Russia's Economy Is Tanking, So Why Is Putin Smiling?

Elvira Nabiullina Russia's Central Bank Chairman

The central bank held $379 billion in foreign exchange and gold as of Feb. 19, up $29 billion from lows touched last April, making Russia the only major emerging market with a gain.

Photographer: Andrey Rudakov/Bloomberg
  • FX, gold reserves -- top priority for Kremlin -- on the rise
  • Ruble sacrificed to focus on preserving, rebuilding reserves

With Russia mired in the longest recession in two decades, there hasn’t been a lot of good economic news lately. But there’s one indicator that’s looking up, and it’s the one that matters most to Vladimir Putin: His hard-currency reserves.

QuickTake Currency Wars

The central bank held $379 billion in foreign exchange and gold as of Feb. 19, up $29 billion from lows touched last April, making Russia the only major emerging market with a gain.

While China and Saudi Arabia have spent tens of billions of dollars to shore up their currencies, the central bank in Moscow has gone cold turkey on intervention. Since blowing more than $67 billion in a failed effort to steady the currency at the end of 2014, Russia hasn’t spent a penny to prop up the ruble. In fact, it bought some foreign currency last spring.

“No amount of spending of currency reserves can stabilize the ruble,” Dmitry Tulin, first deputy governor of the central bank, said last month, a few weeks after the currency dropped to new lows. “It’s very easy to fire your whole arsenal quickly, but that would yield only a temporary, Pyrrhic victory.”

That view reflects Putin’s about-face just over a year ago as he decided to husband the Kremlin’s cash at all costs, amid falling oil prices and U.S. and European Union sanctions that largely cut Russia off from western financial markets. The exchange rate, once a top economic priority, would have to be sacrificed as crude plunged. Spending from Russia’s sovereign-wealth funds, the bulk of which count toward the central bank’s holdings, would be conducted in a way that ensured the overall total didn’t drop. There would be no “burning through the reserves,” Putin said when the central bank cut the ruble loose in December 2014.

The economic experiment reflects his conviction that gold and hard currency in the bank are the best guarantee of Russia’s financial independence, according to senior officials who’ve discussed the issue with him. Since he came to power in 2000, Putin has built up reserves from a mere $13 billion and paid off Russia’s debt, which is now one of the lowest among major economies.

“Vladimir Putin recognized the power of reserves in 2008-2009, when thanks to them he survived the crisis without significant losses,” said Alexei Kudrin, who was then finance minister and still meets Putin regularly to discuss economic policy. “To be left with a small amount of reserves now would be difficult, even just psychologically.”

Tuesday, Putin brushed off calls to use the central bank funds to help revive the economy, telling a business group, “Gold and currency reserves are created by the central bank for other purposes, not for financing current economic problems.”

Rebuilding Reserves

Last spring, when the currency staged a brief recovery, the bank moved in to buy $10.5 billion for its reserves, hastily suspending the effort when the ruble resumed its declines. Most of the rest of the gain in reserves comes from banks repaying hard-currency loans from the central bank and fluctuations in exchange rates, the bank said.

But the toll on the ruble has been heavy. The currency has lost a quarter of its value against the dollar since early last year and gyrated by as much as 5 percent per day early this year as oil prices tested the lowest levels seen in years.

“The central bank is ready to tolerate almost any volatility in the rate in order not to spend reserves,” said Oleg Kouzmin, economist at Renaissance Capital.

Central bank officials watch markets closely for signs Russians might be losing faith in the battered ruble, getting daily reports from banks on demand for foreign currency, according to senior officials. So far, the Kremlin has avoided the kind of market panic that other devaluations triggered.

Ruble Pain

But the ruble’s drop has fueled a spike in inflation, reversing years of progress in the central bank’s efforts to rein in price growth. Consumer prices jumped 12.9 percent last year, the biggest calendar-year rise since 2008. The ruble’s drop accounted for the bulk of the increase, given Russia’s dependence on imports of everything from food to industrial equipment, according to the central bank.

While the weaker currency has opened the way for some local companies to compete with lower prices at home and abroad, the sharp swings in the rate complicate life for business.

“This ruble volatility is bad for us,” said Vladislav Korochkin, president of Russky Ogorod, a mid-sized company based near Moscow that sells seeds and plants and imports about half its raw materials. “Nobody believes anymore that it’s possible to predict what the rate will be in six months,” he added.

The volatility worries Putin, too, according to senior officials who’ve discussed the issue with him, but so far it’s a price he’s willing to pay for preserving the country’s financial security. He regularly asks aides for reports on the remaining reserve balances, according to two senior officials who spoke on condition of anonymity.

Russia also keeps most of the money from its two wealth funds at the central bank. But even as the Kremlin draws those down, officials have found a way to keep the overall reserve total up.

Draining Funds

When the Finance Ministry draws from the rainy-day fund to cover the widening budget deficit, the central bank simply shifts the foreign-currency assets to its own account, issuing rubles to the ministry. To hold inflation down, the central bank drains an equivalent amount of rubles from the system by reducing its lending to banks.

“Contrary to the widely held view, spending from the Reserve Fund doesn’t reduce international reserves,” said Ekaterina Vlasova, a former central bank official who is now economist at Citigroup Inc. in Moscow.  

Putin personally makes decisions on spending the other wealth fund, which is earmarked for infrastructure and other long-term projects, according to senior officials. So far, about a third of the $71 billion total has been committed, with the rest remaining in central bank reserves.

All told, the $379 billion in central bank reserves includes about $99 billion from two the wealth funds. The money is mostly invested in dollar and euro government debt, as well as Russia’s growing holdings of gold.

Officials have said both the wealth funds could be fully depleted by 2018 unless oil prices recover or the government finds other ways to cover the deficit, such as selling state assets or raising debt. Once the funds are empty, the Kremlin will be forced to make painful cuts in spending or hike taxes in order to keep the budget gap under control.

The central bank, meanwhile, is looking to increase its reserves. After Putin’s mandate to hold onto the cash, the central bank announced plans to boost reserves to $500 billion.

Though that target is more than twice what economic theory suggests would typically be required, “That’s the level we’ve become accustomed to,” central bank chief Elvira Nabiullina said in announcing the goal last year.

If attained, that would be a level not seen since early 2014 and just short of the record set in July 2008. Then, the total was $598 billion, enough to rank third in the world behind China and Japan.

Hitting those figures means the ruble’s wobbles are likely to continue. “The central bank is going to stay on the sidelines in the currency market,” said Vlasova, the Citigroup economist. “The financial authorities are serious about maintaining international reserves in the short term and increasing them over the medium term.”