The Price Of Failure

By JOSHUA COOPER RAMO

If you think you had a tough week last week--and who didn't, with the Dow off 482 points?--you might perk up after a chat with Stanley Druckenmiller. A six-footer with deep-set eyes and a grin that creeps sideways across his face like a stock ticker, he has been labeled the world's brightest currency trader, an Einstein of the pits. Druckenmiller's paycheck is signed by George Soros, for whom he oversees $22 billion. Uh, make that a little less. Last week Druckenmiller watched helplessly as the Russian debt market vaporized into fiscal neutrinos, taking the last of $2 billion of Soros' Russia-invested money into hyperspace. Fessing up on CNBC, the crestfallen trader blinked at the camera and softly explained that the Moscow meltdown had turned "a very good year into a mediocre one."

The $2 billion markdown is small change compared with the devastation that the Russian collapse inflicted on central banks and stock markets in other countries, even those seemingly out of harm's way. Venezuelans stumbled through a valiant, painful defense of their bond market, Brazilians scrambled to save their currency, and Americans watched a nervous stock market plummet, pause and plummet again. Russia's slide was a reminder that every investment is at heart a bet on the future. Last week the future looked awful.

The chaos started two weeks ago, when the Yeltsin government effectively devalued the Russian ruble by about 34%. To some folks, this limited devaluation appeared to be a wise move that might strengthen Russia's exhausted central bank. Since the Russian economy had been quietly improving last year, a small relaxation of the currency could have helped boost demand for Russian exports, which would have pushed the recovery along. From an Economics 101 perspective, the approach was a sensible--if risky--way to help Russia through a tough patch. Even Soros argued that a small devaluation, linked with other measures, was prudent.

The problem was that Russia's banking system was a mess, which meant the well-intentioned devaluation quickly turned into a free-for-all. The particular dilemma was that Russia's banks were loaded down with foreign-currency debt, which meant that a decrease in the value of the ruble made repayment more expensive. This made the temptation to default almost irresistible--especially since Russian banks are generally seen as checkbooks for a new class of oligarchs. As the soon to be departed Russian government heads huddled in Moscow to figure a way out of this crisis and to consider how to deal with the devaluation, the halls of their offices began to fill with very worried, very powerful bankers. They had come to deliver a lethal message: they would no longer pay their debts.

Faced with an impossible choice between closing these banks and defaulting on foreign debt, Russia's leaders placated the oligarchs for the time being. The forced restructuring will allow a 90-day moratorium on banks' foreign debt and a rescheduling of $40 billion in domestic debt. Given the decline of the ruble, this was roughly the same as announcing an intention to pay off debt with green cheese. Investors, to no one's surprise, rushed to sell out, until the limp, overloaded markets finally shut down. Russia, deprived of international capital--James Dorn of the Cato Institute calls it "financial morphine"--went into shock. Explained Steven Halliwell, a partner at River Capital Management: "As far as we can tell, Russia is in an absolute panic situation."

The panic spread. Hardest hit were countries in Latin America. To outsiders, the link seemed strange: nations such as Venezuela and Brazil have very little exposure to Russia, but their economies suffered nonetheless. "Latin markets are right to think that this is a moment of complete irrationality," says Bond Snodgrass, an analyst at Warburg Dillon Read in Mexico City. "But this should finally drive home the point: Mexico is no longer just Mexico, Brazil is no longer just Brazil. They're all part of one asset class now, and investors aren't distinguishing between any of them." And the dramatic drop in the U.S. markets--after months of talk about a "Goldilocks economy"--demonstrated once again that markets hate nothing so much as uncertainty. Russia's pain evidently would also be the world's.

It didn't take long for the second guessing to start. Most of the criticism focused on the role of the U.S. and the International Monetary Fund. Since the initial devaluation announcement, the international financial community had seemed to be engaged in a game of hot potato: the U.S. insisted Russia was a European problem; the Europeans said the IMF should run the show; the IMF insisted it needed more U.S. support. But instead of pitching in immediately--and watching billions of dollars disappear--the IMF and the U.S. made a bet that the reformers would hold out until the summit. It was a fatal miscalculation. Says Halliwell: "These guys were asleep at the switch. Russia was going off the tracks."

The "contagion" of the Russian ruble collapse--itself tied to the panic that has followed Asia's currency depreciations--has sent off economists and investors for some soul searching about emerging markets. These young tigers do not yet have the kind of social and business structures they need to build stable, prosperous capitalism. The ultimate effect on the U.S. remains to be seen. Ironically, the hit from Russia may free the Federal Reserve to lower U.S. rates, kicking off another round of strong domestic growth.

But fixing Russia remains a priority. No one in Washington has any plans to put dollars into Russia ("Any money you throw in now will go immediately into Swiss banks," says a White House aide), but they do hope to eventually bring Russia to the point where aid will again be an option. While Clinton and Yeltsin work hard to project confidence in public this week, Deputy Treasury Secretary Lawrence Summers will be trying to help the new Russian government cobble together a plan that will then be sold to the Germans, Japanese and the IMF. If they buy in, Moscow may get a second chance.

It is a slim chance. In Moscow the economy was already slipping out of control--some prices jumped as much as 10% to 30% in a week. If the government responds to social pressures by printing new money, the result would be an acceleration into hyperinflation. "Things are going to get worse before they get better," says Robert Froehlich, chief investment strategist at Scudder Kemper Investments. "When you have a devaluation, the next thing that happens is the economy slows down [further], and then the final thing is that you tend to have social unrest. So it's sort of a roadmap." And while all this may mean a mediocre year for Druckenmiller and friends, it most likely means a hellish year for Russia.

--Reported by Tim Padgett/Mexico City, Aixa M. Pascual/New York, Paul Quinn-Judge/Moscow and Adam Zagorin/Washington

With reporting by Tim Padgett/Mexico City, Aixa M. Pascual/New York, Paul Quinn-Judge/Moscow and Adam Zagorin/Washington