The West should not let Russia fall apart

Talk in Washington and Brussels this week of levying further economic sanctions on Russia seems counterproductive and will only make matters worse for all parties involved. Like it or not, Russia’s economy has grown simply “too big to fail,” and its political and military might is too dangerous to ignore. The West might have better luck in advancing its goals in the region by helping, not hurting, the Russian bear in its time of need.

Russian President Vladimir Putin emerged defiant on Thursday, telling journalists at his annual news conference in Moscow that he would work hard to revive Russia’s broken economy, which he said could take around two years to fix. It was the first time we had heard from Putin since the Russian Central Bank was forced to raise interest rates on Tuesday by an enormous 6.5% to stem a free fall in the value of Russia’s currency, the ruble.

President Putin laid most of the blame for Russia’s economic woes on the sharp drop in oil prices, which is down around 45% since its June highs, roughly equal to the drop in the ruble’s value versus the U.S. dollar this year. But Putin acknowledged that Western sanctions, which were levied earlier this year in response to Russia’s annexation of Crimea, were around 25% to 30% to blame as well.

It is unclear what effect Western sanctions have actually had on Russia’s economic troubles. Putin’s guesstimate of around 25% to 30% seems logical enough. The sanctions started out pretty weak, with travel bans for top Russian officials, but they have steadily increased over the year, making it increasingly difficult for Russia’s financial, energy, and defense sectors to do business.

By September, the U.S. had barred several major Russian companies—most notably Rosneft, the Russian state-controlled energy giant—from accessing the U.S. debt markets. This set the stage for the ruble’s massive drop in value this week.

Since oil is traded in dollars on the international markets, Rosneft has accumulated a great deal of debt denominated in dollars. It is able to service that debt each quarter by borrowing dollars via the U.S. debt markets. The sanctions brought an abrupt end to this dollar-debt merry-go-round, forcing Rosneft to hoard dollars to make its $10 billion debt payment due at the end of the month. To keep Rosneft from defaulting on its debt, the Russian central bank last week agreed to what Fortune’s Geoffrey Smith called an “egregious piece of money-printing,” when it lent Rosneft money against 625 billion rubles worth of newly issued bonds.

By forcing Rosneft and other major Russian companies to hoard dollars to service its debt, the Western sanctions managed to remove one of the largest buyers of Russian rubles from the foreign exchange markets. This created an imbalance in the supply and demand for the ruble, leading to the currency’s drop in value. There were simply too many people wanting to sell rubles and not enough buyers.

The ruble’s collapse has hit the Russian people hard, as 80% of Russian savings are locked up in assets denominated in rubles. But they aren’t the only ones suffering. Western companies that do business in Russia are also feeling the pain. Foreign companies are naturally some of the biggest sellers of rubles, as they are constantly converting rubles into their home currencies. When Daimler-Benz or GM sells a Mercedes or a Corvette in Moscow, they’ll naturally take payment in rubles from their Russian customers, but they’ll eventually need to send euros and dollars back home. This means they need a liquid and fair foreign exchange market that can help it price its merchandise effectively and repatriate its profits efficiently.

But the collapse in the ruble has happened so fast that prices have been thrown out of whack, delivering a major blow to multinational companies. On Tuesday, after the ruble slid 20% in one day, Muscovites went on a shopping spree. You could buy a brand new Audi A5 for the equivalent of $26,000 in rubles, half of what the car sells for in the U.S. or Europe.

Pretty much all foreign auto makers have since suspended sales in rubles, as have many popular electronics makers like Apple. They will only start selling their goods when the currency market stabilizes and they can adjust their prices to suit the realities of a weak ruble. This will just send more buyers away from the market, further exacerbating the supply-demand gap for dollars.

So far, the Russian government has spent around $90 billion this year supporting the ruble and stepping in for absent buyers. This has decreased its dollar reserves by 20% or so, to $419 billion. It will need to shove a lot more cash down the rabbit hole to halt the burn.

Meanwhile, Putin said on Thursday that he wasn’t going to spend Russia’s dollar stockpile forever to support the ruble. Where he will draw the line is anybody’s guess.

Clearly, Russia’s economy has turned into a hot mess. Much of it was its own doing. The Kremlin failed to diversify the nation’s economy, leaving it a slave to the gyrations of the consistently volatile oil markets. Russia was prudent to build a large cash cushion during the fat years, which has saved it from the humiliation of needing to impose market-crushing capital controls or worse, default on the nation’s debt. But as Putin hinted, he is only willing to burn through the nation’s reserves for so long. Eventually, Russia will come to a point where it will decide to let its currency float free, which would cause it to probably drop like a rock.

Such a scenario happened back in 1998, when the Russian government defaulted on its debt, setting off an economic spiral that ended up bankrupting investment firms and governments around the globe. One firm caught in the mess was the legendary Long Term Capital Management (LTCM), which made the mistake of hoovering up tons of Russian debt right before the default. LTCM eventually had to be bailed out to the tune of some $3.6 billion to avoid an all-out market meltdown.

Russia’s economy is much larger and richer than it was in 1998, making a potential default much scarier. Today, Russian corporate and government debt is held by a number of financial institutions around the world, from banks in Italy and France, to asset managers in London and New York. Pimco’s $3.3 billion Emerging Market Bond Fund is made up of 21% Russian bonds, for example. So far, the fund is down 8% on the month and set to go further south.

There is little the West can do to boost oil prices, but it could help things by allowing Russian companies to access the dollar markets, at least temporarily until the panic subsides. After all, the sanctions were designed to punish Russia for its actions in the Ukraine, not kill it. No one, at least no one sane, wants to see Russia default and descend into economic chaos. That’s bad for German auto exporters, bad for U.S. energy companies, bad for Italian banks, and bad for Wall Street. Sure, Russia’s economy isn’t as large as the U.S. or EU in terms of GDP, but its meltdown wouldn’t be an isolated incident. It won’t take long before the contagion spreads to CIS member states and Eastern Europe, both of which maintain strong trade relations with Russia.

Putin commands a reported 80% approval rating among the Russian people—far higher than any leader in the West. He isn’t going anywhere, so Western leaders can forget about regime change. If anything, this will allow Putin to further centralize power under the guise of shoring up the ailing economy.

Yesterday, President Obama said that he would lift economic sanctions on Cuba, ending 50 long years of misery for the Cuban people. His reasoning was that sanctions had clearly failed to do anything except create chaos, so it was time to try something new. That sort of thinking is needed with Russia. Sure, it hasn’t been 50 years, but Russia has been pushed to the brink. Any more pressure and the West could end up wiping out two decades of effort to move Russia from a communist threat to a capitalist partner. No one wants that—not even President Putin.