When asked earlier this month about Russia’s economic hardships, Federal Reserve Chair Janet Yellen said she thought the spillovers to the United States through trade and financial channels would be “small.”
Yellen’s assessment of the risks posed by Russia’s collapsing currency and likely recession contrasts with that of her counterpart to the north. Bank of Canada Governor Stephen Poloz told reporters on Dec. 11 that the situation in Eastern Europe is one of biggest threats facing the global economy in 2015.
Poloz’s comments came before the ruble plunged 6 per cent on Dec. 16 even as Russia’s central bank raised its benchmark interest rate to 17 percent from 10.5 percent. Canada and Russia aren't big trading partners. But Poloz was thinking about the situation on another level. He said he was worried about what an escalation of Russia’s conflict with Ukraine could mean for Europe. The continent’s stagnant economy can ill afford a shock of the type that could be delivered by Russia, whether by way of military aggression or economic collapse.
There has been a tendency to play down the threat of contagion from Russia. That seems naive. Russian turmoil has hit investor confidence hard, causing the currencies of neighbors such as Kazakhstan, Kyrgyzstan, and Tajikistan to fall, and inflation in those countries to rise. Even before oil prices began to plummet, the International Monetary Fund cut its forecast for economic growth in the Commonwealth of Independent States because of the turmoil in Russia. In Europe, major exporters to Russia such as Germany and Finland are also feeling the squeeze from weaker external demand. The current panic will only worsen conditions for Russia’s key trading partners.
Russia’s financial troubles also threaten Europe’s banks, through their exposure to Russian companies. Financial institutions in Austria, Italy, the Netherlands, Sweden and France all do significant business in the country. A depreciating ruble and lower profits from weakened demand are squeezing the liquidity of Russian companies, increasing the probability that they will be unable to service their foreign-denominated debt. A rise in non-performing loans may further weaken the European banking sector and increase the cost of accessing funds for businesses and households; this could further delay a recovery in the euro zone.
Volatility in the Russian economy and financial markets is also increasing fears of global financial volatility, sending investors fleeing to safe haven assets. This is creating lower yields putting upward pressures on currencies such as the British pound; the euro; the Japanese yen; and the US, Canadian and Australian dollars. Signs of global financial instability will cause investors to flee from emerging markets. Those countries face currency depreciation, higher financial volatility and higher risk premiums.
Russian President Vladimir Putin shows little outward sign of wanting to do anything to alleviate the situation. He was defiant at his annual end-of-year press conference, blaming the US and Europe for his country’s economic hardship and offering no policy response to the ruble’s collapse. He prepared Russians to ready for a period of economic hardship that he said could go on for two years.
The situation recalls the Russian financial crisis of 1998. Then, as now, the confidence of international investors in Russia’s economy had deteriorated. In 1998, Russia was caught up in a broad distrust of emerging markets. In 2014, investors are wary of US-led economic sanctions and distrust of Russia’s government and institutions. The two periods also have falling commodity prices in common.
At the same time, Russia is far better prepared to deal with a financial crisis now than it was in the 1990s. The country has built a formidable stash of foreign currency reserves and it has a trade surplus. Investors are wary of Putin’s capriciousness, but Russia’s institutions generally are seen to be stronger today than they were 16 years ago. They will have to be in order to deal with what is coming. The IMF predicted in October that Russia was facing a mild recession. That prediction was based on assumptions of an average oil price of $102.67 in 2014 and $99.36 in 2015, a benchmark interest rate of 9 per cent, and that geopolitical tensions would subside. Russia is facing serious economic pain.
To what extent will that pain be shared with the rest of the world? The immediate impact of the Russian crisis is being felt most strongly by Russia’s neighbours, but further turmoil may have implications for global financial markets. Indeed, if market panic continues, a crisis in Russia could have the effect of disrupting the recovery in the euro zone, reversing emerging market economies' efforts to maintain macroeconomic and financial stability, and further dampening global demand.
The next time Yellen is asked about Russia, her assessment may be different.