A Frightful Wake-Up Call

These are frightful times. The US financial crisis is clearly the worst since the Great Depression. New York University Professor Nouriel Roubini has long forewarned that this crisis was under way.

Subprime mortgages were a sham from the outset, and the government should have regulated them-and the derivatives on which they were based-more closely. Moreover, the US Federal Reserve maintained excessively low interest rates for too long, leading to an excessive monetary expansion.

The US financial system had too little capital for the large credits it issued, especially the ones issued by government-sponsored Freddie Mac and Fannie Mae. The economic boom was too long and magnificent to believe. Booms breed corruption, while recessions strengthen morals. Now, we are waiting for the next shoe to drop. Surprisingly, no hedge fund failure has been truly spectacular as yet, but some private equity funds are bound to be hit.

Amazingly, forecasts for the US economy for next year are still suggesting growth of 2 percent. That is not likely, however, since the current financial turmoil will inevitably hit the real economy. Both investment and consumption are bound to be constrained as US consumers will try to restore a normal savings ratio, and this will make the economy slump further. A number of large companies in sensitive, cyclical industries such as automobile manufacturing, aviation, and construction will probably go under.

On March 26, 2008, I wrote a column in the Moscow Times arguing that Russia was likely to be the safest haven in the event that "the United States approaches a 1929-like depression." Well, now we are there, but I am no longer convinced that "Russia will most likely suffer the least" from the turmoil.

The first reason is that the financial crisis is so violent. Only people with extremely strong nerves are prepared to invest in the current market volatility, which might be the greatest the world has ever experienced. Admittedly, Russian investors have strong nerves, but the volatility on the RTS and the MICEX seems to be the greatest in the world.

Clearly, the current US administration does not know how to resolve the crisis. Instead, it is adopting one desperate ad hoc measure after another. Activity is better than passivity, but the lack of a long-term strategy for recovery is worrisome and likely to undermine public confidence.

Another factor undermining the Russian economy is that international investors withdraw their funds to their home base during a severe crisis. There was some speculation that it might be different this time with booming economies in BRIC countries, but recently the old pattern has reemerged. When the United States catches a cold, the emerging economies contract pneumonia.

The oil price has fallen sharply from its peak in July. As investors run for safety, commodities may appear to be a safe haven, but that is hardly likely to be true in a serious economic slowdown, which the world is clearly facing today. The rebounding oil price reflects a lack of confidence in the US government's economic policy. Since oil and gas contributed roughly 60 percent of Russia's export revenues and half of the government's revenues last year, falling oil prices will force the government to tighten its belt.

One of the worst results for Russia has been a capital outflow of about $40 billion in six weeks. Although this is small in comparison with the total international currency reserves of $600 billion at the end of July, it is a large sum when it is put against the backdrop of a feeble Russian banking system.

Russia's stock values have dropped to extremely low levels. Even if most of the fall is caused by a dearth of international capital, the main reason the country's stock prices have fallen so much is that many investors are convinced that corporate governance is not improving but deteriorating.

Russia is also subject to the vagaries of the dollar exchange rate. Until recently, the country imported inflation because of its combined dollar-euro peg. Because of the global economic slowdown, inflation is likely to abate, but the ruble exchange rate is plummeting because of the capital outflow. For years, the Central Bank has stated that it would move to inflation targeting in three years, but it has never done so. Inflation targeting would help Russia to keep inflation down, to stabilize the exchange rate, and to maintain a normal monetary regime without sharply negative real interest rates or credit squeezes.

The poor monetary and exchange rate policy has caused a credit squeeze in the banking sector that is bound to lead to bank failures. These will hardly be as big as Lehman Brothers, but Russia's banking system is so vulnerable because it is so weak. A potential benefit, though, is that monetization and leverage are so limited that losses to the real economy from financial failures will be limited, as was actually the case in 1998.

One of the most worrisome aspects of Russia's economic policy is that the government has adopted combative protectionism, which is never good for economic development. Three significant hurdles remain for the country's entry into the World Trade Organization. Russia needs to mitigate its protectionism against Ukrainian agricultural goods, to reduce its export tariff for lumber to Finland, and to agree on border controls with Georgia.

The cost to Russia of staying out of the WTO will only increase with time. About 20 percent of the country's exports consist of metals and chemicals, and these goods are often subject to protectionist actions, such as antidumping. Outside of the WTO, however, there is no legal defense against protectionist measures.

Today, it is obvious that Russia is highly vulnerable to global economic volatility, and the dramatic stock market falls have been a shocking wake-up call. Its economy is open and well integrated in the world economy, with exports amounting to about 30 percent of its gross domestic product. The more the Russian government protests against the vagaries in the world economy, the more the country is likely to be hurt, especially as some 80 percent of the country's exports consist of commodities.