Tag: Vladmir Putin | Vivek Kaul

Vivek Kaul

The Russian rouble has been crashing over the last few days. On December 10, 2014, one dollar was worth 55 roubles. After this, the rouble started crashing against the dollar and it even touched 73 to a dollar on December 16, 2014. This happened despite the Russian central bank raising interest rates to 17%.
Interestingly, as I write this in the late evening on December 17, the rouble has recovered to 62 to a dollar, after the Russian central bank promised to sell close to $7 billion to buy roubles, in a bid to push up the value of the currency.
The Russian government is totally dependent on revenue from oil. With the price of Brent Crude Oil falling below $60 per barrel, the Russian economy is expected to contract majorly next year. This has led to foreign investors exiting Russia.
When foreign investors exit Russia they sell the roubles they have and buy dollars. This leads to an excess supply of roubles in the market and a demand for dollars. This led to the rouble crashing against the dollar. The Russian central bank is now selling dollars and buying roubles being sold and in the process has managed to stop the crash for the time being.
But that’s the simple bit. The first question that arises here is how did the Russian economy become so heavily dependent on money coming in from selling oil. Currently, nearly 50% of government’s income comes from oil. Oil also makes up for two-thirds of Russian exports.
The answer to this question is provided by Yegor Gaidar in an excellent research paper titled The Soviet Collapse: Grain and Oil. Between 1991 and 1994, Gaidar was acting prime minister of Russia, minister of economy and the first deputy prime minister.
The story starts with Joseph Stalin who was the leader of the Soviet Union from 1922 till his death in 1952. Stalin essentially forced collectivization and expropriation of agriculture. “The result of the disastrous agriculture policy implemented between the late 1920s and the early 1950s was the sharpest fall of productivity experienced by a major country in the twentieth century,” writes Gaidar.
In the 1960s, this “state production of grain stabilized” and remained fixed at around 65 million tonnes per year, until the late 1980s. The trouble was that the urban population was increasing and more grain was needed. This led to Russia becoming a major importer of food grains.
As Gaidar points out: “The cities, however, continued to grow. What policy could succeed if a country had no increase in grain production and an 80 million–person increase in its urban population? The picture was bleak. Russia, which before World War I was the biggest grain exporter—significantly larger than the United States and Canada—started to be the biggest world importer of grain, more so than Japan and China combined.”
So, the harebrained agricultural policies of Stalin turned the world’s biggest exporter of grains into the world’s biggest importer, in a matter of a few decades. The trouble was that the imports had to be paid for in hard currency (largely dollars). Nations like Japan were also importing food grains, but then they also were exporting a lot of goods using “their machine-building and processing industries” as well. This helped Japan earn the foreign exchange it needed to pay for its imports.
The Soviet Union did not have this ability simply because it had followed a policy of “socialist industrialization” which had resulted in “in the Soviet industry being unable to sell any processed (value-added) products”.
Since no one would buy machine products manufactured in the Soviet Union, it became a big exporter of raw materials which included oil and gas. As Gaidar writes: “The Soviet economy thus hinged on its ability to produce and export raw commodities—namely, oil and gas. The Soviet leadership was extremely fortunate: at almost exactly the time when serious problems with the import of grain emerged, rich oil fields were discovered in the Tyumen region of Western Siberia.”
So, oil and gas helped the Soviet Union earn enough dollars to pay for the food grains that it needed to feed its citizens. The country was totally dependent on the revenue from oil and gas.
In fact, its leaders had to get the Tyumenneftegaz (the production association of the oil and gas industry in the Tyumen region) to produce more than what had been initially planned for. “The Soviet premier, Aleksey Kosygin, used to call the chief of the Tyumenneftegaz, Viktor Muravlenko, and explain the desperation of the situation: “Dai tri milliona ton sverkh plana. S khlebushkom sovsem plokho” [Please give three million tons above the planning level. The situation with the bread is awful],” writes Gaidar.
After the breakup of the Soviet Union in 1991, this model has been followed by Russia as well. The trouble is that over the years Russia started to assume that high oil prices would stay forever. As Gaidar puts it: “ the idea that “high oil revenues are forever” has gained an even wider acceptance.”
Interestingly, The Financial Times reports that around two weeks back, the current Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” As I write this Brent Crude Oil is selling at around $59.3 per barrel, inflation is about to cross 10% and the economy is expected to contract in 2015. Hence, the assumptions are going all wrong.
The Russian government’s budget becomes balanced at a price of close to $100 per barrel, which is nearly 66% higher than the current price of oil. Interestingly, Russia is not the only country which has worked out its government finances assuming a high price of oil.
As Ambrose Evans-Prtichard recently wrote in The Daily Telegraph: “ The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup.”
This applies to the Organization of Petroleum Exporting Countries as well. As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment.”
Moral of the story: Countries cannot be dependent on revenue from just one major source like oil sales. It is like the old investment wisdom which the financial planners never get tired repeating: “Don’t put all your eggs in one basket”.
What applies to long-term investing applies to countries as well. The basic lesson is the same.

Postscript: Yesterday I had written about why the government should not be bailing out SpiceJet. But what has happened is exactly the opposite. In fact, the ministry of civil aviation said in a statement: “Indian banks may be requested to give some working capital loan based on the assurances of the promoter. Banks or financial institutions to lend up to Rs 600 crore backed by a personal guarantee of the chairman, SpiceJet.”
The question is if the promoters of SpiceJet are not willing to sink in any more money into the airline why are banks being “requested” to lend? This in a scenario where the stressed assets of public sector banks is already greater than 10% of their total advances. Beats me totally.

