President Vladimir Putin's annual address to the Russian Federal Assembly in the Kremlin on December 4 occurred in the midst of a perfect financial storm, which he largely ignored. His unspoken main message was that no economic reforms would take place. But the speech might have been his last opportunity to use reforms to save his regime from the financial turmoil that has just started.
The Russian economy has been hit by a triple whammy—poor structural policies, Western financial sanctions, and the oil price collapse. Each is producing negative effects that are reinforcing each other to make the situation disproportionately worse.
Putin's policy of state and crony capitalism plus protectionism has eliminated Russia's economic growth. Since July, Western sanctions have stopped all refinancing of Russian foreign debt, whether private or public. Since June, the price of oil has fallen by 40 percent and with it the ruble exchange rate. Both declines are likely to continue because markets usually overshoot. A lasting oil price of $60 per barrel already looks probable, and many short-sellers have opted for $40 per barrel. Each effect is likely to reduce GDP by 2 to 3 percent next year, which together would reduce GDP by 4 to 6 percent.
My outlook for the Russian economy is much more negative than the mainstream, represented by the Russian Ministry of Economic Development, which has just predicted a GDP decline of 0.8 percent next year.
The current moment is reminiscent of October 1990 when Soviet President Mikhail Gorbachev missed his last chance of reform by dismissing the 500-day reform program. Ten months later he was ousted in a coup. As the late economist Rudiger Dornbusch taught us, "a financial crisis usually happens much later than anybody expected, but when it starts everything goes much faster than anybody could have imagined."
The conventional wisdom is that Russia's total foreign debt is not large—only about one-third of GDP, $678 billion at the end of September according to Morgan Stanley—while Russia's GDP was supposed to be $1.9 trillion (as in 2008) before the big devaluation started. But the devaluation has reduced Russia's GDP in current dollars by 40 percent, leaving Russia's foreign debt at 55 percent of GDP (considering 9 percent inflation). Further depreciation will raise this ratio.
But solvency does not matter when liquidity is absent. In today's Russia, cash is king. The Western financial sanctions amount to a "sudden stop" of all international financing, which the whole world faced for half a year after the Lehman Brothers bankruptcy in September 2008. Not even the Chinese state banks dare to give Russian entities any financing out of fear of the omnipotent American financial regulators.
Conventional wisdom has long claimed that Russia's international reserves are more than sufficient. On November 28, they amounted officially to $420.5 billion. But more than half of these reserves are not very liquid. As I have argued elsewhere, we need to deduct $45 billion of gold and $172 billion of the two sovereign wealth funds, the Reserve Fund and the National Wealth Fund. These two funds are held by the Ministry of Finance, whose assets are neither liquid nor controlled by the Central Bank of Russia, which receives account statements from, but does not control, the Ministry of Finance.
In reality, Russia's effective international reserves are only $203 billion, which is not very reassuring in light of the Minister of Economic Development's expectation that Russia will lose $125 billion in net capital outflows in 2014. The Central Bank of Russia estimates the scheduled foreign debt service of Russian entities in 2015 at $100 billion, after a debt service of $30 billion in December 2014.
But the capital outflows are likely to be much larger. State enterprises cannot receive any refinancing and will have to pay back everything that comes due. Private corporations have a great interest in not only paying off their debt due but also in prepaying because of the expected further depreciation of the ruble. JP Morgan assesses "fictitious" transactions, i.e. genuine capital flight, at $32 billion a year. Russia's wealthy all have reasons to move their fortunes to more hospitable jurisdictions. Many rich Russians are fleeing the country before the political and economic conditions get worse. As capital flight gains momentum, currency controls will become inevitable, and that prospect will further accelerate capital flight. Some Russian banks have already introduced admittedly liberal limits on hard currency cash withdrawals. They are likely to tighten fast.
Many arguments are being raised why this disaster is not likely to happen. JP Morgan notes that Russian banks have accumulated $292 billion in foreign assets. Presumably much of this belongs to the sovereign wealth funds. No private bank will voluntarily part with hard currency assets in the current financial panic. The same is true of the substantial private holdings of foreign cash in Russia. The question is rather when a bank and currency run will start.
Much of the "foreign" debt of Russian private companies is related to debt owed to the Russian owners abroad, but they would not like to transfer money to Russia. Moreover, they might run legal risks of doing so because of the Western sanction regime and Russian deoffshoreization. No nation, not even China, is likely to come to Russia's rescue in this home-made crisis.
Until recently, many Western and Russian financiers have presumed that the US and EU sanctions would lapse next July, but as my Peterson Institute colleagues Gary Hufbauer and Jeffrey Schott have concluded from their empirical study of Western economic sanctions after World War II, sanctions tend to be inert and are rarely eased until they accomplish their aim, which happens in only 30 percent of all cases. Unless Russia withdraws its military forces from Ukraine, the West is unlikely to ease the sanctions.
Russia has no problem with its budget balance, its public debt, or its current account. They all look rock solid. Yet we are seeing the beginning of a depreciation-inflation cycle and economic decline. The Central Bank of Russia will be forced to raise interest rates further to limit both inflation and depreciation. A fall in the oil price of 40 percent means that Russia's exports will fall by 20 percent or $100 billion, which will reduce investment, consumption, and GDP. Although Russia's banks are considered to be well capitalized, many banks are bound to suffer from currency mismatches and the ever cheaper ruble. The costs of bank failures are bound to end up on the state budget.
The distribution of resources will become much more sensitive. From 1999 to 2008, Russia's real income increased ten times, but since 2009 Russia's GDP has grown barely one percent a year on average. Until 2010, the Kremlin gave priority to pensions, but since then its priorities have switched to the military, the secret police and the state administration, while health care and education have received even less funds than before, as the opposition leader Boris Nemtsov has noticed for a long time.
Now, expenditure cuts are becoming more severe, leading to two protests by health care and education personnel in Moscow in the last month. The Kremlin has also used the old trick of delegating expenditures to the regions, while keeping the revenues centralized. Most regions are in a tight financial situation, being forced to cut staff in education and health care, just like Moscow. This is not likely to be very popular among ordinary people in the provinces. Moscow sociology professor Natalia Zubarevich warns of coming social instability in "Russia 2," the large industrial cities with a quarter of a million to one million inhabitants that comprise 30 percent of Russia's population.
But aren't these problems so obvious that Putin will make sure to change policy in time? I doubt it. Throughout his reign, he has received warnings from his liberal economists. In the beginning he listened to them, but he stopped doing so after 2003, and GDP continued to grow until 2008. Putin tends to blame Russia's economic problems on the evil and aggressive West. Since Alexei Kudrin resigned as finance minister in September 2011, no liberal economist has had his ear. Russia's national security council contains no economic official, and neither does Putin's private circle. The secret police have taken over, and they are not likely to believe in any financial crisis until it is too late. It is already late.
Putin's regime appears to have entered a squirrel's wheel. It might still be possible to exit, but the kleptocratic regime in the Kremlin might block the exit. The most probable development seems likely to be that the rulers do little until Russia ends up in a financial meltdown that becomes an economic and then political meltdown. If the late Prime Minister Yegor Gaidar were still alive, he would recognize that his prediction of a repetition of the Soviet breakdown in his book Collapse of an Empire: Lessons for Modern Russia (Brookings 2007) was coming true because his warnings were not heeded.