Russia’s boom going pop?

Dmitri Travin
17 December 2008

As the economic crisis gains momentum, the question as to what the consequences are going to be for Russia becomes more pressing. Assessments vary widely. On the one hand, there are catastrophic predictions that everything that has been built up since Russia's market economy came into existence will be destroyed. On the other, there are wildly optimistic predictions that whatever happens, a wise government has a wise plan of action up its sleeve.

Neither of these extreme scenarios is very likely. The truth lies somewhere in the middle. However, the complicating factor is that we cannot really tell how far the Russian economy is going to fall. For a start, we are too dependent on factors like the price of oil, which is virtually unaffected by the actions of the authorities. How serious the problem becomes also depends on other factors: what will happen to Russia's Gross Domestic Product (GDP) and  people's real income and employment, whether the budget will be balanced, how much devaluation is going to depreciate people's ruble savings, the stability of the banking system, the state of the funds market, the solvency of major Russian borrowers etc. In some of these spheres, Russia will be able to retrench and gather its forces for a decisive leap forward, in rather the way that Russian armies have behaved in major wars, retreating from the western borders to Moscow or even to the Volga. In others, the economy's ability to manoeuvre is strictly limited by existing resources, so a retreat would swiftly turn into a rout.

Let us examine the problems faced by the Russian economy in the crisis one by one, in order to determine how long Russia can hold out in each case, or rather the country's margin of safety in each sphere.

GDP waxing and waning

Russia's safety margin may appear to be quite high. For in recent years GDP has been growing by around 7-8%. This is much higher than in North America and most European countries. A drop of 2-3% to 4-6% per year would clearly not be catastrophic. Right now, some Russian officials are trying to emphasize the fact that even taking crisis into account, GDP will increase by more than 6% in 2008.

However, this fact has little bearing on the real state of affairs in the economy, as the favourable results of the first half of the year are balanced out by the unfavourable results of the second. The last three months (October, November, December) may even show a fall in GDP, according to some experts. In fact, in the second week of December the pundits even started talking about a recession in the Russian economy. They are anticipating that in the first quarter of 2009 things are going to become very difficult, as two quarters without a growth in GDP amounts to  a recession.

What are we to make of the great disconnect between the economy's earlier performance and what seems to lie ahead? Clearly, Russia is too dependent on oil prices. But there is more to the Russian economy than oil, after all. This is undoubtedly true. But we have to take into account the fact that it was the flow of petrodollars onto the Russian market over the last few years that created the consumer demand for many goods. The drop in oil prices not only cause the energy economy to shrink. It affects all the rest of the economy too. With cheap oil, demand bursts like a soap bubble. So in 2009 the reduction in GDP by comparison with 2008 could well be as drastic as the increase we have seen, for example, between 2000 and 1999. 

Balancing the budget

In recent years, the Russian budget has been in surplus. This not only made it possible to guarantee a regular increase in social expenditure, but also to create a reserve fund for use if oil prices fell. That moment has arrived now.

However, it is by no means certain that the fund is large enough to enable the government to plug the gap in state finances. Everything depends on how far oil prices fall, and whether the government will be able to cut back its expenditure. What will happen to oil prices is extremely hard to predict. But we do know what factors will determine whether or not the government can cut the budget.

The government is going to have to reduce its expenditure on investment projects drastically while doing its utmost to keep financing the social programmes. Whether or not it will manage to do this depends on the power of the lobbyists, who are certainly going to oppose any cut-backs to state investment.

Over recent years the decision has been taken to invest massively in the development of the Russian railway network, which is managed by a man extremely close to Putin - Vladimir Yakunin. Another ambitious project is the Sochi 2014 Winter Olympics. Expenditure on the construction of an oil pipeline in the Far East and China has also been expected to increase dramatically. How much these various investment projects gets will to a great extent be determined by the scale of corruption in Russia. The government will be able to balance the budget as long as it is able to face down the opposition of the lobbyists and the corrupt officials who stand behind them.

Putin's political position appears to be quite strong at present. So there is a good chance that he will be able to resist the lobbyists and draw up a competent budget, despite the crisis. Still, social expenditure will not be able to increase as it has in the past. And there is a real danger here, as society has got used to life getting slightly better each year. If people's expectations are disappointed, Putin's authority will suffer. This in turn will strengthen the position of lobbyists, and lead to the budget collapsing. And this would mean once again having a deficit  budget that is covered by floating a state loan, as in the mid-1990s. There would then be a risk of inflation. If there were capital flight from Russia, the government might not be able to float a loan on the market, and would have to revert to the ‘services' of the Central Bank. In other words they would just have to start printing money.

Employment and real income

So while the real income of those who depend on the state budget for their income may not be drastically reduced, the gap between reality and expectations will create serious problems.

