The Unfolding Financial Crisis in Russia

Russia is on the verge of a severe financial crisis. In fact, one could even argue that it's already begun.

The collapse of Russia's currencyThe country's problems are grounded in the collapse of its currency, which has lost roughly half its value relative to the U.S. dollar over the past six months. At the beginning of July, it took 34 rubles to buy a dollar. Today, it takes 64.

Multiple explanations have been offered for the ruble's swoon, but the primary culprit is unquestionably the precipitous drop in oil prices. Thanks to OPEC's strategy to undercut new and more expensive sources of supply, the price of Brent crude oil has fallen from $112 a barrel in May down to just over $60 a barrel today.

The net result is that Russia, which relies heavily on energy exports to fuel its economy (pun intended), has seen the demand for its currency evaporate in foreign exchange markets.

The trappings of an unfolding crisisIn the middle of last week, Russia's central bank responded by increasing its benchmark interest rate by a stunning 6.5 percentage points to 17%. The theory is that high interest rates will reverse the flow of capital out of the country, as foreign investors clamor to lock in double-digit returns on bank deposits and other types of money market instruments denominated in rubles.

But while the move appears to have temporarily stabilized the currency, it has exerted the opposite effect on the country's banks, which, like lenders everywhere else, rely on low short-term interest rates to survive. The first domino fell on Monday, as Russian financial regulators took over OAO National Bank Trust, one of the country's leading retail lenders.

There's no question that a single failure like this may end up being an isolated incident. However, there's also no question that it could just as likely serve as the opening salvo of an incipient panic.

"In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them," wrote Walter Bagehot in Lombard Street: A Description of the Money Market(link opens a PDF), long-considered the bible of central banking.

We've seen this play out time and again in the United States. The Panic of 1857 was triggered by the failure of the Ohio Life & Trust Company. Sixteen years later, the insolvency of Jay Cooke & Company set off the Panic of 1873. The Panic of 1907 was ignited by the shuttering of the Knickerbocker Trust Company. And, of course, the bankruptcy of Lehman Brothers presaged the subsequent downfall of more than 500 banks in the wake of the 2008-2009 financial crisis.

Will the same narrative unfold in Russia? All we can say at this point is that the early indications aren't favorable. Its former finance minister has warned that the country is careening toward a "full-scale economic crisis," and there's evidence that its credit markets are already seizing, which is a telltale sign of panic.

Anticipating the global reverberationsTo be clear, the reverberations in the United States are likely to be muted not only by geography, but also by the fact that many American companies and investors had previously reduced their exposure to Russia in response to U.S.-imposed economic sanctions stemming from the conflict in Ukraine earlier this year.

Yet, we shouldn't fool ourselves into concluding that the U.S. markets are immune to turmoil on the other side of the globe. In 1998, for instance, the devaluation of the ruble caused the demise of Long-Term Capital Management, a pioneering quantitative hedge fund led by, among other people, two Noble Prize-winning economists.

What's important to keep in mind, in turn, is that any resulting major market fluctuations -- which, of course, are still hypothetical -- should be viewed by long-term investors as nothing more than short-term noise. Stocks go up and stocks go down. That's the name of the game. But only by holding pat through the irrational vicissitudes of the market can investors claim the ultimate prize of outsized returns.

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