Why Russia Is Collapsing

Speaking at the World Economic Forum in Davos, Switzerland a few weeks ago, Russian Prime Minister Vladimir Putin declared he would break from the recent pastime of blaming America for the world's economic struggles.

"Virtually every speech on this subject [has] started with criticism of the United States. But I will do nothing of the kind. … I just want to remind you that, just a year ago, American delegates speaking from this rostrum emphasized the U.S. economy's fundamental stability and its cloudless prospects. Today, investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months, they have posted losses exceeding the profits they made in the last 25 years."

With friends like that, who needs enemies? (And to show Mr. Putin how seriously we take his gesture of goodwill, this column will contain no criticism of Russia and certainly no cheap shots at caviar, vodka, bearded men, or fuzzy hats.)

Pot, meet kettle
Of course, despite the best (read: most incompetent) efforts by American firms such as Bank of America (NYSE: BAC  ) and GM (NYSE: GM  ) to post enormous losses and implode our economic system, Russia has been hammered even worse than the U.S. over the past year.

Yet it was not always this way.

Only seven months ago, economic activity in Mother Russia was going swimmingly. The country was riding a wave of cash provided by loose credit and oil prices of more than $140 a barrel, growth and development abounded, and bearded gentlemen in fuzzy hats bathed in vodka and caviar throughout Moscow (perhaps that last part is a bit of a stretch).

Anyhow, things were undeniably good. Then things kind of went … south.

Defining "south"
Buoyed by its seemingly bottomless coffers, Russia adopted a rather confrontational global stance, culminating with its war with Georgia on the eve of the Olympics. Investors, already re-evaluating their risk tolerance in the face of tightening credit markets, became even more skittish when Russian tanks started rolling.

The sell-off of the Russian stock market, which had begun in mid-May, picked up steam. Between Aug. 8 (the start of the Georgian war) and Oct. 24 (a temporary market bottom), Russia's stock market dropped 68% -- including a couple of days in which stocks dropped by double-digit percentages, forcing regulators to stop trading.

In response, the government unveiled a bailout package pledging $86 billion to support banks and corporations and another $6.7 billion to be invested directly into the stock market to prop up equity prices.

Thank you very much
And while our own bank executives were pulled in front of Congress this week to explain the reasons for their astronomical bonuses and failures to increase lending despite taxpayer-funded recapitalizations, Russia may have an even bigger problem on its hands. That's because Russia's bankers took a rather different tack when it came to putting their bailout funds to work.

See, rather than use the liquidity the Russian government pumped into the banks to make loans to restart the economy, Russia's banks used it to make big bets against the ruble.

Let's think that through. The government was boosting the capital levels of the banks so that they could help support the economy through lending. Instead, they kept the funds out of the economy and instead bet against it by speculating on the weakening of the domestic currency, thereby dooming the economy to collapse. Those Russians are cold.

A ruble for your thoughts
Of course, by sabotaging any chance at an economic stimulus, that bet against the ruble turned out to be a pretty good one. With foreign investors pulling money out of the country and domestic companies using what cash they had to pay down piles of foreign-denominated debt, the ruble began to tumble. Normally, exporters (Russia is a net exporting country) like a weak currency because it makes their goods cheaper to foreign buyers. Just ask Japanese exporters like Sony (NYSE: SNE  ) and Panasonic (NYSE: PC  ) what they think about the recent strengthening of the yen.

However, the rapid decline in the global economy meant that even at lower prices, there wasn't demand for Russian exports. Worse, the falling ruble made the massive amounts of foreign-denominated debt still held by Russian companies more burdensome.

To end the freefall, Russia has been forced to dip further into its vast foreign reserves. Since the end of July, Russia's foreign currency reserves have dropped 25%, or $116 billion, as the central bank has tried (and failed) to stop the ruble's slide. Since July, the ruble has lost 33% of its value against the dollar, with a dramatic 17% decline in the past month.

Round 2
Although they made profitable bets on the ruble, the Russian banks also had significant foreign-denominated debt that ate up their proceeds. Now that the few Russian companies to which they had lent are being crushed by a combination of dried-up export markets and heaps of debt, the banks face significant loan write-offs and have returned to Moscow for an additional $14 billion in support.

