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Jun 15, 2009 | 11:08 GMT

17 mins read

The Recession in Russia

special series recession revisited
Summary

The economic outlook for Russia appears bleak, and the road to recovery appears to be a long one. Rising unemployment, falling industrial production and the flight of foreign investment have put a dent in Russia's massive currency reserves. However, the Kremlin has reasserted its power over the country and is in prime position to overcome its short-term challenges.

Editor's Note: This is the eighth part in a series on the global recession and signs indicating how and when the economic recovery will — or will not — begin.

Russian President Dmitri Medvedev spoke of "alarming figures" when discussing the Russian economy during an exclusive interview with U.S. news network CNBC on June 2, pointing specifically to rising unemployment and falling industrial production. Medvedev also highlighted the expected Russian gross domestic product (GDP) decline, which according to him will be "no less than 6 percent" in 2009, but most likely close to 7.5 percent, a figure not seen since the fall of the Soviet Union. Indeed, the prognosis for Russia appears grim. Russian GDP contracted by 9.8 percent year-on-year in the first quarter of 2009; industrial production has averaged double-digit contraction since January, and the April contraction equaled 17 percent year-on-year.

Foreign investment has declined 30 percent year-on-year in the first quarter of 2009, and unemployment is likely to reach double digits by the end of 2009 — a dramatic increase over the 7.7 percent rate of 2008. Moscow's attempt to rein in the crisis is costing it its precious currency reserves and bloating its budget deficit after years of commodity-fueled surpluses. The budget deficit stood at 11 percent of GDP in April, and revenue destined for government coffers declined by a whopping 16.2 percent of GDP between April and May. Russia is staring at an approximate $100 billion budget deficit, a figure that is likely to consume all the cash in its Reserve Fund. Russia does have a lot of money in its various government reserves, the combined value of which totals nearly $600 billion. (Its currency reserves stood at $409 billion on June 1, with the Reserve Fund at $100.9 billion and the National Welfare Fund at $89.9 billion.) There also is potentially another $40 billion to $50 billion in a third, less public fund. This is not too far from the $750 billion Russia had at the beginning of the economic crisis, but the expected $100 billion budget deficit in 2009 will further drain the reserves very quickly.

The Russian Finance Ministry said recently that it might have to enter the international bond market to seek external funding for its budget deficit. However, the effects of the current economic crisis do not foreshadow the decline of the Russian state. Conversely, the crisis has already strengthened the Kremlin's grip on the country's financial sector and its once-independent business elite, the oligarchs. With oil prices starting to rise again and the Kremlin now firmly in control of the country's finances, it is likely that Russia will come out of the crisis with the Kremlin firmly in control of the economy, a natural order for Russia.

The Geography of the Russian Economy

Russia is blessed geologically and geographically, with its vast territory containing the world's largest proven natural gas reserves, second-largest proven coal reserves, third-largest known and recoverable uranium reserves and eighth-largest proven oil reserves. However, from an economic development standpoint, Russia is anything but well endowed. Throughout history, Russia has lacked navigable river transportation and access to ocean trading routes. Furthermore, Russia's population is scattered across its vast territory, its natural resources are mostly found in unpopulated areas and a number of regional challengers constantly threaten its territorial integrity.

Russia's core is essentially the northeastern portion of European Russia. It has no natural borders, forcing Russia to strive continually to extend its control of territory to natural buffers (as far down the North European Plain as possible, to the Carpathian Mountains to the southwest, the Caucasus and Hindu Kush to the south and the Altai Mountains, Tian Shan and Stanovoy Range in the Far East). With vast territory, constant expansion to the buffers and a lack of internal transportation, Russia requires a substantial amount of resources to maintain and defend its borders. It requires top-down management of the economy to focus resources on overcoming geographical impediments to development and security. As such, Russia is not a capital-rich country; it is starved for capital by its infrastructural needs, security costs, chronic low economic productivity, harsh climate and geography.

