Sanctions against Russia will worsen its already poor economic prospects

The sanctions imposed on Russia by the United States, the European Union, and other countries that are against Russia’s war on Ukraine have started damaging its economy and will erode it further in the long term. Russia is, after all, the world’s ninth-largest economy and a critical supplier of energy and other raw materials, so any belief that sanctions alone would immediately bring Russia down and stop the war was misplaced.

Russia’s economy has done better than the spring 2022 projections. Its GDP contracted by about 2 percent[1] relative to the expectations of an 8.5 percent contraction,[2] mainly because of the strong post-COVID-19 recovery, outsized export earnings as Europe’s dependence on Russian energy declined only slowly and oil and commodity prices soared, and Russia’s ability to partially rebuild value chains, which helped the economy weather the sanctions initially.

However, over the medium term Russia will continue to suffer from weak potential growth. Sanctions alone will not defeat Russia, but they can cut access to high-tech inputs, including for the military, and erode Russia's potential growth. Sanctions will deepen the preexisting fault lines in Russia’s outlook of chronic underinvestment, poor productivity growth, and labor shortages. Countries against Russia’s war on Ukraine should keep up the pressure.

The Russian economy entered 2022 on the back of strong post-COVID recovery and high commodity prices, but it contracted later because of sanctions

Russia’s economy contracted by 2.1 percent in 2022.Before the full-scale invasion of Ukraine, Russia had been expected to grow 2.5 to 3.5 percent in 2022. Government spending and, to an extent, publicly supported fixed investment (albeit likely somewhat overstated by official statistics[3]) played a crucial role in supporting the Russian economy in 2022. Private sector investment growth in 2022 was also strong, despite rising economic uncertainty and falling corporate profits.

Following Russia’s full-scale invasion of Ukraine and subsequent sanctions, Russia’s economy held up initially due to: (1) an extraordinary windfall from rising oil and commodity prices, (2) the Fortress Russia strategy—the policy of excessive reserve accumulation to insulate Russia’s economy from external shocks—following the 2014 sanctions, (3) the skillful policy response, and (4) Russia’s ability to partially rebuild its supply chains.

Russia experienced a significant positive terms-of-trade shock in 2022 (figure 1). As a result, its current account surplus was in excess of $230 billion in 2022, an all-time high, and almost double the 2021 record ($122 billion). Furthermore, capital outflows did not contribute to pressure on the ruble and the economy because Russia imposed capital controls in response to sanctions.

As a result of higher oil prices, Russia’s oil exports (redirected to China, India, Turkey, and other friendly countries) increased by $35 billion in March-December 2022. While export volumes contracted immediately post-invasion, they recovered by the summer. For the year as a whole, the volume of oil and oil product exports reduced only marginally.

Russia experienced an extraordinary energy windfall as oil and gas revenues increased 28 percent from 2021.[4] Even so, the nonoil and gas deficit—total deficit minus oil and gas revenues, a measure of fiscal stance for commodity exporters—increased by nearly 3 percentage points of GDP to 8.9 percent, as oil and gas revenues were insufficient to cover the 26 percent spending increase, including military, defense, and anti-sanctions measures, and a 10 percent indexation of pensions and social spending.

Russia used nearly $50 billion from its sovereign wealth fund, the National Wealth Fund (NWF), to cover the budget deficit and support struggling companies as domestic and external debt markets shut down in the postinvasion period. Of the remaining $150 billion in the NWF, around 45 percent is not liquid and cannot be easily used for the budget. In addition to using NWF funds, the Ministry of Finance issued a record 3 trillion rubles ($44 billion) in domestic debt, mainly at floating interest rates. Russian banks are essentially the only remaining buyers and now hold about 10 percent of their assets in Russian government paper.

The Fortress Russia strategy—the policy of economic insulation following 2014 sanctions—and the skillful policy response also helped to protect the economy initially in 2022. Russia’s economy has faced repeated balance-of-payments shocks since 2008. In response, President Vladimir Putin increasingly demanded higher professionalism and a crisis-ready attitude from his government technocrats and corporates. After losing over $200 billion in reserves[5] on an ultimately futile attempt to defend the ruble in 2008, Russia decided to move toward a more flexible exchange rate and inflation targeting starting in 2012.

Following the oil price collapse and financial sanctions in 2014-15, Russia accelerated the move toward inflation targeting and cleaned up its banking system, and, following draconian spending cuts, the Finance Ministry implemented in 2016 a fiscal rule setting aside energy revenues generated from oil prices above $40 per barrel in a special reserve fund.

Despite the success of the Fortress Russia strategy, excessive focus on reserve accumulation and, correspondingly, an overly tight macroeconomic policy mix also caused economic growth to decelerate to a potential of only 1.5 to 2 percent by 2022.

