The Calm Before the Global Financial Storm

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Russia is the largest country in the world by land area and the seventh largest in terms of population. It may also have the eighth-largest economy, which is rapidly climbing up the rankings. But its size does not insulate it from the financial turbulence that is increasingly seizing up the world economy.

Ironically, Soviet Russia -- sealed in its oppressive isolation -- was immune to whatever economic disturbances occurred elsewhere. Even the Great Depression arguably had little impact on the Soviet Union. Clearly, Russia is now fully integrated into the globalized economy, and both the global price shock and the financial meltdown are being felt.

Although seemingly different phenomena, these two largely unanticipated developments share a common source. Both seem to feed from a relatively rapid expansion in global liquidity and, until last summer, a significant reduction in market perceptions of default risk, which encouraged a worldwide borrowing spree in real estate and other assets. The froth in housing markets was felt from the United States to Australia and touched Spain, Britain and others. Financial assets rapidly rose in value, especially securities bundled from mortgage loans and other seemingly safe debt instruments. In a low-inflation environment, cheap and available debt was employed to leverage the returns on these assets.

Then risk perceptions changed. In response to the U.S. subprime market collapse, the Federal Reserve began to ease monetary conditions aggressively. Not surprisingly, once Washington started to ease policy, investors have piled into commodities and other real assets, whose prices have soared.

Even before the widely anticipated reduction in the Federal Reserve rate on March 18, the recent acceleration of inflation in the United States to 4.3 percent has led to the reappearance of negative interest rates. And negative rates fuel speculation. With money effectively free, anyone who can borrow on good terms has every incentive to find something to do with it.

For Russia, the impact is mixed. While for many members of the Organization for Economic Cooperation and Development the surge in commodity prices is delivering a negative supply shock reminiscent of the 1970s, Russia enjoys a continuing positive terms of trade gain. This past Monday, oil prices hit a historic high of $108 per barrel. And it is not just oil. Grains and metals have also reached all-time highs. Gold is flirting with $1,000 per ounce.

Of course, these price shocks also reflect the rapid decline in the dollar. In terms of euros or rubles, the price spikes have not been as sharp. If these price levels are sustained, then the widely anticipated elimination of Russia's current account surplus will be postponed for another year or two, possibly until 2011 or 2012, even with the surge in imports. Assuming no desire to allow a significant nominal appreciation of the ruble, the resulting accumulation of reserves will make it difficult to bring domestic inflation under control.

This resulting overabundance of liquidity is the downside of the commodity boom as far as Russia is concerned. Inflation continued to accelerate in February to 12.7 percent higher than a year earlier. The increase in budgetary spending toward the end of last year and in January, combined with already loose monetary conditions, was the major reason for the continuing inflation acceleration. The government, despite its rhetoric, appears unwilling to use fiscal policy. Anti-inflationary measures, such as the Central Bank's decision to increase basic interest rates by one-quarter percent, the fixing of prices for selected food items and the implementation of export duties on grain, seem to be largely cosmetic.

While Russia and the rest of the world are flooded with liquidity looking for an inflation hedge, the financial meltdown in the United States continues. To some extent the liquidity paradox is an illusion, deriving from the fact that we use the word liquidity to describe different concepts. As investors have discovered in recent months, macro liquidity -- that is, plenty of savings -- does not guarantee cheap and available credit. Nor does it guarantee micro liquidity -- ease of buying and selling in markets.

In fact it seems that a type of vicious cycle is developing. Banks are cutting back on their lending, in large part because of the losses they have suffered as a result of the credit crisis. By lending less to private traders, hedge funds and other participants in the credit market, banks reduce even further the demand for securitized debt instruments, worsening the problems in that market.

More broadly, U.S. equity markets continue to fall from the highs reached last October, losing 18 percent since their peak. The dollar fell last week to an all-time low against the euro of $1.55. And despite aggressive cuts by the Federal Reserve, long-term mortgage rates have risen since January.

In the United States, the credit crunch has provoked Congress to agree to a fiscal package of $168 billion, or 1.2 percent of the gross domestic product. It is interesting that while U.S. monetary policy has focused exclusively on the credit crisis, the European Central Bank and other central banks are more cautiously using the credit crunch to help against incipient inflation.

The U.S. policy response may not help much to prevent a recession but clearly feeds the inflation in global commodity prices. So, even while the United States slides into a recession, forward inflation expectations in the bond market have risen to match the highest levels seen this decade.

After the bubbles in dot.coms and housing, it may now be the turn for commodities. Russia does not need this. Rather a phase of commodity disinflation is what is required to prevent the perception in the market that rising prices are a one-way bet. The message is clear enough, but it is unlikely that anyone will pay much attention in a U.S. election year.

The problem is that the United States, as the traditional key currency country, is, in effect, abandoning its responsibilities on the alter of domestic politics and short-term interests. As the world's largest debtor country, the repricing of risk is playing havoc with overvalued assets and causing U.S. authorities to panic in an effort to forestall the possibility of a serious economic collapse. But the additional liquidity being created is the source of the inflationary pressure worldwide. The risk that inflation expectations might drag down the dollar anchor has been broadly ignored.

Fortunately, the global financial meltdown manifests itself in a relatively limited and manageable manner in Russia. This is no doubt attributable to the hard lessons learned by Russian banks from the 1998 financial crisis and the relatively unsophisticated nature of its financial markets in terms of securitized products. Except for some localized and short-term liquidity concerns of banks that are squeezed to repay foreign loans that cannot be refinanced on attractive terms in current global market conditions at the same time that taxes are due, Russia remains largely immune.

The secondary effects through inflation, however, are less congenial. Russia by itself cannot do much to stem this pressure. And each country, acting on its own, may exacerbate tensions in an increasingly fragile, globalized economy.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.