How is the Russian Economy Doing Under Sanctions?
August 1, 2023
  • Vladimir Milov
    Vice President, Free Russia Foundation
Vladimir Milov claims that Western sanctions are severely hurting the Russian economy. The government is increasingly short on funds while lacking access to foreign investment. In addition, Russia cannot substitute the critically important Western technologies and equipment needed to develop its manufacturing capabilities.
Many argue that the impact of the sanctions levied on Russia after its full-scale invasion of Ukraine has been insignificant, and Russia is coping with the consequences: its GDP in 2022 contracted by a mild 2.1% and is expected to grow 1-2% in 2023. Unemployment is at record lows, inflation has been seemingly brought under control, the lost imports from Western countries have been substituted with goods imported from China, Turkey as well as Cyprus and the UAE. Central Asian countries, as well as Georgia and Armenia. Has Putin managed to dodge the sanctions bullet, finding a new way forward for the Russian economy?

In fact, the figures are misleading. To assess the real situation, you must look beyond just the handful of commonly used macroeconomic indicators like GDP, inflation and unemployment.

The state of the Russian economy

As a result of sanctions and Russia's decoupling from the West, capital investments are down, capital is fleeing Russia in record numbers, new investments from the Global South are not coming and the Russia's economic outlook depends entirely on the government's ability to finance everything. The state's money, however, is running out by the day. A sustainable way forward for the economy is lacking.

Moreover, the government’s deficit spending, combined with the fact that imports have been restored to pre-war levels, is devaluing the ruble and raising inflation. Thus, the Central Bank was recently forced to raise its key interest rate from 7.5% to 8.5%, hinting at likely further rate hikes.

Needless to say, together with the tax hikes being mulled – partially already implemented – the recent moves to slash spending to bring the deficit under control will curb the chances of a real economic recovery.

Central Bank chief Elvira Nabiullina acknowledged at her press conference on July 21 that "the bounce-back of economic growth is nearing its end,” and that economic growth will soon become "more balanced and moderate,” which portends stagnation at best.

Let's look at the numbers. Oil and gas budget revenues in the first six months of 2023 were down 47% year-on-year – a direct result of the EU's oil embargo and Gazprom's voluntary (and apparently irreversible) exit from the European market. As a result, the federal budget deficit after six months (RUB 2.6 trillion) is nearly equal to the whole planned annual deficit for 2023 (RUB 2.9 trillion).

At the St Petersburg Economic Forum in June 2023, top government officials were openly mulling serious tax hikes to keep the deficit under control. However, the Ministry of Finance has taken a different path: seriously cutting spending to minimize the deficit. Federal spending in June was down 33% versus the average monthly spending in January-May 2023.

Thanks to that, the federal deficit was brought down from 117% of the planned annual deficit figure in January-May to just 90% after June. In parallel, the Ministry of Finance has announced plans for "frontal cost reduction" for all the government agencies – amounting to 10% of "non-essential outlays,” or several trillion rubles (the exact figure is not clear yet).

The problem is that government spending is the key factor keeping the economy afloat these days.
“Capital flight from Russia in 2022 hit a record $239 billion, according to the Central Bank, and is projected to be in the tens of billion dollars for 2023-25; meanwhile, no net capital inflow is projected in the forecast horizon.”
Minister of Finance Anton Siluanov. The ministry has announced major spending cuts, though they are sure to face strong opposition from industrial and defense lobbyists. Source: Wiki Commons
The growth in fixed investment in the first quarter of 2023 was down to just 0.7% year-on-year, kept in positive territory only by the government and defense sectors, with private investments significantly down. (For a more detailed analysis, see the author’s report.)

Dearth of investment

Investors from the Global South are not coming to Russia: zero new investment from Chinese, Indian or Middle Eastern companies has been recorded since February 2022. The reason is that since the beginning of the war, Putin's government has introduced draconian capital controls and ownership right restrictions for foreign investors, keeping away businesses from "friendly" countries from the Global South.

While investors are not coming, an economic recovery depends chiefly on the state's ability to fund the economy – as well as defense spending and social commitments.

How much money does the government still have? Well, the deficit of the federal budget for the first six months of 2023 (RUB 2.6 trillion) comprised 38% of the remaining “liquid part” of the National Wealth Fund (RUB 6.8 trillion), according to the Ministry of Finance (MinFin).

The liquid part – cash on MinFin's accounts at the Central Bank – makes up about 54% of total National Wealth Fund money; the other part (RUB 5.9 trillion) is invested into various shares and bonds, mostly of state-affiliated companies ($3 billion was even invested in Ukrainian bonds while Viktor Yanukovych was president), and are not instantly liquid.

Russia has tried hard to push up the discounted prices of oil sold to Asian markets, but to little avail: the Urals oil price average in the first half of 2023 was hardly above $50 per barrel. To raise budget oil revenues significantly, Urals needs to be at least at the level of $70-80 per barrel, which can hardly be expected in the coming years, with the Central Bank keeping its forecast for Urals flat at $55 per barrel in 2023-25. Exports of liquefied natural gas to Europe and piped gas to China via the Power of Siberia gas pipeline do not generate significant revenues, as LNG exports and gas shipments to China are largely tax-exempt.

Another way to control the budget deficit would be to raise taxes – an option widely discussed by top economic officials at the St Petersburg Economic Forum in June. Partially it is already happening, with the imposition of a windfall tax on fertilizer exporters and other businesses and creeping increases of some other taxes. But the government seems concerned that tax hikes, together with Central Bank rate hikes, would kill any possible economic recovery, which is why the MinFin is currently opting for budget cuts as the key measure to keep the deficit under control.