Russia’s export windfalls allowed its corporates to rebuild their value chains severed by sanctions, export controls, and self-sanctioning. In the Russian sanctions context, self-sanctioning refers to companies choosing, albeit not being forced to do so legally, to curb their operations in/with Russia. China, Hong Kong, Turkey, and selected countries in the Commonwealth of Independent States (CIS) and Middle East and North Africa (MENA) regions have stepped in to provide Russia with goods it could no longer acquire from the coalition of countries against the war.

Outlook for 2023 is more challenging

Export earnings are expected to fade in 2023, and the dwindling revenues will likely be directed toward the war effort and oppression of domestic opposition, reducing resources to support its economy.

Some growth may occur in the first quarter of 2023,[6] however, because of increased fiscal spending starting in late 2022. In addition, according to the latest data from Rosstat, private investment has slowed, consumer spending has recovered somewhat, but consumers are cautiously moving a higher share of their savings into short-term deposits and cash following the autumn mobilization of Russians to fight in Ukraine.

Current account inflows will likely decline further, mainly because of the EU embargo and G7 oil price cap on purchases of crude oil and petroleum products. Europe is now also moving away from Russian natural gas faster than most had anticipated. Though Russia’s overall current account surplus reached an all-time high in 2022, it fell from $77.2 billion in the second quarter of 2022 to $37.5 billion in the fourth quarter of 2022 and further to $18.6 billion in the first quarter of 2023.

The Ministry of Finance reported a fiscal deficit of 2.4 trillion rubles (~$30 billion) in the first quarter of 2023, which is 80 percent above the 2023 target, as oil and gas revenues fell by 45 percent year-over-year, while war-related spending increased sharply. This is following the historically high deficit of 4 trillion rubles (~$57 billion) in December 2022. The Ministry of Finance said that some of the 2023Q1 deficit was incurred in order to reduce the typical backloading of expenditures. Still, it is hard to believe that Russia will reach the budget deficit target of only 2 percent of GDP in 2023.

Russia’s long-term potential growth, already poor, will be further undermined by sanctions

Sanctions are no doubt aggravating Russia’s existing and chronic underinvestment, demographic challenges, and low productivity, going back well before 2022. The outlook for Russia’s potential growth has been gloomy since well before the war started and sanctions were imposed. Figure 2 shows a continuous decline in potential growth, to around 1 percent before 2022. The first decade of this century was a time of Russia’s rapid integration into global markets and increased commodity prices. But growth failed to recover in the years following the global financial crisis. It fell by half after the 2014 sanctions imposed when Russia seized control of Crimea.

Except for oil and gas extraction, services, and agricultural and chemical production, Russia has been suffering from chronic underinvestment, particularly over the last decade (see red bars in figure 3).

Little progress has been made in modernizing and diversifying industries as the tentacles of the state extended further into “strategic” economic sectors. Russia’s bias toward government programs supporting state champions has led to dominance in every sector by state-owned enterprises (SOEs) and further dependence on energy exports. The COVID—19 pandemic highlighted Russia’s most recent failed government-managed reform in health care. Export controls will continue undermining the ability to diversify, particularly in nonenergy export-oriented industries. While only around 6 percent of foreign companies have left Russia and roughly 40 percent are in the process of leaving in response to the war and Russia’s crackdown on dissent, most have scaled back operations and will continue to come under pressure to disengage from Russia. All these factors will weigh further on already poor productivity growth.

The massive mobilization for the war effort is limiting labor supply, generating concerns at the Central Bank of the Russian Federation about inflation. Unemployment was down to 3.7 percent by end-2022 (4.3 percent in end-2021). Emigration has reached a historic high, with about 1.3 million persons leaving in 2022 alone (figure 4). Even before Russia’s full-scale invasion of Ukraine, younger and higher-educated people in Russia were looking for opportunities abroad; with the war and mobilization, the trend has accelerated. The situation is particularly dire among information technology specialists, forcing Russia’s government to move from pleading and threatening to providing subsidized mortgages to get them to stay.

In conclusion, Russia’s economic challenges will only worsen as the war continues with no end in sight. But the countries against the war cannot afford to ease up on their pressure.

Notes

1. The GDP estimates do not tell the whole story. High-frequency indicators point to inconsistencies in the national accounts.

2. The International Monetary Fund (IMF) forecasted an 8.5 percent contraction in April 2022.

3. Imports of equipment and machinery relative to investment spending appear to have diverged from their typical correlation, possibly due to difficulties rebuilding value chains but still casting doubt on the magnitude of the investment growth.

4. Including a one-off tax on Gazprom of 1.2 trillion rubles in the last quarter of 2022.

5. Between July 2008 and end of January 2009.

6. The IMF’s 2023 World Economic Outlook forecasts +0.7 percent growth for 2023.