There’s only one thing that can save Russia’s economy, and it’s not Vladimir Putin

Matt O'Brien

Russia might not be a riddle wrapped in a mystery inside an enigma anymore, but there's still one unanswerable question about it: whether its banks or its currency is more doomed.

The latest news is that, after jacking up interest rates from 10.5 to 17 percent to try to prop up the ruble, Russia's central bank has about-faced just six weeks later and cut them back down to 15 percent to try to prop up the financial system. It's a catch-22: Russian President Vladimir Putin can't save either without saving both, but he can only afford to save one.

The problem, as I've said before, is that Russia doesn't have an economy so much as an oil exporting business that subsidizes everything else. But it can't subsidize much when oil prices are only $55-a-barrel. Even worse, cheap oil also means that Russian companies have fewer dollars to turn into rubles, which is just another way of saying that there's less demand for rubles—so its price is falling. Putin can't let it fall too much, though, otherwise Russian companies might not be able to pay back all the dollars they owe, and Russian banks might not be able to give scared depositors all the dollars they want. That's why the central bank increased interest rates all the way up to 17 percent to try to convince people to hold their money in rubles that would pay them a lot instead of dollars that wouldn't. It's also why the the government started spending its war chest reserves—selling dollars to buy rubles—to try to push the currency back up. And why Putin has strong-armed exporters into selling their dollars and, let's say, incentivized oligarchs into bringing their overseas money home, in what amount to kinder, gentler capital controls.

This hasn't worked, though, and it hasn't worked at the expense of Russia's banks. The first problem, as Lars Christensen of Danske Bank told me, is the ruble "should" be worth 68 per dollar as long as oil is $55-a-barrel, and nothing can cover that up for long. It might be even worse than that since a currency doesn't fall to its fair value, but rather to the point at which it's expected to start rising to its fair value. So the ruble should probably be trading around 75 per dollar. That's why, as you can see below, the ruble's rally fizzled out pretty fast despite all this intervention—and has already fallen back to its fair value. That will only continue if the oil drop does, especially now that Russia is reducing rates.

Now let's talk about that rate cut. It's not often you see a central bank raise rates 6.5 percentage points—at an emergency 1 a.m. meeting, no less—and then lower them 2 percentage points a little over a month later. So why did Russia do it? Well, to use a technical term, because first the ruble looked screwed, but then the banks looked even more so. Back in December the biggest risk was an oil-induced loss of confidence in the currency that got so bad that there were bank and even Ikea runs, as people frantically tried to turn their rubles into dollars or, failing that, assemble-it-yourself furniture. But then the ruble panic faded, and a new kind promptly emerged. It turns out that raising rates so much had postponed this currency crisis for a more immediate financial one.

Russia's banks have three problems: oil, sanctions, and interest rates. Russia's companies, who they lent money to, were already having trouble paying them back once the petrodollars dried up. But the banks weren't even been able to cover this up by borrowing more money from abroad, because Western sanctions have barred them from international credit markets. And now sky-high interest rates are crippling the little that's left of their business. That's because it's become more expensive for Russia's banks to borrow the money they need, but too expensive for anybody else to borrow any money from them. Russia's households and corporations are doing the only thing they can afford to—hunkering down—and hoping that rates will start falling to less punitive levels soon. But remember, your spending is my income and my spending is your income, so if we all try to cut back at the same time, the unhappy result will be less spending and less income for us all—in other words, a shrinking economy. Russia's is expected to contract 5 percent this year, which will make it even harder for cash-strapped borrowers to pay back what they owe.

It's added up to a who-knows-how big hole in Russia's banks. So big that the government didn't even want to know. It tried pretending that there wasn't a hole instead, or at least that it was a lot smaller, by telling banks they didn't have to mark their most recent losses to market. But, unlike the czars, markets didn't fall for these Potemkin balance sheets. A mid-sizedbank with Bruce Willis ads needed what was initially supposed to be a $531 million bailout, but a few days later turned out to be $1.9 billion. Then the country's second and third-largest lenders needed $5.9 billion more. And finally, as even more banks looked all-too-ready-to-fail, the government announced there'd be a $23 billion bailout, which, it's not clear, might be in addition to the money they're going to spend on a "bad bank."

But all the money Russia has spent bailing out its banks is money it can't spend bailing out its currency. And that's why it's started cutting interest rates instead. Russia's reserves, you see, are running down pretty fast—$36 billion since December—so it has to do what it can to stop the hole in its banks from getting much bigger. Lower rates should do that by keeping old loans from going bad, and making new loans more attractive. The tradeoff, though, is that lower rates should also mean a lower currency, although oil prices have rebounded enough the past few days for the ruble to rise regardless.

That, as it always has been, is the key. If oil gets back to $80-a-barrel, then Russia's problems will not-so-magically disappear. But if it doesn't, well, Russia will find out that it borders two countries called "a rock" and "a hard place." That's because saving its banks won't work if its currency is still falling—which it might if rates do. A cheaper ruble will make Russian bank assets worth less, make Russian companies less able to pay back their dollar debts, and make more Russian people try to turn their money into dollars. In other words, it will hurt Russia's banks about as much as they're being helped.

"The state will capitalize the banks," one Russian banker warned, "increase its stake in them," and then use them to "buy industrial enterprises" until "all our economy will be state-run." So Putin's attempt to rebuild the Soviet empire might, by isolating it at the worst possible moment, force him to recreate the Soviet economy.

Call it socialism with a KGB face.