No Need to Press the Panic Button Quite Yet

The early days of September have been a terrible time to be an investor in Russia. The Financial Times wrote about the capital flight, the plunge in the ruble against the dollar, the precipitous decline in oil prices, the loss of foreign exchange reserves and the drop in equity markets since the beginning of the Georgian war. The Wall Street Journal underscored the likely funding difficulties for Russian companies and banks whose access to international capital markets may be curtailed, thus restraining investment and future growth. Yet a recent commentary in The Moscow Times offered 10 reasons why the country's economy would falter, seemingly as a consequence of the Caucasus war.

Clearly if you were to base your assessment of Russia's economic and financial prospects only on such sources, you would be well advised to steer clear of the country's assets. After all, media reports have astutely noted the plunge in the country's Morgan Stanley Capital International index by 11.4 percent in the first week of September.

So as a sophisticated investor, you would logically turn your attention to other investment opportunities. But this is where the problem begins.

How about U.S. equities, which are thought of as a "safe haven"? The S&P 500 index declined by 11.5 percent between June 5 and Sept. 5 (before the government's bailout of Fannie Mae and Freddie Mac over the weekend). Or the London equity market? Britain's MSCI index fell by 9.8 percent last week. What about commodities? In dollar terms, The Economist commodity index is down about 3 percent in the last month, and oil fell over 7 percent (and a 27 percent plunge since the peak of $146 per barrel just two months ago). What about the euro? It has dropped against the dollar by about 10 percent in the last two months. Or emerging markets like China? In the same week as the Russian market dropped, China's stock index fell by 8.5 percent and Taiwan's by 11.2 percent. Moreover, Brazil fell by 12.5 percent over the same period.

Closer to home, maybe East European emerging markets are tempting. But Poland's index dropped 10 percent, Hungary fell 12.7 percent and the Czech Republic by 11 percent last week. Sticking with energy plays, perhaps Dubai sounds relatively attractive. For instance, The Wall Street Journal noted last week that five-year credit-default swaps, a measure of credit risk, against Gazprom's bonds have widened to 257 basis points -- up a hefty 38 points in the past month. That looks worrying until you note that the government of Dubai's five-year credit default swaps spreads widened by 60 basis points just last week to 265, and Dubai has had no war to worry investors.

What the worry-mongers in the Financial Times and The Wall Street Journal fail to point out is that Russia is generally in no worse shape than other markets and, unlike most others, has significantly better medium-term prospects supported by sound macroeconomic policy and outcomes.

The country's external and fiscal positions remain strong despite a much lower oil price, the Central Bank has accumulated significant foreign exchange reserves, and the enterprise and household sectors have low levels of indebtedness. As a result, even if there were a further weakening of commodity prices, the positive macroeconomic trends in the country are unlikely to reverse in the medium term. Economic growth rates may slow but should still remain well above 5 percent in real terms over the next few years. The other side of capital flight is lower money expansion, so inflation is decelerating and could return to single digits in 2009. It should then be easier for the Central Bank to ensure that interest rates become positive in real terms. With nominal wages growing by 28 percent on an annual basis, consumption is likely to remain strong. With about $580 billion in foreign exchange reserves, the third largest in the world, the Central Bank cannot be forced to devalue the ruble and is unlikely to do so, although it should certainly exploit this opportunity to make the exchange rate more flexible.

In the short term, of course, a coincidence of unfavorable factors is buffeting the Russian economy. Russia's international isolation after the war with Georgia seems so far to be more verbal than real. It just so happens that the conflict in the Caucasus coincided with a dramatic appreciation of the U.S. dollar and a corresponding drop in the euro, along with a relative collapse in commodity prices, including oil.

The resulting turmoil in international financial markets would not have spared Russia even in the absence of the geopolitical events of last month. In fact, the dollar appreciation against the euro and commodity declines are a sign of trouble to come -- not just of higher volatility, but of a significant real contraction in the economies of the Organization for Economic Cooperation and Development. Certainly this is the signal that the bond markets have been sending for weeks now, and it has nothing to do with a war in the Caucasus.

I'm an economist, not a financial analyst, but I would venture to say that in light of the strong fundamentals of the Russian economy and the relatively weak near- to medium-term prospects elsewhere, Russia looks like a lucrative opportunity for longer-term investors.

Of course, in the short-run, Russian companies will face real funding problems and higher costs. Access to international capital markets, which was taken for granted by many companies, will be problematic and more expensive. Companies that ambitiously overexpanded using too much debt to leverage their investments will be in trouble. The fact that even U.S. municipalities and name-brand firms in other emerging markets face similar problems does not make it any easier.

Fortunately, although funding conditions on the Russian market may become tighter and more expensive, there may be a silver lining in this particular cloud. These long-anticipated, normal monetary conditions should lead to positive real interest rates and facilitate a more realistic and less speculative assessment of economic prospects while helping to deflate bubbles in the making and assist in restructuring the economy. It can also promote the development of the domestic capital market.

All of this may be painful for those companies and their banks and employees that are directly affected. But if the government plays its role in pursuing a disinflationary and conservative macroeconomic policy while implementing its medium-term structural policy framework to make the economy more dynamic, more transparent, less dependent on energy and less corrupt, the country as a whole will gain financial strength and stability.

So in Russia there is no need to hit the panic button as suggested by some of the recent media hype. The war in the Caucasus is a small part of the story and not a major theme. The drop in oil and other commodity prices and the rise of the U.S. dollar are provoking some large readjustments in all markets, and Russia is no exception.

That said, the geopolitical strains resulting from last month's war could lead to unexpected developments. The uncertainty remains high and is priced by the markets into risk premiums for Russian assets. If calm returns, the current undervaluation of Russian securities will correct. If not, then a prudent investor -- despite encouraging fundamentals -- may want to keep that panic button handy.

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