russia is hardly the Baltics (nor for that matter is it in the same kind of trap which has gotten a hold on the United States), so we should not expect the real economy to go into a nosedive an time soon. Reading the entrails on Russia at this point depends on the view you take about the future of energy prices. My own view is that although the global economy is likely to slow considerably, and this slowdown will place temporary pressure on oil prices, in the mid-term oil is likely to rebound as all those emerging economies finally get on with the arduous task of emerging, and this rebound will obviously give the Russian economy its second wind.
So the Russian economy is likely to slow, and investors will more than likely become more nervous about their lending to both Russian consumers and corporates. Growth may well be cut in half in 2009, and fall back from the present 7% rate to something more like 3.5%. But Russia will weather the storm, although the same may not be said for the export-dependent German economy, which has become more and more dependent on Russia as a prime customer following the withering of export growth first to the United States, then Southern Europe and the United Kingdom and now finally to Eastern Europe. German order books are sure to notice September's seven days that shook the Western World, indeed judging by the latest business confidence and purchasing managers index readings, they are already noticing. So, ironically, perhaps the first causality of the Russian crisis will be the eurozone, which may well find itself facing the first full zone-wide recession in its short history as a consequence.
In the longer run, of course, if the underlying issues are not addressed the problems identified here will simply deteriorate and we will get a fullblown crisis. But then, as someone famously said, in the long run we are all dead, so maybe all our economic crises do have something in common after all.
I have a much lengthier a more detailed analysis of the current economic crisis in Russia in this post here.
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