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Analysis & Opinion
26.09.08 Immunizing Russia From U.S. Economic Contagion
Introduced by Vladimir Frolov

“They have set us all up!” angered President Dmitry Medvedev, summing up the Russian leadership’s attitude toward Washington’s disastrous economic policies that led to the buildup of dangerous market bubbles – from housing prices to credit swaps and other under-collateralized securities.

With the subprime debacle, now destroying venerable American financial institutions like Bear Sterns, Lehman Brothers and Merrill Lynch, the U.S. government resorted to socialist policies, nationalizing banks and even insurance companies. “We do not know what else may blow up in the U.S. financial system, and we are afraid to even sneeze in the American direction,” said a Russian investment banker.

With speculative foreign money making up almost 70 percent of liquidity in the Russian stock market and with foreign hedge funds engaging in a fire sale of Russian assets to cover their gigantic losses on U.S. subprime mortgages and credit swaps, the value of Russian stocks plunged by almost 40 percent in one week, leading to a crisis of confidence among Russian financial institutions. All of a sudden, Russia was facing a financial meltdown not of its own making, threatening to wipe out the impressive economic gains of the last ten years.

Medvedev and Vladimir Putin reacted in ways that signaled a fundamental shift. The government now seeks to reduce the role of foreign portfolio investors in Russia’s financial markets, and to restructure the entire system in favor of Russian long-term institutional investors that the government has already created, including the National Wealth Fund.

The decision to invest up to $20 billion of government money into Russian stocks is a breakthrough that ends years of financial orthodoxy, while making a lot of business sense with some of the best Russian companies now valued at laughable price to earnings ratios. This is not government spending, but a very lucrative investment, as some market analysts are projecting the RTS index at 7000 to 8000 points a few years from now.

The government is also encouraging long-term private investment by Russian citizens, by making earnings from stocks and mutual funds held for over a year tax free. It is extremely important to create tax-deductible private pension plans to modernize Russia’s pension system.

All of this is done to make the Russian economy more reliant on long-term Russian money, making growth sustainable and insulated from the U.S. contagion. The idea is to hasten the decoupling of the Russian economy from the U.S.-centered financial crisis.

Will Moscow succeed? Will Russia manage to steer clear of the U.S.-led financial meltdown? How is the Russian government handling the crisis? Is investing government money into the Russian stock market a good idea? Will the crisis reshape the international economic system in favor of Russia?

Vlad Ivanenko, Ph.D., expert on Russian economy, Ottawa, Canada :

The current situation of global financial instability has no precedent and the debate about its real causes and expected consequences cannot be presented in a short summary. That is why I will only answer questions raised by the moderator.

The measures taken by the Russian government to calm the markets are likely to stabilize the situation. But although the Russian stock market capitalization is significant (the RTS data on September 22 values the market at $780 billion), its turnover is not. Since August 8, the accumulated volume of stock sales has been about $1 billion, exposing the falling propensity to trade. It is reasonable to suggest that most foreign investors who reacted to recent news have already left the market. Unlike the moderator, I do not think that the government should intervene as a buyer on the market – because its targeted intervention creates a conflict of interests – but agree that its offer to stand by in time of trouble assuages private and institutional investors’ fears.

The Russian government faces a more difficult situation with the banking sector. The Central Bank (CBR) has reported net money outflows at circa $40 billion since August 8, but the gross amount should be higher by the volume of net export revenue (about $20 billion per month). In total, the gross outflow of capital has been approximately $70 billion, and this amount comes from Russian banks’ reduced exposure to foreign debts (estimated at $90 billion on July 1). The situation with liquidity is likely to deteriorate as companies continue to pay their matured debts and these sums are moved abroad. However, the combined reserves of the CBR and the Ministry of Finance are sufficient to maintain stability in domestic banking and non-financial sectors.

Regarding Russian prospects in the new global environment, I concentrate on the opportunities that it creates, and leave open the question of whether the country will be able to capitalize on them. There are three areas to consider.
Firstly, as the U.S. dollar becomes less stable as a unit of price measurement, international traders start searching for alternatives. This search is, for example, visible in crude oil markets, where countries-exporters express a growing desire to set prices in currencies other than the dollar. Up to now, there has been little progress in this area but, obviously, the idea has potential that Russia may wish to explore.

Secondly, increased uncertainty of the U.S. financial sector makes the dollar less appealing as a reserve currency. The combined actions of the U.S. Treasury Department and the Federal Reserve have temporarily restored foreign investors’ confidence, but the situation is still highly fluid. The holders of U.S. debt abroad need to become convinced that the dollar continues retaining its current value, or they will move out of U.S. currency. In the latter scenario, demand for alternative currencies, including the Russian ruble, will grow.

Finally, if Russia continues to maintain a higher than the global average rate of economic growth, this country becomes more interesting to long-term investors. As the stock of wealth there accumulates, the market for its assets matures with a corresponding increase in demand for financial services associated with this market.