Yet that has its downsides as well, given the extent to which current economic performance is supported by state spending. According to Rosstat, in the first quarter of 2023 government final consumption expenditure surged by 13.5% year-on-year, while other components of GDP – household final consumption expenditure, gross fixed capital formation – were either in decline or stagnating.

Another indicator is the outstripping growth of military-related sectors in industrial production. According to Rosstat, in January-June 2023, year-on-year output in sectors such as "finished metal products other than machinery and equipment” (weapons and ammunition), "computers, electronic and optical products" (radar devices, radio electronics) and "other transport facilities and equipment" (military aircraft, tanks and armored vehicles) was up 20-30%, and in uniforms it was up 76%, whereas overall output in manufacturing industries during the first six months was up just 6.2% year-on-year.

In July, as she explained the decision to raise rates, Russian Central Bank head Elvira Nabiullina said that "during the period of the recovery growth in the economy, demand was predominantly driven by the public sector."

Faced with a stark choice whether to spend the remaining reserves to continue financing the deficit, economic recovery and the war or to raise taxes, the government has opted to cut “non-essential” spending, as the MinFin is afraid both of the negative impact of tax hikes on the economic recovery and of the shrinking room for maneuver should reserves keep being depleted.

However, cutting spending will have a major negative impact on the current economic model, since, in the absence of private and foreign investment, the economy almost totally relies on budget spending. We should assume that the MinFin announcement about major spending cuts is not the end of the story: key industrial and military lobbyists will likely put up fierce opposition to spending cuts in the coming months, with the outcome unpredictable for the MinFin.

It is also worth noting that the current fiscal situation puts major constraints on Russia's ability to wage war, which is why
“Putin would either have to scale back military operations or demand that the MinFin seriously boost the defense budget, reversing the recently announced spending cuts and depleting the reserves quicker.”
Vladimir Putin and Chinese leader Xi Jinping. Moscow, March 2023. Imports from China have skyrocketed, but China is not investing in Russia. Nor are other countries. Source: Wiki Commons
Russia still relies on imports – now Asian instead of Western

There are also other major consequences of the current economic model. First, remarkably, in the year and a half since the invasion, Russia’s import substitution seems not to be working. Imports of consumer and industrial goods have been restored to, and at times have exceeded, pre-war levels, meaning that Russia prefers to import goods and components rather than to develop its own manufacturing capabilities. This should not be surprising: the corrupt, monopolistic environment, hostile to private investment, innovation and competition, is not capable of generating competitive manufacturing.

However, the dramatic growth in imports from China, Turkey and other countries puts additional pressure on the ruble, which has lost nearly half of its value since it peaked on June 2022 at RUB 51 to $1 (it is currently over RUB 90 to $1).

Putin has been relatively successful in circumventing sanctions through countries that did not join the sanctions regime. In this way Russia substitutes the lost supplies of consumer and industrial goods from the West. For instance, imports from Turkey in January-May 2023 more than doubled year-on-year, while imports from China in the first half of 2023 rose 78%.

A recent report based on detailed trade data from 2021-22 emphasizes that Russia established alternative routes fairly quickly, with imports of dual-use and controlled commodities exceeding pre-war levels. The countries most actively facilitating the circumvention of wartime sanctions include the above-mentioned China and Turkey, as well as Cyprus and the UAE. Central Asian countries, as well as Georgia and Armenia also play a significant role.

The takeaway from the cited report is twofold: the post-invasion surge in imports from third countries means that import substitution is not really working and is not compensating for the loss of the most critical Western technologies and equipment needed for the development of Russia’s manufacturing capabilities, since only the most basic goods are being imported.

In addition, the rising imports, combined with the weakening ruble, are fueling inflation – as does the deficit spending. There are other major pro-inflationary factors at play, as admitted by the Central Bank: more expensive logistics of trading with Asia, shortages of skilled labor due to the increasing number of men mobilized for the war and mass emigration, which is a major constraint for economic recovery in its own right.

The inflation risks push the Central Bank to hike rates, which limits a further recovery – a vicious cycle. Does anyone still think sanctions do not work?

No good choices

So, what about Putin’s upbeat claims about GDP growth, and inflation and unemployment being at record lows? The GDP dynamic is probably a useless indicator during wartime, because, as was shown above, defense spending distorts the whole picture. The government can indeed keep GDP growth in positive territory, but only as long as it has the money. Inflation was already discussed above: after just slightly falling following the spring 2022 peak, it is up again, and the Central Bank is worried so much that it is risking further rate hikes despite the potential harm to the economic recovery.

As for the low unemployment, while the official number of unemployed is really at a record-low 3.2%, the picture is marred by hidden unemployment (unpaid leave, downtime, part-time work week), which is kept out of the official numbers. In total, currently over 4 million people, according to Rosstat, are subject to these forms of hidden unemployment (about 70% of them are on unpaid leave). If these are added to the unemployment numbers, the resulting figure will be as high as 9%, close to the worst figures of the 1990s. In manufacturing, hidden unemployment is as high as 20% of the total workforce.

So, beyond a narrow set of surface-level indicators, the economic picture is quite bleak, mainly due to the lack of incoming investment. Even the government does not expect investment to come. There are still reserves available, but they are at the risk of being depleted quickly if the government proceeds with large fiscal stimulus. If it does not, tax hikes or austerity are inevitable, which will curb growth. There are no good choices left for Vladimir Putin and the Kremlin.
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