From Russia, With Volatility

Russia is familiar with these sorts of historical comparisons. After the war in Georgia, many commentators likened its behavior to Soviet aggression of the 1980s. In the last week, however, Russia has been reminded of an all-together different date: 1998. In the so-called "Ruble crisis" of that year, falling commodity prices and evaporating tax revenues caused the Russian government to default on its national debt. 

During the recent global financial crisis, Russia's dollar-based RTS Index lost 21% before officials decided to shut down the exchange for two days. Russian stocks, which had outperformed all other world markets over the last decade, quickly became the cheapest among the world's 20 largest economies. Emerging market analysts pointed to a vortex of despair that wiped out share prices and forced Russian authorities to close equity exchanges.

Earlier this week Russia's Finance Ministry announced that it would make $44b available for its biggest banks, and yesterday President Dmitri Medvedev issued a government rescue plan that would inject about $130b in liquidity into the market. The effect was instant and dramatic. Russia's two main exchanges surged on Friday morning, with trading twice suspended for one-hour periods to prevent overheating. The RTS Index gained 20%, the best single-day performance since the index was introduced in 1995.

Still, traders warned of future volatility in the market. Russia faces a quartet of forces that may compromise the economy's fundamentals. First, the hostile foreign policy coming from the Kremlin has unnerved investors. As a result of the war in Georgia, some $35b has left Russian markets, and the continuing anti-Western diplomacy is unlikely to reverse this trend.

Second, the recent drop in oil prices has put stress on an economy, and indeed a government, that is overwhelmingly dependent on commodity prices. Crude is down 18% since August, and in an effort to spur growth, the administration recently cut the tax on oil companies.

Third, recent business developments in Russia have done little to ensure investors of its commitment to property rights and transparency. Earlier this year, tensions rose between Russian government officials and British executives at TNK-BP, the joint-venture oil company. CEO Robert Dudley was aggressively forced out of the company after shareholders asked the Kremlin to intervene. In July, PM Vladimir Putin openly criticized the chief executive of Mechel, a coal mining and steel company, a moved which wiped $6b in shareholder value from the company. These events took place against the backdrop of a increasingly strong-arm economic policy, which Mr Putin had used to seize state control of Yukos oil in 2004.

Finally, there is the continuing credit freeze that is felt throughout the global economy. Russia once assumed that it would become the world's next financial capital, riding the wave of a commodity boom. Not so fast. Russia must first deepen its domestic capital pool, facilitate a more competitive and effective bank lending system, and streamline the policies of its central bank. The country is in better shape than it was 10 years ago: it has pricing power from immense oil reserves and has the world's third largest hard currency reserves, at more than $560b. But the past week has shown that Russia is not immune to the global credit contagion.

The country's oligarchs have never quite embraced free-market capitalism, instead depending on political influence. For a vibrant economy to grow in Russia, the country would do well to use this period of capital restructuring for something equally pressing: political reform.