At Large

Holding the Bag in Moscow

Thanks to the crude policies of Messrs. Putin and Medvedev, Russia is in deep financial trouble.

By 9.22.08

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While American investors were focused this past week on the precipitous drop in the Dow and Nasdaq, the financial situation in Russia has been at least equally as bad. But the reasons are quite different.

In May the Russian stock markets reached a high point. Flush with the massive oil and gas price increases, Moscow's trade statistics heralded an expectation of Russia rising to a new leadership role in Eurasian finance. Oligarchs of every form and size were being spewed out of the Putin/Medevdev-led economic machine like so many rabbits. Tough guy Putin strutted around like a barnyard rooster.

Then in August Russia decided to sucker the trigger-happy Georgians into launching a military intervention in South Ossetia and the waiting Russian Army rushed in. An easy victory followed for the heavily armed and well-prepared Russians. But an already nervous collection of Western and Russian investors was petrified with the image of Moscow's apparent return to military-driven politics.

In truth, the European financial community began to suffer anxiety a couple of months earlier over Russia's growing financial muscularity when the British Petroleum 50% share in the giant TNK/BP oil venture came under public attack from official Russian sources. In July the British CEO of the joint venture, Robert Dudley, picked up and left Russia, making clear he would no longer stand for the lack of official support.

This was the first real sign that all was not well. Things became worse when Putin, himself, personally attacked the head of the Russian steel producer, Mechel, for what press reports called "price gouging." The company stock listed on the NYSE fell like a stone and the slide of the other Russian issues in Moscow picked up speed. Word of price controls being instituted for fertilizer and cement hit the commodities markets and added to a generalized unrest. And this was all before the war in Georgia.

The swift departure of the foreign investors pulled needed liquidity from the scene. Over $20 billion fled the country in the few weeks after the Georgia adventure just as oil futures simultaneously began plummeting. Over-leveraged Russian investors were forced to sell huge amounts of shares at lowered prices to pay off margin calls, and the blame game began.

The first thing Prime Minister Putin did was to deny the Georgian affair had anything to do with the sharp decline in publicly traded shares. It was all a matter, he said, of a reflection of the global credit crunch due to the American sub-prime interest rate debacle. It is highly doubtful, however, that Vladimir Putin learned much about sub-prime interest mortgages at KGB ops school, but it was a good try.

The business lawyer-turned-President of Russia, Dmitri Medvedev, was able to speak a bit more authoritatively on the matter. He indicated his belief that the drop in Russian share prices (one half the stock market valuation since May) was due 75% to "the international financial crisis" and 25% "from our domestic problems including the consequences of the war in the Caucasus." It was a neat way of getting his old, and perhaps still, boss off the hook, but his intellectual heart was clearly not in it.

The good news for Russia is that it has an estimated $200 billion in so-called sovereign wealth funds to draw on. The bad news is that $143 billion is the fund that was set up to insure against any sharp oil price drop. Although it is estimated that the Russian budget does not go into deficit until oil reaches about $70 per barrel, the surplus at $90 per barrel is judged inadequate to offset the money that the government must inject into the ravaged credit market.

Putin announced after they had closed the stock markets for two days last week that he definitely would not authorize a reinforcement of the stock market with the $200 billion accumulated from the oil income windfall of the past year. His own Finance Minister, Alexei Kudrin, earlier had said that such a recourse was available. In his typical truculent manner, unaided by financial sensibility, P.M. Putin ended the week by announcing there would be a 25 per cent increase in the military budget!

Like the United States, Russia's corporate and private pension funds representing 40 million workers are invested in the markets. It really doesn't matter what Putin's economic/financial philosophy may be. The financial markets have to be protected because that's where the banks' credit strength lies and the post-Soviet pension system is rooted. Putin must use the $200 billion rainy day money or borrow from abroad.

The bottom line is that the August 7 Russian invasion of Georgia precipitated a flight of Western capital. These investments already had become shaky with the negative experience of BP in a project encouraged by the Russian government as an example of European financial cooperation in Russian oil/gas development.

Moscow is now caught up in the global instability and finding itself as vulnerable as the rest of the world is to the United States' ability to institute its own controls and reinforce banking liquidity. It's easy for Putin to blame Russia's financial misfortune on the American mortgage crisis that has affected the entire world, but it's just not true.

Medvedev's 25%-75% equation was clever but not accurate. Russia is in trouble financially because it counted far more on foreign investment than it would admit. Western money has fled and Medvedev/Putin are left holding the financial market bag -- a rather diminished bag at that.

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About the Author
George H. Wittman writes a weekly column on international affairs for The American Spectator online. He was the founding chairman of the National Institute for Public Policy.