State is key to weathering the economic storm

Viewed from financial markets, Russia's situation appears to be no less troublesome. One of the main beneficiaries of the commodities boom of the last decade, the country finds the steep price retreats rather painful. Its headstrong expansion, supported by the export of its vast natural resources, is likely to come to a halt in the short term. Commodity-linked trade flows, which totaled on average nearly 80 percent of all exports in recent years, dwarfed the stream of foreign direct investment, which at $45 billion at the end of 2007 looks set to fall in 2008.

Dark omens abound. Despite the aggressively interventionist stance adopted by the government, the RTS Index has dropped by an astounding 72.4 percent over the past 12 months. Most of the country's blue chips have gone on an international acquisition spree funded by bank loans using those companies' own equity as collateral.

Such schemes helped corporate Russia rise up to its international ambitions as long as the stock market maintained double-digit annual growth rates. Their recent slide prompted a collateral squeeze and forced vulnerable, highly indebted companies to liquidate much of their equity portfolios in haste, thereby fueling a widespread market sell-off. This grim situation looks set to continue for some time, as leverage ratios still have some way to fall before reaching a more sustainable level.

As is typical in such time-sensitive situations, policy choices will be primarily dictated by the expected severity of the phenomenon to be treated and suitability of the treatment to avoid a possibly harmful overshooting. The eroded financial positions of most companies will make it difficult for them to gain access to new lines of credit in the short term as banks struggle to remain afloat and since international debt markets are still under considerable pressure. This leaves state intervention as the only engine capable of steering the economy out of the storm.

The question of what policy must be implemented by the government and the Central Bank remains open. Five main levers can be used: interest rates, exchange rates, taxes, foreign exchange reserves and the stabilization fund. What is the rationale behind the actions already taken by the authorities and what impact will they have?

Monetary policy adjustments may appear to be a safe bet, although not without considerable drawbacks. For most of the past three years the ruble has fluctuated mildly against the U.S. dollar, remaining in a narrow band between 23 rubles and 30 rubles per dollar. In a world of dollar-denominated commodity prices, this policy was perfectly sensible.

In an effort to protect the ruble against other major currencies amid falling commodity prices and generally bad news coming from a beleaguered Russian economy, the Central Bank let its foreign exchange reserves fall by an aggregate 25 percent since August. But currency pegs are not sustainable in the long run without the support of economic fundamentals. Fearing a repeat performance of the 1998 scenario, the Central Bank raised interest rates by a full percentage point in late November — bringing the refinancing rate to 13 percent — in a move to dampen reserve outflows and prevent international capital flights away from the ruble toward higher-yielding currencies.

This interest rate increase will undoubtedly have beneficial effects on the financial health of the country as a whole by stabilizing foreign capital and leaving some dry powder to be used by the Central Bank should things deteriorate further. Yet it will also have a dramatic impact on the real economy. Costlier capital is likely to drain the last remaining pockets of liquidity on the domestic credit market and bring numerous companies on the verge of bankruptcy. Under this scenario, more large corporations will probably be bailed out by the state, but the vast, silent and most fragile majority of smaller entities would then be forced to sail through the crisis on its own.

This phenomenon is likely to be exacerbated by the government's fiscal strategy. The period of fiscal generosity, funded by commodity export tax revenues, will soon come to an end in order to refill the government's steadily depleting coffers and rebuild its balance sheet.

Higher income taxes will hit the country's small and medium-sized enterprises and taxpayers more acutely than large commodity-exporting blue chips since a significant proportion of their revenues originates abroad and is taxed there. In other words, the financial rescue plan on both the fiscal and the monetary front may well result in a net asymmetric transfer from taxpayers and SMEs to large, multinational Russian-based companies.

This would probably not be in the best interest of the country. When the credit crunch eases up and stock market volatility has shown signs of returning to its historical average levels, the largest firms can always tap global capital markets in the short term. But smaller enterprises often cannot rely on this source of funding; they must rely exclusively on inflated bank lending rates.

Moreover, leading commodity market specialists forecast that energy, grains and metals will not remain indefinitely at their present low prices. When they recover, so will the net income of most Russian blue chips. SMEs, on the other hand, cannot expect to benefit as directly from a market rebound. Blue chips need, at most, a temporary loan to cover temporary costs, while SMEs need long-term funds to survive and grow.

State reserve funds would thus be put to much better use if they were invested in SMEs rather than in bail-out plans of the country's blue chips. Most of Russia's largest companies can emerge from the crisis without state subsidies by tapping international markets as long as they have healthy fundamentals to show to investors. Government financing of SMEs will help stabilize the country's economy by reducing its dependency on commodity market prices and by enabling a wider distribution of wealth among the population.

Frederic Bonnevay is a researcher at the Paris School of Economics.

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