What Explains The Russian Economy’s Robustness?
September 29, 2023
  • Yuri Danilov

    Independent economic expert  

Yuri Danilov explains what factors have allowed the Russian economy to stay afloat and suggests that, despite the multitude of these factors, the likelihood of a crisis is rising.
The robustness of the Russian economy, which is facing headwinds from an unprecedented set of sanctions imposed by the world's leading countries, as well as decisions by the Kremlin that have worsened economic conditions, became a hot topic this past summer. Typically, experts pointed to two (superficial) reasons: the market foundation of the economy, which allows it to adapt, and competent actions taken by regulators like the Central Bank and the Ministry of Finance. Plus, 2022 brought Russia gigantic revenues from energy exports.

However, a more complete analysis and more complex explanations are needed, and they have recently begun to emerge. For example, Konstantin Yegorov attributes the stability of the Russian economy to the simplicity of its structure – a large share of industry is engaged in the extraction and processing of commodities and thus traditionally operates amid regular price shocks.

The robustness of the Russian economy is most often understood as the stability of economic dynamics. If we talk about GDP, the generally positive growth was likely predetermined by the rapid rise in military production.

The extent to which the official GDP figures are fudged is a subject for a separate study, though we do see numerous inconsistencies in certain Rosstat indicators, some of which seemingly contribute to the overestimation of economic dynamics. In addition, increasingly Rosstat figures are noticeably out ahead of alternative estimates from non-governmental agencies, primarily the Higher School of Economics and the Center for Macroeconomic Analysis and Short-Term Forecasting. Still, we must admit that overall, such fudging does not invalidate the conclusion that Russia’s GDP is growing, albeit slowly.

Note that the economic dynamics have remained stable against the backdrop of periodic deteriorations in macroeconomic stability.
“Most importantly, the observed stability does not mean an increase in the well-being of the population.”
Below are four explanations for the robustness of the economy, including an assessment of how much the factors have run their course and what the outlook for them is.

Fundamental factors

Russian businessmen, having dealt with an unfavorable business and investment climate for many years, are very adaptable. This “resource” can be considered inexhaustible; however, a higher tax burden, combined with higher interest rates, a shrinking workforce and other phenomena resulting from government actions, is gradually reducing the possibilities for such adaptation.

Another fundamental factor is the economy’s size: many firms do not depend on external markets (and are therefore less affected by sanctions). They are located in different regions that have different sets of advantages, meaning they can be relatively successful even when the country is isolated. This resource is also inexhaustible, as it is a natural factor determined by Russia’s geography.

As for the aforementioned simplicity of the Russian economy: while generally Russia is highly dependent on the global market, relatively speaking Russian business is weakly integrated into global supply chains, in which the level of specialization and accordingly the amount of added value is high.

Russia is integrated into the global economy mainly through commodities, which are easily interchangeable, meaning it does not matter for the market who the producer is. This makes it easier to circumvent sanctions, and it remains possible to redirect to China or India some supplies that previously went to Europe. This is a fundamental factor, and its sustainability is practically unchanging. However, Russia’s place in the international division of labor means that its economy consistently lags the world economy over the long run.

The Russian economy is also characterized by an extremely low dependence of most firms on external financing and accordingly a low sensitivity to shocks (including sanctions) in financial markets. This is why Russia experienced the global financial crisis of 2007-09 relatively late.

Firms can keep going for a long time with existing equipment and their current liquid assets – they do not have to raise new investment – so this resource will not be exhausted soon.
The dollar-ruble exchange rate, April-August 2023.
“Man-made” factors at the beginning of 2022

At the start of the war, Russia could be proud of its macroeconomic stability: public finances had a big backstop. This resource has been largely exhausted. Financial regulators are already putting out one fire after another: a budget crisis has been put off by ruble depreciation, which in turn is making a surge in inflation inevitable.

By the time the decisions on sanctions were made, most firms had accumulated extra inventories. This is partly due to local business practices, as inventories have traditionally (back in the USSR) been used as substitutes for financial resources; however,
“Russian firms likely began accelerating the process of accumulating reserves at the end of 2021, when the risks of a military conflict were clearly on the rise.”
This factor has been completely or almost completely exhausted. Its exhaustion has given an additional boost to demand (today, demand has increased for goods that were previously “in stock” but have run out), though such demand is already fading in most sectors (except for those associated with the military).

