Dmitry Orlov on Russia's financial crisis

Can anybody find me... a central banker to love?

Dmitry Orlov

Club Orlov,

16 December, 2014

[Early morning update: in case you had any doubts, the intervention didn't work. Ruble and oil are continuing to plunge amid increasing financial market turmoil throughout the world.]

[Last minute update: the repo rate has been just hiked to an eyewatering 17%! At the same time, the percentage of bullshit in the rationale given was lowered significantly: it is to prevent further ruble devaluation. Simply put (perhaps too simply), ruble liquidity for currency speculation has just dried up. At the same time, the central bank is backing long-term investments in industry at a far more reasonable 6.5% rate. Will this be enough to stop the slide?]

On December 11 Russia's central bank hiked its rate by one percent, from 9.5% to 10.5%. The rationale offered by the bank's governor Elvira Nabiullina was that this would stop the slide in the value of the ruble. But nobody laughed.

So a more laughable rationale was offered: the rate hike would help contain inflation. Here's why that's funny: suppose I am a Russian manufacturer making widgets and now have to borrow at 10.5% instead of 9.5%. I will price my widgets correspondingly higher in order to pay the higher interest. That's price inflation. Then my workers will start complaining and threatening to defect, and I will have to give them raises; that's wage inflation. That's if my widgets are life-saving and people have no choice but to buy them; if my widgets are discretionary and I hike prices, people would simply buy fewer of them, so instead of taking the loan and increasing production I convert my savings into dollars or euros, close up shop and leave the country, telling everyone that I've had enough of this Russian central bank nonsense. But what if that's exactly what the bureaucrats at Russia's central bank want to see happen? Hmm...

The rate hike didn't stop the ruble's slide, for some very obvious reasons. First, a minor one: the very fact of the hike signaled the expectation that the ruble's slide will continue. In fact, there has been a consistent pattern of Russia's central bank mouthpieces acting as the ruble's worst enemies in signaling that they expect it to drop. Second, the major one: speculators, including powerful insiders such as German Gref, president of Sberbank, are dong all they can to push the ruble down while betting that it will go down even more as people try to rescue their savings by selling their rubles. While most regular Russians go to Sberbank to pay their utility bills and municipal fees, a few highly irregular Russians (and a few foreigners among them) go to Sberbank to sit in posh offices in front of trading terminals and gamble away the regular Russians' savings. The regular Russians are rather upset about this state of affairs, and 70% of them state in opinion polls that they consider currency manipulation to be a crime and want the criminals stopped and punished. Mr. Gref begs to differ and even expressed some political ambitions; is he going to be the next Michael Khodorkovsky?

“We know who the speculators are,” said Putin during his recent state of the nation speech, as the camera zoomed in on Elvira Nabiullina, who blushed and probably peed her panties a tiny bit (I know I would have if I were her). In spite of the Stalinesque overtones, at the moment Putin is pushing on a string. You see, once you staff the central bank with economic liberals trained to follow the dictates of the IMF, and do nothing to shut the revolving door between the central bank and other big banks (after all, if the Wall Street boys can do it, why can't the Russians?) then why wouldn't they rob their own people every chance they get, then attempt to use their ill-gotten gains to subvert the political system—just like the Americans have done?

Some people are starting to loudly criticize Putin for his inaction; but what can he do? Ideologically, he is a statist, and has done a good job of shoring up Russian sovereignty, clawing back control of natural resources from foreign interests and curtailing foreign manipulation of Russian politics. But he is also an economic liberal who believes in market mechanisms and the free flow of capital. He can't go after the bankers on the basis of ideology alone, because what ideological differences are there? And so, once again, he is being patient, letting the bankers burn the old “wooden” ruble all the way to the ground, and their own career prospects in the process. And then he will step in and solve the ensuing political problem, as a political problem rather than as a financial one.

This strategy carries a very substantial opportunity cost. After all, if the central bank acted on behalf of regular Russians and their employers, it could take some very impressive and effective steps. For instance, it could buy out western-held Russian debt and declare force majeur on its repayment until financial sanctions against Russia are lifted. It could drop its interest rate for specifically targeted domestic industries—those involved in import replacement. And, most obviously, it could very effectively curtail the activities of well-connected financial insiders aimed at destroying the value of the ruble. Putin said he knows who they are. I hope that they are wearing adult diapers. I wouldn't be at all surprised if they get Khodorkovskied before too long.

This conversion of an insoluble financial problem into a mundane political problem may take a bit of time, but once it has run its course the longer-term prognosis is still reasonably good. Russia has very low government debt, huge gold reserves, and in spite of the much lower price of oil its energy exports are still profitable. You see, at the wellhead Russian oil costs much less than shale oil in the US, or Canadian tar sands, or Norwegian off-shore oil, and so the Russian oil industry can survive a period of low oil prices, whereas these other producers may no longer be around by the time the price of oil recovers. Because the ruble has dropped even more than oil, the Russian treasury is going to be flush with tax receipts, and won't have to try to finance a budget deficit. The 18% or so of revenue that the Russian treasury gets from energy exports is significant, but even more significant are the remaining 82%, much of which come from payroll taxes (some of the lowest in Europe, by the way). And therein lies a bigger danger: that because of loss of access to western sources of financing due to the sanctions, coupled with central bank shenanigans with hiking rates instead of dropping them, Russia's domestic economy will experience a severe downturn.

With all the political and financial instability sweeping the world, it's hard to make detailed predictions of any sort, but I will venture to issue just one little health warning: Russia's central bankers, along with their friends and colleagues in the financial industry, are poised to experience an extreme lack of love from their own people.