Financial Armageddon II Can Be Avoided
- By Martin Gilman
- Dec. 10 2008 00:00
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For those of us who were veterans of the Russian financial crisis of 1998, it certainly feels eerily familiar right now. Certainly the virulence of the sudden collapse of the country's equity and bond markets since August, the abrupt halt of seemingly unstoppable economic growth, the flight of foreign investors, the hemorrhage of foreign reserves and the pressure on the ruble exchange rate and subsequent depreciation of the rate seem to bring back memories of the events of 10 years ago.
There are indeed many similarities. Perhaps the most obvious is that both financial crises were precipitated by contagion from abroad where significant economic problems led to a rapid collapse in oil and other commodity prices. Another similar occurrence was the withdrawal of foreign investors who abandoned Russian assets to cover losses elsewhere and especially to seek a safe haven as fear of risk and losses overcame the profit motive.
Mood swings among foreigners in their perceptions of Russia also played an important role then as it does now. This was particularly true among the foreign media, rating agencies, regulators and shareholders. Poor communication skills among Russian senior officials are evident in both situations. Last, but perhaps most significant in the current context, the long memories of Russians, who have endured almost a century of perverse economic policies, are pushing them to expect the worst whenever financial variables, especially the exchange rate, come under pressure. Probably the most important of the enduring legacies of 1998 is that the authorities have taken to heart the need to address popular concerns through the maintenance of sound and stable policies.
But the differences between the financial collapse that started in late summer and the 1998 crisis are even more striking. Russia, like some of its neighbors in Asia, learned valuable lessons 10 years ago. Many senior officials, such as Finance Minister Alexei Kudrin and Central Bank head Sergei Ignatyev, were native veterans of the 1998 debacle, and they have acted as bulwarks against imprudent policies ever since. The country has pursued consistently conservative fiscal policies and managed the ruble exchange rate closely in line with the dollar/euro basket. In sharp contrast to 1998, when finance and other ministers were replaced with the rhythm of a merry-go-round, political stability has accompanied policy continuity,
As a result, by the summer huge foreign reserves and large fiscal surpluses tucked away into an oil stabilization fund provided ample cushions to face the new contagion emanating from Wall Street. Indeed, Russia still has the third-largest reserves in the world and has become one of the largest creditor countries. And unlike 1998, when the government was crippled with debt, the country now has low debt levels in most sectors, especially compared with Eastern and Western Europe.
In view of these relative strengths and ample financial cushions, Russia should not have to repeat its earlier history. Even that earlier bout with financial Armageddon was not inevitable, and now Russia can avoid anything close to such an economic collapse. But it is in the government's hands to deliver the country from a completely avoidable recession. The question is whether the authorities will have the political courage to take the right decision and let the ruble exchange rate float. Under current circumstances, this will entail a sharp depreciation of the ruble.
As others have also observed on these pages, the terms of trade -- that is, the price of exports relative to the price of imports -- have turned so sharply against Russia (and other commodity producers) since July that the exchange rate relative to the basket is virtually guaranteed to stymie non-oil exports and to suck in imports. If this were to continue for the months ahead, Russia will plunge into recession along with all of its Group of Eight partners.
For instance, the price of Urals crude has fallen 67 percent since this year's high of $147 on July 11 to $43 a barrel at the end of last week. In the short term, with dismal news from the West and mediocre news from China and India, further price drops cannot be excluded. With these prices, oil exports on average create losses on each barrel shipped, as Prime Minister Vladimir Putin acknowledged in his televised call-in program last week. The balance of payments is probably already in deficit this quarter, and the budget prospects for next year can only balance by drawing upon the stabilization fund (although presumably that is what it is there for).
But the ruble exchange rate has been allowed to weaken relative to the dollar-euro basket by only 7 percent since July. This relatively strong ruble in the face of a collapse in export prices will impoverish the country unless determined action is taken.
To suggest ruble depreciation -- perhaps on the order of 10 percent to 20 percent from today's level -- is not meant as a way to gain unfair competitive advantage for Russia. Some with long memories might recall that beggar-thy-neighbor policies, based upon high tariffs and competitive devaluations, helped spread the Great Depression of the 1930s. The idea now is to float and let the market decide and not to fix at an artificially low rate.
Think of it this way: In 2003 and 2004, with an average Urals oil price of $31 per barrel, Russia's real gross domestic product grew by an average of 7.2 percent each year. So why cannot it to do the same now?
The main difference is that real basket rate of the ruble -- that is, adjusted for cumulative inflation -- has appreciated by about 40 percent over that earlier period. The only way to get at least part of the way back to that relationship is to let the nominal exchange rate depreciate while tightening monetary policy.
My teaching colleague, Evgeny Gavrilenkov, last week noted in these pages that the recent moves toward a gradual depreciation of the ruble can be viewed as a step in the right direction -- but perhaps the wrong step. He was arguing that a more forceful depreciation, timed with the likely January money contraction, was needed. I agree, and I think almost all of the country's leaders, including at the highest level, appreciate perfectly well what is at stake. For example, Putin said last week that the authorities would exercise a more flexible exchange rate policy, allowing the exchange rate to adjust to exogenous pressures.
The problem is not a lack of understanding. It is rather an issue of political will and the courage to do it. Like 1998, there is a strange echo in the Kremlin. No one wants to take responsibility for a decision that everyone knows is the best option available -- one that will likely avoid significant pain for Russians over the medium term. In 1998, wishful thinking about an early rebound in oil prices and the fear of the unknown led to paralysis.
Let's hope that the Kremlin and the White House have really understood the lessons of the 1998 crisis. If not, Russia will follow the United States and Europe into recession that could have been avoided.
Martin Gilman, a former senior representative of the International Monetary Fund in Russia, is a professor at the Higher School of Economics in Moscow.