Holding one’s breath for a 2016 recovery may be hazardous to health. Radical measures may be needed
This post first appeared on Russia Insider
Analysis of Russia’s short-to-medium term economic direction—both in the West and in Russia itself—almost invariably involves a narrow focus on the “headline” price of oil—as in, how will Russia do at $30/barrel vs. $50/barrel, what price will balance its budget, etc.
(This is partly because Russia’s economy is still rather opaque—Moscow’s econometric data is neither as diverse nor as frequently updated as the West’s—and partly because its business papers do not, for the most part, have the resources or expertise to do focused journalism, instead running mostly non-financial/economic content like any other outlet, or at best, press-release-based news on acquisitions, who is suing whom for unpaid electric bills, etc.)
As usual, reality is more nuanced.
First, we must understand that the oil price carried in the headlines is the cost of “front month” (i.e. nearest expiration) delivery of “Light Sweet Crude” (a.k.a. West Texas Intermediate-grade/WTI), Brent, or some other origin/type/blend of oil (depending on where you are in the world and what headlines you read), facilitated through a given futures market/clearinghouse such as the NYMEX (again depending on your location/focus.)
This is not necessarily what Russia or any other major producer receives for its oil at a given time. Only someone fully engaged in Russia’s energy sector would have any idea as to the structure of Russian oil exports, i.e. the average outstanding contract duration or the weighted average price of Russian oil delivered today.
(It is likely that a substantial proportion of Russian oil was never sold at the triple-digit headline prices of mid-2007 to mid-2008 or perhaps even the 2011-2014 rally.)
Given that as much as 90 percent of global oil is still sold through term contracts, large producers such as Russia have a built-in revenue buffer against a sharp, brief fall in the “headline” price. Likewise, Russia would not necessarily draw huge benefits from a short-term price spike.
For this reason, arguing that a rise or fall to price X will have near-term effect Y is a fool’s errand.
It also follows that the effect of the oil crash on Russia’s budget and economy must necessarily be felt with a lag.
Thus, despite hopes that Russia will rebound when the “headline” price notches back fifteen or twenty dollars, it may be that the lag time has only just concluded—i.e., that Russia was getting by on more lucrative, mid- or even late 2014 contracts for June or December 2015 delivery (or whatever off-market arrangements it might have had with its partners such as BP) that have now run their course.
If that is the case, then Russia has only recently entered the danger zone.
Another point: Even in 2013, the last full year of the 2011-2014 three-figure rally, crude oil accounted for only around one-third of Russian exports. What else is there to Russia’s economy besides oil—or gas, for that matter?
Russia is also a major producer, processor (as applicable), and exporter of all base metals, phosphates, coal, industrial diamonds, lumber, etc. All of these goods fall within the broader “commodities” complex, which has been crashing through the floor for over a year.
And if commodities as a whole are doing poorly worldwide, then (going by historical precedent) oil alone will not escape that trend. It may be $20, it may be $50, but it can hardly “break out” and regain its prior highs if the overall asset class is in the down phase of its cycle.
Conversely, if oil stays depressed, then, given the historical correlation within its asset class, most of Russia’s other resource exports (perhaps excluding gas, which seems to have its own dynamics) will stay down as well.
So the problem goes beyond the conventional wisdom that Russia will face a revenue shortfall even with “headline” oil at $45 to $50 per barrel. There are good reasons to believe that the entire commodities complex will struggle for years to come.
And all chatter about Saudi Arabia going into overdrive to put U.S. shale oil producers out of business misses the broader point of a global commodities rout. We are looking at a much broader, deeper phenomenon. Claiming that “Russia will be fine once the Saudis clean out the shale projects” is missing the forest for the trees.
Which brings us to another problem: Russia’s higher-value-added industries sell their wares chiefly to other commodities producers and/or to other developing states whose ability to finance the acquisition of Russian hydroelectric turbines, harvesters/combines, Sukhoi Superjets, nuclear power plants, etc. is severely constricted by the same global credit contraction (or even the mere fear of contraction) and carry-trade unwinds that are feeding into the commodities bust.
