As one of the world's largest producers of raw materials, Russia is hit harder by the financial crisis than most other newly industrialized countries. The massive collapse in oil prices since July 2008 has triggered a negative chain reaction which it may only be possible to stop with drastic economic measures. But even after the crisis, the largest country on earth in terms of area will have to face pressing issues. Investor confidence in the resurgent regional power has noticeably fallen over the last few years. Russia is facing huge economic and social challenges, and it will only be able to build on the boom years of the past if the considerable structural weaknesses in its economy are overcome.
Financial crisis is hitting Russia particularly hard
Russia's attempts to stem the "resource curse" have so far been rather fruitless. Adjusted for price, the long-term growth in per capita income is significantly lower than that of China, leaving it around one third lower today. The capital inflow of the past therefore has not led to comparable increases in productivity as it has in many newly industrialized countries of Asia or Latin America. Consequently, as the oil price collapsed, so did Russia's economy, financial and real estate markets, and the huge rises in income of the last few years came to an abrupt halt. The economic engine has run out of fuel in the form of large revenues from oil and gas exports and foreign investments. Revenues from the past have not been sufficiently invested in new sources of income - alternative industries, in other words - but have been largely consumed or used for highly speculative investments.
The boom was marked by ballooning currency reserves in the Russian central bank, rapid growth in the money supply, double-digit inflation rates and utopian rises in stock and real estate prices. The downturn is going hand in hand with shrinking reserves to prop up the Russian ruble, rapid outflows of foreign capital and huge losses on capital and real estate investments.
The sick man Russian ruble
Russian monetary policy prevents an appropriate monetary policy response to the crisis. Confidence in their own currency has historically been very low in all the states of the former Soviet Union. Even in the market economy, the 1998 Russian financial crisis again wiped out many savings. So it is hardly surprising that it is not only Russian society that is interested in a fixed exchange rate with the euro and the US dollar. But a system of fixed exchange rates greatly constrains the room for maneuver in monetary policy. In boom years, you are tied to the interest rate of the anchor currency, in order not to attract even more capital that will be used for increasingly speculative investments. In a downturn, interest rates cannot be cut sufficiently as this usually prevents capital outflows and parity must be defended.
A comparison with Norway highlights the problem. When oil prices were high, Norway was able to raise interest rates to respond to the overheating economy. Stock prices increased by more than 100% between January 2005 and July 2008. As the oil price fell, Norway's central bank reduced interest rates, and losses on the domestic stock market were limited to around 50% by the end of 2008. Russia, on the other hand, had to reduce interest rates during boom times. Accordingly, the Moscow stock index rose by more than 200%. Against the background of rising key short-term interest rates to prop up the Russian ruble, when the downturn came the index lost a remarkable 65%. The Russian stock market is now one of the biggest losers overall in the financial crisis.
Despite all this, the Russian central bank devalued the Russian ruble by 25% in the second half of 2008 and had to spend 127 billion US dollars to prop it up. Russian savers have become much more nervous as a direct consequence of this. If there should be a further massive flight out of the Russian ruble, the only options remaining to the Russian government would probably be a more aggressive devaluation and controls on capital movements, at least for the domestic population. If it does not want to jeopardize Russia's creditworthiness in the international financial markets, the central bank will at some point be forced to halt sales of more currency reserves for a controlled devaluation of the Russian ruble.
If, contrary to expectations, oil prices should rapidly recover to levels over 70 US dollars per barrel, the pressure on the Russian economy and the ruble would ease. But even then, Russia's fundamental problems still remain to be solved.
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