(Updates with EU ultimatum in 13th paragraph, trade accord in 27th paragraph.)
June 27 (Bloomberg) -- One month he wins the Olympics and kudos from world leaders. The next he grabs Crimea and gets kicked out of their most exclusive club. Now he’s facing a recession with few tools to fight it save the public’s love.
Even Vladimir Putin, in his 15th year in power, can’t convert an 86 percent approval rating into economic growth when global banks stop lending and money flows mostly one way: out.
So far, Putin has paid a small price for the most blatant land grab in Europe since World War II: a few frozen credit cards, some travel restrictions on his billionaire friends and a bit of finger-wagging by U.S. and European Union leaders. For all his vows to modernize and diversify the economy, though, Russia remains a nuclear-armed petrostate and Putin’s remedy for growth now is more, not less, government control.
“The measures the president is proposing will certainly limit competition and freeze modernization,” Alexei Kudrin, a Putin adviser who steered the country’s finances for more than a decade, said in an interview in Moscow. “They will lead to an increase in market regulation and protectionism.”
Since expanding state-controlled lenders OAO Sberbank and VTB Group, whose dominance pushed out foreign rivals such as HSBC Holdings Plc and Barclays Plc, Putin has increasingly used the central bank to provide funding for companies via domestic banks.
Unlike in his first term, when the benefits of major policy achievements such as cutting taxes were spread across the economy, Putin’s recent years have been marked by the creation of national champions in select industries such as energy, technology and aviation.
State enterprises now account for more than half of the economy, up from 30 percent when Putin came to power at the end of 1999, according to BNP Paribas SA. As the bureaucracy swelled during that period, Russia emerged as the world’s most corrupt major economy. It ranks alongside Pakistan and Nicaragua at 127th, out of 176 nations, by Transparency International, down from 82nd in 2000.
With Russia’s $2 trillion economy stagnating, fixed investment falling and the U.S. and the EU warning of a tougher round of sanctions over the pro-Russian revolt in eastern Ukraine, Putin’s solution is a list of proposals revealed in May that involve a greater role for the state. He ordered the central bank to set up long-term financing for manufacturers and called for rules to force “systemically important” companies to move their registrations inside Russia.
Gennady Melikyan, a former deputy central bank chairman, said he wasn’t optimistic about the outlook.
“The situation in the economy isn’t very good,” Melikyan said in an interview in the Russian capital. “Sanctions didn’t have a direct negative impact, but they contributed to the increase in capital outflows.”
Russia’s annexation of Crimea on March 21 and the unrest in Ukraine led the U.S. and the EU to impose asset freezes and travel bans on 99 people and 20 companies. It also prompted the Group of Eight to suspend Russia’s membership, forcing Putin to cancel a planned summit of world leaders in Sochi, the Black Sea resort that hosted the Winter Olympics Feb. 7-23.
EU leaders today ordered Russia to stop the rebellion in Ukraine by Monday, the same day that a newly extended cease-fire declared by Ukrainian President Petro Poroshenko and backed by Russia expires. Foreign Minister Sergei Lavrov welcomed the extension while saying he hoped it wasn’t “just another ultimatum.”
As Putin seeks to patch up relations abroad, at home he’s struggling to shore up an economy that the International Monetary Fund says is contracting for the first time in more than four years.
He also must cope with external debt markets that have been largely closed to Russia since the annexation of Crimea. International bond sales by Russian companies plunged to less than $2 billion in March through May from $19 billion in the same period last year, making it harder for Russian banks and companies to meet their combined $191 billion of foreign debt payments due this year, according to central bank data.
That’s forcing companies to turn to Sberbank, VTB and other domestic lenders to meet the vast bulk of their funding needs. With household deposits declining and net capital outflow projected to reach $90 billion this year, the most since 2008, the lenders, in turn, are tapping the central bank for liquidity at an unprecedented pace.
