Vladimir Putin has delivered his annual press conference and at the top of the agenda was the Russian economy, reflecting that the turmoil buffeting the Russian rouble has reached critical levels.
After a steady depreciation over recent months, the rouble reached an all-time low on December 16. The country is on the verge of a recession as a result of falling oil prices and the impact of Western sanctions over the Ukraine crisis.
The dramatic decision by the Central Bank to raise interest rates to 17% the day before failed to be the game changer that its architects hoped it would be.
Despite Putin’s belief that the Russian Central Bank and government are taking adequate measures to deal with the situation, the rouble is still very weak. As long as the currency continues to fall, so it becomes more likely that capital controls will be imposed as a way for the government to regain control of the economy.
This would bring the flow of capital in and out of the country under government control and would represent a significant u-turn for Russian officials who have dismissed such a step as inconceivable. But drastic times may result in drastic action being taken by the central bank.
The case for capital controls
From a purely economic point of view, capital controls might not appear to be a bad option. After all, Malaysia employed capital controls in 1998 to stave off the ill effects of the Asian financial crisis. Like Russia today, Malaysian policymakers saw a flexible exchange rate policy fail to prevent a rapid depreciation of the ringgit, followed by a severe recession. Once it became apparent that the ringgit was not going to bounce back, capital controls were introduced to stem the tide of currency outflows. In the end, the Malaysian economy recovered quicker than many of the other economies affected by the Asian crisis.
If the authorities perceive the patience of the population to be wearing thin, the temptation for Russian policymakers to introduce similar measures today will surely rise. This might take the form of some or all of the following: forced sales of foreign currency by exporters, limitations of foreign currency withdrawals from banks, limitations on purchases of foreign currency, and controls over bank currency outflows.
Why are capital controls significant?
If capital controls are introduced – and if they were to have the same stabilising effect that they had in Malaysia in the late 1990s – it might appear to be a small price to pay for greater macroeconomic stability. However, any move away from market-based mechanisms for governing the Russian economy need to be placed in the wider context of increasing state control over the most important sectors of the economy.
During the past decade, economic policy in Russia has turned gradually more dirigiste. First the state increased its control over the strategically vital energy sector, exemplified by the expropriation and incarceration of Mikhail Khodorkovsky. This allowed the state to tap natural resource revenues more effectively, enabling it to expand public spending for the best part of a decade. The numbers of buzhetniki – those dependent on the state for income or employment – swelled.
Meanwhile, the state’s control over the financial sector has grown, giving it greater power over which firms would be granted access to finance. Large enterprises with strong links to the state benefited at the expense of small and medium-sized enterprises, most of which are forced to rely on their own cash reserves to finance investment.
State spending on the defence industry also rose. Although Westerners tend to view any increase in arms expenditure in Russia as indicative of a more assertive foreign policy, there is also an important socio-economic dimension. The military-industrial complex is Russia’s largest manufacturing sector, employing large numbers of relatively skilled workers. Russia is the world’s second-largest arms exporter and many in the elite consider armaments to represent one of Russia’s few internationally competitive technology-intensive industries.
As the state’s role in owning, influencing or funding economic activity grew, so reliance on the market-based allocation of resources declined. Even the modernisation agenda which followed the 2008 financial crisis, associated with the ostensibly more liberal prime minister, Dmitri Medvedev, was nothing more than a motley group of ineffectual projects led by powerful interests connected to the state.
While the state’s role grew stronger, property rights – which are key to successful long-term economic development – weakened. In today’s Russia, property rights are, as they were under Peter the Great in the 17th century, conditional on service to the state. Those who cultivate close ties with the ruling elite and who pay due political obeisance in their enterprises are left alone to enjoy their riches. Those who assert any independence often find themselves subjected to legal proceedings that are usually little more than fig leaves used to justify the expropriation of private property, often with the connivance of state officials.
It is against this backdrop that the importance of capital controls becomes clear. If capital controls are imposed, they will represent yet another piece in the jigsaw of what is emerging as Putin’s new economic policy. This policy could, like its eponymous NEP counterpart of the 1920s, reposition the state in control of all the “commanding heights” of the Russian economy, with only a small portion of activity free from state influence.
Capital controls could, by centralising control of financial flows, help the state cement its control over the bulk of financial resources in Russia, further reducing the scope for the emergence of any significant independent economic or political forces in the future.