By Christopher Hartwell for Russia Direct –
While Russia’s Central Bank increased its key interest rate to 17 percent, the steep depreciation of the ruble and the drop in global oil prices have negative implications not only for Russia’s economy, but also for Russia’s ability to integrate with other nations in the Eurasian Union, especially Kazakhstan.
This week, the Russian ruble saw its largest one-day drop since the 1998 crisis, plummeting 8 percent versus both the dollar and the euro on Monday, Dec. 15. The ruble fell to more than 80 rubles to the U.S. dollar and about 100 rubles to the euro on Tuesday. The ruble has now lost about 48.4 percent of its value to the dollar and the euro since January. Meanwhile, Russia’s Central Bank has announced it is increasing its key interest rate from 10.5 percent to 17 percent.
While the Russian economy has been on a downward drift for two years, primarily exacerbated by events in Ukraine, the trigger for this collapse was the decision taken by OPEC at its ministerial meetings on Nov. 27 to keep global oil production at current levels. World oil prices had already been steadily declining over the past six months, but this decision led to a freefall in oil prices that took the ruble with it.
At the same time, Russia’s partner in the Eurasian Union, Kazakhstan, has already seen itself buffeted by the currency and economic turmoil emanating from Russia. Reliant on oil prices, both economies are sensitive to commodity fluctuations, and that highlights just how difficult deeper integration can be for the Eurasian Union. This is especially true when the main source of risk to each economy is the same.
The Russian addiction to oil revenue to fuel the national budget is well-known, and it has gotten worse in the post-global financial crisis world. Oil and gas now make up 68 percent of Russia’s exports and revenues from these sales constitute well over half of the federal budget. Moreover, the government budget has become more reliant on oil’s price remaining consistently high.
The latest estimates from Citibank’s research department put Russia’s breakeven price of oil (the price at which the budget will balance) at $107, nearly double what it was in 2007 ($61) and nearly triple what it was in the economically depressed year of 2009 ($41). Coupled with the huge fiscal burdens taken on by Russia in the past year, notably in Crimea, the country’s sensitivity to oil prices is now entering a danger zone.
This move towards a mono-economy has occurred at the same time that political will has been building in Moscow to accelerate the pace of Eurasian integration amongst Russia, Kazakhstan and Belarus. The Eurasian Union project has promise, but is fraught with difficulties that have thus far overwhelmed any potential gains.
One of these difficulties is the need for greater macroeconomic coordination to ensure stability within the broader Customs Union realm. With people, businesses, and money able to move freely across the Union, it is important for the region to have a harmonized approach to fiscal and monetary policy, in order to not create regional pockets that are out of balance. Simply put, enlarging the economic space requires enlarging the stability of that space, so that businesses can take advantage of the lowered transaction costs and barriers to investment.
To this point, however, macroeconomic coordination has been sorely lacking in the Eurasian Economic Union. Nowhere has this been more apparent than in monetary policies, where Kazakhstan and Russia have rarely been on the same page. And, this year, their policies have substantially diverged.
In February, the National Bank of Kazakhstan (NBK) surprised the markets with an announcement of a devaluation of the tenge, putting the new defense point of the currency at 185 tenge to the dollar (where it had been between 145 and 155 tenge). This real devaluation of 23 percent against the midpoint of the previous exchange rate band was a surprise move to the markets, but came on the heels of Russia’s own fairly sudden, but managed, depreciation of the ruble (it lost approximately 5 percent against the dollar from Jan. 1 to the end of February).While the market’s worries over Russian action in Crimea turned the managed depreciation into a rout in March, the policy was already in place in Moscow to weaken the ruble.
RUSSIA’S OWN LEVELS OF SPENDING, AS EVIDENCED BY THE CLIMBING BREAKEVEN PRICE OF OIL, HAS BEEN FAR TOO HIGH FOR YEARS, WITH MEGA-PROJECTS SUCH AS SOCHI, THE APEC SUMMIT IN VLADIVOSTOK, AND OTHER STATE-LED INITIATIVES PUTTING STRAIN ON THE BUDGET
Of course, exchange rate movements have real (if evanescent) consequences for a country, and especially if they have become more tightly integrated. Kazakhstan relies on Russia for 40 percent of its imports, meaning that consistent depreciation from Russia was bound to mean higher relative prices for Kazakh consumers. With Russia and Kazakhstan actually actively seeking to become more tightly bound, these diverging monetary policies create exactly the sort of centrifugal forces that can tear an economic union apart. Unfortunately, coming back to the reliance on oil, the monetary and exchange rate woes that are causing Kazakhstan and Russia to diverge are also part of the fiscal divergence of the two countries. Russia’s own levels of spending, as evidenced by the climbing breakeven price of oil, has been far too high for years, with mega-projects such as Sochi, the APEC summit in Vladivostok, and other state-led initiatives putting strain on the budget.
Kazakhstan has had somewhat more prudence, even if its deficit to GDP is higher than Russia, but it too is reliant on oil to keep state coffers full. Thus, fiscal woes have led to the need to resort to monetary and exchange rate machinations, which has in turn exposed fissures in the Eurasian Union relationship.
Knowing this, it is time for Russia’s economic leadership to tackle the real issues that are harming the Russian economy. Focusing on the exchange rate is a decoy, a mere symptom of a deeper underlying problem. The Kremlin must rein in spending, avoid prestige projects and resist the temptation to focus on a burst of new military spending. Instead, the Kremlin should leave productive resources in the hands of the private sector, improve the business environment, cut red tape, and reduce the size of government.
All of these steps will have demonstrable benefits for the Russian economy, as well as help to diversify Russia away from its dependence on oil. And a Russia less dependent on oil is one that can better integrate with its neighbors, coordinate with its partners, and fulfill the promise of Eurasian integration.
The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.