Of course, Russia may (and often does) compensate for the poverty of many of its customers with “dealer financing”, but its ability to do so depends on the availability of slush funds built up from years of—you guessed it—lush profits from oil and other resources.
In this manner, the commodities bust hurts the order books of many Russian manufacturers that have nothing to do with resource extraction or processing. Because even the benefits of cheaper (in dollars) Russian manufactures due to the weak ruble may not be enough to offset the sharp winding-down of capital investment/spending and the credit cycle in countries that normally would have bought or considered buying Russia’s value-added exports.
So, sharply reduced demand for commodities overall, and fewer export orders for manufactured goods, could potentially rip through Russia’s regions and devastate employment and income in a way that mere budget shortfalls from lower oil revenue (bad as they are) would not. In fact, that may very well be happening already (and we’re not even getting into what the ruble crash and high interest rates have done to the Russian consumer.)
This is not to say that Russia’s state budget is not in trouble.
There are just too many priorities now. The list of “special” items does not stop growing.
There is Moscow’s financing of the state salaries, pensions, gas/electricity, and armed forces of the Donetsk and Lugansk Peoples’ Republics, totally “off-budget” and very spooky (think Area 51), which likely comes out to hundreds of millions of dollars per month.
There is the fundamentally unwinnable Syrian intervention and arming/supplying of the Syrian army, also likely in the hundreds of millions of dollars per month.
There is the assimilation of Crimea, to include compensation for savers who lost everything when Ukrainian banks simply closed their doors (although that is over and done with at this point); the construction of the Kerch Bridge as well as a massive new power plant and other energy infrastructure for the peninsula; rehabilitation of its roads, military housing, and naval yards; as well as bringing its state salaries and pensions in line with Russian standards, all at a time when Crimea is probably not bringing in much tax revenue due to a high degree of political and business uncertainty as well as periodic electric embargoes from Ukraine. This is certainly in the hundreds of millions of dollars per month.
There is the (non-)construction of the ballyhooed Sila Sibiri (Power of Siberia) gas pipeline to China. Despite all the “eastward pivot" hype from the second quarter of 2014, this project has (besides some heroic photo ops) barely commenced, with the first major tenders not awarded until last September (and most of them cancelled two weeks ago, so nothing has been done), perhaps because Moscow was waiting on China to commit to paying for some of it. Which never happened.
There are grants and subsidies to import substitution projects under way since 2014 (RI cited one little example last August), and now Prime Minister Medvedev is talking about tax breaks for the (domestic) tourism industry.
There is the cost of housing/feeding and in some cases permanently resettling hundreds of thousands of war refugees from the Donbass and tens of thousands of benefits-eligible repatriants from other parts of Ukraine.
There are the three billion dollars wasted on trying to save Yanukovich, and two-plus billion wasted on Turkey's Akkuyu nuclear plant (which was being built at Russian expense, but now seems to be dead in the heavy water), not to mention billions yet to be spent on buying the partial allegiance of perennially-bankrupt Lukashenko in Belarus (along these lines) and other friendly but nearly-failed states like Kyrgyzstan (now in a deep depression.)
Moreover, Tajikistan—with its recent (failed) military coup and the Taliban now sitting on its border—will be lining up for the Moscow gravy train soon.
And then there is the pending, unavoidable bailout of the regions.
Like a body that experiences cold weather by freezing first in the extremities, some of Russia’s weaker regions—which is, in fact, most of them—are starting to run out of money to pay their employees (medical personnel, teachers, local bureaucrats, librarians, etc.)
Salaries are going into arrears or are being cut as much as 40 percent, and I’m talking in ruble terms, not adjusting for inflation.
