Last year has seen the unfolding of a crisis in Russia and this year will be challenging for the policy-makers because the reasons for the crisis will persist and in addition the economy is expected to be in recession. This note addresses the types of crises that have befallen the Russian economy and comments on the policy choices.
Some data1: GDP should end up around USD 1700 billion in 2014 (assuming 42 roubles for 1 US dollar as the yearly average; if the average rate is 60, the Russian GDP will be around USD 1300 billion in 2015). Russia’s foreign currency reserves (including gold) were around USD 388 billion at the end of 2014 (down from around 520 billion at the beginning of the year). The two sovereign funds have around USD 170 billion between them, most of which are in foreign currency, but not as liquid as the central bank’s reserves proper. So, only a fraction of the foreign reserves, perhaps up to one half, can be spent on interventions in the foreign exchange market and for direct support of banks and corporations.
Gross foreign debt is around USD 700 billion (somewhat above 40% of GDP). It is almost evenly split between the public and the private sectors. On the public side, this is mostly the debt of state banks and enterprises, while on the private side it is mostly corporate debt, somewhat less than USD 200 billion, but about 450 billion if the public sector corporate debt is included. Banks, both public and private, owe about USD 200 billion. The rest, about USD 50 billion, are direct public foreign debt.
Two types of crises: Before the oil price shock, the Russian crisis was a variant of a sudden stop crisis, perhaps a ‘creeping’ stop crisis. The possibilities to refinance the foreign debt obligations were gradually diminishing due to the introduction of sanctions. That, together with the capital flight of more than USD 100 billion, led to steady depreciation of the rouble, debt service being higher than anticipated, from around 33 for 1 US dollar at the beginning of the year to about 43 at the end of October; then it climbed to 54 by the end of November only to collapse to close to 70 in early December (close to 80 at one point in mid-day trading), and then came back to around 55 close to the end of December. It has edged up to above 60 with high volatility since then. So, Russia is facing a combination of a financial and an exchange rate crisis. Both are equilibrating responses to the expected changes in the financial and the current accounts. The first from around March 2014 to the end of October 2014 and the second after the collapse of the oil price and the expectation that it would not recover soon, that is from October to December. The exchange rate crisis may be over, while the financial crisis will be a more enduring one.
The policy responses: The central bank, primarily, has not clearly differentiated between the two types of crises. In the case of the exchange rate crisis, especially the one driven by terms of trade shocks, there is no point in defending the exchange rate because devaluation is needed to sustain the trade balance and the current account – the right response is to float the exchange rate. The problem usually is that foreign debt exposure is not hedged, due to the previous managed or fixed exchange rate regime, which may trigger a financial crisis due to currency mismatch in the balance sheets of banks and corporations. But if reserves are to be spent, it is better if those are used to recapitalise banks and corporations rather than to prop up an overvalued exchange rate. The central bank eventually did let the exchange rate float, but then hiked the interest rate to stabilise the rouble. So, currently, the improved exchange rate may have stopped the increase of the foreign debt service in dollars, but its cost in roubles has increased dramatically (apparently, the interbank interest rate is above 23%; with negative growth prospects, that risks a banking crisis).
As for the financial crisis, due to the gradual strengthening of the sanctions, it may have been underappreciated because of the early forecasts that sanctions would be short lived. The central bank intervened to stabilise the exchange rate, but was rather timid in using the interest rate. That resulted in a loss of reserves without achieving any financial consolidation. However, after the oil shock, and after additional interventions had not made much difference, the interest rate was hiked dramatically, to 17%. That, indeed, made roubles scarcer and stabilised the exchange rate, but may have exasperated the financial problems of the banks and of the corporations, some of which had to be recapitalised.
In both types of crisis, the exchange rate needs to adjust, so floating it is the right policy. In the case of the financial crisis, when money is flowing out of the country, interest rates may have to be hiked, while in the case of a currency crisis, an interest rate hike may eventually lead to sharper devaluation.
Two policy strategies: Assuming that the correction in the price of oil is permanent, and so is the impaired access to foreign finance, i.e. to dollars and euros, the stabilisation of the Russian economy may require short- to medium-term trade and current account deficits, if the sovereign funds are used to spur domestic investment. Also, the elimination of currency mismatches in the balance sheets of banks and corporations, so that roubles appear on both sides, would be helpful. That may require a higher interest rate in the medium term, in order to keep inflation under control, which may present transitional financial problems for banks, which may be exacerbated by a recession in the short run. That strategy would call for a nearly complete turnaround to a more closed economy and probably even more authoritarian governance. This is like an industrialisation strategy without modernisation (as modernisation means Europeanizsation in the Russian context)2.
Alternatively, there is the IMF, but that is no solution to the financial crisis, if the regime of sanctions persists. In 1998, sovereign bonds in roubles were offered at ever increasing interest rates. That strategy was supported by the IMF. Then, the state defaulted on those debts to widespread surprise. There was almost a global financial crisis. This time around, debt denominated in roubles is mostly domestic, so the banks can default on it, but the government cannot. This time around, reserves may continue to be spent to prop up the financial system and to stabilise the rouble, with little support for investment. This could be called the austerity strategy.
Looking forward: This year, and possibly the next years too, increased surpluses in the current account are expected due to collapsing consumption and investment while no clear strategic decision-making is in evidence. This suggests that the austerity strategy, without IMF support, is the one that is being pursued implicitly. Politically, that is consistent with the presumption that the regime of sanctions will be dismantled relatively soon, though there is scant evidence that political steps are being taken in Moscow that would enable it. The risk is that if this does not happen and the financial crisis is prolonged, the reserves will be spent in a couple of years with further economic deterioration. One hopes that at least then, and perhaps even before, the strategy of industrialisation with modernisation will be adopted – i.e. there will be normalisation with the EU with internal democratisation and economic diversification.