The article originally appeared on The Daily Reckoning, on Dec 18, 2014

Vivek Kaul

Sergei Glazyev, a close advisor to the Russian President Vladmir Putin, recently threatened that if the United States imposed sanctions on Russia, over what is happening in Ukraine, then Russia might be forced drop the dollar as a reserve currency. He also said that if the United States froze the bank accounts of Russian businesses, then Russia will recommend that all investors of US government bonds start selling them.
How credible is this threat? Is Russia really in a position to drop dollar as a reserve currency? Or is any country in that position for that matter?
There are a host of factors which seem to suggest that the dollar will continue to be at the heart of the international financial system. As Barry Eichengreen writes in Exorbitant Privilege – The Rise and Fall of the Dollar, “The dollar remains far and away the most important currency for invoicing and settling international transactions, including even imports and exports that do not touch US shores. South Korea and Thailand set the prices of more than 80 percent of their trade in dollars despite the fact that only 20 percent of their exports go to American buyers. Fully 70 percent of Australia’s exports are invoiced in dollars despite the fact that fewer than 6 percent are destined for the United States…A recent study for Canada, a county with especially detailed data, shows that nearly 75 percent of all imports fromcountries other than United States continue to be invoiced and settled in U.S. dollars”
So, most international transactions are priced in dollars. Most commodities including oil and gold are priced in dollars. Over and above this dollar remains the main currency in the foreign exchange market. As Jermey Warner writes in The Telegraph “For instance, if you were looking to buy Singapore dollars with Russian roubles, you would typically first buy US dollars with your roubles and then swap them into Singapore dollars.”
Hence, a major part of the foreign exchange transactions happens in dollars. As the most recent Triennial Central Bank Survey of the Bank for International Settlements points out “The US dollar remained the dominant vehicle currency; it was on one side of 87% of all trades in April 2013. The euro was the second most traded currency, but its share fell to 33% in April 2013 from 39% in April 2010.”
Over and above this, another good data point to look at is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund complies this data.
The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence, the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves.
We can take a look at the allocated reserves over a period of time and figure whether the composition of the foreign exchange reserves of countries around the world is changing. Are countries moving more and more of their reserves out of the dollar and into other currencies?Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall.
In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as of the first quarter of of 2013, dollars formed 62.4% of the total allocable foreign exchange reserves.
Euro, which was seen as a challenger to the dollar has fizzled out because Europe is in a bigger financial and economic mess than the United States is in. Given this, there is no alternative to the dollar and hence, dollar continues to be at the heart of the international financial system.
So where does that leave the Russian rouble and the recent threat that has made against the dollar? Here is the basic point. When the entire world has their reserves in dollars, they are going to continue to buy and sell things in dollars. So, when Russia exports stuff it will get paid in dollars, and when its imports stuff it will have to pay in dollars. And unless it earns dollars through exports, it won’t be able to pay for its imports.
Any country looking to get away from the dollar is virtually destined for economic suicide. Russia can throw some weight around in its neighbourhood and look to move some of its international trade away from the dollar. The Russian company Gazprom, in which the Russian government has a controlling stake, is the largest extractor of natural gas in the world, being responsible for nearly 20% of the world’s supply.
The gas that Gazprom sells in Russia is sold at a loss, a legacy of the communist days. But the company also provides gas to 25 European nations and this makes it very important in the scheme of global energy security. The company backed by the Russian state has been known to act whimsically in the past and shut down gas supplies during the peak of winter, which has led to major factory shutdowns in Eastern Europe.
This is Russia’s way of trying to reassert the dominance the erstwhile Soviet Union used to have over the world, before it broke up. But even when Soviet Union was a superpower it could not trade internationally in dollars, all the time, because nobody wanted Russian roubles, everyone wanted the US dollar.
The next step in the process is likely
to be an effort to price the natural gas which Russia sells through Gazprom in Europe in terms of its own currency, the rouble. Vladamir Putin has spoken out against the dollar in the past, calling for dropping the dollar as an international reserve currency.
This makes it highly likely that Russia might start selling its gas in terms of roubles. Countries which buy gas from Russia would need to start accumulating roubles as a part of their international reserves. Hence, there is a high chance of the rouble emerging as a regional reserve currency in Europe and thus undermine the importance of the dollar to some extent. Whether that happens remains to be seen.
The most likely currency to displace the dollar as the international reserve currency is the Chinese yuan. But that process, if it happens, will take a long time. As Warner writes in The Telegraph “this process is on a very long fuse and basically depends on China eventually displacing the US as the world’s largest economy.”
While the future of the Chinese yuan as an international reserve currency is very optimistic, it is highly unlikely that the yuan will replace the dollar as an international reserve in a hurry. For that to happen the Chinese government will have set the yuan free and allow the market forces to determine its value, which is not the case currently.
The People’s Bank of China, the Chinese central bank, intervenes in the market regularly to ensure that the yuan does not appreciate in value against the dollar, which would mean a huge inconvenience for the exporters. An appreciating yuan will make Chinese exports uncompetitive and that is something that the Chinese government cannot afford to do.
These are things that China is not yet ready for. Hence, even though yuan has a good chance of becoming an international reserve currency it is not going to happen anytime soon. Economist Andy Xie believes that “There is no alternative to the dollar as a trading currency in Asia.” He feels that the yuan will replace the dollar in Asia but it will take at least thirty to forty years.
Meanwhile, the Russians can go and take a walk.

The article originally appeared on www.FirstBiz.com on March 7, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek)

Lesson from the rouble crash: Don’t put all your eggs in one basket

Why there is no alternative to the dollar, the Russian threat notwithstanding