“The banking system is close to having a deficit of assets that can be used as collateral to get funds from the central bank, while demand for refinancing is continuously increasing,” Sberbank Chief Executive Officer Herman Gref, Putin’s economy minister during his first two terms as president, said by e- mail.
The system is in a vicious cycle. Spooked by events in Ukraine, investors sold Russian assets, which weakened the ruble and prompted the central bank to sell dollars to support the currency. This pulled money out of circulation, stoking inflation and choking spending.
Since Putin installed his former economic aide, Elvira Nabiullina, as chairman of the central bank a year ago, Bank of Russia financing for commercial lenders has more than doubled. It reached $142 billion in April, or about 9.5 percent of the industry’s total liabilities, according to data compiled by Bloomberg.
At the same time, the Micex Index is at about 1,500, close to where it was before bloody protests in Kiev led to the ouster of Kremlin-backed President Viktor Yanukovych in February. It’s rebounded from an almost four-year low of 1,182.89 on March 14. The ruble, buoyed by interventions, is hovering near a five- month high versus the basket of dollars and euros used by the central bank to manage the currency.
Vladimir Pantyushin, senior strategist at Sberbank-CIB, said there were several reasons explaining how stock markets and the ruble can rise while capital is fleeing Russian assets.
“‘In Russia, capital flight and the stock market are unrelated,’’ Pantyushin said. ‘‘The stock market in Russia is not a dominant part of the financial sector. Outflows don’t necessarily mean money is escaping, it often means companies and people are moving rubles into foreign currencies.’’
While Putin’s policies in Ukraine have been condemned by the U.S. and the EU, they’ve been applauded almost universally at home, even by outspoken critics. As a result, less than two years after the biggest protests against his rule, Putin’s popularity is close to an all-time peak reached in 2008.
‘‘The fact that Russia was kicked out of the G-8 hasn’t made people proud, but the feeling of isolation has driven the population to believe that no one in the West loves us, so there’s nothing left to do but rely on the current leadership,” said Alexei Grazhdankin, deputy head of Levada Center, an independent polling group in Moscow.
Putin’s rating has risen to a six-year high of 86 percent, bolstered by his annexation of Crimea and handling of the Ukraine conflict, according to the latest poll by Levada, conducted June 20-June 23.
Michael McFaul, the U.S. ambassador to Russia before stepping down this year, said Putin is risking a backlash among the country’s business elite by pursuing policies that will lead to tougher penalties if they aren’t halted.
“Given the kind of political regime you have in Russia, the most likely way it feeds back is with the elites, with economic elites who have economic interests in integration with the global economy,” McFaul, who now teaches at Stanford University, based near Palo Alto, California, said by phone. “Those are the folks who are going to suffer.”
The EU has been looking at possible deeper penalties since March and they may be discussed at a leaders’ summit that began yesterday. Today, the bloc signed free-trade agreements with Ukraine, Georgia and Moldova. President Barack Obama’s administration is preparing new sanctions aimed at specific areas of the Russian economy, including energy and technology, according to three people briefed on the plans.
For the economy, time is running out, according to Alexey Vedev, head of the Gaidar Institute’s Center for Structural Research in Moscow.
“The geopolitical tension is bad, but the problem with financing is far more serious,” Vedev said in an interview.
Economic growth during the entire Putin era has been based on consumption rather than savings, unlike in China. There, savings account for about half of gross domestic product, versus 23 percent in Russia, Vedev said.
“This can’t go on forever,” Vedev said. “China’s modernization taps into savings. Russia’s comes from loans.”
When you have a financing model that’s tied to the population’s savings, the allocation of resources is more efficient than in an overly centralized system like Russia’s, said Yevgeny Yasin, a former economy minister who’s an academic supervisor at the Higher School of Economics in Moscow.
“The authorities have chosen an economic model whose main feature is that all the decisions, including investment, are made at the very top,” Yasin said. “It’s a rotten model.”