The Russian stock market last week saw its most severe decline since the shattering economic collapse of 1998, after suffering the lethal combination of worldwide financial mayhem, falling commodity prices and a local credit crunch.
Russia's supposed immunity to the global financial downturn was over as trading was suspended on the Russian stock exchanges amid record falls.
Analysts attributed the plummet in share prices to the international economic situation but said that the Russian military action in Georgia last month had affected confidence in among Western investors.
The government has now announced an increased lending package to the country's three biggest banks, in the hope of inducing stability.
An incarnation of 1998?
In 1998, the Russian economy defaulted, forcing the country into economic crisis and sending foreign investors fleeing. There were several factors contributing to the 1998 collapse including the Asian financial crisis, low oil prices, political instability and rouble/dollar exchange rate problems. Ten years on, and history appears to be repeating itself as it has a habit of doing. Ripples from the financial crisis in the West are being shadowed in the Moscow Interbank Currency Exchange (MICEX). Oil prices are making record fluctuations. The situation in Georgia is threatening political stability. The dollar is precarious.
Of course, some of these observations are just coincidental and one should not make spurious links. However, it is clear that Russia’s economy is not indestructible.
The initial American financial crisis barely touched Russia, but the global economic slowdown brought about a decline in oil and other commodity prices by more than one-third since July, which was a big blow. All the other hits, however, have been self-inflicted.
The country's benchmark Russian Trading System (RTS) Index has fallen 54% year-to-date and 36% in September alone, making it one of the worst performers globally. The global macro issues - the liquidity crisis and falling commodity prices - as well as increased concern over Russia's political risks were the fundamental reasons for the sell-off, while the indiscriminate liquidation selling by funds and leveraged investors added fuel to the fire.
Thus far, the damage is limited to losses sustained by domestic and foreign equity investors, but the crisis now threatens to spread to the real economy and the country's financial system as a whole. Already, several Russian banks are rumored to be in trouble after being unable to repay debts collateralized by rapidly plunging shares, while car sales have plunged in August, most likely a reflection of the declining availability of credit. Banks and real estate developers, both heavily dependent on external funding and lax lending standards, could be among the first real victims.
The government's response to date has been adequate. The Central Bank has provided the three major banks - Sberbank, VTB and Gazprombank - with $44 billion in emergency funding to be used to improve liquidity throughout the banking system. At the same time, the government has thus far steered away from the direct intervention in the stock market - and correctly so because it would amount to bailing out portfolio investors using Russian government (taxpayers) funds, which has proven to be very ineffective in the past in many other markets, and not a little politically unpopular.
As a resource-rich nation composed of the world's largest natural gas reserves, the second largest coal reserves, and the eighth largest oil reserves, Russia is vulnerable to commodity price fluctuations. According to IMF and World Bank data, the oil and gas industry make up around 60% of Russia’s export revenues, thus any price change is critical. Russia is right to be concerned should the recent dips in oil prices to less than $100 per barrel continue.
Although oil prices over recent days have experienced tense inconsistencies however, they remain almost ten times higher than a decade ago. Moscow claims it is justified in its confidence. Ronald Smith, chief strategist at Moscow's Alfa-Bank says Russia's prospects could not look more different.
"If you compare it to 1998, the outlook for the economy is fundamentally good," he said. "We will come out of this with growth that is maybe slower than we had... but relatively high."
The conflict with Georgia has done Russia’s markets no favours. Reputations in politics come across as unreliable, quixotic, and unpredictable. Markets on the other hand like trustworthiness, stability, and predictability.
Not surprisingly, foreign investors have not been attracted by the current situation. Within a week of its attack on Georgia, Russia recorded a capital outflow of $16 billion, which has since increased to $30 billion. This is a small sum relative to Russia's currency reserves, but plenty for the underdeveloped banking system, which experienced a severe credit squeeze.
