Russia - panicked and peaked

By bne IntelliNews September 25, 2008

Ben Aris in Berlin -

At the start of September there was a sight that hasn't been seen for years: a queue of people lining up to change their rubles into dollars outside the exchange kiosk near the Kievskaya metro in central Moscow. Then it got a whole lot worse. A "death spiral" started of redemptions and margin calls, forcing traders to sell, which drove down prices and triggered more selling and redemptions.

The statistics are ugly. The Russian market's capitalisation was cut in half as the RTS plummeted to 1058, from a peak of 2488 set on May 19. Then it flat-lined completely on September 17 after the Russian stock market regulator stepped in and closed the markets for two days. Likewise, the Micex index tanked from a high of 1966 on May 25 to 788 before the exchange was shuttered. The last time the RTS market was closed was in 2000.

At the same time, Russia's hard currency reserves dropped from just under $590bn to $560bn in two weeks and the huge outflow of money caused the ruble's value to tank. The central bank responded by widening the trading band of the ruble against a basket of dollars and euros. This only put the willies up traders, as the last time Russia widened the trading band was in the run-up to the August 1998 default.

Fear turned to raw panic after the market watched the Wall Street doyen of Lehman Brothers go down in flames the same week. That was bad enough, but the near-failure of insurance company American Insurance Group would almost certainly have sparked systemic failures throughout the US bank system.

However, by Thursday, September 18 the leading central banks around the world had rallied their forces. The US government bailed out AIG and injected massive gobs of cash into the system in coordination with other leading central banks around the world. In Russia, the government slashed mandatory reserve requirements at banks, injected tens of billions of dollars into the frozen interbank market, earmarked another RUB1.8 trillion rubles ($68bn) for fighting financial fires and promised to spend up to RUB500bn ($20bn) on buying back stock to support the equity market. When trading resumed on Friday, September 19, trading on the RTS had to be suspended again - but this time because prices were rising so fast.

At the time of writing, the combined Central Bank of Russia and Ministry of Finance action has probably seen off fears of a banking sector crisis, but Russia was not out of the woods. The US annual financial reporting season doesn't finish until the end of September and more shocks could be in store. bne is following the development of the story day-to-day on its website and with the Russian Business List. However, barring more failures in the US, investors were expecting the market to recover at least some of their losses: at its nadir in mid-September, Russian stocks were so cheap it was theoretically possible to buy a bank for less money than it had in its vaults. "At present, everyone is agreed that by any traditional methodology the Russian stock market is cheap and oversold - but it was cheap and oversold five hundred points ago," says Julian Rimmer, a trader with Uralsib in London.

Russia has been taking hit after hit this year and its reputation as a "safe haven" in the emerging market world lies in tatters. But provided the global financial system doesn't collapse, the meltdown on the Russian equity markets could turn out to be a huge buying opportunity. The Russian government was at pains to point out that there is nothing fundamentally wrong with the economy and a mild contraction with oil prices dipping from their historical highs to about $80 would actually be good for the economy. "There are no doubts that we will easily get through these developments in the global economy," Prime Minister Vladimir Putin said at a meeting with Azerbaijan's President Ilkham Aliyev on September 16. "We do not doubt that the safety cushions created earlier will work. We are also examining the use of central bank's long-term instruments of influence."

Russia's economy has been overheating. Soaring oil and commodity prices have been driving up inflation and the ruble appreciated too fast. However, the lasting impact of this sell-off is it will accelerate big changes in the way Russia's economy works that were already on the cards. The easy money from simply catching up with rest of the world is over and now the hard work of building a normal economy begins.

Russia's economy will almost certainly slow now. But it was already slowing as companies began to bang up against a hard ceiling imposed by the proliferating bottlenecks in the economy. Roads, rail, ports and airport are all overloaded. Supplies of basic materials and more sophisticated inputs like experienced staff are in short supply, driving up costs. The huge profits a few companies are making have been sending up wages faster than productivity. And if GDP growth continues at the 8% rate that Russia put in over the first half of this year, Russian companies will run out of power as soon as 2009.

The root of the problem is that the state has invested nothing into replacing Soviet-era infrastructure for a decade and half as it battled to bring inflation under control. Infrastructure is the beams that hold the economic house up, but after eight years of strong growth the house has simply become too small to contain all the companies that live inside.

The global investment/GDP ratio is about 23%, says Troika Dialog in a recent report, and in fast-growing emerging markets closer to 30%. However, in Russia it fell to 15% in 1998 and only caught up to the global average in 2007. More recently, the impact of the current global turmoil has sent the rate down to 9.9% over the first six months of this year, although the consensus is that the rate will recover soonish.

More specifically, the infrastructure investment/GDP in Russia is also low at around 4-5% of GDP compared with the Growth Commission's (a World Bank-sponsored organization) estimates of a necessary level of 5-7%. For comparison, China spent 8% of GDP on infrastructure in 2007, say Troika. "The investment backlog is nearly three times the level of GDP, with three main drivers: underinvestment over the last decade; the need to tool up for a capitalist economy; and the move to provide commodities for the industrialization of China," said Troika's Bond.

Bottlenecks proliferate

• Power demand and supply of power is matched, no spare capacity

• Transport delays for trucks crossings the borders can last for weeks

• Roads roads in Moscow are 60% overloaded, less than 1% of new roads built in the last eight years

• Ports delays at Russia's three main ports are endemic

• Aviation the crash of Moscow-Perm flight killing on September 14 highlights the decaying state of Russian aviation

• Materials booming economy has produced shortages of materials; Russian cement the most expensive in the world

• Human capital corruption in the education system and lack of training have lead to chronic shortages of managers; poaching is driving up wages faster than productivity

The big change to the way Russia's economy works had already arrived before the September sell-off. Russia has been battered by a series of hits over the last year and a half. Indeed, the fall out the collapse of confidence in September has been mitigated as companies were already pulling their heads below the parapets since the credit crisis started in the summer of 2007.