(Crank up your Google Translator and see here, here, here, here, here, here, here, here, here, here, here [this one refers to non-salary expenses], and here [no more money for adopted child payments], for starters. Then witness this tragedy, whereby little Tuva Republic [population about 310,000] owes its workers an astounding 748 million rubles, and another sad tale whereby coal stokers at district heating stations supporting the Zabaikalskii Krai town of Domna, home to families of Syria-deployed pilots from Domna Air Base, are threatening to turn down the heat due to not being paid or having enough safety equipment. Also see here, here, and here for reports of salary arrears to federal Emergency Situations Ministry personnel in the regions—not a good sign at all.)
(And this at a time when 63 percent of Russian doctors and nurses are already making less than 20,000 rubles per month [or $267 at the current exchange rate.])
In short, regional tax revenues are evidently way down, and in the absence of U.S.-style “solutions” (e.g. state university tuition hikes offset by greater student loans) or reasonable private-sector credit, there is no way for most of Russia’s oblasts, krais, and republics to deal with insufficient funds other than by going into arrears on salaries, contract payments, and other budget lines, then praying that things pick up soon or that Moscow steps in with a bailout (the latter hope stated rather bluntly by the governor of Altai Krai a few weeks ago.)
This bailout will surely come, and it won’t be cheap.
In 2012, Russia’s regions were tasked with meeting substantially expanded social goals and priorities, and they resorted to debt to make that happen. Russia’s total regional debt—in the form of bank loans, bonds, guarantees of commercial debt, or loans from Moscow—grew from the 600-700 billion ruble range in 2008, to 1719 billion rubles as of January 1, 2014, to 2093 billion rubles as of June 1st, 2015. And the situation has most likely continued to deteriorate since then.
Because the ongoing revenue problems must be making things much worse.
Granted, this is not yet strongly felt in Moscow or St. Petersburg, nor is it an acceptable topic for the nightly news. But it is very much reminiscent of what happened in 2008-2009, and moreover, given that most of the pay arrears (per earlier links) arose only in the last few months (seemingly in line with the "lag time" I proposed earlier), the trend is accelerating.
So we are potentially talking about a bailout in the ruble equivalent of tens of billions of dollars over just a few years. In fact, the bailout already started last year with a 310 billion-ruble federal appropriation to pay off some regional commercial debt, to include hard currency debt, replacing it with near-zero interest obligations to Moscow.
So add that to the “special” budget items list.
And if something can't be funded with tax revenues, that means dipping into Russia’s Reserve Fund or National Welfare Fund, or raiding the Finance Ministry's general account at the expense of planned/regular outlays (or simply getting ahead of the budget plan as revenues falter), leading to outcomes such as those experienced by the unpaid Emergency Situations Ministry personnel. (This is probably the start of a trend, so watch closely.)
Ultimately, they may start shaking down state enterprises for loose change, as in Greece. But how long can that last?
After all, the state must hold something back, to support further regions that may break off from Ukraine, deal with natural or manmade disasters, or for other unforeseen needs. They can’t blow it all. And they certainly can't go spending the Central Bank's reserves on domestic needs—those are required to stabilize (relatively speaking) the ruble, and to loan hard currency to importers (if it comes to that.)
Also, little measures like doing away with cost-of-living-adjustments for those filthy rich “working pensioners”—when inflation is over ten percent—can’t even begin to plug the holes that have been created (not to mention that the measure just cited takes full effect only in 2017.)
Then there is the recent adjustment of the Finance Ministry’s privatization revenues target for 2016 from 33.2 billion rubles to one trillion rubles. (Yes, you read that right.) Wearers of rose-tinted glasses might be interested to know that only countries facing catastrophic problems suddenly decide to sell off everything not bolted down and double-riveted.
In play is not only the same roughly 20-percent stake in Rosneft that Moscow has talked of selling for over a year (you’d think they’d have found a buyer by now), but also pieces of Bashneft, Aeroflot, the state’s stake in diamond-miner Alrosa, and even the Russian postal service (you couldn’t make this up if you tried), among other concerns.
Of course, the time to privatize is when you can get a good price for your assets, oil companies included, not when investors are running away from all of the world’s oil companies. Or when both foreign investors and your own elites have been hauling money out of your country for almost two years.
