Putin’s Economic Model Showing Strain As Russia Is Cut Off From Global Finance

By Carol Matlack
June 27, 2014
Russia warned Ukraine today that it faces “grave” economic consequences, including potential new restrictions on trade, after President Petro Poroshenko signed a free-trade agreement with the European Union.

Such retaliation would certainly harm Ukraine, which sends about one-fourth of its exports to Russia. But the construction of new trade barriers only underscores the bunker mentality that underlies President Vladimir Putin’s management of Russia’s economy–and the increasing risk it poses to the country’s economic health.

In an eye-opening report today, Bloomberg News journalists in Moscow describe an economic system that’s increasingly run by the Kremlin, isolated from global markets, and starved for financing. Among the key points:

State-controlled enterprises now account for more than half the national economy, up from 30 percent when Putin came to power in 1999.
The central bank is pouring unprecedented sums into a troubled banking system that’s largely under state control after foreign competitors were squeezed out.
Now the overstretched central bank is being ordered to step up long-term financing to designated industries.

As relations with the West deteriorate, economic xenophobia seems to be taking root. In recent weeks, Putin has called for restrictions on imports of advanced technologies, in an effort to stimulate domestic technology development. He’s set up a state-run payments system to compete with Visa (V) and MasterCard (MA). And a law taking effect on Aug. 1 will require foreign companies operating messaging and social networking services in Russia to store user data and messages on servers within the country.

Ultimately, these steps will probably hurt Russia more than its trading partners. “The measures the president is proposing will certainly limit competition and freeze modernization. They will lead to an increase in market regulation and protectionism.” No, that’s not a wild-eyed government critic speaking–it’s Alexei Kudrin, a member of Putin’s economic council who was Russia’s finance minister from 2000 to 2011, speaking to Bloomberg News in an interview.

About $90 billion in capital is expected to flee Russia this year, and higher borrowing costs have largely shut Russian companies out of external debt markets since the annexation of Crimea. That leaves Russian companies scrambling to find other sources of financing. Just today, state-run oil company Rosneft (ROSN:RM) raised at least $1.5 billion by getting BP (BP) to prepay for fuel it expects to receive over the next five years.

Most Russian companies, though, aren’t sitting on billions of dollars worth of oil. Instead, they’re turning to domestic lenders such as state-controlled Sberbank (SBER:RM) and VTB Bank (VTBR:RM). Central bank financing to commercial lenders has more than doubled in the past year, to $142 billion in April. Adding to pressure on the central bank, Putin has ordered it to set up a new financing mechanism for Russian industry.

“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 told Bloomberg News.

Why aren’t more business leaders sounding the alarm? Fear of Kremlin retaliation is certainly one factor. Another is Putin’s 86 percent approval rating–which has been strengthened, at least in the short term, by a population rallying around its embattled leader.

Time is running short, though. “The geopolitical tension is bad, but the problem with financing is far more serious,” says Alexey Vedev, head of the Gaidar Institute’s Center for Structural Research in Moscow. “This can’t go on forever.”

Matlack is a Paris correspondent for Bloomberg Businessweek.