Two years ago I wrote a piece entitled “A history of Russian crises”. Time to update it.

“Russia has crises regularly. They happen for a variety of reasons: poor regulations, the lack of institutional checks and balances, rank corruption, heavy debt, no money in reserve, shallow capital markets, weak banking sectors and external shocks. And they cause havoc when they happen,” the article opened.

Now we can add “invasion of other countries” to that list of causes. The attack on Ukraine on February 24 has caused the biggest crisis since the August 17, 1998 meltdown of the Russian financial sector. However, this crisis will do less damage than that one.

The ruble has lost a third of its value in just the last few days and the market capitalisation of the Russian stock market has been halved, with the RTS index falling from its peak of 1,900 in October just before the military posturing around Ukraine started to 935 now. In 1998 the ruble lost 75% of its value and the RTS index fell from circa 600 at its peak in October 1997 to a mere 38 a year later.

 

The Russian economy is much stronger today than then. Its gross international reserves (GIR) are an order of magnitude bigger. Russia is running a triple surplus of trade, current account and federal budget. Its bank sector has been cleaned up and is profitable and well capitalised. Unemployment is at post-Soviet lows and inflation, and while higher than comfortable, it is still in single digits (for now). Russia is in a much better state to weather this storm than at the end of the 1990s, when that crisis wiped out the entire top tier of the Russian banking system and plunged the country back into economic chaos. No wonder the Russians hate the 1990s so much.

However, the real pain on the Russian economy this time is the nature of the sanctions that have just been imposed. While the macroeconomic, banking sector and stock market indicators are not as bad as in 1998, the big difference is these sanctions are designed to permanently hobble Russia’s economic development.

Thanks to the fiscal fortress that Russian President Vladimir Putin has built in an attempt to sanction-proof the economy (the success of which is now in question after the EU unexpectedly imposed sanctions on the Central Bank of Russia’s gross international reserves (GIR) on February 27), Russia has been running an austerity budget that has kept its growth potential to only 2% when it should be more than double this amount.

Russia was condemned to underperform the global economic growth before the sanctions, but now it will fall even further behind as its growth potential has been even further reduced. Putin has doomed Russia to slowly end up as at best “a raw materials appendage to China,” for as long as this sanctions regime remains.

1998 crash and recovery

The 1998 crash was a disaster, especially for the normal people that once again saw their life savings evaporate overnight. But it also reset the economy and laid the groundwork for a rapid recovery.

Putin took over in 2000 and pushed through a radical set of reforms such as rewriting the labour code, setting realistic flat income tax rates that are still in place today (with a few tweaks such as those to VAT) and he began to raise public wages by 10% a year over the next decade.

Most importantly, what academics Barry Ickes and Clifford Gaddy had dubbed “the virtual economy” was destroyed – a system where business was done almost entirely on barter. The collapse in the value of the ruble forced a re-monetarisation of the economy that allowed the bank sector to work again, and tax revenues began to pour into the federal coffers.

As ruble-denominated labour wages were slashed by three quarters, oil companies that earned dollars on the international markets became cash cows overnight and primed the pump. The oil companies invested more in just 1999 than they had collectively over the previous decade. And their business only got better after the oil prices began their inexorable climb to a peak of $150 per barrel over the next five years.

Having cleared out the oligarch banks – the so-called “Financial Industrial Groups” – the banks that were left were mostly more commercially minded and flourished as they rushed to tap the international capital markets where they could “borrow long and cheap overseas, but lend short and expensive at home.” Banks like Russky Standart, a POS retail specialist that pioneered the unsecured lending business, boomed.

None of these conditions exist this time round, with the exception of more profitable oil companies. The collapse of the ruble this week will lead to high inflation. The CBR imposed an emergency 20% rate hike on February 28 that will take years to unwind and will stifle growth. The SWIFT sanctions and the US ban on US investors buying any new Russian Ministry of Finance ruble-denominated OFZ treasury bills will cut Russia off from the international capital markets.

Instead of booming during a bounce-back, Russia’s economy under this sanctions regime is doomed to sub-par growth for years to come. Putin’s fiscal fortress is probably strong enough to prevent a crisis in the short term, but the sanctions will stymie Russia’s long-term growth prospects and could condemn the country to a Latin America in the 1970s-style stagnation over the long term.

Five big crises

There have been five really big crises before this one: in 1991 when the Soviet Union collapsed; in 1998 when the ruble collapsed and Russia defaulted on its debt; in 2008 when the collapse of the US housing market caused a global financial crisis; in 2014 following Russia’s annexation of the Crimea; and most recently in 2020 with a double whammy of the collapse in oil prices and the start of the global coronavirus (COVID-19) pandemic.

However, after three decades each successive crisis did less damage than the previous one. Russia remains an emerging market and so while it still has not brought its economy up to the level of the more developed nations, in the last 30 years it has made constant progress, making it better able to weather the storms each time they happen.

