Some Thoughts on the Financial Crisis

What with all the noise about the ongoing credit crunch, all around financial apocalypse and burgeoning signs that it is beginning to spill over into Main Street like a torrent of water from a collapsing dam, I thought it’s about time we take a look at this “sucker” (to use Bush’s blunt term) and it’s likely effect on Russia.

The MSM highlights the problems of Russian banks in attaining credit, which has lead to a drastic slowdown in construction, much harder access to credit and the near collapse of Russia’s major stock market, the RTS. Moscow house prices fell by around 25% from their peak, to my personal consternation.

Nonetheless, despite the torrent of sad tidings, I remain bullish on the Russian economy. Its strong fundamentals and relatively low level of integration into the world financial system mean that it will weather the storm much better than either the insolvent financial systems of the Anglo-Saxon sphere or the many catastrophically over-leveraged, deficit-wracked economies of East-Central Europe.

Other people have different opinions. La Russophobe has embarked on a bizarre series of posts purporting to show the ‘horror of life in Vladimir Putin’s Russia’ as supposedly reflected in the RTSI over the past month (but obviously not the past decade). Actually, the linkages between the real economy and financial markets are very complex and vary between countries. In the Anglo-Saxon ‘shareholder’ model, equity financing plays a key role in financing companies so stock markets are vital in assessing the overall state of the economy. In Russia, most economic sectors are weakly tied to the RTS, much of whose capitalization can even be described as ‘prestige’ listings. Even though the RTS has fallen twice as fast as the Dow Jones or FTSE, its collapse is far less damaging to the Russian economy than the latter are to the American and British economies.

(The same can be said for China, and to a lesser extend ‘stakeholder’ economies like Germany or Japan. For instance, the Shanghai SSE‘s implosion did not affect China’s GDP growth in the slightest. The contraction of the Nikkei by three-quarters from its 1990 peak resulted, or rather reflected, not a depression but merely a decade of slow absolute GDP growth).

Although the astronomical rise in the RTS from 1999 to 2006 has been correlated to Russia’s economic boom, it would never have reached such stratospheric heights without cheap global credit coupled with institutional investors chasing the best returns. The recent evaporation of credit has demoralized those investors, who have fled from risk towards ostensible safe-havens, e.g. US treasure bills.

Russia is not only an emerging market, but most of the value of the RTS is composed of energy companies. Since commodity prices have lurched sharply downwards due to weakening Western consumption and lower appetite for (risky) commodity speculation, Russia’s RTS has been hit with a ‘double wammy’, which explains why it has fallen so far down, out of all proportion to its fundamentals or most other emerging markets. Its armed intervention against Georgia’s invasion of South Ossetia had little to no effect – as the Nikitsky Fund’s most recent issue of their newsletter Truth & Beauty (and Russian Finance), Hope, shows in the article Anatomy of a Crisis, the RTSI has been going down at a linear rate from April 2008, with few discernable disruptions during or soon after that war.

In short, the collapse of the RTS does not herald Russian financial apocalypse, contrary to what La Russophobe thinks (but obvious to anyone whose views on the economy and finances aren’t exclusively shaped by the quack intellectual Illarianov and others of his ilk). It seems that the ignorance of Kim Ziegfeld and her fawning sycophants is exceeded only by their sheer hatred of Russia and its people (e.g. see Frank’s comments here – is that shit allowed on Blogger??).

Now I have only a layman’s knowledge of finance, so one would expect Craig Pirrong, a “Streetwise” Professor of Finance at the University of Houston (a respectable institution, AFAIK) with a special interest in Russia, to knock me down hard with amazing arguments and financial gobledegook well in advance of any objection I could muster. Alas and alack, I suspect his populist Russophobia got the better of him, based on his articles Under Pressure and Check Out Michel’s Comments.

Still, they’re useful in that they’ve provided me with a kind of focus to put down my own take on Russia’s financial straits. So what I’ll do is selectively quote from the two articles (selectively not in the bad smearing way, but in the summarizing, getting all the salient points down way) and provide rebuttals.

[Unsupported waffle about violence specialists in warring clans]

Everyone’s attention is turning to the stability fund. In virtually all of the commentary written since the beginning of the meltdown in August, the phrase “the $570 billion dollar stability fund” has been repeated like a mantra, an incantation that will ward off a return to 1998. As commentor Michel points out, however, the government has already committed a substantial fraction of this sum in various market and bank support schemes, none of which have stemmed the bleeding.
…
The market apparently has its doubts too. Credit default swaps (EEEEEEEK! CDSs! Run for the hills!) on Russian government debt rose 52 basis points to 352 bp, as compared to 36 bp in May ‘07. If the stability fund makes Russia immune from default, why the bulge in CDS prices? (Part of that is due to an increase in the market price of risk in these unsettled times, but certainly part reflects a perceived increase in the probability and severity of a default.)

I think Michel has put his finger on the matter. He conjectures that “[m]any have been lusting after those billions for years, and the crisis was the perfect cover to launder piles of money from the reserves to the offshore accounts of friends of the regime.”

