Impact of sanctions on the Russian Economy
Recently, the near-term outlook for the Russian economy has improved. Consensus forecasts of 2022 contraction have been lowered from -10-30% to -6-9.5%. Consensus forecasts for 2022 inflation have also been reduced from ~20% to 12-15%. Recent PMIs have moved back into expansion territory. This improved 2022 outlook has been underpinned by high oil and gas revenues, which have helped the RUB to recover, and in combination with policy support, has partially shielded the economy from the impact of the initial wave of sanctions. As the RUB has recovered and inflation expectations have eased, the central bank has reduced interest rates from the post-invasion peak of 20% to 8%, and eased capital controls.
However, we see this as a temporary improvement, and see Russian performance as weak and the Russian outlook as fragile for several reasons:
First, it is a weak performance despite high oil and gas export earnings. Despite high oil and gas prices – which underpinned the strong current account surplus which helped to stabilise the RUB, control inflation and allow the CBR to cut rates – Russia still contracted in 2Q22, down by 4.9%YoY. This weak performance compares to strong growth among other oil and gas exporters, such as the 11.8%YoY expansion recorded by Saudi Arabia in 2Q22. We believe the striking gap between Russia and Saudi performance – of some 15pp – is largely explained by the impact of sanctions.
Second, oil and gas export earnings – Russia’s key defence against sanctions – are set to decline from here. The key sanctions on oil and gas are having an impact: for instance, the Central Bank of Russia reported that the average selling price for Russian oil in 2Q was slightly under $80/bbl, when the average price was $113/bbl, confirming the discount on Russian crude at around the previously estimated $35/bbl. This implies a 2Q loss of around $20 bn on oil earnings as a result of sanctions. More importantly, oil and gas sanctions are set to bite much deeper as the European oil embargo – from December 5th on Russian seaborne crude, and from February 5th on oil products – drives oil earnings lower. Meanwhile, the volume of Russian gas sales to Europe is running at one third of last year’s levels, and looks set to decline from here, and effectively stop no later than 2024, when Germany expects to be fully independent of Russian gas.
In particular, Putin’s Russia has experienced a balance of payments crisis in 2008, 2014-15 and 2020 when oil and gas revenues have fallen sharply. Next year, as the European oil embargo is implemented, we expect, based on standard pricing and volume assumptions, a 40% reduction in Russia’s oil and gas revenues. With the RUB under pressure, Russia will then face a difficult choice between high inflation and tighter policy. In either scenario its capacity to support its economy and prosecute its imperial war of aggression in Ukraine will be significantly impaired. Moreover, if Europe stops buying Russian gas – now down to only just over 10% of Europe’s gas supply and immediately replaceable, we believe, by reopening the valves at the Groningen gas field – Russian oil and gas revenue next year would fall to the critical level of $150 bn per annum, which has triggered balance of payments crises in the recent past.
Third, sanctions are hitting the domestic Russian economy. Industrial production is down 1.8%YoY in June – including car production down 62%YoY – 2Q GDP is down 4.9%YoY, and real incomes are down 6.1%YoY in May. We expect further impact over the summer, as company exits start to bite and the impact of sanctions cumulates, with unemployment expected to rise sharply. We also see the Russian move to reduce the level of public disclosure on economic performance – with detailed trade and banking data already classified and a recent decree proposing to classify reserves data – as further evidence that sanctions are proving effective.
Fourth, Russia has seen a sharp contraction in trade, led by a 22% contraction in imports. While this may score as a positive in GDP accounting terms by boosting net exports, it is generally a sign of fragility. Russia is often dependent upon these imports and will struggle without them, as seen in the recent media report of Russian airlines cannabilising their aircraft for spare parts, and the RUSI study that estimated that Russian needs access to 450 components for military hardware which are only produced in advanced economies which are part of the sanction coalition. More generally, we argue that Russia’s attempt to reorient its trade and investment relations from the advanced to developing economies has a high cost, which will widen the gap between Russia and the advanced economies, as a result of reduced skills and technology transfer, and higher logistical, infrastructure and entry costs. In particular, we estimate that the shift will drive a permanent loss of around $80 bn in annual Russian exports, as gas and oil products currently exported to Europe stay in the ground.
Fifth, Russia has started to cut its social spending. To date the cuts are a relatively modest at ~$ 26 bn cuts planned for 2023-2025 (~2.5% of the budget annually, at $315 bn budget revenues plan) on social and investment programmes, to finance the Russian government’s priorities of military spending and support to Russian companies and banks hit by sanctions. The RF government announced spending another $130bn support for economy to counteract sanctions this year – however there has been no proof that it materialized. However, this support has been bolstered by the National Wealth Fund, which has already committed around a third of its resources since the war began. Looking ahead, as sanctions bite and oil and gas earnings fall, we expect the wider impact in the economy to fall on the public sector balance sheet, consuming Russia’s oil funds, triggering large losses at the CBR, which is backstopping the banking system, and squeezing the resources available for Russian public services and pensions.
However, the critical impact of sanctions is unlikely to materialize before the end of 2023, unless more sanctions are implemented. Putin’s Russia had a balance of payments crisis in 2008, 2014-15 and 2020 when oil and gas revenues fell sharply. Next year, as the European oil embargo is implemented, we expect a 40% reduction in Russia’s oil and gas revenues. With the RUB under pressure, Russia’s ability to wage war on Ukraine will be weakened. And if Europe stops buying Russian gas – possible immediately, the KSE institute argues – Russia’s oil and gas revenue next year would fall critically low.
Once oil and gas revenues fall below a critical level – which seems to be about $150 bn per annum – then external balance will require either the extensive use of international reserves and/or a major adjustment in the RUB exchange rate. In practice, we think the Russian authorities would then face a difficult choice between letting the RUB weaken, and accepting a reacceleration of inflation, which will squeeze real incomes, or implementing a sharp tightening in policy, as seen this spring, to weaken outflows and support the RUB, which will slow the economy. In either scenario, the Russian economy will be seriously impaired – with the impact similar to the levels of 2009, 2014, 2019 crises – weakening Putin’s ability to continue waging his war of imperial aggression against Ukraine. With the current level of sanctions this will happen by the end of 2023, but this moment could be reached sooner if further sanctions were imposed, notably a European gas embargo.
The 22% 2Q-22 contraction in Russia’s imports is a sign of fragility. Russia depends on the technology embedded in these imports and will struggle without them – as seen in Russian airlines cannibalizing their aircraft for spare parts, and the Russian military’s dependence on components from Ukraine’s allies for its military hardware.
Russia’s attempt to reorient its trade and investment relations from the advanced to developing economies has a high cost, which will widen the gap between Russia and the advanced economies due to reduced skills and technology transfer, and higher logistical, infrastructure and entry costs. In particular, the KSE institute estimates that the shift will drive a permanent loss of around $80 bn in annual Russian exports, as gas and oil products currently exported to Europe stay in the ground.