Note to Paul Krugman: Russia is Not a debtor country

As I stressed in my last post, understanding capital flight is essential in assessing Russia’s fundamental economic position. Apart from political risk, which to some extent is unquantifiable, most observers agree that capital flight is the biggest challenge facing the Russian central bank (CRB).

Therefore, I was delighted when I recently discovered this NYT article by Paul Krugman in which he ponders about Russian capital flight. He basically starts with this graph that charts Russia’s current account surpluses over the past 20 years.


To quote Krugman’s view of the matter,

It has been in consistent large surplus, with a cumulative surplus of more than $900 billion. Russia should not be a debtor country. It has managed this nonetheless, presumably because corporations and banks have borrowed abroad, and somehow that money has ended up invested in luxury London real estate and other things. It would be nice to have a good picture of how the flow of funds worked.

He is puzzled by the fact that Russia, despite its huge cumulative external surpluses is a creditor country. Although he doesn’t explain his reasoning, I suspect that he was mentally referring to Russia’s external debt load (USD 650 billion) which featured prominently in the financial press during the December Ruble crash (see my post on this topic).

So, what’s wrong with that view?

It turns out, quite a lot. Obviously, the mere fact that there are external debts doesn’t mean the country is a NET external debtor. As with any corporation, the balance sheet of the economy as a whole also has TWO sides. You surely have to account for the foreign assets of Russian’s and the Russian state before determining its overall financial position. Only after taking into account Russia’s external assets can we determine its Net International Investment Position (NIIP). Fortunately we do not have to guess, as the CRB calculates this figure on a quarterly basis according to standard IMF methodology. There we see that at the end of Q3 2014, Russia’s NIIP stood at a positive USD 232 billion (see Excel at the bottom of this page here). Conclusion: not only is Russia NOT a creditor, but it is a net (external) creditor to the tune of 12 percent of GDP, according to official figures.

Furthermore, I will argue that the IMF methodology overstates Russia’s external liabilities in the NIIP calculation (and hence underestimates its NIIP), due to a specific feature of Russian business life: offshore holding companies.

Let’s have a look.

According to the NIIP accounts Russian residents had international liabilities of about USD 1178 billion as of 30.9.2014. In case you are confused, this is higher than the external debt figure (about 650 billion) touted in the media and used in my original post. Don’t worry, there is nothing wrong here. It is just that the liability definition, as used for NIIP calculations, also includes equity stakes that are owned by foreign residents. This is because NIIP is calculated using national accounts whose purpose is to measure money flows between economies. From the perspective of flows, it is irrelevant whether the flow is debt or equity. A liability in this case just means a financial claim – any kind of claim – of a foreign entity towards a Russian entity.

I want to focus on the direct investment figure (USD 476.5 billion) which includes direct, i.e. non securitized, equity investments (USD 325 billion) as well as direct debt financings (USD 151 billion). (The latter figure is part of the external debt of USD 650 billion). These are transactions that typically arise as a result of foreign direct investment (FDI). These are not portfolio flows, or “hot money” as it is often called in the literature.

Now, you have certainly heard of Russian oligarchs’ Cypriot, Caribbean etc. holdings with the help of which they steer their businesses. Yukos is a case in point. Although, everybody knew that its ultimate owner was M. Khodorkovsky, its official owner was a holding incorporated in Gibraltar (Menatep). Yukos is by no means an exception – virtually every large Russian businessman operates this way (for reasons that do not only have to do with property rights). In this case, every capital increase or earnings used for the upgrading of plants and not distributed would be treated as an investment by a foreigner for NIIP purposes. And this is matters for the discussion at hand. For instance, some analysts suggest that up to 50% of the external debt of Russian corporations is quasi-equity provided by such offshore holding companies.

What do we make of that?

Obviously, we can only guess about the true size of this phenomenon, but I think it is safe to assume that these types of flows are material. Moreover, if the proportion of these types of flows really amount 50 percent of external debt, as some analysts suggest, then it is reasonable to assume that the proportion is even higher for the direct equity flows. For instance, retained earnings of a Russian commodity producer held via a Cypriot holding would show up here. In order to put a figure on my thoughts, I will simply postulate that 50% of the direct investment flows mentioned above, i.e. about USD 235 billion, are not truly foreign claims on Russia, but claims by Russians disguised as foreign claims. Obviously, this is not very scientific, but it helps puts things into perspective.

So what’s the point of this exercise?

Reducing the USD 1178 billion in external claims by USD 235 billion doubles Russia’s NIIP to around USD 470 billion, or more than 20 percent of GDP, or about the same size as China’s NIIP! China is hardly the country that is usually associated with external debt issues. Further, it is this figure that needs to be compared to the cumulative USD 900 billion in current account surpluses mentioned by Krugman. If you accept my reasoning and subtract 470 from 900, one gets a rough USD 430 billion. This would be my estimate for the cumulative capital flight from Russia over the past 20 years – makes USD 20 billion/year. I think most people would be surprised by the rather low figure. I was surprised too.


Krugman is flat wrong to state that Russia is a debtor nation when in fact is a substantial net creditor. This is probably not intentional. After all, I have seen too many mainstream economists struggle with simple accounting principles. This is also shown time and again by Keynesians’ exclusive focus on flow measures like GDP and never differentiating between debt driven growth and pure economic growth. As an old hand in analyzing currency crisis, however, he should know the difference between a positive and a negative NIIP.

The article nevertheless was inspiring. Reading it, I immediately recognized the flaw in his thinking and it made me want to research this topic. Honestly, what I found surpassed my expectations. I certainly need to dig deeper into this, but I think there is a high probability that Russian capital flight is much less than commonly believed. I am convinced that the main risk to my long Russia thesis is political – not fundamental.

(Disclosure: long RUB as well as select Russian bonds and stocks)


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