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Russia Wrestles With Ruble Collapse

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Bad decisions when times were fat spell a rough road ahead for those who hold their savings in Russian currency.  It is amazing how things change in a few months. In September, Russia was on top of the world, the returning global power. Today, it is slipping into obscurity. If it did not have nuclear weapons, most would not even care what happens.

Russian economic growth in this decade was completely driven by rising commodity prices, mainly of oil and gas. As the global economy goes into recession and commodity prices either decline or remain at today’s levels, Russia will relive the horrible 1990s when it defaulted on its debt and suffered from a severe inflation. Think of Russia as a very large oil and gas producing company that is run for the most part by a government that makes General Motors’ (nyse: GMnews people ) and Ford’s (nyse: Fnews people ) management and autoworkers’ unions look like progressive thinkers.

Over the last five years, Russia de-privatized (a clever euphemism for “stole”) oil assets from private investors and has been milking petro cash flows from now state-owned oil companies. The government is simply not equipped to manage projects that have a multidecade life. Russia underinvested in exploration and development of oil and gas in the last decade and that is why its oil and gas production is declining.

Communism failed for a reason: Government is a horrible capital allocator. The time horizon and time in office of a government bureaucrat is much shorter than the horizon of an oil company, therefore when choosing between drilling holes in the middle of nowhere that will increase oil production years down the road or raising benefits to retirees, retirees win.

But it gets worse. As oil prices rose, the Russian government decided that it did not need the West anymore. It felt that the contracts it signed with BP (nyse: BPnews people ) and Royal Dutch Shell (nyse: RDSAnews people ) in the 1990s–when oil prices were much, much lower and no one wanted to invest in Russia–were not advantageous anymore. Using deceptive legal practices, it unilaterally renegotiated those contracts muscling away lucrative projects from these companies.

It is just amazing how things changed in six months. Declining oil prices will likely force Russia to come back to foreign investors begging for investment, but this time it will not receive it. Would you blame them?

Yes, it gets even worse. The return on capital in oil and commodity-related industries was much higher than in any other industry. This siphoned capital from other industries, which caused investments in these industries to decline. The rise of commodity exports drove up the Russian currency, making noncommodity industries even less competitive in the world market. Once you take high commodity prices away, Russia is worse off than it was before.

On top of this, when Russia did well, it acceded to pressures to increase social programs. While the revenues were flowing, Russia paid off its foreign debts and created a Stabilization Fund, a multihundred-billion dollar savings account. But it is hard to say how long this fund will last as Russia spent (wasted) $57.5 billion on defending the ruble in September.

Russia is strong on a balance sheet basis, but that is a reflection of the past. The future, as reflected in its future income statements, looks horrible. To some degree it is almost a mirror image of the U.S.; our balance sheet is weaker but our earnings power is strong. Despite all the problems we have in the U.S., we have the most diversified economy in the world. Unfortunately, that is not the case with Russia.

The Russian currency will decline substantially over the next several years as Russia will try to print itself out of the problem. Despite the intervention, the ruble already declined close to 20% versus the U.S. dollar since July, but the decline has only started. Money is leaving Russia, which is why the ruble is collapsing.

Construction projects big or small came to a halt in September and October. People took their money and ran. I called my childhood friends in Russia last month and advised them to move their ruble denominated savings out of ruble into dollars and/or euros (either should be better than the ruble), preferably also taking their savings out of Russian banks and either transferring into big European banks or just putting them into a safety deposit box.

Yes, unfortunately, I believe the Russian ruble will collapse.

Vitaliy N. Katsenelson, CFA, is director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

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  1. A bold prediction, Mr. Katsenelson. If you are correct, this proves that the Russians do not yet understand the prerequisites of a successful capitalist economy. I did not believe that the erstwhile strength of the Russian markets was a signal of fundamental improvement in their economic system, because of their poor treatment of foreign investors. The recent action in Georgia was yet another reason for me to continue in my USSR-era boyhood belief that the Russians simply cannot be trusted (yourself as a notable exception, of course).

  2. “Communism failed for a reason: Government is a horrible capital allocator.”

    Do you think we could get that statement put on a bunch of large signs and put them up around Washington?

  3. I too have an issue with “The time horizon and time in office of a government bureaucrat is much shorter than the horizon of an oil company,”

    I think the Wall Street scandals have shown the opposite.

    The time horizon of a person in business is up to the next bonus or raise or promotion. Fast-trackers in business frequently spend less than a year in a position, put some stuff in place, and move on, leaving trails of disorganization and confusion. This can be sublimely masked by a fast-growing business, but in flat or down times, the roaches come out of the cupboard and things go south quickly. In decline, business leaders if lucky have moved on to the next musical chair, or, if unlucky, are mush.

    Read Reich’s “Supercapitalism”. The original myth that business builds for the long term with the good of it’s employees, community, or even it’s own long term interests in mind is revealed therein to be today a much bigger myth than it originally was. Most business leaders are just hoping they can survive until they get to an exit strategy – before anyone finds out what the real state of affairs is. Accounting provides a Taleb-like trail of data which people believe until they don’t.

    At least a govt. bureaucrat might be in a job “to serve the public interest”, and, for more than a year or so.

  4. It is amazing to see how quickly everyone dismisses the high oil prices we have been experiencing the past few years as a speculative bubble akin to the dot com era and that now oil prices have fallen back to their rightfull levels below $40. Would suggest you get yourself a copy of the IEA World Energy Outlook 2008 report. Higher oil prices will be the norm not the exception in the future and we all better get used to that. The theory of Peak Oil is fundamentally very true. The ability to increase supply will not match the growth in the global demand for it and that results in shortages of something the entire globe is addicted to. Ever seen the movie Mad Max?

    Russia controls the some of the largest reserves of oil and natural gas (outside of your pal Iran & SA) in the world. More importantly though they control its distribution to Europe and the rest of the world. And like it or not, you and me and everyone else out there needs it. Mark my words, Russia intends for us to pay very heavily for it. The military move into Georgia had nothing to do about protecting the Russian people. It was all about securing the transit lines for Caspian oil. The Russians now control it and believe me they will use this leverage when the time is right.
    You are predicting the collapse of the Ruble….I will predict the collapse of the USD beforehand. Your country is bankrupt. You have no savings. You have no oil. You have no gold.

    Right now the outcome for the USD is all about confidence. Short term people see it as a safe haven. Once the printing presses are unleashed at full speed by “Helicopter Ben”, this confidence will wain and the USD will fall, never to be seen again. Read some financial history my friend. The similarities between the US and Germany in the 1920’s is utterly striking! As you phoned your friends in Russia, I phone my friends in the US and tell them to get out of USD….and into gold….and then get your gold out of the US.

    Here is a link to the IEA site FYI:

    All the best for the New Year

  5. Actually Russian growth was highest when oil traded at 15$ per barrel in 2000. High commidity prices actually curtailed growth slightly as this led to a rapid appreciation of the ruble and caused problems for domestic manufatcuring. This is known as the “Dutch Disease” by economists. Sloppy and outright false reporting. Learn the facts befor you regurgitate:

    Russian GDP

    price of oil:

    In fact Oil just broke the 50$ mark in 2005 and traded at 64 in 2007. Expect a rapid return to GDP growth in Russia with the very beneficial devaluation of the ruble -excluding world financial armageddon – which is very possible. In this case Russia will be o.k. too(in a relative sense, compared to other countries) as they are the only self sufficient country in the world(Oil, gas, grain, uranium etc..)

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