In brief, although the existence of the fund makes survival of the current system in Russia more likely than it would be in its absence, it is not a talisman. If the crisis–in the US, in Europe, and in Russia too–shows anything, it shows that $570 billion can evaporate in a trice. That is especially true in a country like Russia, where the formal institutional safeguards are so weak. In a highly personalized natural state, rife with corruption, where the state is essentially the cash cow for aggressive and amoral individuals who are comfortable with the use of violence, when the deluge begins, no property is safe. So, to those who repeat “the $570 billion dollar stabilization fund” to lull themselves to sleep, I say–there are monsters under the bed. And it is at times like these that they come out and play.

OK so the main argument is that CDS prices on Russian sovereign debt has soared therefore things are bad. CDS are basically bets on the country or company or whatever defaulting on their debts. It’s his first (and I think strongest argument).

On the other hand CDS have soared throughout the world. Some casual Googling has revealed that oil-rich Kazakhstan, which also doesn’t lack for petrodollars, has a spread of more than 1000 points; Ukraine is at 1700. Many other countries in east-central Europe, the Baltics and the Balkans rate in the hundreds. Iceland is at 567, so…

What!? Granted the article is from September 29th, but Iceland in the same league as Russia (a large net creditor) and below Ukraine!? Iceland, whose liabilities even then had soared well past its puny GDP, since it had taken over Glitnir, and with its other main two banks about to hurtle into the abyss!? I can only conclude that CDS are driven mostly by market sentiment and don’t provide a realistic appraisal of the risk of default relative to other countries…

Now to quote the commentator Michel…

Today, the Russian media has answered my question as to how long it will take before the funds run dry.

According to gazeta.ru: 110 business days.

“Золотовалютные резервы России сокращаются, в борьбе с кризисом, и если в таком объеме тратить их дальше, то резервов, по оценке экспертов, хватит на 110 торговых дней.” (source: http://gazeta.ru/financial/2008/10/09/2852776.shtml).

Vedomosti put it a bit more poetically as their entitled their article “Reserves Melting Right Under Our Eyes.”

They give the reserves half-a-year at the present rate of spending: “Проблемы могут начаться, если продолжать такую политику полгода-год: в ситуации снижения темпов экономического роста накачка ликвидностью может вызвать необходимость девальвации.”

Taking foreign currency reserves have lessened by 16bn$ in a week and thus arriving at the idea that they will diminish to nothing within a few months is just meaningless linear extrapolation. It’s like saying that since the US total public debt grew 573bn $ in the last month from October 9th, it would reach 17tn $ (from 10.3tn $ today) by the same period next year.

But that’s not even the main point. What I’d like to ask is why did Michel not bother pointing out that of that week’s 16bn $ fall, some 10bn $ of that was directly linked to the strengthening dollar – which was mentioned on the very same article he linked to?

Finally, the entire point of having foreign reserves is to use them to avoid crashes in times of international financial crisis. I mean, that’s what they’re for, right? A continuation of smooth growth in a period of severe Western recession would be well worth the entirety of those reserves.

Michel then links us to another article, curiously enough entitled Russia: Better placed than most to weather the crisis. Curiously, because he uses it as the basis to continue his criticism.

One final comment. In reading the Financial Times, one article notes that “Alexei Kudrin, the finance minister, said on September 16 that the federal budget would begin to run a deficit if oil fell below $70 a barrel.” However, on September 19th, the Russian government announced that it would be increasing military spending by 25%. If you put these two facts together, you realize that if the price of oil drop anywhere near $70 a barrel, the Russian government will be running a deficit. The price of oil is already in the mid 80 dollar range and the global recession has just begun. This means that the Russian state may already begin running deficit budgets by next year, just as its reserve funds start to dry up.

All well and good, except that: a) average prices for the year, which is what matters, are well higher than 70$ (remember the recent 147$ spike and all that?), b) military spending has risen at those rates for years, in line with growth in its nominal GDP, and in fact most of that 25% rise is just a restatement of already existing spending plans that have been played up by the Western media rather than anything new and c) this ignores Russia’s and OPEC’s mutual interest in keeping the oil price high, at around 90-100$ (Saudi Arabia also needs those kinds of prices to balance their budget), and their recent moves towards closer co-operation to achieve that goal.

Now unless China suffers a serious shock to its economic ascent, reduced American oil usage will be more than compensated. Otherwise, the oil price will be squeezed up, wedged as it is between the Scylla of stagnant or falling extraction and the Charybdis of soaring demand from industrializing Asia (sorry, I’ve really fallen in love with that phrase. When that happens I sometimes just start incorporating them into my writing for a few weeks, whether the situation calls for it or not). Sorry to rain on your gas-fueled party, Michel.

You are right, they are probably there already. And, the 6-months predicted as to when the reserves disappearing is based simply on what the Central Bank has been dishing out to stabilize the ruble (i.e. keep it within the 25-26 ruble to the dollar range). The 200 billion or so in new spending will have to come out of the budget, which will push it deeper into the red.

