Russia's battle to save the rouble

Under the leadership of Vladimir Putin, Russia has been re-establishing much of its lost Soviet-era strength. This has given rise to the possibility - and even the probability - that Russia again will become a potent adversary of the Western world.

But now, Russia is yet again on the cusp of a set of massive currency devaluations that could destroy much of the country's financial system. With a crashing currency, the disappearance of foreign capital, greatly decreased energy revenues and currency reserves flying out of the bank, the Western perception is that Russia is on the verge of collapsing once again. Consequently, many Western countries have started to grow complacent about Russia's ability to further project power abroad.

But this is Russia. And Russia rarely follows anyone else's rulebook.

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The state of the Russian state

Russia has faced a slew of economic problems in the past six months. Incoming foreign direct investment, which reached a record high of $28 billion in 2007, has reportedly dried up to just a few billion. Russia's two stock markets, the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (MICEX), have fallen 78% and 67% respectively since their highs in May 2008. And Russians have withdrawn $290 billion from the country's banks in fear of a financial collapse.

One of Moscow's sharpest financial pains came in the form of a slumping Russian rouble, which has dropped by about one-third against the dollar since August 2008. Thus far, the Kremlin has spent $200 billion defending its currency, a startling number given that the currency still dropped by 35%. The Russian government has allowed dozens of mini-devaluations since August; the rouble's fall has pushed the currency past its lowest point in the 1998 rouble crash.

The Kremlin now faces three options.

First, it can continue defending the rouble by pouring more money into what looks like a black hole. Realistically, this can last only another six months or so, as Russia's combined reserves of $750 billion in August 2008 have dropped to just less than $400 billion due to various recession-battling measures (of which currency defence is only one). This option would also limit Russia's future anti-recession measures to currency defence alone. In essence, this option relies on merely hoping the global recession ends before the till runs dry.

The second option would be to abandon any defence of the rouble and just let the currency crash. This option will not hurt Moscow or its prized industries (such as those in the energy and metals sectors) too much, as the Kremlin, its institutions and most large Russian companies hold their reserves in dollars and euros. Smaller businesses and the Russian people would lose everything, however, just as in the August 1998 rouble crash. This may sound harsh, but the Kremlin has proved repeatedly - during the Imperial, Soviet and present eras - that it is willing to put the survival of the Russian state before the welfare and survival of the people.

The third option is much like the second. It involves sealing the currency system off completely from international trade, relegating it only to use in purely domestic exchanges. But turning to a closed system would make the rouble absolutely worthless abroad, and probably within Russia as well - the black market and small businesses would be forced to follow the government's example and switch to the euro, or more likely, the US dollar. (Russians tend to trust the dollar more than the euro.)

According to the predominant rumour in Moscow, the Kremlin will opt for combining the first and second options, allowing a series of small devaluations, but continuing a partial defence of the currency to avoid a single 1998-style collapse. Such a hybrid approach would reflect internal politicking.

The lack of angst within the government over the disappearance of the rouble as a symbol of Russian strength is most intriguing. Instead of discussing how to preserve Russian financial power, the debate is now over how to let the currency crash. The destruction of this particular symbol of Russian strength over the past ten years has now become a given in the Kremlin's thinking, as has the end of the growth and economic strength seen in recent years.

Washington is interpreting the Russian acceptance of economic failure as a sort of surrender. It is not difficult to see why. For most states - powerful or not - a deep recession coupled with a currency collapse would indicate an evisceration of the ability to project power, or even the end of the road. After all, similar economic collapses in 1992 and 1998 heralded periods in which Russian power simply evaporated, allowing the Americans free rein across the Russian sphere of influence. Russia has been using its economic strength to revive its influence as of late, so - as the American thinking goes - the destruction of that strength should lead to a new period of Russian weakness.

Geography and development

But before one can truly understand the roots of Russian power, the reality and role of the Russian economy must be examined. From this perspective, the past several years are most certainly an aberration - and we are not simply speaking of the post-Soviet collapse.