President Dmitry Medvedev last week said that 75% of Russia's economic woes were due to the international situation, while 25 per cent were due to internal factors, including the crisis in the Caucasus. Mr Putin, however, said last week that the US crisis had led investors to withdraw speculative capital, and that the downturn had little to do with Russia's invasion of Georgia.
"Putin's comments on Mechel made the initial impact, then after Georgia everyone started pulling out of the stock markets," said a British lawyer working in Moscow who has seen deals cancelled and business dry up over the past few weeks. "Add in to the mix that energy and commodity stocks have been falling worldwide on fears of a worldwide recession and you have a fairly bleak picture. If Putin knew how to behave, the crisis would be a lot less serious, as investors had until very recently seen Russia as a good place to weather the global economic storm."
Survival
The Russian economy is thus facing its biggest test since the crisis of August 1998, but one of the biggest differences, of course, is that the country's finances are in much better shape now than 10 years ago, with nearly $600 billion in Central Bank reserves and several reserve funds. Today, the economy is also more diversified, and its banking system better capitalized and regulated.
Some analysts downplayed the severity of the crisis and said it was unlikely to affect ordinary Russians in the way that the credit crunch is being felt in Western countries. "I still expect overall GDP growth of 6-7 per cent this year, and no full-fledged credit crunch," said Yaroslav Lissovolik, chief economist at Deutsche Bank in Moscow. "This is very different from 1998, because Russia has built up substantial fiscal and monetary reserves over the past eight years."
"Fundamentally, Russia still represents an attractive destination for foreign investors; its case is still strong," said Mr Lissovolik.
Over the last two decades, Russia has progressed well economically. Having recovered from the 1998 economic crisis, it has used its oil wealth to write off public debt and furthermore its vast ‘stabilization fund’ is in place for times like these. Finance Minister Alexei Kudrin yesterday said that the crisis was not yet serious enough to start using funds from the stabilisation fund, but analysts expect the government to do so soon.
Nonetheless, it is crucial for investors to see concrete evidence that the safety cushion the country has created during the sunny days of constantly climbing oil prices will be sufficient to defend the banking system and the currency. They also need to be assured that domestic consumption will continue to expand even if oil prices drop to $70 per barrel and that the government is ready to swiftly and effectively react to the crisis with appropriate policy measures.
Prime Minister Vladimir Putin said that Russia will be able to relatively easily survive the current crisis, while Finance Minister Alexei Kudrin said the Russian budget will remain in surplus in 2009 even if oil averages $70 per barrel next year. Russia's reserves seem more than adequate compared to around $23 billion that foreign investors have so far withdrawn since the conflict with Georgia broke out in early August. Moreover, with virtually no debt, the Russian state has substantial borrowing capacity. It does not appear to be going bankrupt as it did in 1998.
The country's largest companies continue to generate massive cash flows even at reduced commodity prices, and its economy remains strong. True, the economy is slowing because of declining investments amid a serious credit crunch, but the absolute growth rates of both gross domestic product and corporate earnings remain healthy.
The falling commodity prices and rising focus on costs by major Russian companies are likely to reduce inflation to a more manageable level. While decoupling from the fortunes of the U.S. economy or broader global economic models is impossible in these jittery markets, the resilience of the Russian economy and corporate earnings will ultimately be recognized by investors.
Over time, markets such as Russia’s with strong fundamentals and low valuations always recover after corrections. Therefore it is likely to recover sooner or later. The hysterical forced-selling in September could be the harbinger of the market's true bottom approaching.
It is too bold to declare an end to the crisis. We can expect more failures among the financial institutions and possibly among real estate developers when external financing dries up. It will also take some time for the liquidity in the banking system and the stock market to stabilize.
Still, it is important to remember that all major emerging market crises in history were predominantly top-down in nature, usually involving defaults on sovereign debt, massive currency devaluations and political upheaval, or a combination of the above. The crash has exposed blemishes in the financial system, but oil wealth has allowed the Kremlin to smooth over the cracks and avoid a repeat of the 1998 financial crisis.
Author: Jo Amey
