This week, for those following global financial events, we have been witnessing the financial deterioration of a giant economy, Russia.

All the classic ingredients appear to be present, heightening the volatility of the situation: increasing economic instability, possible financial isolation, rapid fluctuations in currency values, downward export price movements (oil), foreign direct inbound investments withdrawing, worried investors, and Russian residents’ fears of rampant inflation — all exacerbated by recent international sanctions.

If we chose to monitor this global scene as it unfolds, Bermuda residents may learn some interesting economic lessons as:

1. What happens when the price for a country’s major export product decreases abruptly, and the supply of the product far outweighs the demand (or investors don’t want to buy it at all);

2. How these events can impact an ordinary investor’s portfolio that is highly correlated, nor adequately diversified.

How does an economy stumble?

In economic normality, a modern country exports desirable products or services at a fair price, creating demand while encouraging foreign direct investment into the country. Foreign investors build business infrastructures, invest in the domestic stock markets, finance foreign and domestic corporations, partnerships, private ventures, and employ domestic country residents. The successful domestic economic operations both inbound and outbound brings highly prized major foreign currencies: US dollars, euros, sterling, etc into business and government coffers to be used for governmental social and domestic programmes, economic initiatives such as increased international business ventures, and increased foreign capital reserves. Success generates more success where a stable economy is indicative of a successful profitable business economy.

Abrupt changes to a country’s business model can destabilise the economic success story for the short or long term.

In March 2014, in response to Russian aggression in the Ukraine, international sanctions started to be issued against Russia by the US and the European Union followed by further rounds of sanctions that included other countries’ participation: Canada, Japan, Albania, Iceland, Ukraine, Switzerland, Australia and other governments constituted travel bans against Russian politicians, officials, business persons, business transactions, major energy firms, banks and other entities along with trade restrictions, asset freezing provisions, and targeted financial and trade sanctions.

Further, in a matter of months global oil prices dropped dramatically, reducing significantly foreign cash needed for current and future economic progress.

The fallout

Investors hate uncertainty. When foreign investors in a country lose confidence they withdraw investments and close operations, thereby limiting foreign currency inflows. With less hard foreign currency available to purchase foreign goods, domestic residents start hoarding foreign currency, while a central bank may hike deposit interest rates dramatically in efforts to keep depositors from withdrawing their domestic cash.

Further dramatic efforts to control money flows may mean exchange controls and capital containment. High net worth domestic investors (and those in the know who can) start converting local currency into US dollars, euros, UK sterling, Swiss francs, etc, then parking their cash outside the country.

When domestic currency loses value against foreign hard currency, domestic prices start to escalate, sometimes very rapidly for food, services, retail products and other tangible goods, while stock market valuations in domestic stocks decrease.

Last Wednesday it was also reported that Russian residents were on a buying spree, purchasing every good in sight in face of significantly higher prices for the same goods in the next day or so.

The cost of debt repayment to foreign investors increases as domestic currency devalues. The country’s domestic corporations have increased difficulty in meeting debt obligations as the value of their stocks tumble. Debt is very often collateralised by a corporation’s stock value to certain limits. The government also may have trouble raising foreign currency and may decide to just “default” on its sovereign debt (Argentina, Brazil, and Russia in 1998 employed this tactic) by simply not repaying foreign investors who invested in the domestic government bonds.

Interdependency and the ripple effect

When one country’s economy becomes unstable, investors within major capital markets reflect that uncertainty and fear of loss. Market shocks can become contagious as higher risk investments are liquidated (sometimes at any price) and investors flee to safety — to the safety of highly stable very low risk — you guessed it sovereign debt — United States Treasuries and more limited quantities, other very stable secure governments.

Summary

A country with isolationist policies may function with large reserve funds for internal financing, along with great natural resources that are in global demand. Sooner or later, though, such policies will impact the local populace and the local economy. We are all, today, interdependent upon each other to perfect free markets. The capital flow of money, goods, and services across the globe between countries, companies, governments, individuals provides opportunities to better lives for everyone.

Next, in part 2, the investor who chooses to focus and invest in only the out performing securities of the day, may live to see those same out performers tank. We review why a seriously diversified portfolio structure with non-correlated assets can provide a cushion for the small investor.

Note that this is just a very general overview. Economic and capital market conditions are the subject of vast amounts of data, study, complexity, expertise, and media coverage.

Martha Harris Myron CPA CFP JSM Masters of Law: International Tax and Financial Services, appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland. Principal: The Pondstraddler* Life Consultancy: international financial planning, publications, presentations for the challenging lifestyles of multinational individuals and their families residing, working, crossing borders, and straddling ponds in the North Atlantic Quadrangle. Specific focus for residents of Bermuda, the premier international finance centre. Contact: martha.myron@gmail.com