The Russian Economy and the Georgian War

Dmitri Travin
18 September 2008

16 September 2008 was immediately labelled Black Tuesday by the Russian press. With good reason. The concept of "Black Tuesday" is extremely significant for many people in Russia: it dates back to October 1994, when the ruble lost a third of its value to the dollar in one day. And although the developments in Russian financial markets on 16 September 2008 were completely different, comparisons with the situation 14 years ago were clearly inevitable.

On this Black Tuesday, the Russian stock markets fell drastically:  the RTS index fell by 11.47%, and MICEX by 17.45%. Players were so eager to sell their stocks that trading actually had to be suspended until the end of the working day, but on Wednesday the fall continued and trading was once more suspended.

All the leading world stock markets were in free fall on 16 September, but nowhere was it as severe as in Russia. This came as a real shock to many people in Moscow and the shock was particularly powerful, because in mid-summer there had been nothing to suggest that such a cataclysm might be imminent. Stock market growth was stable, accurately reflecting the almost 10 years of strong and stable GDP growth rates.

The economic problems followed hard on the heels of the military operations in the Caucasus, so it is tempting to attribute them to Russia's growing international isolation. However, it seems to me that the present Russian crisis is more complex in nature and that there are four factors of key importance. They are both objective factors and ones resulting mainly from the short-sighted actions of the Russian leadership.

Serious problems on the stock market began as early as July, after Prime Minister Vladimir Putin's harsh criticism of the leading mining and metals company Mechel. There were suspicions of tax evasion by price manipulation, and Putin made it publicly clear that those responsible could face serious difficulties.

It is right that the problem of tax evasion should be addressed and this should not of itself cause panic in business. In Russia, however, everyone remembers what happened to Mikhail Khodorkovsky's company YUKOS, destroyed by an avalanche of tax claims when its owner got into a serious conflict with Putin. Naturally many saw the latest criticism by the Prime Minister as an attempt to destroy Mechel, and furthermore as the authorities' intention to continue the campaign of expropriating money from businessmen whom they dislike. In this atmosphere, some investors began taking capital out of Russia, and the stock market showed a clear downward trend.

This had, of course, not been Putin's intention.  He hoped that negotiations between the company management and the government would resolve the conflict with Mechel and the stock market would then recover. The conflict was in fact resolved, but at this moment oil prices on the world markets began to fall. One negative factor for Russia was combined with another.

Oil is of enormous importance in the Russian economy. If revenues from sales drop significantly, the population has less money to spend and the market is no longer so attractive for those engaged in selling goods. It is hardly surprising that a fall in oil prices is seen by stock market players as a signal of the need to send capital out of the country.

Prices were still falling when this article was being written, but this need not of itself signify a crisis in the Russian economy. The country has enormous reserves of stability owing to the considerable hike in oil prices over recent years. The present stock market crisis has come about as a result of a combination of falling prices, Mechel, and the August problems in the Caucasus.

In August Georgia and Russia engaged in military conflict. This was the third factor influencing the development of the crisis. Like the first two, this factor would not by itself have had catastrophic consequences for the Russian economy. International isolation would have seriously affected the economy only if Europe had declared an embargo on purchasing oil and gas from Russia. It very soon became clear, however, that the West's negative attitude towards Kremlin actions in South Ossetia would in no way result in such a serious outcome.  

Even before troops entered Georgian territory, Putin had, of course, predicted that the European Union would not resort to such a radical break in relations. However, it is unlikely that the Russian leader realised that his unpredictable behaviour on the international stage would increase the flight of capital from Russia.   He probably assumed there would be some panic, which would calm down after a while, but at that point the fourth negative factor for Russia came into play - the fall of stock markets in the West.

Here it should be noted that during the economic crisis of 1998, which Russians remember so well, capital flight from Russia was provoked by problems on foreign markets. At that time it was the markets in Asian countries - Indonesia, Thailand and South Korea. Practice has shown that investors and speculators regard Russia as a potential risk zone, from which they should withdraw their capital at the first sign of danger. Over the last 10 years, of course, the Russian economy has become much stronger, but today the signs of a crisis situation on the stock market are coming from the East and from the West too. And furthermore, the three previous instability factors had caused panic among stock market players.

Capital flight from Russia continued for the first half of September. In an attempt to reassure business and society, some officials announced that just $5 billion had left the country. However, few specialists gave this any credence. The unofficial figure was $20-$25 billion. This was indirectly confirmed by the fact that immediately after the beginning of the conflict in the Caucasus, Finance Minister Alexei Kudrin announced that $7 billion had left the country. And the situation since then has deteriorated, rather than improved.

The short-term negative consequences of the events of the last two months are clear. But the question arises as to how stable the Russian economy is in the medium term.

