From his taste in sturdy mahogany office furniture to his precise focus in collecting art (Russian pre-avant-garde, 1895-1920), Peter Aven is far from the stereotypically flashy oligarch. As Russia becomes swept up in financial crisis, his measured demeanour is that of a man who has seen it all before.

“Our clients know us, they stayed with us in 1998 and they survived, and they will stay with us now because they trust us,” says the president and co-owner of Moscow’s Alfa Bank. Comparisons with 1998 – when the rouble lost 75 per cent of its value and all but a handful of well-connected banks collapsed – pop up more and more frequently in conversations with Russian billionaires.

Even as the country’s stock market plummeted in August, in response not just to global market weakness but also war in Georgia as well as a perception that the Kremlin was meddling in the markets by picking favourites, the domestic economy seemed impregnable. “It’s nothing like 1998” was the oft-heard refrain from bankers and businessmen. With the third-largest hard currency reserves in the world and an oil-fuelled trade surplus, Russia was certain to weather what was sure to be a short-term financial storm.

But now, a picture is emerging of Russia’s economy that is worse than most had feared. “We had huge growth, and this led to bubbles, and now some of those bubbles are bursting,” says Mr Aven, a former minister of foreign economic relations and, according to Forbes, the world’s 243rd richest man.

The underlying problem is much the same as in the US and western Europe: much of the credit in the economy was backed by assets that fell sharply in value. In the west these were largely mortgage backed securities, which collapsed when the housing market fell, while in Russia much of the credit had shares as the collateral. In each case, the declining market has fed on itself in a vicious cycle, as falling prices forced asset holders to come up with additional cash to cover losses, which led to the forced selling and further falls in asset prices.

In Russia, however, matters have been exacerbated by the country’s vulnerability to the shifting tides of foreign investment. Cheap credit lines from foreign banks were a critical source of funding for long-term investment. “Our entire financial system was based on foreign money, not on domestic savings,” says Elena Sharipova, senior economist at Renaissance Capital, another Moscow investment bank. When the inflow reversed, “this made us tremendously vulnerable”.

What is more, Russia’s status as a leading exporter of oil and gas is looking like much less of a cushion. With crude prices down to around $65 a barrel, the Russian budget for 2009 barely breaks even. After two months of crisis, meanwhile, Russia’s currency reserves have dropped from $597bn in August to $515bn on October 17, partly as a result of defending the rouble. Capital flight is running at $12bn-$16bn a week. The Moscow interbank lending rate hit 22 per cent last week before settling back to 17 per cent, by far its highest level this decade, reflecting the scale of the stress in the banking system. Domestic banks are seeing depositors’ confidence evaporate – four retail banks have experienced runs and been sold off in a hurry.

Below: Prices shrink middle class

This month, the central bank instituted the first measures designed to prevent a speculative attack on the rouble when it banned currency swaps. But analysts are starting to ask how long the authorities can stand as substitute for the cut-off foreign investment and seized-up credit markets. “They have enough reserves to last a year at this rate, maybe 18 months,” says an economist at a Moscow bank.

As elsewhere, the crisis in the financial sector has started to hit the real economy. Factories have begun shedding jobs or even closing, buyers cannot pay suppliers and many oligarchs are in trouble – they may forfeit many of their assets to the state in exchange for bail-out funds, in an ironic reversal of the chaotic 1990s privatisations. That could set the stage for a massive redistribution of property. “There will be a very big adjustment similar to 1998,” adds the Alfa chief. “But the reasons are very different. In 1998 there was purely a state debt crisis. Today ... it is mainly a private sector problem.”

Ten years ago, the state defaulted after having borrowed from the oligarchs and given them collateral in state shareholdings. That handed them some of Russia’s most valuable companies on a platter. But under a bail-out plan announced last month, says Mr Aven (right), “a lot of private stakes will go to the state – that’s for sure”.

Despite the announcement of over $200bn in bail-out funds and additional liquidity measures, the stock market keeps falling: it has lost more than 75 per cent of its value from its high in May. The bail-out, which at 13 per cent of gross domestic product is higher than any other announced in a Group of Eight industrial country, has also failed to unfreeze the credit markets.

Another source of capital that has meanwhile dried up is the ability to tap western equity markets. Russian companies this year expected $50bn in proceeds from initial public offerings. Just $2.5bn has materialised and the prospect of more is virtually nil, according to Chris Weafer, head of strategy at Uralsib, also a Moscow investment bank.

Alexander Lebedev, owner of National Reserve Bank and part-owner of Aeroflot, the national air carrier, says the government and central bank have been slow in allocating funds and in allowing the consolidation of banking and other industries to proceed. Some banks have been insolvent for weeks and should be merged, he adds, but have not been allowed to do so by the central bank. The authorities are “not in a hurry, that’s for sure ... It is great to say that we’ll emerge from the crisis stronger, that this will bring consolidation of the banking sector. But this requires the government to act on a day-to-day basis and it isn’t doing so”.

