``There are two main consequences for Russia, a lack of confidence and a lack of liquidity,'' Sharonov, a deputy economy minister until resigning in July last year, said in a Bloomberg Television interview in Moscow. ``This problem is not only for financial institutions, but for the whole of industry, for the whole economy. Many companies feel these problems with debt financing.''

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

Russia's economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia's "go it alone" attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: "The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest' since at least January 2003".



Oil Output Down


And just to cap it all, Russia's oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world's second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry's CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don't think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don't expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know......

I think it is important to bear in mind here that Russia's economy actually grew at an annual 7.5% in the second quarter, while manufacturing growth was nearer 5%. Which means that in a "newly industrialising country" the weight of industry in the economy is declining. This is obviously unsustainable, since however resource rich Russia maybe, you cannot live from oil alone, especially when your oil output has a ceiling. Basically the more living standards in Russia rise, the less important oil will become as a percentage of GDP, and the more dependent the Russian economy will become on other sectors. This is why the current consumer price and wage inflation levels are no mere trifle.

Obviously the Russian authorities have deperately needed to get a grip on the inflation problem, and this is just what the central bank has clearly failed to do, with the annual rate rising again to 15 percent in August, up from 14.7 percent in July. So one part of the present financial crisis is clearly an institutional crisis of confidence. With the benchmark interest rate at the central bank currently at 11%, Russia has negative interest rates of 4% which obviously make it very easy to fuel a lending driven consumer and construction boom, but very much more difficult to communicate to observers that you actually know what you are doing. So while the fx muscle that the central bank can put to work in the short term to stamp out the present will in all probability work, they are clearly not able to prevent such forest fires breaking out in the first place, and we should, of course, expect more. Brazil's central bank which currently has interest rates at 13.75% while inflation is just over 6% (ie 7.5% positive interest rates) is currently justifiably earning for itself a reputation as Latin America's new Bundesbank, a way in which it would never ocur to anyone to refer to the Russian equivalent. And the comparison I would make with Brazil is not meant idly, since Brazil is, of course, also an oil and resource rich emerging economy.



So it is clear that Russia has special problems, which set what is happening in Russia rather apart from what is currently happening in a lot of emerging market economies.

Rout On The Bourses

Both Russia's MICEX and RTS exchanges remained effectively closed first thing this morning following trading being suspended again yesterday (Wednesday) - they were in fact open for less than two hours - in order to prevent a further sell-off on top Monday's record-breaking falls. The ruble-denominated Micex Stock Exchange did resume some very limited trading at 11:00 this morning, but only limited operations were authorsied - the decision was effectively simply to allow participants to close repurchase deals still outstanding from Sept. 16 and Sept. 17.

Russian stocks have now plunged around 60 percent since their May peak, and while the Micex did initially gain 7.6 percent in initial trading yesterday, this gains were very rapidly erased and then turned negative, as the index plunged as much as 10 percent before a halt was called. Russia's dollar-denominated RTS index stood at 1,058 points when trading was halted, nearly 58 percent down from its peak of 2,498 points reached in May.

Emerging Market Woes

In part Russia's problems only reflect more general "risk aversion" issues which are facing all emerging market economies. Emerging-market stocks have fallen the most in 11 years this week, their currencies have been falling, and the cost of insuring emerging market bonds has rocketed as rising lending rates and tumbling commodities have prompted investors to sell riskier assets.

Every emerging stock market in MSCI indexes has been retreating this month, and the MSCI Emerging Markets Index fell 2 percent yesterday to 768.92 a time, its lowest level since October 2006. The index is now down 19.59% since the start of the month, and 29.27% over the past 3 months.



The Russian MSCI index, in comparison, is down 36.1% on the month, and 54.2% over the past three months.



Of course, to put the recent fall in perspective, this recent fall follows several years of rising stock values, and thus is to some extent cyclical, as can be seen from the 4 year MSCI index chart (below).




Falling Oil Prices


In the forefront of the fall in Russia share prices have been energy stocks, including Russian oil producers like OAO Gazprom and OAO Rosneft, who have declined substantially following the sharp drop in crude prices. Gazprom, the world's biggest natural-gas producer, lost 18 percent to 158.41 rubles in the latest turmoil, while Rosneft, Russia's largest oil company, sank 22 percent to 132.20 rubbles.

Oil prices were down again this morning, after bouncing back somewhat yesterday. Light, sweet crude for October delivery fell 97 cents to $96.19 a barrel in electronic trading on the New York Mercantile Exchange midafternoon in Singapore. Overnight, the contract rose $6.01 to settle at $97.16, after having dropped $10.03 the previous two trading sessions. But the trend is decidedly down, and crude has now fallen more than $50 — or over 35 percent — from its all-time trading record of $147.27 reached July 11.




