Currency problems are looming.

Photographer: Andrey Rudakov/Bloomberg

How Close Is Russia to Financial Crisis?

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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As the central bank of Russia appears to be losing control of its currency market, the global financial media is warning about a possible financial crisis there. Some experts have even drawn parallels to August 1998, when a Russian default caused global economic and financial disruptions. Against this background, here are the seven things to know about what’s going on in Russia now.

  1. Buffeted by Western sanctions and lower oil prices, Russia has suffered a significant decline in net foreign earnings. Capital is fleeing the country, and corporations and households are looking to switch out of rubles and into dollars and other “hard” currencies. The result has been a sharp fall in both international reserves and the value of the ruble, contributing to a rising threat of domestic financial turmoil.
  2. At the same time, it is only a matter of time until the country’s economy has to deal with an even stronger stagflationary wind. The currency’s sharp depreciation is sure to fuel inflation, while the drop in foreign income will curtail domestic economic activity.
  3. The central bank’s retreat from propping up the ruble highlights the fix the country is in. The authorities’ initial response was to use ample international reserves to counter the impact of sanctions imposed by the West after Russia’s actions in Ukraine. They backed this up by intervening in the foreign-exchange and repo markets, which readily exchange securities for cash,  and by raising interest rates.  This moderated what would have been more disorderly pressures on the ruble and an even faster loss of confidence. But the subsequent collapse in oil prices and the pickup in capital flight overwhelmed this strategy, forcing the central bank last week to retreat from its policy and fully float the currency.
  4. Something will have to give in the next few weeks.  The country’s foreign-exchange situation could spin further out of control, at one extreme, or the Russian authorities might respond strongly with a range of fiscal and monetary measures, on the other, including higher interest rates and spending cuts.  Either approach would risk depressing economic activity even more in the short run. The most likely outcome is somewhere in between -- some interest-rate increases and the use of controls to try to buy time by limiting dollar use and channeling more foreign exchange to the government.
  5. While Russia’s creditworthiness is under significant pressure, with international reserves still above $400 billion, the country’s debt-servicing capacity isn’t exhausted, provided the authorities can better manage the movement from rubles into dollars. Yet even then, it is probably only a matter of time until the country loses its investment-grade credit rating, raising its borrowing costs and narrowing further its creditor base. The situation will be acute for companies and banks whose balance-sheet positioning requires them to pay more rubles to obtain the dollars needed to meet their foreign obligations.
  6. The negative spillover effects of Russia’s financial turmoil are a lot less than they were in 1998. While some Western banks and investors still have notable exposures, quite a few responded to Western sanctions in the last few months by reducing their holdings and preparing for further turmoil.
  7. National politics and global geopolitics are the biggest jokers in the pack. President Vladimir Putin, whose popularity surged when he acted in Ukraine earlier this year, faces one of two choices; and it is far from clear which one he is likely to pursue. He can moderate Russia’s involvement in Ukraine as a means of relaxing Western sanctions. Or he can press even harder in Ukraine to distract attention at home away from the economy but risk another round of sanctions and countersanctions that would aggravate the economic and financial turmoil in Russia, and potentially tip Europe into recession.  The market implications of the two courses are polar opposites.

Aggravated by lower oil prices, the recent financial turmoil reflects the geopolitical tensions and Russia’s decision to favor regional adventures over internal economic and financial stability. The sovereign analysis that the vast majority of investors use isn’t often comprehensive enough to easily and effectively capture this reality.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor on this story:
Katy Roberts at kroberts29@bloomberg.net