Not to mention that the desperate Saudis are also now looking at selling off part of their Saudi Aramco. So where is all the cash to buy this privatized stuff to come from? At best, we are talking about a shell game within Russia, probably involving Sberbank or some other state-dominated institution(s), not something that actually brings new money into the economy or stimulates growth in any way.
Worse still, potential foreign financing avenues are now almost totally closed off.
It is inconceivable that Western investors would now buy Russian state bonds at anything remotely approaching an acceptable (to Moscow) yield. The last thing Russia's Finance Ministry would want is to find out what happens if it even tried to hold an auction with foreign participation.
As for “private clients” potentially doing off-market deals, last year's Great White Pivot Hope, China, burned through more than a half-trillion dollars of reserves last year ($108 billion in December alone) trying to control the value of its currency as well as prop up its stock market. And we know how that's going. So as well-loaded as it still is, if the Dragon has not yet offered Russia any charity, then it probably won’t, going forward.
Likewise, the Persian Gulf monarchies have their own problems (news of which has been reposted on this site more than a few times—see this, for example.) They are also on the other side of the Syria war from Moscow. Ever heard any follow-up on that Saudi plan to invest ten billion dollars in Russia? Didn't think so. People don't hand money to their own enemies.
So Russia must rely on its own resources, which involves burning through its seed corn and then, if things haven’t picked up…
Well, that could be a problem.
One of the laws of the universe as we know it today is that while the U.S., Europe, and Japan can issue all the digital funny-money they want, with the market reaction always being “Yes! Give us more!”, a country like Russia doing the same thing would experience hyperinflation and massive capital flight.
But is there any way for Russia to bend this law?
One of President Putin’s key economic advisers, the outspoken economist, former politician and presidential candidate, and U.S. sanctions blacklist victim Sergei Glaziev, thinks so, and he has been talking to anyone who would listen—even obscure Internet TV/YouTube channels, which a man of his stature normally wouldn’t bother with.
By now, the outlines of Glaziev’s plan are well-known within Russia.
In the interests of building an authentic national "monetary-credit system", Glaziev basically calls for new money creation—20 trillion rubles over five years—to support low-interest loan-refinancing by the state, as well as “targeted”, “goal-oriented” state loans in support of import substitution projects and other capital improvements, which would both stimulate economic activity and leave Russia much stronger in the long term.
Firms taking these loans would commit to delivering to the state or its agents X volume of goods, material, or services over Y period, or provide some other demonstrable results, or else pay the state for the unmet balance.
(Despite the general rule that companies don't do capital improvements when market demand is down—i.e. when there seems to be no hope of recouping those investments—, in Russia's case, the import substitution drive as well as the antiquated state of equipment in key sectors such as agribusiness supports Glaziev’s claim that many firms are gasping for loans for productive use.)
Glaziev portrays the alternative to his plan as, at best, a long period of credit starvation and economic drift. Yet the fact that he is going so far as to sell it on the Internet suggests that his real views on Russia’s economy are even darker.
Indeed, some of Glaziev’s pronouncements and his demeanor have very much an "August 1941" feel. (Presenting to Russia’s Security Council last year, he claimed that his plan is essential to preserving the country’s existence.)
To prevent capital flight while his plan is being executed, Glaziev calls for a host of complex restrictions on Russia’s capital account, i.e. to fight speculators and the panic-stricken.
However, the fines, rules, and restrictions he has proposed—including requiring all hard currency export earnings to be sold (for rubles) to the state—amount to neither a full nor an effective closure of the capital account.
Rather, in my view, they would further corrupt the state and economy with a massive administrative burdern and unmanageable complexity, leaving the door open to Venezuela-style gaming of the system by importers, banks, airline companies, etc., which would lead to a fast bleeding of state reserves and drive the country into a black hole.
If Russia is to go the capital controls route, then, with very few exceptions, no digital/bank money—in any amount—can leave Russia except for repayments of preexisting debt, payments for real goods imports (not services that can be faked—foreigners can be paid for these domestically), and repatriation of profits by foreign concerns or their previously-established, wholly- or majority-owned local affiliates.