Urals crude peaked at $140.80 a barrel on July 3, and has fallen about 36 percent to $90.01 since then. Still, the oil price averaged $108.65 a barrel so far this year, compared with $63.54 a barrel January 02 through Sept. 18 last year.


Foreign Exchange Reserves


Evidently the Russian economy is in no evident danger of short term default, and foreign exchange reserves, which stood at $560.3 billion on September 12 (according to data from the Russian central bank) - the third largest globally, after China and Japan - are evidently ample. In addition Russia has a $163 billion SWF (the National Welfare Fund), which is split into two parts, $130 billion in a reserve fund, and $33 billion in the National Wealth Fund (the SWF proper).




Nonetheless, the reserves have dropped quite sharply since early August, and are now down some $37 billion since their August 8 peak, and reserves declined by $13.3 billion to $560.30 billion in the week ended Sept. 12, after falling $8.9 billion in the previous week. About 47 percent of Russia's reserves are held in U.S. dollars, 42 percent in euros, 10 percent in pounds and 1 percent in yen, according to the most recent figures released by the central bank (June 30, 2007.

Part of this reduction in reserves is a result of central bank intervention in support of the ruble, since Russia operates a policy of trying to maintain the currency steady within a trading band set against a basket of euros and dollars. Evgeniy Nadorhsin, a senior economist at Trust Investment Bank in Moscow, estimates that the central bank sold approximately $3 billion in fx reserves last week.


So Where Do We Go Now?

This is very hard to say. Clearly we should expect the economy to slow substantially in the last quarter of 2008 and the first quarter of 2009, as credit conditions tighten for households, and the decline in oil prices restricts revenue flows. As just one indication of the worsening credit conditions we could note that Russian 5-year credit default swaps are trading with a spread of around 253-255 basis points, little changed this week but more than double the level seen before the start of the conflict with Georgia.


On the other hand Russia is hardly the Baltics, so we should not expect the economy to go into a nosedive. A lot depends on the view you take about the future of energy prices. Since my own view is that the global economy will slow down considerably - in addition to the reduction in growth rates we have seen so far this year -following the most recent bout of financial turmoil, and this will serve top bring oil prices down even further, but we should see a floor, at around $80 perhaps.

More importantly I am not expecting a long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009.

As we can see in the JP Morgan EMBI+ index (see below), bonds from these economies have taken one hell of a battering in September. Looked at the other way round, the extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries has been going up, and today rose 2 basis points to 4.24 percentage points, the widest spread since September 2004, according to the EMBI+ index. So EM bonds have been taking a battering but they have taken a battering because of nervousness about the implications of a financial crisis in the developed economies, rather that as the result of any inherent problems in their own ones. That is what sets this crisis apart from the 1998 one, and that is what means that the financial markets in these economies will in all probablilty bounce back again quite substantially once all the nervousness dies down. Basically most of these markets are neither "oversold" nor are they "maxed out".

What is interesting about the above chart is the way in which things seem to have really taken a decisive turn for the worst in late August, and it is curious to note on the chart below that the Russian MSCI index also started to deteriorate further starting on or around 2 September (see chart below which is from May 2008 to date). So while the Georgia factor may have made people nervous, other, deeper, structural factors are obviously at work.

And while I am on deep structural factors, and the MSCI Emerging Markets index, I would like to conclude by pointing out that the decline since mid May has been pretty generalised, and in some sense is obviously cyclical. The point is that this fall will at some point hit bottom, after which time we should be ready to see a rebound, as investors move in and snap up what will obviously be seen as very attractive buying opportunities.

``We could be in for a volatile period until there is a resolution to what's going on in Georgia,'' said Vlad Milev, an analyst at Metzler Payden, which oversees $1 billion in East European stocks. ``We are not trading on economic fundamentals or company earnings. We are trading on headline news, and the headlines have been largely negative since the events in Georgia started.''

Russia's ambassador to Moldova, meanwhile, said the country's leaders should be wary of what happened in Georgia and avoid a "bloody and catastrophic trend of events" in the separatist, pro-Russia region of Trans-Dniester. The ambassador, Valeri Kuzmin, said Russia recognized the independence of South Ossetia and Abkhazia because of "Georgia's aggression against South Ossetia." Trans-Dniester broke away from the former Soviet republic of Moldova in 1990. A war broke out between Moldovan forces and separatists in 1992 leaving 1,500 dead. Trans-Dniester is supported by Russia but is not recognized internationally. Russia has 1,500 troops stationed there to guard weapons facilities.