This failed bailout is just adding to the problems caused by falling oil prices. The 2009 budget was originally written under the assumption of oil prices around $95. With prices hovering around $40, Russia is looking at a $181 billion budget shortfall. While the government can draw from its $220 billion sovereign wealth funds to meet its needs, Putin called for a rewritten budget with more realistic assumptions. This will likely mean Russia will have to follow the example of companies like Schlumberger (NYSE: SLB  ) and ConocoPhillips (NYSE: COP  ) , cutting expenses and postponing expansion projects.

The moral of the story
This economic downturn has repeatedly revealed the flaws of once-invincible companies and countries. As discussed a few weeks ago, some countries are better placed to make it through the storm. The same goes for companies.

Our Motley Fool Global Gains team searches the globe to bring you companies with strong growth prospects supported by strong balance sheets that allow them to survive uncertain times. If you'd like to see what we've uncovered, click here to join Global Gains free for 30 days.

And that, dear Fools, was this week in the emerging markets. It's getting crazy out there.

Nate Weisshaar is a senior analyst for Motley Fool Global Gains. If you'd like to learn more about investing abroad, click here to join Global Gains free for 30 days. There is no obligation to subscribe. Nate does not own shares of any of the companies mentioned above. Bank of America is a former Motley Fool Income Investor pick. The Fool's disclosure policy wears fat laces with pride.


Read/Post Comments (8) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 12, 2009, at 8:04 PM, MedPeddler wrote:

    At least Putin called for a budget re-write. We'd never see that here.

  • Report this Comment On February 12, 2009, at 10:04 PM, MaxSharpe wrote:

    Controlled, smooth devaluation is not the same as betting against one's own currency. While I agree that articles that explain things in plain English are useful, issues such as the outflow of foreign money from Russian capital markets, the lack of FDI, or the rewriting of the Russian federal budget are not subjects which lend themselves to this type of writing.

    The article seems biased, as if the author has a grudge against Russia. The opening comment didn't have the effect that the author intended -- Mr. Putin didn't criticize the American system or blame it for anything, he simply stated fact (and without referring to Big Macs, supersizing, and reality shows -- which have caught on in Russia). But if it makes him feel good to country-bash, so be it. It's hard to find an easier victim at this point that Russia.

  • Report this Comment On February 13, 2009, at 1:15 AM, esefes wrote:

    Russian bankers selling the ruble short ???? How vile can you get. Its good to know that not not a single U.S. Bank Executive sold their bank short before the collapse, or likewise created a Credit Default Derivative. Not in this country.

    Them Russians citizens sure are stooges, eh.

  • Report this Comment On February 13, 2009, at 9:48 AM, bkaalon wrote:

    Well, dear Fools, this time Russia will not sit around and watch....they'll launch nukes at us....it's inevitable unless this whole global meltdown comes to a halt and or we all become GOOD and help eachother etc. Which, seems is highly unlikely!

  • Report this Comment On February 13, 2009, at 10:02 AM, catoismymotor wrote:

    If Russia would redesign their oil drums to look like those little Russian dolls that nest inside each other then I would pay 30% above the market price just for the novelty of having one. If the doll shaped barrels are painted with beards I would pay an extra 40%. I would pay an extra 50% for a barrel made to look like an ICBM so I could give it to bkaalon. If the ICBM was painted with a beard I would pay 75%!

  • Report this Comment On February 13, 2009, at 10:32 AM, TMFTheSnake wrote:

    Max-

    The jury is still out on the wisom of Russia's central bank's approach to the ruble, but I think describing the ruble's slide as controlled and smooth is being generous (and my use of the word generous is being generous).

    Also, I have no grudge against Russia. Never met the man. I did not blame the Russian system for anything, just relayed a series of facts. You'll notice I never even mentioned the recent stealth re-nationalization of major industries or the blatant disregard for property rights Putin has displayed over the years.

    And just to be clear, if I wanted to country bash, Latvia would have been a far easier target. They don't have the wonderful $220 billion dollar safety cushion that Russia wisely built up while commodity prices were sky-high. Hmm, neither does the US for that matter.

  • Report this Comment On February 14, 2009, at 9:28 AM, eekthecat wrote:

    I spent a semester in Moscow in 2005, and I don't recall noticing a lot of beards. I wasn't even aware of this stereotype until I read this article.

  • Report this Comment On April 04, 2009, at 3:23 PM, Fooloprunes wrote:

    I'm still laughing! Great piece. (Ras)Putin may be intelligent, but he seems to have as much class and common sense as a turnip.

    What do the Russian people expect if they allow a KGB peon to run the place? I suppose they get what they deserve.

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