To limit corruption or favoritism, every transation would need to be referenced (by machines to the extent possible) against a single list of valid entities and be approved from one office within the Central Bank.
As for money going into Russia—leave it alone!
Interestingly, to my knowledge, Glaziev has not spoken of a fixed/official exchange rate (which worked so “well” in Venezuela, for example.) He seems to be willing to let the ruble find its own level.
Note, it is rare for a country to institute capital controls without an enforced exchange rate. The beauty of this is that Russia would not waste resources defending the indefensible, which fixed rates tend to be—it would merely ensure that enough money stays within Russian borders for productive uses.
But again, this would only work with a near-total lockdown of the capital account.
And as no one knows what the ruble’s “own level” would be once such measures are enacted, the whole thing is predicated on Russia having enough reserves going into it. (After all, today's Russia can’t function without certain imports, which must be paid for in hard currency.)
So this can’t wait forever. If serious capital controls are to be implemented, then the sooner that happens, the more effective it will be. And it is clear that pissing away $100 billion of reserves for nothing—as Russia’s Central Bank did in 2014, trying to defend the ruble which crashed anyway—does not set the stage for a successful move in this direction.
The other issue concerns hyperinflation. We know from history that huge monetary emissions outside of the modern-day U.S./Europe/Japan almost always lead to very high price inflation if not outright financial or even political collapse (think Weimar Germany, Yugoslavia, the USSR in its last year, or Zimbabwe.)
Glaziev claims that his “targeted” approach would not have this result. But—other than lectures on cash vs. debt-money, which miss the point that even debt-money can and often does inflate prices (just look at the U.S. housing bubble)—he is strangely vague on how or why it won’t, i.e. why Russia will succeed where others have failed.
Filling in the huge blanks, we might suggest a partial replay of the Soviet monetary reforms of 1930-1932, which created a multi-tiered money system, with a notional currency for state enterprises to trade between each other, a paper note-oriented currency to pay urban workers, and another notional one to compensate collective farm workers (beyond the subsistence produce allowances they were already receiving.)
By allowing for enormous monetary emissions that did not lead to unmanageable inflation, it is likely that these reforms contributed substantially to the Soviet economic boom of the 1930s, which then enabled the country to fight Germany on near-equal terms.
In other words, simply playing with the nature of money enabled the USSR to grow almost exclusively on its own resources, with almost no foreign direct investment or foreign loans (even if foreign technical expertise remained critical.)
Yes, it sounds like science fiction, but it happened.
(Incidentally, Nazi Germany pulled itself out of the Great Depression also using a tiered money system, although that involved just two tiers.)
Yet even this would lead to catastrophe without some way to limit the flow of newly-emitted money (e.g. Glaziev's 20 trillion rubles) into the consumer economy, where it could inflate prices beyond anything seen in modern Russia to date.
Today, with Russia’s more market-oriented economy and total freedom of labor and movement (and no more state farms), this could involve just two tiers of money.
The existing ruble would remain in place with no changes.
The state would loan out (at low interest) “industrial” money to firms wishing to quantitatively expand or qualitatively improve their production, transportation, or other processes, establishing and maintaining its value by accepting it as payment for corporate taxes economy-wide, even from firms not themselves taking the loans.
The state could give a discount (say, 10 percent) to federal and regional tax payments in “industrial” rubles, thereby raising their value against standard rubles, making them more desirable for companies to acquire.
As companies maintain their “industrial” rubles on account with private banks, those banks could loan them to other companies on a fractional reserve basis, or keep them on account with the Central Bank, further establishing them in the economy. The state could also redenominate into industrial rubles some of the debt owed to it by the regions.
Firms would continue to pay employees in standard rubles, while using “industrial” rubles to order materials or services from each other, or posting them as collateral for hard currency loans, or whatever other uses can be found, besides paying taxes.
