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Crimea Annexation Threatens Already Weakened Russian Economy

The fall of the ruble can have unpredictable consequences, one analyst says, because the exchange rate is constantly in the public's mind.
The fall of the ruble can have unpredictable consequences, one analyst says, because the exchange rate is constantly in the public's mind.
Capital flight from Russia reached $35 billion in the first two months of this year, Russian Economic Development Minister Aleksei Ulyukayev said this week.

That outflow has only increased in recent weeks and by the end of the first quarter, it could exceed the $65 billion capital-flight figure recorded for all of 2013, analysts say.

This trend -- and other factors including likely international sanctions, the falling value of the ruble, and the costs of integrating Crimea into the Russian economy -- could tip the sluggish Russian economy into recession.

"The sum of these factors -- the decline in investment and a slowdown in consumer demand -- in my view will mean that the economy is on the edge of a recession," says Kirill Tremasov, an economist with Nomos-Bank in Moscow. "Although you can still hear predictions from government bureaucrats that the economy might grow by 2 or 3 percent, I think these predictions are completely unfounded."

The ruble lost about 6 percent of its value in the second half of 2013, and that fall has accelerated to an additional 10 percent so far this year. As a result, the Russian Central Bank has intervened strongly in the currency market and has raised its base interest rate from 5.5 percent to 7 percent. The last time the bank made such a dramatic change in interest rates was shortly before the government's default in August 1998.

Slight Growth Potential

Natalya Orlova, the chief economist at Alfa-Bank in Moscow, is concerned about the developments, but still sees some economic growth. "In February we saw a higher-than-expected growth in domestic consumption. Therefore, overall, we are predicting some GDP growth this year. It could be about 1 percent," she says. "Of course, we really need to see the March figures, which will show us the indirect effect that raising interests rates is having on the economy."

Aleksei Devyatov, chief economist of the Uralsib Kaptial investment house, agrees with the 1 percent growth prognosis. However he worries that further erosion of investor confidence "will put considerable pressure on the Russian economy." He notes that investors "will view Russia has a country of growing risk" and that will result in higher borrowing costs throughout the economy.

Partly because of the declining ruble, corporate debt in Russia -- about one-third of which is denominated in dollars -- has increased by about 10 percent.

The fall of the ruble can have unpredictable consequences, analyst Tremasov says, because the exchange rate is constantly in the public's mind. "This is the basic, psychological factor by which people judge whether there is a crisis in the country or not. Stocks might fall, bonds might fall, but this doesn't particularly worry average citizens. The Russian population doesn't invest much in securities," he explains. "But absolutely everyone is watching the ruble-dollar exchange rate."

A Question Of Resources

The incorporation of Crimea into the Russian economy will be a further significant drag on growth, analysts say. Before the annexation, Russia's budget was slightly in deficit, according to Finance Minister Anton Siluanov. Already, 74 of Russia's now 85 regions take more from the federal budget than they contribute, and Crimea is expected to join the ranks of the most heavily subsidized.

About 560,000 of the region's 2 million people are pensioners, many of them military veterans with enhanced benefits. In addition, there are roughly 200,000 state-sector employees in the region, meaning that over 40 percent of the peninsula's population is directly dependent on budget spending.

"Overall the present state of Crimea, by our analysis, makes it about an average subsidized Russian region -- it is about at the same level as, say, the North Caucasus, Tuva, or Buryatia," says Karen Vartapetov, an analyst at the Moscow office of the Standard & Poor's rating agency. "That is, by its average income, pensions, and per capita GDP, it roughly corresponds to those regions."

Vartapetov says the "minimal estimate" of the direct budget subsidies for the Black Sea peninsula, even without the tax breaks and special subsidies that have been discussed in recent weeks, would be about $1.1 billion annually.

He adds, however, that the resources in Russia's Reserve Fund and National Welfare Fund are sufficient to meet this burden. But using these resources to subsidize Crimea could prompt difficult queries from other Russian regions.

About 15 Russian regions have debts that are near the legal maximum of 100 percent of revenues, Vartapetov notes. "The federal authorities are going to have a hard time explaining to the regions who are in such dire financial straits why they are not getting any help, while some new subject of the federation is," he adds.

In the last week, two leading international ratings agencies, Standard & Poor's and Fitch, reduced Russia's rating from "stable" to "negative." Both agencies, in their announcements, cited worries about the possibility of broad economic sanctions being imposed against Russia by Western countries.
Robert Coalson contributed to this report from Prague

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