There Is Only One Cure for What Plagues Russia

Belatedly, financial markets have realized that July 16 was Russia's Lehman moment. On that day, the United States imposed sectoral sanctions on Russia because of its military aggression in eastern Ukraine. Two weeks later the European Union introduced similar sanctions. However, it was only in December that the markets recognized the severity and tenacity of the financial sanctions.

Since July, Russia has received no significant international financing—not even from Chinese state banks—because everybody is afraid of the US financial regulators. Like most of the world after the bankruptcy of the Lehman Brothers investment bank on September 15, 2008, Russia suffers from a liquidity freeze. It will not end until US financial sanctions are lifted.

Without international funding, Russian companies—private or state-owned—are unable to refinance and have to repay all foreign debt due. The small scale of Russia's foreign debt relative to its gross domestic product is of no relevance. Only the ratio of the foreign debt relative to liquid international reserves and the current account balance matters. That leaves Russia with liquid international reserves of $202 billion against a total foreign indebtedness of $600 billion at the end of 2014, after a net capital outflow of $125 billion this year. In both 2015 and 2016, Russia has net external debt payments equal to $100 billion after subtracting its current account surplus. In other words Russia's liquid reserves would be finished after two years.

Officially, the international reserves of the Central Bank of Russia (CBR) are $416 billion, but not all of it is liquid. Gold reserves represent $45 billion. The official reserves include the two sovereign wealth funds, the National Wealth Fund ($82 billion) and the Reserve Fund ($89 billion), which are held by the finance ministry and spoken for.

Until December 10, the oil price and the ruble exchange rate moved in tandem, as they traditionally do. Since mid-June, the oil price had fallen by 45 percent and the ruble by 39 percent in relation to the US dollar. In the past four trading days, the ruble has plummeted far more than the oil price, by 25 percent versus 6 percent. This disparity makes sense. The exchange rate should fall more than the oil price because the liquidity freeze also has an impact on it.

The CBR appears helpless because it is. Whatever it does, the Russian economy will be destabilized. On December 12, the CBR raised its key policy rate by 100 basis points to 10.5 percent, but the rout of the ruble continued. On the night of December 15, the CBR tried to play catch-up by hiking its interest rate to 17 percent, but the ruble's collapse accelerated. Sergey Aleksashenko, former deputy chairman of the CBR, has called, in the Russian media, for a drastic rate increase to 100 percent. If the CBR intervenes, its reserves will swiftly run out. Currency controls are likely but they have never been effective in Russia. No monetary policy can offer a cure, because the basic problem of frozen liquidity remains.

The liquidity freeze, the falling oil price, and the financial havoc will inevitably damage the real economy. President Vladimir Putin has emphasized that as long as the ruble falls with the oil price, the ruble revenues of the state budget remain about the same. However, as Mr. Aleksashenko has pointed out, the problem lies on the expenditure side of the budget. The cost of imports rises sharply with a falling ruble, and this will hit the state budget as well as all the components of GDP.

The current financial meltdown is bound to cause major damage to the Russian economy. On December 15, the CBR forecast a GDP decline of 4.5 to 4.7 percent in 2015 if oil prices remain at $60 per barrel.

Since the root cause is Western financial sanctions, the only realistic cure is to have these sanctions lifted. The Kremlin can accomplish that by fully and credibly evacuating its troops and armaments from eastern Ukraine. No other action is likely to have a significant economic effect.

The big policy lesson that might arise from this drama is that financial sanctions are far more effective in the modern globalized world than many thought possible.