The Fundamental Weakness of the Russian Economy and Why Sanctions Do Not Exploit Them
July 2, 2024
  • Alexander Libman
    Professor of Russian and East European Politics, Freie Universität Berlin
Economist Alexander Libman looks at the fundamental problems of the Russian economy and why Western sanctions are ineffective at exploiting them.
Two and a half years after the full-scale invasion of Ukraine, despite numerous waves of EU and US sanctions, the Russian economy remains stable. This, in fact, is a crucial factor allowing Putin’s regime to function in the way it does: most people in Russia have not seen a major deterioration in their living conditions. Many, especially those working in areas of particular labor scarcity, like blue-collar jobs, enjoy rising wages.
The regime has enough resources to continue the war, including offering financial incentives for those willing to join in the army. Such payments go up constantly – in 2024, some Russian regions pay a one-time bonus of over EUR 10,000 for enlisting. This allows the Kremlin to avoid highly unpopular mobilization.

Certainly, the Russian economy could suffer black-swan events – exogenous shocks that are hardly predictable, like a plunge in oil prices or disastrous developments on the front line. In this essay, however, I look at the economy’s structural challenges, which do not depend on such events.

I am particularly interested in phenomena satisfying the following two conditions: first, they should be logical consequences of the processes developing in Russia right now, even if as of today their effects are more limited; second, they are unlikely to effectively addressed by the Putin regime – either because of its ideational foundation or due to a lack of necessary tools.
Sevmash, a shipbuilder belonging to the Russian military-industrial complex. Severodvinsk, Arkhangelsk Region. Source: Wiki Commons
Overheating and inflation

The first fundamental problem is a direct consequence of the growth model in Russia. Russian economic growth is driven by a combination of large military expenditures and labor shortages. The need to attract scarce workers leads to higher real wages and thus consumption spending, which, together with government spending, fuels growth.

Though this model seems to have functioned relatively well in the past one and a half years, at some point in time it is bound to reach its natural limit. To further increase output, more workers will be needed, but they are simply unavailable on the job market. One reason is that Russia is an ageing society with low birth rates, while another is the constant outflow of men into the army.
“Already in April 2024, Russia had an unemployment rate of 2.6%, the lowest level on record in the post-Soviet era. This means that there is no potential to increase employment in the short run.”
Similar problems exist in terms of machinery and equipment. Capacity utilization in some sectors of Russian industry exceeds 80%. This makes it impossible to boost output without buying more machines or improving the efficiency of existing facilities.
To solve this problem, the Russian government would need to increase the labor supply and/or invest more in machinery to compensate for the deficit of labor. Increasing the labor supply, in turn, would require reducing the outflow of men into the army and/or encouraging immigration, or somehow increasing fertility (the last solution would obviously work only in the long run).

The first solution is one the Russian government clearly rejects, and one cannot imagine Putin opting for it – the war and recruitment into the army remain the top priority of his regime.

As for encouraging labor immigration, Russia has relied on this tool throughout the last decades, but it is now becoming more and more of a problem. Because of Western sanctions, labor migrants find it increasingly difficult to transfer earnings back to their home countries. This makes Russia as a destination less attractive for them. Another factor with the same effect is the overall uncertainty in the country – take, for example, the frequent reports about migrants being lured or coerced to enlist in the Russian army.

The third solution, i.e., raising the birth rate, is what Putin’s government pays enormous attention to, but it is also the least likely to work, even in the relatively distant future: it looks simply impossible to significantly increase birth rates in urban educated societies.

Buying machines and equipment is seriously hindered by sanctions. Although Russian companies have managed to overcome sanctions barriers to some extent, the question remains as to whether an extensive technological overhaul is capable of being carried out.

Furthermore, the Russian regime faces a political problem: if the demand for labor goes down, the growth of wages will stop, and this is bound to affect Putin’s popularity.
Under these conditions, at some point in time, government and private spending, instead of generating more growth, will merely lead to higher inflation. Already, as of June 2024, projected annual inflation in Russia projected by the Russian statistical agency Rosstat exceeds 8.5%.

A probable scenario for Russia is stagflation: a combination of high inflation with low (or even zero) growth. High inflation, in addition to its detrimental economic effects, is also a threat to public support for the regime – it eats into the rising wages of workers.
As long as the regime is committed to the war in Ukraine (requiring an endless number of soldiers) and remains dependent on the supply of machines and equipment from abroad, no real solution to the problem exists.
“On the contrary, to attract new soldiers and ensure the loyalty of key groups like the siloviki, Putin constantly creates new spending mandates, which accelerate inflation.”
Redistribution and incentives

Whereas overheating is driven by purely economic factors, another problem faced by the Russian economy is associated primarily with the actions of the state. Parallel to the war in Ukraine, another hidden war is ongoing in Russia – the fight for control over lucrative companies between different political clans and interest groups.

Some of them strive to boost the state’s share in the economy, for ideological reasons and/or to increase the power of government agencies and thus the rents bureaucrats can capture. Others seek to seize property.

In Russia, the use of state force in battles for control over companies (including through investigations of the Prosecutor General and Investigative Committee) is nothing new; however, since the start of the full-scale war in Ukraine, instances in which the government has challenged the current ownership of assets have become more numerous and significant.

As of March 2024, the Prosecutor General filed over 40 claims (on renationalization see also Russia.Post here and here) demanding the renationalization of over 180 companies. Some of these cases concern companies that were privatized as far back as the early 1990s. Some were filed against minority shareholders who had bought their shares on the Moscow Stock Exchange (and were in no way related to the individuals who had originally privatized the company), while some were filed after the statute of limitations had expired.

