<html> <head><style type ="text/css">body { font-family: "Bloomberg Prop Unicode I", Verdana, sans-serif; font-size:125%; letter-spacing: -0.3pt; color: #FF9F0F; background-color: #000000; text-align: left; } p {line-height: 1.25em; max-width:900px; width:expression(document.body.clientWidth > 900? "900px": "auto" );} h1, h2, h3 { text-align: left; font-weight: normal; color: #FFFFFF; } h1 { font-size: 130%; } h2 { font-size: 115%; } h3 { font-size: 100%; } #bb-style { font-size: 90%; max-width:900px; width:expression(document.body.clientWidth > 900? "900px": "auto" ); } b, strong { font-weight: bold; } i, em { color: #FEC54A; } pre { font-family: "Andale Mono", "Monaco", "Lucida Console"; letter-spacing: -0.3pt; line-height: 1.25em; } table { border: 0; font-size: 90%; width: 100%; margin-left: auto; margin-right: auto; } td, tr { text-align: left; } td.numeric { text-align: right; } a:link { color:#53B2F5; text-decoration: none; } a:visited {color:#53B2F5} a:active {color:#53B2F5} a:hover {color:#53B2F5} </style> </head> <body> <p>By Leonid Bershidsky</p> <p>The European economic crisis is heading toward Russia. It could present a much greater threat to the regime of President Vladimir Putin than did throngs of anti-government protesters in Moscow.</p> <p>The ratings company Moody's laid out the scenarios this week <a href="http://www.4-traders.com/news/Moody-s-Puts-Russian-Banks-on-Notice-For-Downgrade--14426570/">in a report </a>on the banking systems of Russia and other nations of the Commonwealth of Independent States. In the worst case, if the euro area debt crisis escalates, a quarter of all bank loans in the CIS would go sour and capital in the banking system would fall below regulatory minimums. Russia’s economy would shrink by 5 percent in the next 12 months and the ruble would lose 30 percent of its value. In the base case scenario, Russia would see a 10 percent depreciation of the ruble and a deceleration in growth to 3.5 percent over the next year, from 4.3 percent last year.</p> <p>The problem, as Moscow's Higher School of Economics noted <a href="http://www.hse.ru/data/2012/07/17/1257753911/KGB_25f.pdf">in a recent report</a>, is that Russia’s trade surplus is shrinking and capital flight is gaining momentum. Even high oil prices don’t help as much as they used to, because the government’s turn toward isolationism, xenophobia and authoritarianism is prompting people to send their money elsewhere. In the second quarter of 2012, capital flight reached $22 billion, a 200 percent increase from the same period in 2011 and on a scale comparable to that seen in 2008.</p> <p>Russians who are unwilling or unable to move their money out of the country are looking for devaluation-proof investments. Money is pouring into already overpriced Moscow real estate. The property agency Domus Finance <a href="http://realty.lenta.ru/news/2012/07/24/investments/">released a report </a>saying that in June, 46 percent of new home buyers in and around the Russian capital paid cash. Normally, 75 percent of deals in this market involved mortgage financing. Domus attributed the growth in cash deals to devaluation rumors and the expectations of financial crisis.</p> <p>Russian officials are making things worse by insisting that nothing is wrong. In an interview with the pro-Kremlin daily Izvestia, Alexei Ulyukayev, deputy chief of the Russian Central Bank, <a href="http://izvestia.ru/news/530657">said that a sharp depreciation of the ruble was “impossible”</a> and insisted that no new wave of the global crisis was coming.</p> <p>Russians remember well how officials offered the same denials just before the cataclysmic devaluation and default of 1998. “If the authorities say the ruble is going to be strong, that means it's going to drop,” blogger <a href="http://foma-n-10.livejournal.com/">foma_n_10</a> wrote in a typical comment on LiveJournal. “This has happened many times in the last 20 years.”</p> <p>If economic troubles lead to a deterioration in the Russian government’s finances, Putin will be hard pressed to bring the budget back into balance. The Kremlin has been boosting payments to the military and to pensioners in an effort to maintain their loyalty and contain protests in Moscow and other large cities. Austerity could be a political disaster.</p> <p>Ukraine, Russia's biggest ex-Soviet neighbor, is in an even tougher fix. Its government is making burdensome social promises ahead of October elections, which could see the ruling Regions Party lose its majority in parliament. So it is forced to borrow in international markets at increasing cost: The government just borrowed $2 billion for five years at a whopping yield of 9.25 percent. Even crisis-addled Spain can borrow at about 7 percent.</p> <p>Ukrainian Finance Minister Yuri Kolobov attracted ridicule <a href="http://economics.lb.ua/finances/2012/07/23/161985_kolobov_schitaet_visokoy_tsenu.html">by asserting </a>that the country had actually gotten a good deal, because it could have expected to pay as much as 11 percent. “Well, the main thing is to forget that on the same day as Ukraine sold a five-year bond at 9.25 percent, Sri Lanka marketed a 10-year one at 5.75 percent,” <a href="http://blogs.lb.ua/sergei_fursa/161809_vozvrashchenie_bludnoy_ukraini.html?utm_source=lbua&amp;utm_medium=link&amp;utm_campaign=more">wrote </a>Sergei Fursa, a debt expert with the Kiev investment bank Dragon Capital. “That, despite a recently ended civil war, two highways and three traffic lights in the entire nation and the utter impossibility of Colombo hosting the 2022 Winter Olympics.”</p> <p>Expectations of a devaluation in Ukraine are at least as strong as in Russia. Valery Geyets, head of the Ukrainian Academy of Sciences' Institute of Economics and Forecasting, points out that the exchange rate of the Ukrainian currency, the hryvnia, has not changed since 2009, while inflation has topped 15 percent. Meanwhile, a poor harvest this year might hurt Ukraine's exports, putting more pressure on the currency to fall. According to Geyets, in the best-case scenario the exchange rate of the hryvnia to the U.S. dollar will move to 8.5 by the end of the year, from 8 now. In the worst-case scenario it will reach 10 per dollar. All of this would, of course, happen after the election.</p> <p>The shifting economic winds could have major political consequences. In Russia, anti-government protests have so far been limited largely to the middle class in the most affluent cities. Throughout most of the country, the Putin-era social contract of loyalty in return for economic stability remains intact. If the economy falters, that deal could be broken beyond repair. No wonder government officials remain in denial.</p> <p>(Leonid Bershidsky, an editor and novelist, is Moscow and Kiev correspondent for World View. Opinions expressed are his own.)</p> <p>To contact the writer of this column: bershidsky@gmail.com.</p> <p>To contact the editor responsible for this column: Mark Whitehouse at mwhitehouse1@bloomberg.net</p> <p> </p> </body> </html>