Russia Feels the Effects of Europe's Financial Crisis

9 MINS READNov 29, 2011 | 13:00 GMT
Demonstrators rally in Moscow in support of Russia's currency
Russia has begun feeling the effects of the European financial crisis. Not only has the crisis created an air of uncertainty about Russia's economic stability, it is also endangering the Kremlin's massive modernization and privatization programs. These programs, meant to attract foreign technology and investment into Russia's strategic economic sectors, depended greatly on European investment and cooperation. With Europe in financial chaos and complications arising for Moscow, the future of those programs — and of Russia's plans to resurge into the region — is uncertain.

The effects of Europe's financial crisis are not confined to the Continent; they are being felt around the world, and Russia is not immune. Europe's large neighbor has developed complex strategies — strategies that require both money and a stable Russia — to solidify its hold over its former Soviet territory and influence its periphery, mainly Europe. Europe's crisis has given Moscow a rare opportunity, in that Russia can pick up cheap strategic assets around Europe and act as the beacon of stability for the region. However, as Europe's crisis deepens, it could affect Russia negatively enough that the Kremlin might temper its plans to expand its influence abroad. For Russia, the European financial crisis is a mixed blessing.

Russia's Economic Connections to Europe

Europe is Russia's most important economic partner. Europe accounts for 47 percent of Russia's trade, 75 percent of foreign direct investment into Russia and most of Russia's energy income. With Europe faltering financially and institutionally, Russia logically would be one of the hardest-hit economies outside of Europe.

The European crisis has had an effect on the Russian economy. The Russian stock exchanges — the Moscow Interbank Currency Exchange and the Russian Trade System — have risen and fallen with every new development in Europe over the past few months. The Russian ruble also has been fluctuating; it lost 20 percent of its value in September when it was announced that the Europeans had not reached an agreement on resolving their financial crisis — an event that forced the Kremlin to intervene to stabilize its currency.

But the Russian stock exchanges and ruble typically are poor indicators of the true state of Russia's economy. Russia actually is doing fairly well, despite the crisis next door. Russia's gross domestic product (GDP) growth is expected to be around 4.5 percent for 2011, and inflation is around 7 percent, the lowest level since the fall of the Soviet Union. Because of high energy prices, Russia officially has $580 billion in currency reserves and another $150 billion in its rainy day funds, and Stratfor sources in Moscow have said another $600 billion is stashed away in private funds. However, this does not mean Russia will remain unfazed by the crisis in Europe, which comes at a time when Russia has no clear financial policy leader.

Russia's Concerns

The Kremlin's first priority is to assure the Russian people that Russia will not suffer the same fate as Europe. A poll conducted by Russia's Public Opinion Foundation in September found that 45 percent of Russians feared the devaluation of the ruble and another major economic crisis above anything else. The Russian people remember the crises of the 1990s, when the country economically collapsed and suffered from hyperinflation and a ruble crash. When the ruble fluctuated in September, there were small runs on banks — a signal to the Kremlin to step in. Moreover, Russia was hit especially hard by the 2008 financial crisis.

To help bolster the Russian people's confidence, the Kremlin is attempting to show that it has a strong leader in place for the next few years capable of withstanding the shifts taking place globally. Russian Prime Minister Vladimir Putin will be returning to his former post as president in March 2012. Many in Russia consider Putin's more authoritative leadership style a better choice to navigate uncertain times than that of current Russian President Dmitri Medvedev. Ahead of Russia's legislative elections in December and the March 2012 presidential election, Putin plans to add $6 billion to the Russian economic system — specifically via social aid and government enterprises, such as creating jobs — in order to raise support and approval for the government. This is the first time the Kremlin has publicly injected cash into the system before an election.

Second, the Kremlin is making attempts to prop up the ruble in unconventional ways. The Russian government and major Russian businesses — such as energy, steel and manufacturing — traditionally use foreign currency instead of the ruble. Thus, these major players have long been unconcerned with the ruble except as it affects domestic stability. With the euro's future uncertain, Moscow is now moving to make the ruble a more important international currency and, in turn, a more stable domestic currency. The Kremlin plans to require that many of its top trade partners make payments in rubles rather than in euros. Some former Soviet states such as Kazakhstan and Armenia already pay Russia in rubles, but Moscow is asking Ukraine — a major energy customer — to start making its billion-dollar monthly payments in rubles in December. If Russia can convince more countries to follow suit, it could raise the ruble's status and use the large demand for Russian energy to stabilize the currency.