Unlike the United States or the United Kingdom, where industrial and post-industrial economic development can spring forth with little or no direction thanks to favorable geography (intricate river transportation systems in the United States and access to oceanic trade routes for both) and the relative security of oceanic barriers, Russia has had to rely on firm state-driven economic development. The current crisis has therefore returned the Russian economic system to its "natural" state, one in which the state is the main driver of activity. Gone is the experiment with nonstate-directed capitalism (roughly between 1991 and 2003), the Wild West, Russian style, where different elites and power groupings vied for economic and political power. The state's ability to now marshal and focus resources toward infrastructure projects and resource exploration will help Russia in the short term.

State direction and control will also help Russia focus its financial resources toward certain key foreign policy goals. In the long term, however, a lack of nonstate funding and private capital will be a problem, creating inefficiencies across the spectrum, particularly in areas where the state does not focus all of its resources. Additionally, Russia is facing a staffing problem. Running the vast country and its economy may simply be far too complex for its ever-more powerful executive.

The Current Recession: The Government Reclaims Control

To understand how the Russian state has fully returned to its natural position as the helmsman of the Russian economy, it is important to examine the effects of the crisis on the Russian financial and corporate systems. The main negative effect of the current crisis for Russia is the credit crunch, which is even more serious than low commodity prices. Credit in Russia is scarce and is therefore essentially one of the most important imports for the country. Businesses that are not state-controlled require funding from abroad because the state hoards capital and only lends it through political links. As a result, Russian private banks and corporations that had gorged on the cheap credit that flowed on the international markets since 2001 were particularly hungry for foreign capital. The government was not going to supply this capital by sharing the surplus from commodity sales, particularly if the capital was going to private entities it did not control.

While the credit crunch does not hurt Russia's government-controlled strategic industries — whose profits are in dollars anyway — it will cause a restructuring of the private financial and corporate sectors. When the financial crisis hit in mid-September 2008, the first place foreign investors looked to pull capital from were emerging markets. Investors had already soured on Russia because of the Kremlin's repeated meddling in foreign ventures, and because of Russia's August 2008 intervention in Georgia (after which $63 billion in foreign investment was pulled immediately). Consequently, Russia was first on the list of places to withdraw from. Net capital outflows from Russia reached a record $130 billion in 2008, followed by $39 billion in the first quarter of 2009. Investors scrambled to sell their Russian assets and then used those rubles to buy dollars, francs, yen or gold. When this deluge of rubles hit the foreign exchange market, the ruble's value fell off a cliff, stoking fears in Russia of another "ruble crisis" that could cause social discontent, as it did in 1998.

To counteract the effects of capital outflows pushing the ruble's value down, the Central Bank of Russia (CBR) intervened, using its massive reserves of dollars and euros to purchase rubles on the open market. Had domestic banks not sold their ruble-denominated government handouts, the CBR's $210 billion defense of the ruble might have been less expensive. But instead of letting the ruble crash, the Kremlin opted to manage the inevitable decline and has since bought the ruble enough times for it to be supported by real demand. Though the ruble has now stabilized, its fall in value has been a considerable problem for private banks and corporations, particularly those not engaged in commodity sales.

Russian enterprises that engaged in commodity exports had no problem with a declining ruble, because all of their revenue is in foreign currency, and their costs (salaries, operation costs, etc.) are in rubles. However, private banks and corporations that depend on internal demand and consumption for revenue — everything from regional retail banks to auto manufacturers — were suddenly left holding enormous foreign-denominated loans with no way to repay them. Russian banks and corporations owe approximately $400 billion in external debt over the next four years, with $90 billion worth of debt due between the second and fourth quarters of 2009 for banks alone (although it is estimated that about $40 billion of that may be held by foreign bank subsidiaries). In 2010, Russian banks will have to repay another $75 billion.

This is where the Kremlin has firmly stepped in. Its strategy from the very beginning of the crisis has been to consolidate the banking system under its control, with the primary source of capitalization being short-term, high-interest loans designed to quickly transfer banks' obligations from foreign hands into the Kremlin's steely grip. These loans will now be coming due for small regional banks, and it is likely that Russian state-owned banking behemoths Sberbank and VTB will greatly enhance their market share as result of the consolidation. The government is already the single largest creditor to banks, with 12 percent of all bank liabilities held by the state (mostly short-term loans with 8.5 percent interest). At the same time, banks and businesses that owe money to the state, but that the state does not want to save, will be allowed to fail, further consolidating different economic sectors in the hands of a few government-controlled or directly owned enterprises.