Mr Weafer says: “What’s hitting confidence is that the ambulances were not getting to the front line but the casualties were already starting to appear.”

The bail-out will also put the state in a position to choose the winners and losers in the crisis, to oversee the redistribution of property as it sees fit. “How the government (and the different factions within it) and the state controlled banks allocate that liquidity could create winners and losers on a scale not seen in Russia perhaps since the 1998 crisis,” according to a research report by Renaissance Capital.

Igor Shuvalov, first deputy prime minister, says economic expediency rather than politics will determine priorities. In an interview with the Financial Times, he adds that the turmoil in credit markets is already starting to abate and the government is keeping a careful eye on the banking sector. “This situation will calm down slowly but will not calm down immediately, because it has already affected the psychology of people. The interbank [market] has started working normally, the rates are high but coming down. Banks have started crediting sectors again. But we still need two or three weeks for the situation to start improving.”

As for banks, he says the government is hoping that the crisis will cause some consolidation in the sector.

In addition to banking, the government is paying special attention to the retail and construction sectors. “Our priority is that there should be no malfunctions in the supply chain. Retail, for example, is a priority because it should run like clockwork. It is a very sensitive sector. If they malfunction, then agriculture malfunctions, and so on down the line. No one would get paid and they would get nervous. It would cause a big chain reaction ... One link breaks and it would start big problems. Same with construction. If they freeze projects, then metal and cement are hurt.”

Retail and construction are indeed the non-financial sectors that look the most vulnerable. Supermarket chains have seen sales fall: X5 Retail Group, which claims to be Russia’s biggest stores chain, says it has cut staff in Moscow and regional offices by 30 per cent. GK Viktoria, another retailer, has reduced total staff by 10 per cent. Among property developers that have acted to freeze projects is Mirax Group, which is building many of the sleek chrome and glass skyscrapers to house the “Moscow City” financial centre, inspired by London’s Canary Wharf.

Mikhail Delyagin of the Institute of the Problems of Globalisation says the bail-out measures have not helped and is pessimistic about the ability of the state to step in and save the markets. “They settled the short-term problem but the long term problem remained,” he says. “And right now there is a very sharp braking of the economic process.

“The system has moved suddenly from a developing and growth-oriented economy to a survival economy. If you are driving your car in fifth gear and suddenly you shift into first, what happens to the engine?” he asks. “It blows up.

PRICES SHRINK MIDDLE CLASS

The average Russian has yet to feel the full brunt of the financial crisis, which so far has drastically reduced the wealth of just the 3 per cent of the population who own stocks. But according to Mikhail Delyagin, head of the Moscow-based Institute of the Problems of Globalisation, the real economic killer has yet to make itself fully felt: inflation.

Already running at a six-year high of 15 per cent before the crisis, it is likely to grow as the government continues to pump bail-out credits into the economy. “Our priority is stabilisation over the risk of inflation,” says Igor Shuvalov, first deputy prime minister.

Inflation has already hurt living standards, which is politically problematic for Russia, where the population has become used to around 10 per cent annual growth in real wages over the past eight years under Vladimir Putin, former president and now prime minister.

Official statistics for real wages show a 14 per cent year-on-year rise even in the crisis month of September. However, Mr Delyagin cites polls conducted by marketing agencies that show a much different picture. As a result of inflation, the proportion of Russians who according to marketing surveys constitute the middle class – meaning they can afford to buy household appliances and mobile phones – has shrunk this year for the first time this decade, from 25 per cent to 18 per cent.

He says that as a result of the crisis, consumer credit will further be reduced which will mean access to a consumer lifestyle, important to prestige-conscious Russians, will be further reduced. This could have political consequences: “It’s one thing to be the head of a country that is prosperous and quite another to be the head of a country that is entering a systemic crisis.”

Peter Aven, president of Russia’s Alfa Bank, agrees that the crisis will have political consequences for a country where real income has been growing so steadily. “Over the last decade, people here became used to living 10 per cent better every year. But we will start a period of much more moderate growth and a much different trend.

“The popularity of the government mainly depends on economic results,” he adds. “This government is popular because of the successful development of the economy over the last several years. Any economic slowdown hurts the government’s popularity.”

For his part, Mr Delyagin does not need to be the highly trained economist that he is to see there is something wrong with Russia’s economy. The budget of his institute, funded by private corporations, has been cut by 70 per cent and he has had to shed half his staff.

“Of course, when there is a sharp deterioration in the economic situation, naturally people do not cut production first but rather consulting programmes,” he says ruefully.

By Charles Clover

October 26 2008

The Financial Times Limited 2008