The Kremlin's Crisis

In June 2008, even as the world economy began to crumble, Russian Prime Minister Vladimir Putin was sanguine about his country's economic prospects. "We have no crisis," he said. For the moment, he was on top of it all. Russia's economy had grown by seven percent every year from 1999 to 2007, and Putin was predicting that it would surpass Germany as the fifth-largest economy in the world by 2020.

This, however, would soon prove to be an illusion. At first, Putin and his allies in the Kremlin continued to act invincible, either in denial or opportunistic about the threat the crisis posed. But as the crisis deepened, more liberal figures close to President Dmitri Medvedev were able to push through an initial round of much-needed economic policy adjustments. The third phase of the Russian response will become clear over the next few months, as the Kremlin chooses either to continue down the path of reform or to halt structural changes.

The crisis hit Russia after a decade of high economic growth. By early August 2008, thanks to a steady balance of payment surpluses, Russia had accumulated international currency reserves of $598 billion, the third largest in the world. Inflation plateaued at 15 percent; if anyone worried, it was about the Russian economy overheating.

But then the price of oil -- which had peaked in July at $147 per barrel -- started to plummet. In December, it hit a low of $35 per barrel, a potentially devastating change of fortune for a country in which commodities account for 85 percent of all exports.

After the outbreak of the war in Georgia last August, Russia's stock market started plunging relentlessly, dropping a total of 80 percent from its height in May to its nadir in October. New revelations emerged about Russia's oligarchs -- it turned out they had borrowed more than anybody realized -- and much of their wealth vanished. Within a few months, two-thirds of the country's 100 wealthiest were no longer billionaires.

Russia's first anticrisis response was to refinance the foreign loans of strategic Russian companies -- most notably Russian Aluminum -- and pour liquidity into the banking system. Putin and his allies who control large state corporations were not scared by the crisis. Instead, they saw it as an opportunity to nationalize large private firms and began to spread rumors about major nationalization of metallurgical and mining companies.

The Kremlin believed the oil-price decline to be temporary and thus that both businesses and consumers with hard-currency loans would be shielded from huge losses. This proved wrong, with serious consequences: in November, the Russian Central Bank abandoned its peg to a basket of dollars and euros, undertaking a gradual devaluation of the ruble. The public responded by shifting savings to dollars and euros. At the same time, the central bank tried to expand liquidity, but it was instantly transformed into foreign currency. The result was that by the end of January Russia had lost $212 billion, or more than one-third of its currency reserves.

In the first quarter of 2009, GDP fell by 9.5 percent compared to the first quarter of 2008, and industrial production declined by 14 percent. Falling exports, which have driven the decline, are set to plummet by nearly 50 percent this year. Naturally, the sudden economic crisis has hurt the population at large. In December, real disposable income fell by 12 percent, in sharp contrast to the steep rise in real income most Russians had experienced over the last several years. Official unemployment has reached 9.5 percent, but the government has decided to stop publishing such unfortunate numbers.

Private foreign debt has also become an acute problem. Russia's consumers and businesses owe an estimated $500 billion -- approximating the total market capitalization of the Russian stock market. The main reason for this substantial private foreign debt is Russia's poor banking system, half of which belongs to five state banks that are mostly devoted to the Kremlin's funny business. The many private banks are too small to serve the country's largest companies, which are forced to borrow abroad, incurring considerable risks from currency fluctuations.

The crisis has revealed how little Putin has done for the well-being of the Russian population during his time in office. The high economic growth of the last decade has been driven by market transformation, free capacity, and high oil prices.

Putin has been responsible for none of the above and has done nothing to help the country's current business environment, which is awful and getting worse. Most shocking is Russia's extraordinary corruption. According to Transparency International, Russia is the 33rd most corrupt country out of 180 countries. (The only country richer in terms of per capita and more corrupt than Russia is Equatorial Guinea.) One consequence is that Russia cannot undertake major infrastructure projects. Its road network, for example, has not expanded since Putin came to power in 2000.

Putin is no longer president, but he remains the most powerful figure in the country. Meanwhile, Medvedev has repeatedly stated that he makes the ultimate decisions. The personal relationship between Putin and Medvedev might be cordial, but behind them are people of very different inclinations.