The culling of the Russian banking system will not be without its serious effects, and the transition from private hands to government ownership will not be smooth. The recession has already cut domestic demand, which is a problem because Russian industry (aside from extractive industry) depends almost solely on domestic consumers, with some trade with the other Former Soviet Union states — which are themselves facing a difficult recession. Domestic manufacturing was already down 25 percent in April year-on-year, a figure that foreshadows a mounting number of bankruptcies. As bankruptcies rise and companies default on their loans, the rate of nonperforming loans (NPLs) rises as well; it is already more than 4 percent and predicted to reach 10 percent. NPLs are usually a solid gauge of how well an economy is performing, and in the Western world, a rate of above 3 percent is usually considered a serious problem. In 1998, the rate of NPLs in Russia hit 40 percent. However, according to Renaissance Capital's calculations, even if the share of NPLs reaches 20 percent in the current recession, the required recapitalization (money the state would have to throw at the problem in order to fix it) would be less than $30 billion — easily covered by Russian state coffers. This is mainly because the government has already devoted a considerable amount of money to the problem. But though the banks now have abundant capital (albeit in foreign currency), they are loath to lend to businesses, thus further exacerbating the crisis.

Part of the Russian government's latest recapitalization efforts is the $89 billion crisis measure fund, which was announced in April and will come on line sometime in June or July. A large part of the package, $52.9 billion, will go to various banking programs intended to recapitalize the banks; $23 billion will go to industry (the largest chunk to profit tax cuts that should benefit energy exporters and auto industry support); and $13.1 billion to labor market measures (including helping pensioners and unemployed people weather the crisis). The latter is intended to nip in the bud any social unrest stemming from rising unemployment. Russia's steel industry, for instance, is strategic, has a powerful lobby and employs many people. Interestingly, while global steel demand and prices remain depressed, the utilization of production capacities at Russian steel companies has increased from around 57 percent to 71 percent since the beginning of the year.

Despite the Kremlin's measures, domestic steel demand remains weak, and thus the increase does not so much reflect increased foreign demand for Russian steel for government-funded infrastructure projects in China, India, and the Middle East. Rather, it reflects pressure by the Kremlin on Russian steelmakers to keep production going — therefore ensuring employment and stability in Russia's one-industry towns — even if it means exporting steel below cost. Social unrest, however, rarely causes revolutionary political change in Russia. The most famous examples of social unrest resulting in part from economic crisis, such as the revolutions of 1905 and February (March by the Gregorian calendar) 1917, essentially failed and had to wait for an elite-driven revolution (such as the October 1917) to succeed. In fact, when ruled by a focused and powerful central government, Russia's population can be heavily strained, a fact that served Stalin's industrialization efforts of the 1930s well. In order for the Kremlin to attain its goals of rapid industrialization, it drove much of the population into the ground. The social aspects of this effort are particularly notable and are different from other countries — particularly those in the West — in that the government's economic efforts are not focused on profit, lowering unemployment and social stability. Russia's main economic imperatives are dictated by its massive security costs, and are therefore concentrated on maintaining security and clamping down on social dissent and internal political or ethnic fragmentation, or both.

The current economic crisis is not without a social evolution of its own, although it is one where the government has turned on an elite group that threatened the Kremlin's grip on Russia's economy: the oligarchs. Because most successful regime changes in Russia are elite-driven, the oligarchs at one time represented a serious challenge to the Kremlin's power. One of the most fundamental changes this economic crisis has had on the Russian economic system is that it has stripped the power of independent business empires run by the oligarchs. Indebted abroad when the crisis hit, the oligarchs were told that they would receive access to state funding only if they made substantial capital injections into the Russian economy themselves — particularly into the crashing stock market. In fact, Prime Minister Vladimir Putin made it a point to call all the major oligarchs to a meeting at the Kremlin as the crisis was unfolding, giving them a choice of either helping immediately or forsaking any future help from the state.

