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The Man Who Saved Russia's Economy Counts the Cost of Crimea

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It's money, more than oil and gas, that Russia needs now. But Putin is playing a 19th-century game, valuing territory and a naval base over international goodwill and the free flow of capital and expertise.

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If anybody knows how much Russia will pay for its confrontation with the West over Ukraine, it should be Alexei Kudrin. As finance minister from 2000-2011, Kudrin engineered his country's transformation from bankrupt backwater to proud fiscal model. He oversaw 11 years of budgetary surpluses, and managed to sock away the savings in huge reserve funds that rescued Russia after the world crisis of 2008-'09.  He finally left government, ironically, after publicly opposing then-President Dmitry Medvedev's plans for a rapid increase in military expenditure.

Last week, Kudrin offered some ballpark estimates of the cost of the Kremlin's Ukraine policy, and they were dire. Even a "mild version" of sanctions from the US and European Union would likely cut Russia's economic growth from a projected 2.5% this year to "less than 1% and maybe zero," the ex-minister told a business conference in his home city of St. Petersburg.  By "mild" he meant sanctions that "remain on the level of freezing accounts of individual citizens, companies and operations." That is to say, the process that Washington and Brussels commenced immediately after Sunday's kangaroo referendum in the breakaway Ukrainian province of Crimea.

The reason such seemingly slap-on-the-wrist measures could inflict so much damage is a simple one that has been largely overlooked in discussions about the new East-West standoff: Russia, despite its virtuous national savings, runs on credit from abroad, and that credit in turn runs on a confidence that the Ukraine crisis is badly shaking.  International bank loans to Russian corporations come to some $700 billion, according to Kudrin, more than one-third of Russia's annual gross domestic product. "That volume will decrease because many credits will not be rolled over and certain joint projects will stop. This has already begun," Kudrin warned.

The $700 billion is much more funding than Russia can replace domestically. It currently has about $175 billion on tap in its two savings vehicles, the Reserve Fund and National Welfare Fund. The state development bank, known as Vnesheconombank or VEB, is already tapped out and in need of recapitalization after an orgy of credit to fund the post-2009 recovery and the $50 billion Sochi Olympics last month. Of course the foreign lending won't all disappear at once.  But unless Vladimir Putin ratchets down Ukraine tensions quickly, there will be a painful contraction.

Serious pain has already been inflicted via the ruble, which has fallen more than 3% against the dollar over the past month while most other emerging markets currencies rallied, and is off 15% over the past year. That nearly matches the 18% crash in the Turkish lire, although Russia has none of Turkey's macroeconomic frailties or internal political turmoil.  As Sergei Guriev, a respected Russian economist now teaching in Paris, says, ordinary Russians own no securities, so they are largely indifferent to falls in the stock market, which has plummeted by 17% in the past month despite a 5% "relief rally" on Monday.  But with so many consumer goods imported, the shrinking ruble will hurt almost every family, and soon.

And those are the results of mild sanctions. Kudrin envisions a second wave of measures that would "limit the operations of our financial institutions with hard currency on world markets." The most immediate result would be a $50 billion increase in capital flight from Russia over "the first quarter or two," he predicts. Russia perennially bleeds capital, but the total estimate for 2013 was about $65 billion, so the extra loss would be substantial. In fact, Goldman Sachs (NYSE:GS) recently estimated that as much as $50 billion has already left the country in the first two nervous months of 2014.

Kudrin was a protégé of Putin's from the leader's early days in St. Petersburg municipal government. Putin used to listen to Kudrin and other internationally minded economists in his entourage like German Gref, who now heads the massive state bank Sberbank (OTCMKTS:SBRCY) and Elvira Nabiullina, who is the current central bank chief. 

The US and EU are giving Putin every chance to quit while he is ahead in Ukraine, freeze the de facto independence of Crimea in place without annexing it to Russia, and let it all simmer down to one of those intractable back-burner peace processes that go on forever while everyone gets on with the rest of their lives. Unfortunately he seems to have boxed himself in with an intensive propaganda campaign that has convinced most Russians that the new authorities in Kiev are "fascists" bent on ethnic Russian blood, and elated them with the thrill of bloodless victory in an emotionally significant theater. The chances of him backing away from annexation now, and the resulting Western retaliation, look slight.

It has become clear that Putin is playing a 19th-century game in a 21st-century world. He is valuing territory (an absurdly mismanaged territory that costs Kiev $1 billion per year in subsidies) and a naval base (which Russia already had anyway) over international goodwill and the free flow of capital and expertise. He picked a good strategic moment for his land grab, when the other side could offer no resistance, but a poor economic moment, when Russian growth was already sputtering and the long-term alternatives to its energy resources are expanding rapidly.

What's a bit odder is Western commentators' decidedly analog framing of the issue. The lead story on Bloomberg's website Monday afternoon, for instance, concluded that "the US and its European allies have few levers to deter Putin" because they cannot immediately replace Russia's $160 billion per year in oil and gas exports. An array of experts lined up to explain why the Free World is helpless in the face of Russian expansionism. But the man who built Russia's economy knows better. It's money, more even than oil and gas, that makes the world go round. Given even steady symbolic pressure from the West, money will extract a cost that may soon make Putin less of a hero at home.
No positions in stocks mentioned.

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