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. Last Updated: 07/27/2016

The Weak Link

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The selling panic that is rocking equity markets is unlikely to topple the global financial system. Investors worry that financial institutions will curb lending in response to the subprime mortgage crisis in the United States. Major central banks, however, led by the U.S. Federal Reserve, have demonstrated that they will add as much liquidity to the banking system as needed to avoid a credit crunch. They have already pumped in hundreds of billions dollars worth since early August, allaying investors' fears.

But the global financial system is not out of danger yet. What could push it over the brink is if a major player -- a top-tier financial institution -- suffers a default. In 1998, Russia's debt default and ruble devaluation nearly triggered an international financial meltdown, dragging down Long-Term Capital Management, a blue chip U.S. hedge fund.

The situation is different now as far as Russia is concerned. It has emerged as a favorite among financial investors. Its eurobonds are now rated investment grade, or BBB+, by rating agencies. The ruble has strengthened against the euro and the dollar, and in real, or inflation-adjusted, terms it is now far stronger than it was before devaluation. But this time the currency is supported by a cache of Central Bank reserves that, at more than $400 billion, is the world's third largest after China's and Japan's.

Foreigners are not only active investors on the Moscow stock exchange but are buying ruble-denominated bonds as well. The issuance of ruble bonds, on which the government defaulted to the tune of $40 billion in 1998, totaled more than $30 billion over the past two years.

On paper at least, the Russian market might seem to be protected from global turmoil. It is a major producer of oil, gas and other commodities and should be able to weather the crisis well and even emerge as something of a safe haven.

In reality, it is the other way around. Russia may still be the Achilles' heel of the global economy -- even more than in 1998. If jitters in global financial markets endure for a few months and translate into slower global economic growth, it could implode again.

The oil boom under way since 1999 has been very good for Moscow. Crude prices have increased more than seven times while its oil production and exports expanded. Other commodity prices, including metals and timber, also increased. Petrodollars stimulated domestic demand and spurred the revival of moribund Soviet-era sectors as well as the creation of new industries, especially in consumer goods and distributive trades.

Still, Russia remains heavily reliant on oil and other commodity revenues. While the economy has been growing by more than 8 percent per year in recent periods, an index compiled by VTB-Europe, a London-based subsidiary of Russia's state-owned bank VTB, shows that non-oil growth in gross domestic product has been slowing for nine months and measures a less impressive 6.3 percent.

High oil prices, meanwhile, underpinned a borrowing spree by Russian companies in international capital markets. While the government has not issued any sovereign debt under President Vladimir Putin, corporate borrowers more than made up for the shortfall. At the end of 2006, the cumulative foreign debt of the corporate sector measured around $260 billion, which, depending on how you tally it, measures one-quarter to one-third of its nominal GDP.

Interest and principal payments next year will add up to $88 billion, larger than the country's projected trade surplus, especially as the import bill continues to rise along with domestic consumption.

In fact, global financial turmoil might prove a blessing for the economy. Analysts calculate that before the credit crunch, Russian companies planned to add another $125 billion to their foreign debt burden in 2008.

This debt could still be paid off in full from its hard currency reserves if push came to shove. But international financial markets have other kinds of exposure to Russia. Companies have been active in the London market for initial public offerings, gobbling up a lion's shares of available funds. Last year, they placed $20 billion worth of shares, and this year they are on track to raise an additional $30 billion.

VTB raised $8.2 billion in May by selling a 22.5 percent stake. Its shares are down 20 percent from their peaks, even though the government still stands behind it.

The banking sector is top-heavy yet fragmented. It is also weak and nontransparent. Sberbank holds a stunning 50 percent share of the national retail banking market. The sector also includes some 1,200 fly-by-night small fries. Over the past two years, lending has exploded. With overall lending growing by around 45 percent, consumer loans spiked 75 percent last year alone.

How this will play out in a serious credit crunch is anyone's guess. In early March, when global stock markets were unsettled by selling in China, the RTS index fell by an even larger margin than the Composite Index in Shanghai. Sharp declines have been seen in August as well, with the RTS losing more than 10 percent. Unlike other emerging stock markets, Moscow shows virtually no gain this year.

In 1998, Russia's default had far deeper repercussions in global financial markets than the country's economic weight would have suggested. While it followed on the heels of the 1997 Asian financial debacle, the U.S. economy at the time was booming and Wall Street was humming along. Now, the credit crunch is spreading from the over-leveraged U.S. economy, and Russia is now one of the world's 12 largest economies based on the size of its GDP.

The reason why Russia's default spooked world markets back then was wider political implications. Even though Moscow has been off the radar screen in Washington, financial markets understand that it remains very much a superpower -- at least as far as its nuclear arsenal is concerned. Economic turmoil in what is still an unsettled country could change the global political landscape radically.

Under Putin, Russia has been moving away from the free market and toward an increasingly rigid form of state capitalism. The government has renationalized strategically important resource industries and has built state-controlled quasi-monopolies in other sectors as well.

An economic crisis is likely to reinforce the trend toward state capitalism. As inflationary pressures in the economy picked up, driven largely by higher global prices for corn, State Duma Speaker Boris Gryzlov has talked darkly about prosecuting price gougers.

Even more troubling is the threat of social turmoil. The collapse of communism and the disintegration of the Soviet Union came off relatively peacefully and without bloodshed, and the 1998 default triggered no street protests. But that was in the 1990s, when the country's population was poor and traumatized by 75 years of brutal communist rule. Now, Russia has seen nearly a decade of prosperity but, unfortunately, this wealth has not trickled down in any meaningful way to the lower layers of the social pyramid -- or made its way much beyond the capital's city limits.

Even within Moscow, free-floating anger is difficult to contain; it is palpable in any sized crowd. The danger is that in an economic downturn, it could gel and find a ready outlet -- as it did in Indonesia, for instance, after the 1997 crisis.

Alexei Bayer, a native Muscovite, is a New York-based economist.