Ukraine financial fall-out exposes Russia's economic weakness

MOSCOW Mon Mar 3, 2014 10:43am EST

Ukrainian servicemen gather on the territory of their military unit, with their relatives seen in the foreground, in the village of Lyubimovka near a local airfield, some 80 km (50 miles) southwest of Simferopol, Crimea's capital March 3, 2014. REUTERS/Vasily Fedosenko

Ukrainian servicemen gather on the territory of their military unit, with their relatives seen in the foreground, in the village of Lyubimovka near a local airfield, some 80 km (50 miles) southwest of Simferopol, Crimea's capital March 3, 2014.

Credit: Reuters/Vasily Fedosenko

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MOSCOW (Reuters) - President Vladimir Putin's decision to raise the stakes in Ukraine could cause lasting damage to Russia's own economy.

While attention initially focused on Russia's direct economic and business interests in Ukraine, it is now shifting towards the broader question of Russia's economic ties with the West and how disrupting them threatens to derail a struggling economy that is already near stagnation.

It hasn't taken long for Russian financial markets to react to developments at the weekend, when Putin won parliamentary approval for military action in Ukraine as Russian forces consolidated control over Crimea, raising the prospect of a real war with Ukraine and a new Cold War with the West.

Moscow share price indexes plunged on Monday by over 10 percent, while the central bank has dramatically raised interest rates and spent an estimated $10 billion in reserves to defend the rouble after it hit a record low.

Analysts warn that steps already taken to defend the rouble threaten to push the economy into recession. If East-West tensions persist, they could further deter foreign investment, perpetuate economic stagnation and perhaps ultimately undermine Russia's own political stability.

"The big problem is that Russia clearly needs to increase inward investment and it needs to keep Russian money in the economy," said Chris Weafer, senior partner at Macro-Advisory consultancy in Moscow.

"If this crisis continues, so as to make Russia an uninvestible country - some sort of pariah state - the money simply won't come here."

NIGHTMARE SCENARIO

Much depends on how matters develop in Ukraine, with scenarios ranging from a quick diplomatic settlement to a nightmare military confrontation.

But even the immediate impact - higher Russian interest rates - threatens to kill growth altogether in a sickly economy that grew by just 1.3 percent in 2013.

"The growth rate we had is looking unrealistic and now a realistic growth rate looks close to zero," said Natalia Orlova, economist at Russia's Alfa Bank. "And this is the best-case scenario assuming that the situation does not escalate."

Other economists now expect the economy to shrink in the coming months.

"The risk of recession was probable even before this decision (on rates). Now it certainly increases," said Vladimir Kolychev, chief economist at VTB Capital.

At the root of the financial squeeze is the economy's vulnerability to volatile capital flows. Both foreign and domestic investors are reacting to the diplomatic crisis by selling roubles in droves to stock up on western currency.

"It's a big event. The market compares this with 2008," said Alfa Bank's Orlova.

Many draw a parallel between the present financial crash and one that occurred in 2008, when Russia's brief war with Georgia was the initial catalyst for a massive capital outflow that, exacerbated by the onset of the global financial crisis, culminated in a 30 percent devaluation in the rouble.

The current flight from the rouble means large net capital outflows, which have been around $60 billion annually in the last two years - and $17 billion in January this year - are set to increase.

"All this suggests that the net capital outflow from Russia remains very, very strong, and I honestly don't see any reason why it should decelerate in the near future," Orlova said.

SANCTIONS THREAT?

A more uncertain question is how potential, but so far vague, western sanctions could hurt Russia. Many believe that in this respect the West's bark may me worse than its bite.

"Sanctions hurt both sides - maybe even the side applying the sanctions more than the side being sanctioned," said Alexis Rodzianko, president of the American Chamber of Commerce in Moscow.

But with or without sanctions, antagonistic relations between Russia and the West are a deterrent to the foreign capital which not only plays a big role in Russian financial markets, but is also needed to power long-term economic growth.

Neil Shearing, emerging market economist at Capital Economics in London, argued that with almost $500 billion in foreign exchange reserves, Russia can withstand short-term pressure on the rouble without huge negative consequences.

"There's a lot of speculation about how rate hikes could tip the Russian economy into recession. Frankly that misses the point," he said.

The deeper question, he said, is how a protracted period of East-West tensions could deter long-term foreign investment.

"One of the ways we could see a revival in the Russian economy is through an increase in investment. One important source of that would be foreign direct investment. All of this (Ukraine crisis) tarnishes Russia's image overseas."

Investment by companies in Russia was stagnant last year and fell by 7 percent in January. Russia scores particularly badly on foreign direct investment, seeing a net outflow over recent quarters when other major emerging markets have seen net inflows, Capital Economics calculates.

For optimists, the worrying economic consequences of a protracted diplomatic or military conflict appear to be a powerful argument for Putin wanting to see the Ukrainian crisis settled quickly and bloodlessly.

But if he casts these seemingly weighty considerations aside and continues to escalate the crisis, some now wonder how years of economic stagnation or depression may one day even shake Putin's apparently solid grip over Russia itself.

"If Russia can't attract capital and can't do joint ventures with major international companies, then the economy is going to remain in this rut, and risks sliding into recession," said Weafer. "And that of course would have political implications."

(Additional reporting by Ian Bateson; editing by Elizabeth Piper and Giles Elgood)

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