The Kremlin is also attempting to curb its exposure to the euro. Fifty-five percent of Russia's currency reserves was in euros in early 2011, but since August the Kremlin has been swapping out the euro. Thirty percent of Russia's currency reserves is now in euros and 55 percent is in U.S. dollars (the rest is a mixture of Canadian dollars, Chinese yuan, gold and other currencies).

Another concern is that the European crisis could lead to a drop in Europe's demand for Russian energy, which would affect Russia's revenue and reserves. Energy exports to Europe make up 40 percent of Russia's government revenues, so any drop in demand could force Russia to re-evaluate its budget. Moreover, every $1 drop in the price of oil per barrel means $1.8 billion less going into Russia's coffers. The Kremlin has set up alternative budgets in order to determine what projects and expenditures to cut should the price of oil change. Stratfor sources in Moscow have said the Russian government's current 2012 budget is based on a global oil price of $100 per barrel, but there are other budgets prepared in case oil falls to around $60 per barrel, and even as low as $38 per barrel. The Russian government also has already approved accessing reserve funds at any time when oil is below $93 per barrel.

Longer-Term Effects of Europe's Crisis

The Kremlin is already calculating the longer-term effects the European crisis could have in Russia, beyond the current uncertainty the crisis is creating — particularly the effects Europe's situation could have on Russia's plans to modernize and strengthen its economy.

At the end of 2009, Russia introduced two programs — modernization and privatization — meant to attract modern foreign technology (and large amounts of foreign cash) to Russia's strategic sectors. The programs counted on Europe being Russia's primary partner in most of these projects.

With Europe in financial chaos, the hundreds of billions of dollars in investment Russia expected likely will be frozen. In the first part of 2011, foreign investment in Russia had increased compared to the previous year. According to the Russian Federal State Statistics Service, foreign direct investment in Russia in the first nine months amounted to nearly $12 billion, an increase of 43 percent from the previous year that is largely related to the launch of the modernization and privatization programs. Now, the Central Bank of Russia (CBR) has said foreign investment has stagnated, with estimates expected to plateau for the fourth quarter of 2011. Moreover, the CBR has said there has been mass European capital flight from Russia. Before September the CBR estimated European capital outflows from Russia for 2011 at $36 billion, but in November it re-estimated those outflows at $64 billion and said the total could reach $80 billion to $100 billion — nearly 6 percent of Russia's GDP — by the end of the year. Capital flight has risen drastically since the crisis in Europe worsened.

Discussions are taking place in the Kremlin now about the modernization and privatization programs' future. Deputy Prime Minister and important Kremlin player Igor Sechin called on Putin to postpone the privatization of many of Russia's most strategic firms until the Kremlin can decide on a suitable price not based on the current global economic slowdown. Sberbank chief German Gref said that if Sechin gets his way, the privatization program could be delayed for years.

Russia could still move ahead with the programs, inviting European partnerships in its privatization and modernization efforts. However, the Kremlin would have to provide enough cash to attract the nervous Europeans. Medvedev said Nov. 20 that the Kremlin would be working on a plan to this effect, investing alongside foreign groups to make sure the programs are successful.

Russia's Financial Leadership and Direction

All of this comes at a time when Russia is without a clear financial policymaking leader. Previously, long-term Finance Minister Alexei Kudrin drove Russia's policies on finance and the economy. However, a dispute with Medvedev drove him to resign, leaving the spot empty. Interim Finance Minister Anton Siluanov and Medvedev's chief adviser, Arkady Dvorkovich, are attempting to run the financial decision-making, but no one since Kudrin's resignation has displayed an understanding of the complexity of balancing Russia's difficult economic situation with the need to use fiscal and economic policies to ensure Russia's national security (even if it does not make financial sense). Stratfor sources in Moscow have said Putin feels confident he can handle making such decisions for the country, but with the major crisis occurring right in Europe, the Kremlin needs someone focused solely on countering the effects of the Europeans' crisis. With so many other strategic projects to manage, Putin alone cannot handle this matter.

These complications come amid Russia's complex, large-scale strategies to solidify its power in Eurasia — strategies with strong economic or financial components. The Eurasian Union is based on the European Union's model, though it looks strikingly similar to previous Russian or Soviet empires. Russia's other strategy is to take advantage of Europe's financial woes by picking up strategic assets, mostly in Central Europe. Both of these plans require a strong and economically stable Russia.

Russia has been able to act freely in Eurasia until now. As the European financial crisis begins to affect Moscow, the Kremlin will have to compensate for those effects. Russia still has the funds and clout to follow through with its grand strategies to resurge into the region. However, it will not be able to act as aggressively. Instead, Moscow will have to make sure it does not overextend itself as the region reels from the European crisis.

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