 

 

 

(click chart to enlarge) After that initial choice, the oligarchs were essentially told that they would either toe the Kremlin's line on economic and political matters, or receive no help at all as foreign banks recalled their debts. Once the oligarchs were sufficiently bled of capital, the state offered to bail them out in select cases, with funding coming with strings attached. The oligarchs that survive the culling will be the ones the Kremlin has selected for survival, thus creating evolutionary pressures that will breed loyalty and subservience. An illustration of this dynamic was Russian steel magnate Igor Zyuzin, who gave the Kremlin billions, reducing his worth from more than $10 billion to just $1 billion. Only after he proved his loyalty, which at the time had been questioned due to a public fallout with Putin, did the state-controlled Vnesheconombank offer him credit.

 

 

 

Oligarchs will still exist as an elite, but they essentially will be reduced to the role of "capital emissaries" of the Kremlin to the West and the rest of the world. As such, they will be a powerful (but not independent) tool for the Kremlin's foreign policy designs, another addition to the already-powerful arsenal that also contains intelligence networks and energy exports. Oligarchs may have acquired their fortunes through guile and luck, but they are also the most business-savvy elite — particularly in terms of Western business practices — in Russia. They know exactly how the West is run, having made many partnerships abroad through acquisitions and investments. This makes them extremely valuable, particularly as the Kremlin begins to direct its resources to foreign investments in strategic industries (such as energy), and for political reasons.

An example of this new role for the oligarchs is Oleg Deripaska, who at one point was the richest man in Russia. Deripaska is the chief of RUSAL, the world's second-largest aluminum producer, and investment firm Basic Element. Deripaska's wealth dropped from an estimated $36 billion to somewhere between $3 billion and $4 billion as he poured immense funds into his company and the Kremlin. As a reward for his efforts, Deripaska could become the chief of a rumored consolidated — and state- directed — metals conglomerate, giving him enormous power, but power that he will exercise at the whim of the Kremlin. He also will be one of the Kremlin's first "capital emissaries" abroad, as signified by a recent partnership between the state-owned Sberbank and Deripaska-controlled auto manufacturer GAZ in the purchase of German carmaker Opel. Deripaska was able to use his partnership with Canadian auto parts manufacturer Magna International Inc., and state funding through Sberbank, to form a partnership that will see Opel producing cars in Russia.

This is exactly the sort of deal the Kremlin wants to encourage. It is also the kind of deal that the Russian oligarchs, with their considerable foreign business acumen, can provide — combining foreign partners acquired through their businesses, Russian state financing and impressive personal charisma to conclude politically motivated business deals. With the purchase of Opel, Russia has come to the aid of a crucial European power and its leader, German Chancellor Angela Merkel, three months before general elections — a favor Merkel will not forget should she return to power, which she most likely will. In the past, Moscow would have been unable to so effectively pair government funding and oligarch business acumen. Now it can do so in pursuit of foreign policy goals. The Opel bailout is part of Moscow's strategic move to widen the rift emerging between Germany and the United States, and is therefore an extremely important — and very well-played — foreign policy initiative, and not just any other business deal. In the long term, greater government control will not resolve the endemic problems Russia faces. Combined with its geographic and infrastructural challenges, Russia is also facing a daunting demographic challenge — a low birthrate combined with rising prevalence of HIV/AIDS and drug use — and an overall economic overreliance on energy exports.

The share of energy exports as a percentage of overall exports has increased from 50.3 percent in 2000 to 65.8 percent in 2008, despite rhetoric from the Kremlin that it had been seeking to diversify the economy since Putin's arrival on the political scene in 1999. Furthermore, demographic and geographical challenges are continuing to depress Russian productivity, with Russian labor productivity at only one-third of U.S. productivity. Nonetheless, when the account of the costs and benefits of the current financial crisis is made, it will show that the crisis cost the Kremlin much of its currency reserves and money accumulated during the boom years between 1999 and 2008. However, the crisis also returned the Kremlin to the driver's seat of the Russian economy, which is in fact the natural state of affairs because of Russia's geography and impediments to security. It is from this position that the Kremlin will face the much more serious challenge to Russian economic well-being in the next five years: decreasing energy exports caused by European diversification efforts away from Russian natural gas, and the continuing demographic challenge. While the current recession may have bolstered the Kremlin's powers in the short term, how the Kremlin tackles the long-term crises will define Russia in the 21st century.

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