Russia's rouble trouble could destroy the whole of the European economy

A new potential hazard for markets to contend with

SUDDENLY there is a new worry for the markets - Russia. Up to now Russia has hardly ever come up on the radar as a potential hazard. We have been right through the revolution, the collapse of the rouble, the dramatic decline in the country's output, and most recently, the modest signs of recovery, without the West paying much attention.

The reason is simple: though, if you measure it properly, the Russian economy is still very large, it only interacts with the West at a limited number of points.

We don't buy much from them; they don't buy much from us. We used not to do much trade because under communism most of the region's economic activity was centrally-directed trade between Russia and its satellites in Eastern Europe. Nowadays we don't do much trade because though there is great potential, the economic chaos has inhibited its growth.

So why has the world suddenly started to worry? Two reasons. First, while the Russian economy is not directly of much importance to the rest of the developed world, the emerging economies of Eastern Europe are, and trouble in Russia puts pressure on these.

Second, Russia is an additional source of potential instability for the West's banks - it matters in financial terms more than it matters in economic terms.

The Eastern European economic story is a fascinating one. You probably hadn't realised (I hadn't, until I saw some figures dug out by HSBC Markets) that Eastern Europe is the fastest-growing export market for the UK. Exports to the region are running more than 30 per cent up year-on-year.

Russia itself accounts for only 0.6 per cent of our exports, but "emerging Europe", economist-speak for the former Comecon countries, accounts for 4.2 per cent. That is nearly half as much as Asia excluding Japan. For some other European countries the export dependence is even larger: Germany exports nearly 11 per cent of its output to emerging Europe, Italy nearly 10 per cent, in both cases larger than their exports to Asia - see left- hand graph.

So if the Russian troubles extend to the rest of Eastern Europe, the whole European economy is clobbered.

The mechanism which might link the two is a sharp devaluation of the rouble. Over the last couple of years the rouble has been quite strong, certainly by comparison to many other East European currencies. There is no economic need for a devaluation: at the moment, Russia is running a small current account deficit, but nothing to worry about. So there is no competitiveness problem.

But were the rouble to be devalued, this would both make Russia super- competitive against the rest of Eastern Europe, which would be bad for those economies, and it might provoke a more general economic crisis in Russia itself.

Why is everyone talking, then, about a rouble devaluation? Russia has run into a liquidity crunch. The problem is not so much its total indebtedness, but rather the excessively short-term nature of its debts.

Short-term debt relative to foreign exchange reserves (right-hand graph) is desperately, ludicrously, high. You do not need to be an economic expert to realise that if you have too many short-term borrowings you are vulnerable to any loss of confidence.

You have to keep rolling over those borrowings to avoid default, and if confidence slips you may find it difficult to keep the paper circulating. The danger is that a liquidity crisis could lead to devaluation and/or default, even though there is no underlying problem in solvency. That would be deeply disagreeable for Western banks, particularly continental European ones.

Banks seem to have made their usual mistake: heading, herd-like, into the same market at the same time. British banks have been pretty cautious about lending to Eastern Europe, but Continental ones have been increasing their lending sharply during the last couple of years.

Even in a worst possible case, it is very hard to see default in Russia requiring the formal rescue of any major bank, but the threat is one more point of pressure. Just at the moment when Russia needs to borrow more from the banks to try and lengthen the maturity of its debt, it finds that the main banks who might lend it the money are feeling twitchy about new loans.

Yesterday talks were reported to be taking place in Frankfurt between Deutsche Bank and a Russian government team to see if the banks could do a biggish syndicated loan of say $5-6bn.

But it is hard to see that happening until and unless the main industrial countries organise some kind of more general bail-out involving the IMF.

Talks on lending to Russia take place this week at the IMF in Washington. I suppose something will be cobbled together, but there is always a danger in these situations that the negotiators make a mistake.

The big issue here, though, is not whether and on what terms the IMF and the banks lend to Russia, but whether the gradual and often painful reintegration of the Russian economy into the Western European economy continues.

The game here is maintaining the momentum not just of reform but of stitching Eastern Europe into Western Europe. Before the First World War the European economy was a seamless one, with an effective free trade zone from the Atlantic to the Urals.

Of course, the level of development varied from west to east, but money and goods moved without restriction. The physical reminders of that trade remain in the fine commercial buildings, circa 1890, in St Petersburg, Moscow and Kiev. Now, most of Eastern Europe is booming, but the boom has spread unevenly: Poland is whizzing away; the Ukraine is - well, it is back of the queue.

And that, I think, is the underlying explanation for the current concern over Russia. We are less than ten years into the reform process in Eastern Europe. Objectively that reform has turned out pretty well - stunningly well in some regards, witness those export figures. That reform process probably cannot now go wrong whatever happens in Russia.

But it is not completely secure. If only Russia can manage another couple of years of reform - and see the benefits of that spread more widely among its citizens - then all will be well. If only.