• 1991 crash

In 1991 the entire economy collapsed. The centrally planned five-year plans were shown up for the fakes they were and with the borders thrown open to imports no one wanted to buy the shoddy consumer goods the state-owned dinosaurs were putting out. Almost everything went bust. The value of the ruble effectively fell to zero and the country had no GIR to speak of. The economy went into a decade-long recession and at its worst inflation soared to 1,400%.

• 1998 crash

In 1998 also caused an economic collapse, but the damage was limited to destroying the entire top tier of the banking sector. The ruble suffered another deep devaluation but this time by “only” 75%. Unemployment had been falling as new companies came into being, but it soared again, rising from 5.1% in 1991 to its all-time post-Soviet peak of 13.3% in 1998. Inflation also jumped but rose to “only” 84% that autumn.

• 2008 crash

The economy collapsed again in September 2008 as a result of the Global Financial Crisis. This time it was not Russia’s fault. The US financial regulator’s failure to head off the subprime mortgage disaster saw the entire US housing market collapse, which sent shock waves around the world. The economy had been booming for most of the noughties with GDP growth running at between 6% and 8%. Wages had been growing at 10% a year for most of that decade and in 2007 inflation fell into single digits for the first time since the collapse of the USSR, leading Putin to announce a $1 trillion infrastructure investment programme. But as the economy went into meltdown – growth went from 7% growth to a 7% contraction in a matter of months – this time the authorities were better prepared.

Only one bank went bust, and that was rescued by lunchtime the same day. The ruble devalued again, but this time by only 30%. Unemployment jumped but the Kremlin pumped $200bn into the economy and managed to keep most people in their jobs. With oil still at over $100 the economy recovered relatively quickly in 2009, but the boom was over. Russian capital that had flooded into the economy – oligarchs returning their capital flight money to Russia as it looked like such a great investment – turned tail and fled. 2006 and 2007 were the only years in the last thirty that saw net inflows of capital as Russian businessmen for the first time believed in the future of their country. Following the crash the entire $130bn that had come in left the country again.   

• 2014 crash

Already weakened by the onset of stagnation that set in in 2013 when economic growth fell to zero despite $100 oil, November 2014 brought yet another collapse in oil prices as the Kingdom of Saudi Arabia tried to kill the burgeoning US shale oil business by flooding the market with crude.

The ruble crashed again, dropping by more than half as the exchange rate blew out from around RUB35 to the dollar to touch on RUB80, before falling back to around RUB65-RUB70 to the dollar where it has remained until recently. The larger fall in the ruble’s value in this crisis was due to the fact that as part of the CBR’s response to the 2008 crisis the central bank had freed the ruble and ended its trading corridor, thus allowing the currency to absorb most of the oil price collapse shock.

Inflation spiked but only rose to 10%, although food prices increased by half. With years of experience under its belt the Kremlin support package meant that no one lost their jobs and unemployment rose very modestly from 5.2% in 2014 to 5.6% the next year.

Like in 1998, the 2014 crisis had some beneficial effects: mainly it goaded the government into making some of the long-missing deep structural reforms Russia has so long needed. In particular, the Ministry of Finance was totally revamped and the now Prime Minister Mikhail Mishustin, who ran the tax service then, replaced the IT system and vigorously shut down long-running tax scams. The tax take increased by 20%, although the tax burden only went up by 2pp in the same period in an extraordinarily successful reform.  

• 2020 crash

The 2020 crash was dramatic but relatively short-lived and the bounce-back was extremely fast: while the double whammy of an oil price shock in March following Russia’s decision to pull out of the OPEC+ deal quickly followed by the start of the coronavirus (COVID-19) pandemic hit the economy hard, it did relatively little damage. As soon as the vaccines started to appear at the end of the same year the economy quickly rallied.

The Russian economy started 2020 in spectacularly good shape. Inflation was a mere 2.4% and fell to a post-Soviet low of 2.3% in February. Unemployment was also at an all-time low of 4.7% in January 2020. The ruble/dollar exchange rate was a strong RUB63 the same month, a big improvement from the RUB75.5 it started 2019 with, and looked like it would strengthen further.

The tragedy of the current crisis is if Putin had not moved against Ukraine Russia should have been enjoying a boom this year – a resumption of the boom that was already clearly underway at the start of 2020 before the multiple shocks hit the economy.  

Growth was gathering pace throughout 2019 as the economy finally emerged from a four-year long recession caused by the 2014 crisis, and both banks and companies started earning healthy profits. 2020 was on course to be a good year, but got side-tracked by the coronacrisis. 

However, inflation started to rise immediately, climbing to 4.8% in December 2020, and carried on increasing throughout 2021 until it reached the current 8.7%. Unemployment rose too, to peak at 6.4% in August 2020, but as the economy began to pick up in the third quarter of that year it started to fall again as Russians were let out of their apartments and went back to work. By July 2021 it had fallen to 4.5%, below the pre-crisis rate.  

