FYI | Feb 12 2009
By Greg Peel
When the Berlin Wall fell the world cheered, but no one expected it to be easy for eighty years of communist regime to segue smoothly into democratic capitalism overnight. It was no help either that a foolish Boris Yeltsin was in charge. Nor that the former Soviet Union fractured into constituent states, arbitrarily dividing resources, industry and military installations. Russia’s first big post-communist industry was the global illegal arms trade, as former Soviet generals in Russia, Georgia, Ukraine and elsewhere found themselves with the keys to the arsenal and no one around to claim them. Any other form of industry could not adapt swiftly, and in 1998 Russia defaulted on its sovereign debt.
That brought the end of Yeltsin, but also an opportunity to try and start again from scratch. The last decade of world growth has seen Russia move towards a more westernized capitalist economy, but once again a unique post-communist structure provided smart first-movers with unbelievable opportunity for exploitation. This brought to prominence both the Russian Mafia and the so-called “oligarchs” – those who were quick to snap up once state-owned major industry as their own and become obscenely rich in the process. High on the list of must-haves for your standard Russian oligarch were supercars, superyachts and English Premier League football teams.
The decade also saw the rise of former KGB agent and pin-up boy Vladimir Putin who, despite exuding western democratic charm when on show, appears to have a keen sense of longing for the days before 1989 when a man could truly call himself a dictator. Putin’s dealings with ethnic separatists, with neighbouring FSU states who unfortunately scored vital gas pipelines in the division, with former cold war enemies, and with laws that suggest a President has but only a limited term in office all lead one to question whether Putin, as token prime minister, may not have a longer term agenda of returning Russia to its former superpower glory at the expense of any democratic or capitalist evolution achieved to date.
If ever there were a chance to achieve such an agenda, the global financial crisis may have provided it.
The oligarchs are gone. Dead in the water. Mere mortals once again. No longer do they yield economic power to rival that of the state. But this is only reflective of a more general malaise in the Russian economy. The global demand for oil has collapsed in the wake of economic recession. As Morgan Stanley puts it, the Russian economy is “all about oil”.
Russia had done extremely well out of the rising price of oil and gas up until mid 2008, allowing the central bank to build up significant foreign currency reserves. Even as we speak, legacy contracts are still delivering sizeable receipts but those are now fading as prices adjust to market. With the global energy market in disarray, the ruble is under extreme pressure. Morgan Stanley believes there are sufficient currency reserves left to defend the ruble and maintain the desired exchange rate band against a US dollar/euro basket through most of 2009, but a turnaround in oil demand would then be needed to sustain such an exchange rate any longer. Morgan Stanley has become, however, even more bearish on the price of oil over the next two years.
One answer is to allow a controlled devaluation of the ruble to a new band. A growing belief that this cannot be avoided is currently disrupting the real economy in Russia. While such a move proved a success in 1998, Morgan Stanley doubts the same benefits would follow this time.
While rising energy prices have supported Russia’s strong growth of recent times, they have not been the only contributor. Russian observer Peter Ziehan of Stratfor (in correspondence with Dennis Gartman of The Gartman Letter) suggests “Russia is not a producer of capital – never has been”. Indeed, the prime driver of Russian growth in the last decade has been the practice of Russian banks taking out US dollar- and euro-denominated loans from European banks and then making ruble-denominated loans locally.
This makes the Russian economy one big exchange rate risk.
That risk has made substantial profits for Russian banks in the good times, but the times aren’t good anymore. The ruble is down 40% from its peak, and Ziehan believes the aforementioned devaluation is imminent. Not only do Russian banks have to pay their creditors more and more rubles, local Russian borrowers are struggling to make ruble payments to the banks. The banks are caught on both sides.
Ziehan suggests it would make sense in post-communist Russia for the Russian banks to sit down with their European lenders and sort out some sort of loan restructure, featuring lesser payments over a longer maturity. Neither side wishes the Russian banks to default. However, Ziehan further suggests the market is wrong to expect this to happen.
He believes that the Kremlin’s plan is to allow the banks to fail so that it may seize control of the sector. The Kremlin could use remaining foreign reserves to buy out European bank loans, such that the Russian banks would now be indebted only to the Kremlin, or it could nationalize the failed banks and take over the foreign debt. Whatever the strategy, Ziehan believes:
“Two facts should be kept in mind. First, the Kremlin’s primary concern will not be economics or profitability, but control of the sector and the severing of the foreign exposure. Second, insomuch as economics or profitability colour the Kremlin’s thinking, it will value Russian economics over Western economics.”
This does not bode well for those European banks with exposure to Russia. It will likely be the Russian government determining who might get paid back and when.
Morgan Stanley has not specifically entertained such an outcome in its latest Russian economic update. The economists have, however, suggested that a public uprising of the like seen recently in other FSU countries is not likely in Russia. Putin is popular, and much-improved living standards achieved under capitalism still have a ways to drop before the natives become restless.
There is unlikely to be another Bolshevik revolution of the masses. But there might be one from the government.