All states economies' to a great degree reflect their geographies. In the United States, the presence of large, interconnected river systems in the central third of the country, the intracoastal waterway along the Gulf and Atlantic coasts, the vastness of San Francisco Bay, the numerous rivers flowing to the sea from the eastern slopes of the Appalachian Mountains and the abundance of ideal port locations made the country easy to develop. The cost of transporting goods was nil, and scarce capital could be dedicated to other pursuits. The result was a massive economy with an equally massive leg up on any competition.

Russia's geography is the polar opposite. Hardly any of Russia's rivers are interconnected. The country has several massive ones - the Pechora, the Ob, the Yenisei, the Lena and the Kolyma - but they drain the nearly unpopulated Siberia to the Arctic Ocean, making them useless for commerce. The only river that cuts through Russia's core, the Volga, drains not to the ocean but to the landlocked and sparsely populated Caspian Sea, the center of a sparsely populated region. Also unlike the United States, Russia has few useful ports. Kaliningrad is not connected to the main body of Russia. The Gulf of Finland freezes in winter, isolating St. Petersburg. The only true deepwater and warm-water ocean ports, Vladivostok and Murmansk, are simply too far from Russia's core to be useful. So while geography handed the United States the perfect transport network free of charge, Russia has had to use every available kopek to link its country together with an expensive road, rail and canal network.

One of the many side effects of this geography situation is that the United States had extra capital that it could dedicate to finance in a relatively democratic manner, while Russia's chronic capital deficit prompted it to concentrate what little capital resources it had into a single set of hands - Moscow's hands. So while the United States became the poster child for the free market, Russia (whether the Russian Empire, Soviet Union or Russian Federation) has always tended toward central planning.

Russian industrialisation and militarisation began in earnest under Josef Stalin in the 1930s. Under centralised planning, all industry and services were nationalised, while industrial leaders were given predetermined output quotas.

Perhaps the most noteworthy difference between the Western and Russian development paths was the different use of finance. At the start of Stalin's massive economic undertaking, international loans to build the economy were unavailable, both because the new government had repudiated the czarist regime's international debts and because industrialised countries - the potential lenders - were coping with the onset of their own economic crisis (eg: the Great Depression).

With loans and bonds unavailable, Stalin turned to another centrally controlled resource to 'fund' Russian development: labour. Trade unions were converted into mechanisms for capturing all available labour as well as for increasing worker productivity. Russia essentially substitutes labour for capital, so it is no surprise that Stalin - like all Russian leaders before him - ran his population into the ground. Stalin called this his "revolution from above."

Over the long term, the centralised system is highly inefficient, as it does not take the basic economic drivers of supply and demand into account - to say nothing of how it crushes the common worker. But for a country as geographically massive as Russia, it was (and remains) questionable whether Western finance-driven development is even feasible, due to the lack of cheap transit options and the massive distances involved. Development driven by the crushing of the labour pool was probably the best Russia could hope for, and the same holds true today.

In stark contrast to ages past, for the past five years foreign money has underwritten Russian development. Russian banks did not depend upon government funding - which was accumulated into vast reserves - but instead tapped foreign lenders and bondholders. Russian banks took this money and used it to lend to Russian firms. Meanwhile, as the Russian government asserted control over the country's energy industries during the last several years, it created a completely separate economy that only rarely intersected with other aspects of Russian economic life. So when the current global recession helped lead to the evaporation of foreign credit, the core of the government/energy economy was broadly unaffected, even as the rest of the Russian economy ingloriously crashed to earth.

Since Putin's rise, the Kremlin has sought to project an image of a strong, stable and financially powerful Russia. This vision of strength has been the cornerstone of Russian confidence for years. Note that STRATFOR is saying "vision," not "reality." For in reality, Russian financial confidence is solely the result of cash brought in from strong oil and natural gas prices - something largely beyond the Russians' ability to manipulate - not the result of any restructuring of the Russian system. As such, the revelation that the emperor has no clothes - that Russia is still a complete financial mess - is more a blow to Moscow's ego than a signal of a fundamental change in the reality of Russian power.

This article is a shortened version of 'The Financial Crisis and the Six Pillars of Russian Strength' by Lauren Goodrich and Peter Zeihan, published on 3 March 2009 by Stratfor Global Intelligence. Read the full article here