Once “industrial” rubles have been well-established, the state could use them pay for contract work (i.e. infrastructure and housing improvements) directly, rather than just loaning them out.
The effect of diminished standard ruble revenues would be offset as the state collects “industrial” rubles through taxes or loan repayments, retires them, and replaces them with standard rubles to pay its salaries, pensions, etc.
To keep price inflation in some kind of check, this retirement could take place on something other than a one-for-one basis, say, a three-for-two basis or some flexible ratio, responding to price levels in the economy.
“Industrial” and standard rubles would not be directly/officially convertible by anyone other than the state, as that could be destructively inflationary. Nor would private individuals be allowed to maintain “industrial” ruble accounts. In fact, to prevent small companies from becoming de facto money-changers, firms with less than X annual revenues could be prohibited from holding “industrial” ruble accounts.
Gresham’s law should not be an issue, as the newly-emitted form of money would be more valuable due to the tax discount, even as people have no choice but to value and pursue standard rubles for their own daily needs.
Another method for preventing loss of faith in Russia’s currency—under this plan or independently of it—would be to bring in the gold factor.
As discussed here, tying a modern currency directly to gold is a great way to lose all your gold very quickly. But Russia could issue a series of ruble bonds, tradeable on the Moscow market (with open participation), with a maturation of five or ten years, and with the face value paid either in rubles, or in a (fixed) quantity of Central Bank gold equal in value to the discounted ruble value of the bond at the time of issue—as per the bondholder’s preference.
Given Russia's not-insubstantial gold reserves and how much it still has in the ground, these bonds could come into demand internationally as a long-term instrument to hedge a fall in the gold price. The fact that they are ruble bonds only tradeable within Russia would hold up demand for the currency and support its value. Tying the gold option on the bonds to the discounted value would also ensure a lower yield.
Of course, the Central Bank would have to figure out how to deliver upon redemption (perhaps under Swiss supervision, to avoid any Kolchak trains.) But that’s just details.
Yet even supporting the ruble is not enough. As of today, Russian farmers and industrialists engaged in import-substitution projects (and the bankers that increasingly turn them down for loans) just don’t know if those projects will be justified by the exchange rate one or five years from now.
Thus, Russia’s Central Bank and/or its Finance Ministry could, without delimiting a “bottom” range, declare that while the ruble will not collapse in an uncontrolled fashion, neither will it be allowed to rise above X to the dollar within the next Y years.
This would provide some peace-of-mind to those now engaged (or desiring to be engaged) in growing Russia’s real economy and providing reasonably-priced, Russian-made goods to the nation's consumers, builders, etc.
But of course, this is all highly speculative and esoteric.
How much of it is likely to be effected before total catastrophe arrives (if ever)?
It is always easier for politicians to nail-shut and brick-up the barn door after the horses have made it to the next valley (while shouting, “No one could have foreseen this!”), than to upset all the vested interests, cronies, rent-collectors, etc., by taking the proverbial “ounce of prevention.”
As for Glaziev, if he really thinks that Russia can substantially expand its money supply without a sterilization mechanism, even with capital controls, and not dig itself ten kilometers underground, I’d have to admit he is a quack. Which I hope he isn’t.
But at least his heart is in the right place.
At this time, as in 1930-1932, original if not revolutionary solutions are needed, or else (if we are in a true, epochal commodities bust) Russia will likely sink into many years of extreme economic pain, increasing sociopolitical disorder and the repression that comes with it, and a crashing birth rate together with a rising death rate.
In other words, more or less the 1990s all over again, except this time with a hostile relationship with the West.
Sadly, one thing we can count on is that President Putin and Prime Minister Medvedev, being politicians, will not choose to take any potentially dangerous or radical action for as long as they feel (rightly or wrongly) that there is any choice left.
If or when that happens, hopefully it will not be too late.
(PS: Many readers must have some deep thoughts and ideas on this subject. If you think what you've just read has too many holes, the comments section would really like to hear your own detailed/unique solution, or at least a way to make Glaziev’s plan work.)
This post first appeared on Russia Insider
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