And the ruble weakened after the oil shock and pandemic appeared, falling to RUB79 by October 2020, before strengthening again in the last months of the year to start 2021 at RUB76.2. These fluctuations were painful, but not extreme. The currency continued to strengthen throughout 2021, rising to RUB70.7 in October as the economy continued to improve but that the end of that month a new dynamic appeared, with the first reports in the Washington Post of Russia’s military build-up on the Ukrainian border.  

Thanks to the so-called budget rule, the ruble has long since largely disengaged from the oil price (which was rising throughout 2021) but has become extremely sensitive to geopolitical tensions. By the end of November 2021 the ruble was trading at RUB74.7, then weakened again to RUB78 in January just before the first Geneva round of diplomatic meetings started between the Kremlin and the US over the growing Ukraine crisis. It jumped again to RUB84 following Putin’s decision to recognise the breakaway republics of Donetsk and Luhansk on February 21. It crashed to RUB108 to the dollar on news of the invasion of Ukraine but is currently in the high 90s against the dollar, as tensions remain sky high.  

• 2022 crash

In this crash the ruble has lost 30% of its value in just the last few days, putting this crisis on a par with earlier crises but not quite as bad as in 2014. That is due to the huge reserves the central bank has built up and also the much greater confidence in the regulator; in 2014 CBR Governor Elvira Nabiullina was seen as green and untested, but today she is seen as a titan amongst central bankers and the “most conservative governor in the world.”

The impact on unemployment is likely to be very small. Joblessness spiked in 2020 due to the lockdown as people literally couldn't go to work, but it rapidly recovered as the coronavirus (COVID-19) restrictions came off in the autumn of that year. Currently unemployment is back at its post-Soviet lows of 4.3% as of December 2021. How far it rises from here will depend on the severity of the recession that will almost certainly begin now.

Inflation will also rise. Inflation is currently 8.7% as of January this year and was rising all last year, despite an aggressive string of rate hikes: March (25bp), April (50bp), June (50bp), July (100bp), September (25bp), October (75bp), December (100bp), January (100bp) and February (1,500bp).

The CBR’s emergency doubling of overnight rates on February 28 will curb the further rise but the 30% devaluation will feed through into more inflation over the next six-nine months. However, in the previous crisis the CBR said it was pleasantly surprised as the devaluation-driving inflationary effects were surprisingly mild and fed through more quickly than expected. However, in those crises the economic bounce-back was also better than anticipated. Again just how bad the inflation problem gets will depend on the depth and duration of the coming recession.

The banking sector has been largely undamaged, although not unaffected, in each crisis since the disaster in 1998, which wiped out the entire top tier, but there is moderate danger of a banking crisis this time round. As bne IntelliNews reported, there is a dangerous mismatch between the state-owned banks dollar liabilities and their dollar assets: in short, the big state-owned banks don't have enough dollars on hand to meet demand if withdrawals soar – and demand is soaring after the US effectively cut both Sber and VTB Bank off from using dollars. On balance it seems the CBR has enough dollars to cover the shortfall if needed, but the story highlights how painful the SWIFT sanctions are proving to be.

From the macro-economic point of view this crisis is actually milder than the previous ones, or at least on a par, even slightly better than that of 2014. But there is one big difference: Putin’s decision condemns Russia to sub-par growth in the long term, as he has destroyed what little confidence domestic business has in the future of Russia.

The noughties boom was driven, and was gathering momentum, because Russian business was returning its flight capital to the Motherland, confident in the future. Russia’s development does not depend on foreign direct investment (FDI) or access to the capital markets. It depends on persuading its own businessmen to build and invest into the economy.

Those businessmen were nervous before. Now they will simply not invest in Russia any more, as it has no future. Russia cannot grow strongly unless its domestic businessmen participate, and following this crisis they will not.  

The previous crises of 1998, 2008 and 2014 were not Russia’s fault. They were due respectively to a currency crisis in Asia, the US failure to manage its mortgage markets and OPEC's decision to flood the markets with crude. This crisis is entirely and exclusively of Putin’s own making. The biggest long-term consequence of this crisis is Putin will have destroyed what little confidence his own businessmen have in his leadership. Indeed, a few of Russia’s business elite have already come out and publicly criticised the invasion of Ukraine, including Rusal owner Oleg Deripaska, Alfa group founder Mikhail Fridman and Kremlin insider Anatoly Chubais.

Prominent businesses have told bne IntelliNews in the past that they built up big businesses that have made them rich, but they have stopped there. “Why risk borrowing when that could mean I could lose control of my business? I am already rich. I don't see the point of risking what I already have,” one medium-sized successful businessman told bne IntelliNews.

The Kremlin has tried to force domestic businesses to invest into Russia with laws that penalise companies who don't repatriate the ownership of their companies. It is also in the process of passing a law that will penalise unsanctioned companies from doing business with sanctioned ones that will end up infecting the whole economy. But the only way to get businessmen to invest into Russia is to create a conducive investment climate. But as long as Putin emphasises security over capitalism that will never happen. Inflows of the domestic capital belonging to “minigarch” and other successful businessmen from offshore havens to Russia remain miniscule.