Employment is going to pose another problem, as is the real income of people working in the non-state sector of the economy. The extent to which unemployment in Russia will grow depends, as we have seen, on what happens to GDP. A fall in production will inevitably lead to a drop in employment.

We are already having problems with unemployment, though the available data suggests that this autumn a large number of people who lost their jobs found new ones relatively quickly. Still, in the long term, the situation on the labor market will doubtless deteriorate. For a start, people who have been warned that their jobs are on the line will lose them. Secondly, while employers have been fairly optimistic up until now, and have been trying to hold on to the staff, they will soon become pessimistic and start laying off employees. Thirdly, the crisis, which is mainly affecting industry at present, is also going to hit the labour-intensive retail and service sphere. Then a lot of jobs will go at once.

President Medvedev recently announced that financial support would be made available to enterprises experiencing difficulties because of the crisis. But it is unlikely that much money will be allocated for this purpose. It is usually only the powerful lobbyists who get such large injections of money, and we have already discussed the reasons why pressure from this quarter needs to be resisted. So most enterprises are probably going to have to pull through the crisis on their own. Russia does not have deep enough reserves to bail them out.   

Still, it seems unlikely that unemployment will have a great impact on the state of things in Russia. Even in the 1990s, in the big cities it was not hard to find work which offered a reasonable salary. It will be worse in medium and small cities , like Magnitogorsk, where the vast majority of jobs depend on one or two enterprises. If these close down, unemployment will leap up. However, since we have no real democracy, the voice of the impoverished provinces will probably not be heard in Moscow. People from the provinces have no means of applying pressure through deputies, through the mass media, or by organizing rallies and demonstrations. So the unemployment problems of regions a long way from Moscow are unlikely to provoke a political crisis.


The Central Bank of Russia has already been carrying out a slow devaluation of the ruble for over a month. This is because the foreign currency reserves it is drawing on to support the exchange rate are being used up very fast. Over $150 billion has already been lost. Devaluation means that you get more rubles for every dollar spent from the reserves. So the value of the foreign currency interventions is increasing every week. Even so, the most recent information on the size of the foreign currency reserves shows that they are still being spent very quickly. So the Central Bank will evidently be forced to speed up devaluation. Especially as it is also forced to spend its currency reserves on loans to several state companies, like Rosneft, which have large debts to foreign creditors.

At the moment, it is impossible to predict the level at which the market for foreign currency will reach equilibrium (ie when it reaches the point where demand for foreign currency will be covered by supply without the help of the Central Bank). For we do not know how much people are going to engage in currency speculation, playing on the fall of the ruble, or how prepared they will be to leave their savings in ruble deposits in banks. For one thing, this is less a question of economics than of psychology. Information about the extent of the crisis also affects different sections of the population unevenly. However, it is clear that the monetary authorities will not allow the complete loss of their reserves, as happened in August 1998.

Devaluation will have both good and bad consequences for Russia. On the one hand, it will lead to a depreciation of the ruble, not only in relation to foreign currency, but also in relation to commodities, as imported goods rise in price. However, it is hard to say whether inflation will increase overall. For prices will also be falling because of the drop in oil prices. What's more, inflation rates will be determined by the monetary policy of the Central Bank. There is no knowing what this policy will be in the foreseeable future. So while some Russian experts are expecting inflation to increase in 2009, others are talking of deflation.

However, as in 1998, devaluation could become an important factor in resolving the crisis, as it will gradually raise the competitiveness of Russian goods as against imported goods. As long as the rate of devaluation remains slow, we are not likely to see anything like what happened in August 1998, when the ruble fell in value by five and a half times in just a few months.

Stabilising the banking system

The devaluation is already prompting people to withdraw their ruble deposits from commercial banks. Some of these deposits are being put into foreign currency, but a great deal of the money is being stashed in wallets, stockings and drawers, as people are frightened that the banking system might collapse.

Interventions to rescue the banks are being made in two ways. They are either being bought by a major state bank, using easily accessible loans from government and the Central Bank, or they are being taken under the protection of the Agency for Deposit Insurance. As long as the crisis does not affect a large number of banks, these measures will be enough. But if hundreds of financial institutions need to be saved at once, there will be mass bankruptcies. Is this a real possibility? This depends how much panic there is among depositors, and also on the level of devaluation of the ruble.

If small banks go bankrupt, the depositors will receive compensation from the Agency for Deposit Insurance. The state will try to preserve several dozen major financial institutions, those which handle a large volume of financial transactions in the economy. If this also proves difficult, the authorities' will concentrate their efforts on saving the main state banks, where most people keep their savings. It is unlikely that these will go bankrupt, as the Russian monetary authorities will save them even at the cost of serious inflation.

In other words, if the banking system collapses, this would be another factor that would feed inflation. This could prove decisive for Russia. However, at present this scenario is unlikely.

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