Developing a crisis early warning system

By bne IntelliNews December 8, 2011

Ben Aris in Moscow -

How can you tell when a crisis is coming? It would certainly be nice to know. So the people at Otkritie Finance Corporation are having a go with their Financial Stability Index (FSI), which they hope will predict the next meltdown. The good news is that despite the brouhaha in the Eurozone, Russia's economy is far from the trouble zone.

Otkritie has teamed up with the Gaidar Institute, a leading Russian think-tank, to measure 12 indicators, including GDP growth, industrial production, exchange rates and interest rates amongst others, that are supposed to give a clearer picture of how the economy is faring in the face of Europe's sovereign debt crisis.

The Russian economy has been surprising stable since the turbulence hit the world again this summer. "Between August-October, only one of the 15 indicators of the FSI signalled rising instability in Russia's financial system, the indicator that represents the sum of deposits of commercial banks with Central Bank of Russia (CBR) and CBR bonds held by credit institutions, which tumbled by 45%," Otkritie's most recent report says.

What this means in plain English is that the liquidity of the banking sector shrank as a result of the net outflow of capital: the CBR estimates that some $60bn of cash has already left the country and a total of $85bn will leave this year. The problem was exacerbated by a high demand for dollars on the foreign exchange market, driven by foreign banks tapping their Russian branches for cash to deal with the crisis back home. Indeed, the volumes of forex purchases became so high that the CBR called in the heads of the foreign banks in December and warned them that caps would be imposed on these transfers if they continued.

By the start of December, the liquidity problem persisted and was made even worse by the annual tax payments season that always sucks cash out of the banking sector. The CBR has been forced to continue providing the sector with extra liquidity as the pressure, albeit manageable, is still on, according to economists. The FSI was 0.2 in November on a scale of 0 to 5, which is significantly below the 2.8 it measured just ahead of the onset of the crisis in 2008.

Nervous times

The introduction of the FSI is timely, as fears of a second wave of the crisis have resurfaced in August when Russia's stock market sold off heavily, with the RTS index falling from over 2000 to around 1200 in a matter of weeks. More recently, the market has recovered to around 1500, but traders remain nervous and Russia's market continues to underperform. Investors would welcome a bit of certainty about now. "We back-tested the index to 1998 and it works well, and what it shows for between August and November this year when the markets were very volatile our index barely moved," says Vladimir Savov, head of research at Otkritie.

Predicting crises should be a bit easier than it seems to be. The award-winning book, "This time is different: Eight centuries of financial folly," by Carmen Reinhart and Kenneth Rogoff, makes the point that crises are almost never different. The authors identified several common causes of crises, such as excessive sovereign debt or more commonly a sharp slowdown in industrial production, and Otkritie's index covers all these factors and more. And the CBR has clearly been doing a good job thanks to its decision to allow greater flexibility in the ruble exchange rate. "Has Russia's financial system be destabilised? The answer is no. If the ruble falls [in value against the dollar], then the CBR can increase interest rates and the two actions cancel each other out," say Savov. "The system we have now is flexible and stable than what we had before [the crisis began in 2008]. There won't be a banking crisis in Russia, but banks are being squeezed by the general slowdown and low risk tolerance at the moment."

What the index doesn't take into account is what impact a collapse of the financial system in Europe would have on Russia. There are several channels by which crises can be transmitted from one country to another like foreign ownership of banks or the collapse of credit markets. However, the last crisis has closed most of these channels down in Russia's case and oil price dynamics remain Russia's most significant Achilles' heel. "The current depression is driven largely by sentiment as none of the usual channels that transmit crises have been affected. Even oil prices at the moment reflect the real supply and demand," says Savov. "So we will have to wait for the rest of Europe to sort out its problems and then go back to work."

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