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There is only one cure for what plagues Russia
From the Financial Times of Wed, 17 Dec 2014 06:14:53 GMT
epa04514118 Russian President Vladimir Putin addresses the Federal Assembly in the Kremlin in Moscow, Russia, 04 December 2014. Meanwhile, as many as 16 people are feared dead after Islamist militants clashed with security forces in a gunbattle in Chechnya on 04 December, government officials said. EPA/SERGEI ILNITSKY©EPA

Belatedly, financial markets have realised that July 16 was Russia’s Lehman moment. On that day, the US imposed sectoral sanctions on Russia because of its military aggression in eastern Ukraine. Two weeks later the EU introduced similar sanctions. However, it was only in December that the markets recognised 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 Lehman Brothers investment bank on September 15, 2008, Russia suffers from a liquidity freeze. It will not end until the 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 $202bn against a total foreign indebtedness of $600bn at the end of 2014, after a net capital outflow of $125bn this year. In each of 2015 and 2016, Russia has net external debt payments equal to $100bn 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 $416bn, but not all of it is liquid. Gold reserves represent $45bn. The official reserves include the two sovereign wealth funds, the National Wealth Fund ($82bn) and the Reserve Fund ($89bn), which are held by the finance ministry and spoken for.

Until December 10, the oil price and the rouble exchange rate moved in tandem, as they traditionally do. Since mid-June, the oil price had fallen by 45 per cent and the rouble by 39 per cent in relation to the US dollar. In the past four trading days, the rouble has plummeted far more than the oil price, by 25 per cent versus 6 per cent. 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 destabilised. On December 12, the CBR raised its key policy rate by 100 basis point to 10.5 per cent, but the rout of the rouble continued. In the night of December 15, the CBR tried to play catch-up BY hiking its interest rate to 17 per cent, but the rouble’s collapse accelerated. Sergey Aleksashenko, former deputy chairman of the CBR, has called, in the Russian media, for a drastic rate increase to 100 per cent. 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 emphasised that as long as the rouble falls with the oil price, the rouble 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 rouble, 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 4.5-4.7 per cent in 2015 if oil prices remain at $60 per barrel.

Since the root cause is the 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 globalised world than many thought possible.

The writer is a senior fellow at the Peterson Institute for International Economics

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