About the same time, the government launched a $1-trillion investment programme designed to deal with the infrastructure problem. Trouble is, that 80% of this was supposed to be financed by private investors, IPOs and public-private partnerships.

The entire Russian financial sector is being squeezed. The cost of capital was already rising, but now it will rise even further, which has knock-on effects for everyone. "The long-term affects of the current crisis is that it will force the banks of the region to work more closely together," says Ian Hague, co-founder and manager of Firebird Capital. "Capital will increasingly be sourced from within the region."

Cut off from its main source of long-term cheap international credits, banks will have to slow lending, which will crimp spending. The engine of Russia's economic growth is already changing from consumer spending to state-led investment. Forced to source money from the domestic market, banks are already seeing the cost of capital rise, slowing consumer spending and causing problems for bond issuers. Banks were already putting up interest rates before September. Mortgage credits were up by 0.5 percentage points in August and had become harder to get. Then at the start of September, state-owned Sberbank announced its rates on new corporate loans would rise by 3 percentage points.

Consumer lending was already slowing at the end of last year and so banks had switched to the more profitable business of corporate lending at the start of this year. But corporate lending growth stalled in July with only $12bn of loans issued, 62% of the level a year earlier - this will probably fall even more sharply now.

The rising cost of capital has also hit the bond markets, which were effectively shut down in September. The volume and size of bond issues has been nearly doubling every year since the market reappeared in 2001. However, there is a huge mismatch between the maturities of bonds (typically three years) and the projects payback period (typically about eight years). Issuers have assumed they can roll over the bonds at about the same cost. But not anymore. "It has been a sort of bubble as many third-tier companies should have been borrowing from banks and not issuing bonds in the first place," says Renaissance Capital's chief economist Alexei Moisseev. "Now they couldn't issue a bond even if they wanted to."

This mismatch was already causing problems - at the start of September, Russia saw its first ever ruble bond defaults. Bankers report other bond issuers were forced to sell assets to cover their obligations, while more had to accept a doubling of interest rates. The frenetic race to grab market share amongst highly leveraged retailers has come to a screeching halt and bankers say prices in the property market are also in danger, as developers have borrowed heavily to finance the construction boom. (see box, "Retailers squeezed").

Grasping the nettle

Driving growth by letting private companies sell tellies to Russian punters is pretty easy to organise, but driving growth with a state-led, $1-trillion investment programme to 2020 is a lot harder to pull off.

To its credit, the Kremlin saw these problems coming and has already grasped the nettle in most cases. But in many cases, the Kremlin's assault on things like red tape and corruption has only just started in earnest. During his eight years as president, Vladimir Putin tackled many of the big issues, like reforming the bank sector and starting the process of breaking up the power sector. However, most of the fiddly reforms that require attention to detail, such as tackling corruption and reducing red tape, were ignored.

Since taking over as president at the start of this year, Dmitry Medvedev has begun work on the small stuff. Almost the first law he signed was designed to cut red tape and boost small- and medium-sized enterprise. The most recent was long overdue anti-corruption bill that he signed at the start of September. Both are welcome reforms, but Russia is continuing to fall in the World Bank's "Ease of Doing Business" ranking and remains near the bottom of Transparency International's corruption table.

So is Russia facing another crisis? Ironically, the current crisis could be a boon for the Kremlin in the medium term.

When the dust settles, Russia should emerge in much better shape than most of the other countries in the CIS thanks to its large twin budget and trade surplus. The government has prudently used the windfall of rising commodity prices to build up a massive $860bn strong war chest and total state external debt was a mere 5.3% at the end of the first half of this year.

However, the state's Achilles' heel is its dependence on oil: although the extractive industries' share of GDP has fallen to around 9%, according to Rosstat, oil and metal exports still account for almost three-quarters of both Russia's export earnings and the state's budget revenues.

Oil prices were tanking in September on fear of a global recession and some fall is actually welcome. "No one is sure how much space there is under us and what the optimum price for oil is," says Renaissance Capital's chief economist Alexei Moisseev. "But with oil at $150, inflation was shooting up, the ruble was appreciating too fast and the economy was overheating. Clearly, $150 was too high." But where oil prices settle will determine how hard Russia's recovery will be.

Oil prices can fall quiet a long way before doing any real damage. Russian Finance Minister Alexei Kudrin said in September that the budget is balanced down to $70. Traders had priced in an effective price of oil at $50 a barrel during the worst of the sell-off in September, while actual prices were hovering around $92.

UBS released a study in the midst of the crisis that looked at what happens with average oil prices at $100, $80 and $60 that gives some succour. With oil at $100, the domestic sector's earnings would fall only 4%; at $60, earnings will fall 15%. Of course, the commodity sectors would be much harder hit, seeing earnings fall by 15% and 46% respectively. Much lower oil prices would also take the edge off growth, which would fall to 6.3% at $100 oil and 5.2% at $60, while average wage growth would be 21% and 15% respectively.

However, these falls come with a silver lining (that UBS says it didn't factor into its study). Falling oil prices would also see consumer price inflation fall to 9% with $100 oil and 7% at $60 oil (a new record low), as well as significantly slowing the ruble's appreciation. Falling inflation and a slower ruble appreciation removes the two heaviest fetters on government plans to invest twelve-digit figures into the economy and this spending is almost not factored into the study. "The government's plan to spend over $1 trillion over the next decade and half won't drive inflation back up if the other inflationary pressures wither," says Standard & Poor's Russian analyst Frank Gill. "Today, inflation is much less a source of concern than it was only three weeks ago."

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