The fall of the stock market may influence it in two ways.

Firstly, it will mean financial losses for Russian citizens who have invested their savings in stocks and investment funds that act as a sort of intermediary between investors and stock markets. The relative deterioration of people's financial position will have a negative effect on sales, and, accordingly, on the economy as a whole.

In recent years some Russian citizens have invested their money in stocks, as low interest rates on bank deposits did not even protect them from depreciation as a result of inflation. Overall, however, not many people invested their money in this way: some were scared of the risk, and others have little idea of what the stock market is. For this reason it is unlikely that falling markets will directly affect most Russians and the effect of the crisis from this point of view on economic growth in Russia will be insignificant.

Secondly, stock market problems may create an investment crisis, thus affecting the economy as a whole. The day after Black Tuesday there were reports that several major companies were concerned about the drop in their share prices and had rushed to repurchase them. They obviously needed funds for this and money spent on keeping the share rate stable can no longer be used for drilling new oil wells or developing new technology.  

What is even worse is that in a falling stock market, companies trying to attract investment cease to be of interest to owners of disposable capital, either in Russia or abroad. This capital will go elsewhere, which means that Russia will not get the funds needed to develop the economy and create new jobs.

The effect of the downturn in investments on the economy will probably only be gradual. In years to come it will slow down the growth of GDP. If, however, the negative factors analysed above become once more positive, it might be possible to overcome the investment crisis. On the one hand stabilisation depends on objective factors e.g. the price of oil and the state of the stock market in Western countries.  On the other hand the Russian leadership could help to solve the crisis by putting an end to its quarrels with America and the European Union, and also by no longer threatening Russian business with the sort of repression endured by YUKOS.

Is a drastic drop in GDP growth rates in Russia possible today? This depends less on the state of affairs on the stock market than on oil and gas prices, which comprise a large part of the country's production. If the fall in oil prices does not stop, the situation could become threatening.

Finance Minister Alexei Kudrin said that if the price per barrel falls below $70, budget expenditure will have to be reviewed, as state revenues will simply be insufficient to cover planned government expenditure. Naturally the salaries, pensions and benefits of some Russian citizens will be affected by the worsening financial situation in Russia. But, more importantly, the real salaries of employees of many employees (including in the private sector) will stop growing. Some firms will even close down because of the lack of consumer demand.

Another important issue for Russia is whether the ruble will fall. In the 1998 crisis, capital flight caused a crisis on the currency markets, as the removal of funds from Russia necessarily entailed the conversion of rubles to dollars. It was the five-fold depreciation of the ruble against the dollar that was the biggest catastrophe for Russian citizens, whose savings lost all value as a result. Over the last 10 years, however, the situation has changed fundamentally.

Today, capital flight also involves the conversion of rubles to dollars or euros, but the Central Bank of Russia has accumulated enormous gold reserves, over $550 billion. This means the financial authorities of the country can sell dollars from their reserves and shore up the value of the ruble. The Central Bank will probably not abuse its powers: if capital flight from Russia continues, it will allow the ruble to "fall gently", but it will not allow a drastic fall.

If oil prices do fall significantly and over a long period, and if there is a downturn in Russian exports, which are determined by these prices, then the ruble will weaken considerably in the medium term against both the dollar and the euro. However, I stress once more that under no circumstances will there be a drastic, sudden fall like the one in August 1998.

Finally, there is the problem of the Russian bank stability. The crisis may hit some of them quite hard. There are two reasons for this.

Firstly, the memory of the 1998 crisis, when capital flight not only led to the fall of the ruble, but the collapse of several major banks, could have a very telling effect. Many Russians have the idea that in a serious economic crisis they should immediately withdraw their savings from banks. True, Russia has put in place a system of  bank deposit insurance, so there would be compensation for a possible loss of small savings. However, it is unlikely that the general public is well informed about this new system. They may panic, as they did in 1998. If this should happen on a large scale in the near future, some banks may not be able to withstand the onslaught of depositors wanting to withdraw their money. 

Secondly, banks may face problems owing to the fact that crisis conditions have a significant effect on mutual trust.  It is already difficult to borrow money at a relatively low interest rate. As a result, people who expected to solve their problems by taking out a loan may face serious problems. Major banks controlled by the state (such as Sberbank and VTB) will probably not be seriously affected by the crisis because they will be supported by the Central Bank and Finance Ministry.

So the "Black Tuesday" of 16 September 2008 does not mean the collapse of the Russian economy, although it is a sign of the rather serious problems that have accumulated over the Putin years of apparent prosperity. We can assume that these events cannot but leave their mark. A number of industrial companies, banks and individual citizens will feel the impact of the crisis.

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