Putin’s Secret Gamble on Reserves Backfires Into Currency Crisis

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EU Split Over Further Sanctions on Russia
A column of tanks drive from a rebel-territory to Donetsk near the town of Shakhtarsk, eastern Ukraine on Nov. 10. Photographer: Dimitar Dilkoff/AFP via Getty Images

Kremlin insiders gathered in secret last February to answer a crucial question for Vladimir Putin: Could Russia afford the economic blowback from taking over Crimea?

Moscow said yes.

Markets aren’t so sure.

As President Putin exulted at the Winter Olympics in Sochi 10 months ago, aides assured him Russia was rich enough to withstand the financial repercussions from a possible incursion into Ukraine, according to two officials involved in the talks.

That conclusion now looks like a grave miscalculation. Russia has driven interest rates to punishing levels and spent at least $87 billion, or 17 percent, of its foreign-exchange reserves trying to prevent a collapse in the ruble from spiraling into a panic. So far, nothing has worked.

Despite the assurances in Sochi, Putin now faces what could be the nation’s most serious economic crisis since 1998, when Russia’s devaluation and default reverberated around the world. U.S. and European sanctions and, more significantly, plummeting oil prices are eroding the reserves that emboldened Putin to annex Crimea despite an international outcry.

The story of Russia’s foreign-exchange reserves traces, in hard numbers, the arc of Putin’s power, from the collapse of the late 1990s to the oil-soaked riches of the 2000s to the new dread that prevails today.

Putin’s Pride

When rising crude prices were firing the economy, Russia’s swelling reserves became a symbol of economic might and a point of pride for Putin.

Three government officials characterized the February discussions as critical to Putin’s thinking on Ukraine. The series of talks came before Russia helped Viktor Yanukovych, then-president of Ukraine and a Putin ally, flee from violent protests.

Putin, 62, was told Russia had enough foreign currency reserves to annex Crimea and withstand any sanctions that might follow. The president might not have proceeded had Russia not built up its cash cushion in good times, said the three officials, who spoke on the condition of anonymity because of the sensitive nature of the discussions.

Dmitry Peskov, Putin’s spokesman, declined to comment.

‘Uncontrollable Shock’

The central bank shouldn’t “thoughtlessly burn up” its reserves, Putin said today at his annual news conference. “Thank god, they even grew during this year.”

As of Dec. 12, Russia had $415 billion in total reserves, with about $169 billion spread between two specialized funds. But with the ruble’s collapse, this trove is being depleted faster than almost anyone had predicted. Panic has begun to set in among ordinary Russians.

“We’re facing an uncontrollable shock that will undermine trust in Putin’s entire economic model,” said Kirill Rogov, a senior research fellow at the Gaidar Institute for Economic Policy who’s advised the government in Moscow. “The reserves aren’t enough.”

For policy makers, there are no easy answers. The central bank unexpectedly raised its benchmark interest rate to 17 percent on Tuesday and could drive rates higher still, further jeopardizing growth.

Russia could also keep using its hard currency to buy rubles on the open market, in hopes of stabilizing the exchange rate. The Bank of Russia will probably spend another $70 billion to defend the ruble, which has almost halved against the dollar this year, according to the median estimate of six economists surveyed by Bloomberg.

‘Political Power’

But reaching into reserves would make it more difficult for Putin to cushion a looming recession with government spending, coddle favored business leaders and project power abroad. It could also threaten Russia’s credit rating.

“For Putin, the reserves that Russia has accumulated over the past 14 years equal political power,” Alexei Kudrin, who ran the country’s finances from 2000 to 2011, said in an interview in Moscow.

When Putin entered the Kremlin, in 1999, Russia was nearly broke. He had less than $13 billion at his disposal and faced $133 billion of foreign debt, mostly from the Soviet era.

Over the next eight years, rising crude prices fueled average growth of 7 percent a year, filled state coffers and prompted ratings companies to raise their assessments.

Russian Confidence

That, in turn, helped embolden Putin. In 2007, when reserves surged passed $300 billion, the president openly criticized the U.S. In 2008, as the cash pile reached a record $598 billion, Russia went to war with Georgia. Foreign currency holdings sank to $376 billion in 2009 during the global financial crisis.

Putin views reserves as a proxy for Russian strength and adjusts foreign policy accordingly, said Tony Brenton, Britain’s ambassador to Russia from 2004 to 2008. For instance, Russia would have reacted more strongly to the 1999 NATO bombing of Serbia, an ally, had it not been so dependent on Western aid at the time, Brenton said.

“Part of Russia’s international self-confidence has undoubtedly been the strength of the reserves,” said Brenton, who now advises companies doing business in Russia.

As the latest ruble crisis deepens, some Russian lawmakers have called for Putin to impose capital controls, a step both the president and the central bank have publicly opposed. The Finance Ministry, for its part, is urging exporters to convert more revenue into rubles to support the currency.

‘Sacred Figure’

If sanctions persist, Russia could lose its investment-grade credit rating, Deutsche Bank AG has warned. Such a development would represent a personal embarrassment for Putin, as would a further decline in reserves, said Gleb Pavlovsky, a former Kremlin adviser.

“The level of reserves is a sacred figure for Putin,” Pavlovsky said.

A cut below investment grade would also force some funds to sell what Russian government debt they hold. It could also lead to downgrades of major companies such as OAO Gazprom and OAO Lukoil, adding further pressure to the market. Russia is currently rated one level above junk by Standard & Poor’s and two steps above at Moody’s Investors Service and Fitch Ratings.

Money Printing

About 40 percent of Russia’s reserves are held in two sovereign wealth funds that are controlled by the Finance Ministry. The government is looking for ways to tap these funds to help cash-strapped enterprises while maintaining as much international currency as possible. Russian companies have about $50 billion in non-ruble bonds and loans due by the end of 2015, according to data compiled by Bloomberg.

One option is to convert some of the $80 billion Wellbeing Fund, which was designed to safeguard the pension system, into rubles to provide emergency loans to select companies.

The Finance Ministry has already said it will use the other sovereign fund, the $89 billion Reserve Fund to cover at least half a projected 1 trillion-ruble budget shortfall next year.

However this money is used, attempting to solve one problem will compound another.

The only way to lend this way would be for the ministry to sell foreign currency to the central bank, which would then have to print rubles, increasing the money supply, according to Ekaterina Vlasova, an economist at Citigroup Inc. in Moscow. Inflation, already running at more than 9 percent, would probably accelerate, Vlasova said.

Officials have acknowledged that tapping reserves could further imperil the country’s standing with investors.

“Using the wealth funds is a serious risk for Russia’s credit rating,” said Konstantin Vyshkovsky, head of the Finance Ministry’s debt department in Moscow. “We understand this.”

Few in Moscow, however, expect Putin to panic.

“For Putin, just one thing matters: is there money?” said Sergei Aleksashenko, a former first deputy chairman of the central bank. “Yes. So, goodbye!”

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