Russia’s foreign currency reserves have plummeted by more than $140 billion since the beginning of 2014, but the current level of $360 billion is more than adequate to cover short-term debt payments. Because of the structure of the reserves, however, they are actually more vulnerable than appears at first glance, writes IMR analyst Ezekiel Pfeifer.

 

Each of Russia’s two sovereign wealth funds, known as the Reserve Fund and the National Wealth Fund, has the equivalent of about $75 billion right now, or roughly 6 percent of GDP, and the government has started liberally dipping into this money.

 

In December 1999, just weeks before the once-obscure KGB officer Vladimir Putin took the presidency, the Russian Central Bank had about $12 billion in foreign currency reserves. Russia’s economy was in tatters after the country defaulted in August 1998, a result of massive government debt expansion in the 1990s, the Asian financial crisis of 1997, and a steep falloff in the price of oil to $13 a barrel in 1998, among other factors. But good times were on the horizon: oil was about to begin a precipitous climb to triple digits, just as Putin was taking over the country’s leadership. Over Putin’s time as head of the government, Russia’s foreign reserves—which are a crucial tool for supporting the value of the ruble, investing in big projects, and paying off foreign debt—grew together with the price of oil. “For the first time in a long time, Russia has become a politically and economically stable country,” Putin said triumphantly in his state-of-the-nation address in May 2004, when reserves had risen to $83 billion. They reached $100 billion in late 2004, jumped to $300 billion by late 2006, and hit a peak of $598 billion in August 2008, before the global financial crisis hit. That crisis caused reserves to drop temporarily, but they rebounded to $544 billion in August 2011. They stayed above $500 billion until January 2014.

Building up foreign reserves during boom times is what most countries do that rely on sales of natural resources. In this way, Russia followed the proper path—but not to the degree that it probably should have. Former Finance Minister Alexei Kudrin pointed out in a recent paper that Russia averaged a budget deficit equal to 0.1 percent of GDP during the high tide in the oil price from 2011 to 2014—one of the worst fiscal performances of any major oil-producing nation. Norway, for example, averaged a budget surplus of 11.6 percent of GDP over that period, while Saudi Arabia averaged a surplus equal to 8.8 percent of GDP and Azerbaijan averaged a surplus equal to 4.3 percent of GDP. As Kudrin writes, the desirable model is to maintain a surplus during an upswing in the oil price and squirrel away the savings, then open the spigot on the reserves and maintain a deficit during a price dip. Because Russia failed to adequately follow this policy, it could end up running critically low on foreign currency reserves in the coming years.

Since falling below the symbolic total of $500 billion in mid-January 2014, Russia has hemorrhaged reserves, especially late last year when it spent billions per day in an attempt to support the value of the ruble, which plummeted to 68.5 to the dollar in December 2014. As of July 17, the Central Bank had $358.2 billion in foreign currency reserves, a modest increase from the 8-year low of $350.5 billion reached on April 17. Putin has said the government will prioritize building this level back up to the nice round number of $500 billion, and for the last few months the Central Bank has been dutifully spending rubles to buy as much as $200 million per day. Central Bank officials admit that this process could take as long as five to seven years—and this is a highly optimistic view.

The Kremlin has been sanguine, even positive, about the fact that replenishing reserves will hold down the value of the ruble, since a weak ruble should theoretically make Russian goods more attractive internationally. (While import substitution may be a sound policy in the long run, the policy seems doomed to failure in the short term.) But the Central Bank may not be able to keep up these purchases. After the ruble strengthened back to 49 to the dollar in mid-May, it has fallen sharply again after hedge funds started to bet against it and was approaching 60 as of July 27. Analysts believe that Central Bank authorities are currently aiming to keep it within a range of 55-60 to the dollar.

The Kremlin may not mind more depreciation in the value of the ruble, but problems could snowball if the government isn’t careful. The recent Iran nuclear deal means that Iranian crude could soon be unleashed onto the market, potentially pushing the price of oil even lower—it has already dropped down below $55 per barrel as of July 27—and the ruble is closely linked to the price of oil. Most economists now predict that the U.S. Fed will raise interest rates in September, a move that would put additional downward pressure on emerging market currencies around the globe (because it would make investment in dollar-denominated assets even more attractive). Economist Tom Levinson, who is chief strategist for forex at Sberbank’s investment banking arm, recently predicted that a Fed rate hike could push the ruble to 65 to the dollar. The Central Bank has touted its new policy of a more free-floating ruble rate, but if the currency starts falling quickly, it may decide to intervene.