The relatively high profitability of many Russian firms allowed them to increase wages without significant losses, which was necessary given the labor shortage. In addition, they managed to switch to more expensive supplies of raw materials and components, including through so-called “parallel imports.”

It can be assumed that in about a quarter of sectors, average sector-wide profitability in the first four months of 2023 fell below the level at which it would be economically profitable to expand production using borrowed money.

The combination of the depreciating ruble and rising interest rates will likely make at least an equal contribution to the profitability decline in domestically oriented sectors. By the end of 2023, the scope for absorbing lower profitability should run out for approximately half of the firms on the civilian side of the economy.

Another result of government policy is a property (construction) bubble, which accounts for a significant portion of the demand within the economy as a whole. This has largely run its course: falling incomes and savings are reducing demand for housing, despite preferential mortgages and other government support measures. Note that the continuation of preferential mortgages is already regarded by the Central Bank as a serious threat to financial stability.
Volgograd Tractor Plant. Source: Wiki Commons
“Man-made” factors after February 24, 2022

The result of the massive fiscal support for the economy was a spike in demand from the defense industry and army. Now, a potential war of attrition is creating ever-increasing demand, though that brings a sharp rise in fiscal risks – in the medium term, it could transform the budget into a pyramid scheme.

Significant injections of budget funds into the economy balloon the imbalances and risks, including of a budget crisis, inflation and under certain conditions a socio-political crisis. A more or less balanced fiscal policy, meanwhile, would preclude further growth in demand.

Perhaps the Ministry of Finance does not want to completely abandon a balanced policy – this is evidenced by the sharp slowdown in the growth of the budget deficit in August. Yet recent decisions to slap additional taxes on exports (a “depreciation tax”) might not allow the Ministry of Finance to act how it would like. Attempts to pad budget revenues in this way undermine the market nature of the Russian economy – the most important factor for its robustness.

The jump in defense spending – given that many defense-related firms are located in economically depressed areas – has led to a diversification of industry across regions. This factor is almost completely exhausted, as it is no longer possible to significantly ratchet up budget spending.

On the whole, the actions of the financial and economic bloc of the government and the Central Bank have made it possible to reduce or postpone risks – for example, fiscal ones. As long as their current leaderships remain, this factor will remain in effect; however, as resources decrease and especially as fewer and fewer options remain at the disposal of the Central Bank and the government, the impact of their actions will steadily decline.

To circumvent sanctions, with regard to both the sale of commodities and the purchase of necessary imports, methods from the “black” and “gray” economy, honed in the 1990s, are being actively used – seemingly with the support or under the direction of the state. The impact of this factor may be seriously reduced in the future (in the short to medium term) as the West improves measures to counter sanctions circumvention. However, at this point they remain insufficiently effective, and increasing their effectiveness may mean significant costs for Western governments and international organizations.

Behavioral factors

Long-term optimistic expectations of households and business are based on the objective factors mentioned above, such as the adaptability of Russian business and effective actions by the government’s financial and economic bloc and the Central Bank. In addition, optimistic sentiment is ginned up by propaganda. Inevitably, however, optimism is gradually decreasing, though overall it looks set to persist until some kind of “black swan” drastically changes the mood.

The fundamental factors should remain in effect either for a long time or forever. However, those factors contributing to the robustness of the economy that had been created by Russian regulators and firms and lasted for a long time have now been exhausted to a large extent or entirely. The efforts to create a sanctions-proof economy after February 2022 are gradually losing their effectiveness, and this trend is likely to continue in the coming months and years.

In the short term, there are practically no risks of a “collapse” of the Russian economy. But it is no less obvious that in the medium term and especially in the long term, the economy will continue to lose its robustness as crisis phenomena gradually rear their heads.

The most important element of the robustness – macroeconomic stability, the establishment of which took many years of titanic efforts by economic and financial regulators – has been significantly undermined. Therefore, even though in the short term, the risks of a crisis scenario taking hold in the Russian economy are relatively small, they are now becoming chronic, and should a “black swan” appear, they might materialize quite quickly, transforming the crisis into a catastrophe.
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