By Krishna Koundinya

Edited by Anjini Chandra, Senior Editor, The Indian Economist

India’s old friend finds itself right in the centre of yet another crisis. Alarm bells rung when the Central Bank of Russia raised interest rates from a manageable 6.5% to heights of 17% in just one day. This shows the gravity of the situation and the Central Bank’s acknowledgement of the same. This is a desperate attempt by the central bank, which is in a fire-fighting mode to save the Rouble. It fell by nearly 50% as compared to the US dollar in six months. The Central Bank had to give up on the unlimited foreign exchange market interventions it was carrying out, to support the Rouble. The Rouble is hitting an all time low, which is definitely causing nightmares in the Kremlin. It is also to be noted that the Interbank lending market in Russia has virtually ceased to operate, which is a symptom of a deeper malaise.

The Russian currency crisis stems from the fact that the central bank is losing its credibility and investors are pulling out from the Rouble market, which spirals downwards. The reasons that cause this are-

Western Sanctions

With the Russian annexation of Crimea (even though the referendum was denounced as invalid by UN), economic sanctions were imposed on Russia. The Central Bank first tried to counter the sanctions imposed by intervening in the For-Ex markets, Repo markets and increasing interest rates. This softened the blow to some extent but with the unexpected flight of capital from the Russian Economy and the crash of global oil prices, the Central Bank finally had to float the currency. This shows the real intrinsic market value of Rouble.

The US and EU have isolated Russian banks from their economies as a part of the sanctions levied. Banks which were already in debt had no choice but to approach the Central Bank for refinancing their debts, which further worsened the financial health.

Oil Prices

Russia is an oil dependent economy as 67% of all its exports are oil and gas which contributes to 50% of its budget revenues. When the first round of sanctions was discussed, the global oil prices were hovering around $110/barrel. That means that Russia was losing around $40 billion per year, due to sanctions. Russia was however, in a comfortable position and the EU had no leverage against it, as approximately 30% of all EU gas supply comes from Russia. Hence the Kremlin was managing perfectly.

Now, the oil prices are around $60/ barrel. Russia was counting on $100/barrel for the financial year of 2015, to balance their books. However, the tug of war between the oil sheikhs of OPEC and the shale oil tycoons of the US have turned the tables to Russia’s disadvantage.

Speculators

Speculators in the currency market have turned a bad situation worse. All the money is now being converted to “hard” currencies from the Rouble. As the currency is floating now, all it can see is the nether regions.

Russia’s Options

Support the Rouble

Russia has one of the largest For-Ex war chests, which is reportedly around $400-$450 billion. In 2014, the Central Bank spent around $80 billion, which is one-fifth, on supporting the Rouble. In case the Central Bank decides to support it once again, then its reserves, though vast, would finish.

At that point of time, the economy will be completely vulnerable. As of now, there is no serious threat of a default, but if it goes with this option, the threat may actually materialize.

Currency Control

Imposing currency control is also not a very good idea. Since it involves prohibiting the people from taking money outside Russia, it would not help reverse the bearish sentiment or improve the confidence of its investors. It will only be a matter of time before the country falls into stagflation. There is a good chance that it may exacerbate the current situation into a full-blown crisis.

Tighter Policy

Imposing spending cuts and increasing interest rates, which is already being done, will invariably lead to a slowing of the economy. It will adversely affect the day to day lives of its citizens, however, if able to properly navigate through the crisis, it will eventually ride out of the storm, intact. This third option seems to be the best of the worst available options.

Parallels drawn between the Soviet Collapse and the 1988 crisis

The collapse of the Soviet Union can be traced to the oil politics of 1985. Saudi Arabia’s oil minister Sheik Yamani altered the oil policy, stopping its program of protecting oil prices. To maintain its revenues, they substituted prices with volume. Oil production increased four fold in the next six months, which led to a crash in global oil prices.

The Soviet had designed policies based on the assumption that oil prices will remain high forever. In addition to this, they lacked the funds and could not raise it from banks. Mass food shortages weakened Moscow and it eventually led to a declaration of independence by the Eastern European states.

Similarly, OPEC did not agree for a cut in oil production, which led to surplus oil in global markets, leading to a fall in oil prices and history repeated itself.

In 1988, Russia fought an expensive war, with irrational spending on social services nearly bankrupting the state. Both the government and private firms were deeply in debt. The Central Bank had already spent $27 billion saving the Rouble, until it finally exhausted its reserves, which revealed the real market value of the Rouble. This was much lower than what it was pegged at. The 1988 crisis is a self-fulfilling one. Once the weak position of government was revealed, speculations, expectations of the eventual default by the government set in. Bulls turn to bears even though the situation did not warrant it. Nobody wanted to be the last person to sell the Rouble, and panic selling set in, which eventually resulted in a crisis.

The present day Russia is definitely different from Yeltsin’s Russia but the parallels are now too strong to be ignored. It is difficult to predict the exact outcome in the future, however we can be sure that all is not well in Putin’s Russia.

He is an entrepreneur, Co-Founder of an e-Commerce start up. He holds MBA from IMT–Ghaziabad, B Tech gold medallist, state level boxer, cricketer, amateur musician & graphologist (AP Judiciary). He worked with Deloitte, Infosys, Vizag Steel specializing in IT, Finance. He assisted CFO, GMs in financial valuations and planning. He co-founded a robotics platform for R&D and successfully implemented home automation projects, car tracking and vibration test rigs using smart phone, https://www.facebook.com/krishna.koundinya.7, krishnakoundinyam.1988@gmail.com

Posted by The Indian Economist | For the Curious Mind