Given that few people predict that Putin will implement major structural reforms to the economy in the near future, the two biggest factors likely to determine the state of Russias reserves are: 1) the price of oil and 2) the situation in eastern Ukraine.

There are several risks presented by an even weaker ruble. Perhaps the biggest potential problem is the risk of more inflation, which has been slowing but still stood at 15.3 percent at the end of June. “The inflation risks of this policy [of increasing foreign currency reserves] must be taken into account. The Bank of Russia must track the situation on the currency market closely and go from decreasing currency liquidity to increasing it if the risk of panic on the currency market appears,” wrote Gaidar Institute economists in a July report. A weaker ruble would also add to the growing list of challenges for industries, from the military to machine-building to transportation, that have become dependent on imported parts and equipment. And it would inflict even more pain on consumers, including the small but politically influential middle class in Moscow and St. Petersburg, who had grown accustomed to being able to afford certain imports.

One risk that does not exist to the same extent as it does in, say, China, is debt. Whereas Russian companies have actually been paying down their debt recently after being cut off from foreign financing—the country’s total external debt went from $728.8 billion in January 2014 to an estimated $556.1 billion this month—China has built up trillions of dollars worth of debt in order to sustain growth. So even though China has a mammoth stockpile of currency reserves—over $3.7 trillion at the end of the first quarter of 2015—it is vulnerable because of the pressure the debt burden is putting on the currency. Some predict a disastrous unraveling of this situation. And compared to certain countries that struggled during the 2008-2009 economic crisis due to low reserves—such as Mexico, which had reserves equal to just 7 percent of GDP—Russia’s level of about 19 percent of GDP is high.

Russia’s not-so-hidden problem lies elsewhere—in the structure of its forex reserves. The Central Bank is open about what funds are included in the reserves, but they don’t exactly advertise one key fact: the total includes most of Russia’s two sovereign wealth funds, known as the Reserve Fund and the National Wealth Fund. These funds were formed in 2008 out of the Stabilization Fund, which was created in 2004 to collect surplus revenues from energy exports. Each of these two caches has the equivalent of about $75 billion in it right now, or roughly 6 percent of GDP, and the government has started liberally dipping into this money. It is using the Reserve Fund to cover an estimated budget deficit of 3.7 percent of GDP this year (2.68 trillion rubles), while more than 500 billion rubles from the National Wealth Fund has been earmarked for investment projects and to help struggling state-owned companies. Requests by government corporations for money from the National Wealth Fund far exceed the actual total in the coffers. (Putin decided at a meeting in February that he personally would choose which projects get support.) And the current 2016 budget envisions a deficit of about 2.4 percent of GDP—meaning that if there is another deficit in 2017, the Reserve Fund could become tapped out. Economist Sergei Guriev recently warned that it could even run out by the end of 2016. Another $48 billion of Russia’s “currency” reserves is actually holdings of gold—the value of which recently plunged 4.2 percent, part of an across-the-board drop in global commodity prices.

What this means is that, like in the case of China, even though Russia’s $360 billion in forex reserves appears to be more than sufficient on the surface, the funds are actually vulnerable. Given that few people predict that Putin will implement major structural reforms to the economy in the near future, the two biggest factors likely to determine the state of Russia’s reserves are: 1) the price of oil and 2) the situation in eastern Ukraine. (Experts also mention the risks presented by slowing growth in China and the consequences of a potential Grexit.) There are always unforeseen events and circumstances, but in the short-to-medium term, these two factors will play a significant role in determining Russia’s financial health. As commentator Maria Snegovaya has pointed out, oil-exporting regimes like Putin’s tend to get more assertive when the price of oil goes up, since it gives them a greater ability to cover the costs of their military adventures. So if the price of oil stays low compared to recent years ($60 or cheaper), it is less likely that Putin will order an offensive in eastern Ukraine and thereby endanger Russia’s reserves even more. (There are mixed signals regarding the Kremlin’s current plan in the Donbass, but there is clearly a buildup of Russian troops near the Ukraine border.) If the price of oil goes back up, then Putin will have more flexibility. This seems unlikely in the short term, but it could certainly happen, given that it is nearly impossible to accurately predict commodity prices.

In the medium term, even with an increase in the price of oil, the outlook for Russia’s economy is not good. As Kudrin points out in his recent paper, the Kremlin’s economic model of relying on domestic consumption for growth—a model that has already begun to flounder in the current recession—is unsustainable even if oil gets more expensive again. Yes, you read that right: even if oil goes up again, it’s not going to save the Russian economy. If that doesn’t scare Putin into changing course, what will?

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