This is wrong on two counts. Firstly, the budget for 2008 is projected to be firmly in the black (+4.5% of GDP). Secondly, and more importantly, the money for propping up the domestic financial sector is not even coming from the budget. It comes from repatriating Russian reserves parked abroad in G7 sovereign debt securities. Since the problem with the credit markets in Russia is overwhelmingly one of illiquidity (rather than insolvency, as in the Anglo-Saxon economies) it’s unlikely that a large portion of these reserves will actually be lost.

And now it’s time for the Professor to take the reins again…

The country teeters on the economic brink–the world does, but Russia is arguably closer to the brink than just about anybody else–and if the deluge comes, a disappointed people that had put its faith in Putin and Putinism will turn on him (and it) in a fury.

This statement is beyond my powers to comprehend. Iceland is worse off. So are many over-leveraged (mostly central-east European) states with huge current account deficits – Latvia, Estonia, Ukraine, Turkey, Argentina, Bulgaria, Hungary, Romania, etc. So is, in all likelihood, the US and Britain, who’s financial systems increasingly appear to be generally insolvent. Do you still live on Earth, Professor?

The $5 billion loan to Iceland, another extravagance apparently driven by geopolitical calculation, is another bizarre choice under the circumstances.

5bn $ in relation to 500bn $ is nothing. And it’s still far from decided. Although, I think paying 5bn $ for Keflavik without an Operation Red Storm Rising and neutralizing the SOSUS line (not that I think Russia will achieve so much, but still…) is far more cost-effective than spending 700bn $ on, erm – how exactly did the US benefit from Iraq??

Anyway, I’m done with the Professor. Though I’d like to thank him, Michel and La Russophobe for summarizing the Russia “doomer” arguments and making it easier for me to marshal my own take on it into what I hope has been at least a semi-coherent form.

My predictions? The RTS will continue its decline, but at a slower pace for the rest of the year. Then investors will realize that everything there is insanely undervalued, like in 1999, and it will explode back into four-digit territory next year. This will roughly coincide with a rally in oil prices from December 2008.

The construction sector will decline next year, although general consumption should not be affected as much since little of that depended on credit, even as late as 2008 (that’s the advantage of having weak linkages to the global financial system). Investment will fall for one or two quarters, but will stage a resurgence after that once confidence is regained. Russia will grow at around 7.0% this year and 5.5%-6.5% in 2009, while much of the G7 goes into a severe recession.

But before we go, what of the global financial crisis itself?

Notice that all these countries which depend on oil revenues to balance their budgets, from fiscal conservatives like Russia to populist spendthrifts like Venezuela and Iran to countries that live almost exclusively from oil exports like Saudi Arabia all need at least 70$ to balance their budgets.

Now consider that since oil is a relatively competitive industry on the global level and collusion generally fails even within OPEC, prices will tend towards marginal cost by standard microeconomic theory. The unpalatable implication is that the marginal cost of oil extraction has risen dramatically in the past few years, and is today well in excess of 50$ per barrel (a few Google searches confirm this deduction).

(Hence Kudrin’s, IMO misguided, push to lower windfall taxes on Russian oil company profits – I’d rather continue taxation, invest the proceeds in building up a more sustainable energy infrastructure and reap the benefits of higher oil prices for an oil-exporting country. Taxes can be lowered to boost production in the future when oil prices become much higher relative to today).

Supply has become limited and it now takes ever more capital and energy inputs to produce another barrel, thus costs rise exponentially and an ever share of the industrial base must be devoted to energy extraction to prevent decline. Meanwhile, gradually plateauing net energy extraction makes the prospect of continuous traditional economic growth far into the future an increasingly unrealistic proposition, and recognized as such. The result? Collapse of a financial system build on the assumptions of continuous growth.

Perhaps this crisis is simply an unconscious recognition of this inconvenient truth?

In any case I suspect it is merely the first of many that will percolate through the global economy as oil supplies reach their peak, ushering in an era of oscillation between grinding deflationary recessions and tepid, inflationary recoveries. The time has come when long-term planning becomes ever more difficult. I suppose you could model it as the tipping point when political capital no longer renews itself sustainably. Lol.

Gross output, starting with oil-importers who use energy with the most inefficiency, will decline. Demand destruction will presumably start with its most inefficient users, e.g. away from SUV drivers, air conditioners, etc. Energy flows will increasingly accrue either to those who would make the most efficient use of it (perhaps in proportion to their level of human capital and the energy-efficiency of physical capital in their industrial base, which would favor countries like Germany, Japan, Korea and China, but hurt the likes of the US, Britain, the Mediterranean and Mexico), or to those who can lock them in (either via sovereignty over energy sources, e.g. Russia, Saudi Arabia, Iran, etc, or through military conquest, e.g. possibly the US in Iraq).

However, overall world GDP will continue to grow until at least the point when energy production is at its maximum (and provided that it isn’t first overwhelmed by a pollution crisis). If by then a sufficiently large sustainable energy infrastructure is not yet in place, terminal decline and collapse will follow.

As I mentioned in my article on Russia and Limits to Growth, the fate of humanity will be determined by which of these exponential trends – resource and pollution limits to growth versus sustainability and universal informatization – will win out. Perhaps I should do a thesis on this or something?