In total, the current turmoil in the global financial system presents Russia with more opportunities than risks in the long run. However, I am uncertain that Moscow will be able to exploit the favorable situation. In my opinion, president Medvedev has adequate tactical plans, but they might not be sufficient for success if not complemented with a strong political will and the desire to dare.

Ethan S. Burger, Adjunct Professor, Georgetown University Law Center, & Scholar-in-Residence, School of International Service, American University, Washington DC:

I wish that the Russian government's recent steps to stabilize the country's economy (or at least insulate it to some extent from the global financial crisis) succeed. Unfortunately, I doubt this will occur in isolation from the economic recovery of other states, the United States and the EU member states in particular. I hope whatever steps are taken in Russia and elsewhere take into account all the citizens of the world, and not just those with the greatest net worth or strongest political connections -- though I am not optimistic that this will indeed be the case.

Russia is primarily an exporter of raw materials (oil, gas, metals, etc). If the demand for its commodities from existing markets decreases, Russian producers must find new markets. I doubt that in the current environment export-oriented countries like China can fill the gap, or Africa, East Asia, India, the Middle East, and South America (after all who will purchase their goods?) can generate sufficient new demand for Russian exports (much less find the necessary financing). This suggests that Russian economic goals cannot be achieved without the economic recovery of its principal trade partners.

The subjects of prices, value and wealth creation are not thoroughly understood. Beliefs in economic systems share a common feature with most religious ones -- the importance of faith over science. Just because the study of economics applies quantitative methods to the analysis of markets, economics is not physics or chemistry. It depends on irrational human behavior that is largely the product of expectations; people have different experiences which shape their behavior. Actors in the market have different capabilities, preferences, and information. Thus, government policymaking in this area inevitably involves a high level of guesswork.

Russian economic actors have recently dealt with major financial hardships in the 1990s. For most Americans who play an active role in the economy, the Great Depression is a subject of academic study. Whether first-hand experience with economically troubled times is a benefit or a hindrance is not clear.

Consequently, policymakers may adopt seemingly logical emergency steps to address difficult problems, but there is no guarantee of success. Since 1945, with some minor setbacks, the U.S. and most of the Western economies enjoyed unprecedented growth. With a few dissenters, such as Milton Friedman, there was a general Keynesian consensus about macro-economics and confidence in the world's international economic institutions (e.g. the IMF, the World Bank, etc). The past is not always an accurate predictor of the future. Even persons regarded as very intelligent can be wrong -- particularly since it is not possible to predict the interplay of new forces, such as technological changes, allowing for the rapid transfer of information (and funds) and the creation of new financial instruments (derivatives) on international economic relations.

I believe that mass consumerism combined with greed largely produced the current crisis. Few seemed bothered by deficit spending or consumers buying homes and goods that they could not afford. Skepticism was widely ignored. How could people be confident that their salaries would be sufficient to pay off their growing debt in light of global labor competition? How could increases in consumption outpace increases in productivity?

If shareholders are making money, they tend not to ask questions about the conduct of corporate officers and directors. Starting in the 1990s, corporate officers and their senior managers were under extreme pressure to show that their corporations were making profits (which not only led the price of their companies' stock to increase, but also drove up their compensation).

Simultaneously, financial institutions and other large corporations worked hard to minimize oversight of their activity. To achieve these goals, they were able to hire the best lobbyists and the most "creative" accounting and law firms. Those individuals and organizations that wanted a better regulated market lacked the resources to achieve their political aims and most taxpayers (especially the wealthiest) wanted to pay as little taxes as possible, thus limiting the governments' ability to perform effective oversight of economic activity. This inevitably led to more risky behavior by business entities and a higher level of economic crime. Now, governmental officials, financial analysts, businessmen, investors and consumers are entering unchartered territory.

Professor Stephen Blank, the U.S. Army War College, Carlyle Barracks, PA:

It may well be the case that Russia will not be alone in moving toward even more economic nationalism by insulating itself from the global economy, but that is not an optimal response to this crisis. While American policy has much to answer for, the roots of Russia's problems are at least as much domestic as they are foreign.
It has clearly become popular for Medvedev and Putin to blame America for setting Russia up (as if we planned a global crisis) as a way of averting responsibility for insider deals, massive corruption, suboptimal investment programs that do not build infrastructure, attacks on property rights, economic autarchy that drives out foreign companies, reckless domestic lending and debt policies by corporations, and excessive government spending during inflation.

Under such conditions economic nationalism seems politically and economically the answer, but what Moscow is doing is merely extending state control over the economy, even as it creates the needed pension funds and domestic investment markets. Where are the Duma members who, like the Congress, question government policy and demand accountability in state investment policies? Instead, we see the usual governmental intrigues, in this case between Putin and Medvedev's entourages over a host of domestic issues and the position of Finance Minister Alexey Kudrin.
The steps taken over the weekend may quell the crisis for now (or may not, that remains to be seen), but the fact is that this system is inherently a crisis-plagued and threatened system, due to its political and economic inferiority and suboptimal economic outcomes. Moscow may have shut the door for now, but the wolf is still there and will remain for a very long time. When the crisis comes (and we have yet to see the full impact of inflation), it will be severe.
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