Redistribution battles are dangerous for the Russian economy for two reasons. First, they entail the transfer of property rights to owners who lack management expertise and ability (and sometimes even the willingness) to effectively run the companies. Their only “competitive advantage” is better political connections. Second, and more importantly, politically motivated redistribution of property increases uncertainty in the eyes of the private business, which, in turn, leads to less investment and innovation.
Vladimir Putin at the St Petersburg International Economic Forum. June 2024. Source: VK
At least some groups within the Russian leadership seem to recognize these problems. For example, the Central Bank has openly criticized some of the criminal investigations launched by the Prosecutor General. Putin himself has repeatedly claimed that no wide-ranging renationalization is on the table. At the 2024 St Petersburg International Economic Forum, he even suggested introducing a law protecting company owners who had bought their assets a sufficiently long ago.

These promises look, however, less than credible in the eyes of the business community. And not just because Putin can ad libitum revisit any promise he makes or ignore it altogether, but also because the Russian political leadership has little if any respect for private property rights.

As Putin has repeatedly pointed out, he is not a fan of a planned economy; however, his own words suggest that he regards private property as “conditional”: businesspeople can own industrial property, as long as the owners serve the goals of the country. Most recently, he made this clear while addressing the Russian Union of Industrialists and Entrepreneurs in April 2024, and at the recent economic forum in St Petersburg.
“In his April 2024 speech, Putin explicitly linked renationalization to situations when the ‘action or inaction of owners directly harms the security of the state and national interests’.”
Igor Krasnov, Russia's Prosecutor General. Source: Wiki Commons
Prosecutor General Igor Krasnov made a similar argument while speaking at the economic forum, saying that his office puts companies under scrutiny if the owners “systematically destroy the economic potential of the company.”

From the perspective of business owners, such an approach creates enormous risks. Firstly, because it is not always possible to reconcile economic logic and politicians’ views on national interests, and secondly, because competitors tend to use this argument to denounce the current owners and seize control over property.

Another, though as of today relatively minor example of how uncertain the business environment in Russia has become is the change of the income tax rate. Since early 2000s, Russia has had a flat income tax, which, when it was introduced, was praised by liberal reformers as a major achievement of Putin’s government.

The original rationale for introducing the flat tax was to reduce the workload of the overburdened tax administration and encourage citizens to pay taxes in an environment in which tax evasion had become widespread. Since then, the capacity of the tax administration has improved substantially and tax evasion has gone down, which makes the reintroduction of a progressive income tax a feasible step.

At the same time, it is unclear why the government decided to do this right now (as well as to simultaneously increase the corporate profit tax). Whether the goal is to pad the budget or reduce social inequality, these moves create uncertainty for private business, especially because in the past Putin repeatedly promised to keep the flat tax.
To ease the fears of private business, the government should credibly signal that it prioritizes economic stability over political goals – but this is unlikely.

The ambiguous role of economic sanctions

The above factors are mostly independent of sanctions. Sanctions do negatively affect Russian firms’ access to imported machinery and equipment and reduce the inflow of labor migrants, exacerbating the overheating problem; however, the labor deficit and the uncertainty around redistribution are the main long-term problem for the Russian economy and are entirely domestic in nature.

Somewhat paradoxically, sanctions even reduce the pressure the regime faces. Though in the wake of the large-scale invasion of Ukraine, many Russians left their country, followed by even more after mobilization was called in the autumn of 2022, many of them appear to have gone back. The reasons are straightforward: sanctions make it nearly impossible to transfer savings from Russia and make it hard to get entry visas.

Even more pronounced is the effect of sanctions on the behavior of business.
“Despite the enormous uncertainty they face in Russia, many oligarchs prefer, if possible, to transfer their fortunes back to Russia, where it is protected from sanctions.”
Tactical Missiles Corporation, Korolyov, Moscow Region. Source: Wiki Commons
Russian firms, which otherwise would have reacted to the uncertainty with massive capital flight (as they did, for example, in the 1990s), today are “stuck” in Russia and have no choice but to invest their capital into the Russian economy. Putin’s regime can afford to create a much higher level of uncertainty for the private sector than would have been the case if it were easier for capital to leave Russia for a safer place.

This is yet another argument for a reevaluation of sanctions policy. Essentially, the original EU and US sanctions focused on limiting the revenues of the Russian state from resource exports and disrupting production chains in Russia. It is possible, however, that they missed the actual weak spots of the Russian economy: a shortage of labor and the uncertainty of the business environment, which leads to capital flight.

Welcoming people and capital from Russia would be in the interests of the West. Therefore, the sanctions focused on banks and transactions are suboptimal. Indeed, by constraining cross-border financial flows from and to Russia, the West has tried to limit Russia’s access to dual-use goods and technology. But this goal could have been achieved by using other tools, possibly more complicated at their inception but in the long run free from negative side effects.

One example would be systematic control over technological exports to Russia through a system similar to the Coordinating Committee for Multilateral Export Controls (COCOM). During the Cold War, COCOM effectively constrained the Soviet Union’s access to new technology. Of course, today the effectiveness of such tools would be not as high as it was back in the 1970s or 1980s, since the technological potential of the world is less concentrated in the West, and there are alternative sources for technological exports to Russia.

Yet it would still be preferable to the current model of sanctions, which in a sense is even helping Putin to deal with some of Russia’s essential economic problems that his regime has created.
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