By the end of 2Q22, the common belief was that the Russian economy was already hurtling towards disaster, buckling under the weight of sanctions. The "unofficial" sanctions, e.g., Western logistics and transport companies boycotting Russia and Russian counterparties, were just as damaging, especially for those industries reliant on imported components.
Economy was expected to show steep decline. It was widely believed that GDP would contract by between 15% and 20% in 2022 and unemployment would spike towards this range also. We now know that the headline contraction was closer to 2.5% and the unemployment rate ended the year at approximately 4%. Inflation, which spiked to over 17% in the spring, and which was also predicted to rise to almost double that, ended the year at 11.9% and is set to fall further in the coming months.
So, what happened or, more importantly, what did not happen, to allow the economy to avoid the predicted collapse? There are several factors to combine:
Structure of the economy: The government either directly or indirectly controls over 60% of GDP – a legacy of the Soviet-era which has not changed much. The “curse of resource wealth” meant there has been little pressure for major economic reforms since 2000. SMEs and entrepreneurs account for only about 25% of GDP.
This means that in good years, when the economy should be fast growing, it does not because of the “state anchor”. But of course SME sectors and the non-state sectors have boomed in these years, but by too little to have had a major impact on the top line.
In difficult years, such as also the Covid year (2020), the state influence acts as a stabiliser. The government is able to channel funds into state organisations to preserve employment and incomes.
It means that while the headline number stays within a narrow positive and negative range, the non-state sectors have much greater volatility. For example, in 2022, the auto-manufacturing sector collapsed by over 40%.
Preparations since 2014: Russia has been dealing with sanctions since the spring of 2014. The state, corporations and investors have been adapting to tightening sanctions since then. Various state agencies and companies have been adapting to sanctions and, crucially, carrying out stress testing to discover future weaknesses and correct them. For sure, nobody prepared for the scale of sanctions applied since February 2022 but the mechanisms and the mindset had been fully adapted to tighter sanctions. By mid-February 2022, Russia was already subject to almost 3,000 sanctions since 2014.
The Central Bank was particularly active and effective in this area. It diversified its FX reserves (not enough but still effectively) and it strengthened the banking system so there was no, nor is any, danger of a bank sector collapse.
Diversification: In 2014, the EU complained about Russia energy exposure but actually did nothing about it until 2022. But also in 2014 Russia woke up to the reality that the economy was critically vulnerable to European export risk. Since then, Moscow has been very active in building new trade partnerships and in diversifying energy export risk.
Since 2014 Russia and China have constructed the 1.2mn barrel per day (bpd) ESPO pipeline, inaugurated the Power of Siberia 1 gas line to China and built a major LNG production facility in Yamal. All of these continue to operate and are unaffected by sanctions.
Strong Western demand: The EU was unable to sanction Russian oil, gas, coal and other materials immediately after February 2022. It was too dependant on Russian supplies. The bans were staged (coal from August), seaborne crude from December 5 and, most recently, oil products from February 5). It meant that traders and other counterparties scrambled to buy as much Russian product as possible ahead of the bans.
In 2022, Russia reported a trade surplus of over $270bn (from $190bn in 2021) and a current account surplus of $240bn (from $120bn). Some of that was because of the big drop in imports, especially in 2Q23 and 3Q23, but most was because of the surge in demand and higher average export prices last year.
That meant the state had plenty of money to channel into the state agencies and to pay for employment support and social supports.
Localisation: Localisation efforts since 2014, although patchy at best, also helped the economy and government avoid major problems in 2022. For example, in 2013 Russia imported approximately 65% of all food consumed in the country (another example of the lazy effect of the “resource curse” since 2000). But in 2021 Russia was self-sufficient in all basic food types and had become a major exporter of wheat and several other food types.
The same success has not been replicated in other areas, such as the auto-manufacturing sector or other technology based industries.
New trade routes: There was a noticeable shortage of products in March-April as traditional trade routes closed and many foreign companies stopped supplying Russian customers. But by May-June these products started to reappear. New trade routes appeared, or existing routes expanded via Turkey, the Caucasus, Central Asia and, latterly, via India and the INSTC rail line.
Of course none of these countries will handle any sanctioned good, such as micro-chips, but are allowing alternative supply routes for non-legally sanctioned goods. The trade data from these countries show a surge in Russia exports in 2022.
This alternative trade is now recognised and regulated under so-called parallel imports “rules”. It means that many industries are again accessing non-sanctioned components and Russian consumers are able to buy most of the products they had access to pre-February 24, 2022.
Effective management: The state agencies, such as the Central Bank, the Finance, Economy and Trade Ministries, etc, all handled the unfolding crisis quite efficiently. There was no panic (they were used to sanctions since 2014) and, crucially, had financial resources and tested alternatives to rely on.
Working with multinationals: The government engaged with major multinationals early. The priority was to try to keep those in essential services (pharma, consumer sectors, etc) and to work with others leaving to ensure the market remained working and without interruption. This was to ensure major employers retained the workforce and paid them. Also, to ensure the uninterrupted supply of essential products and services for the economy.
For those companies which had decided to leave, the engagement was, and remains, aimed at ensuring a new owner is found or that the business is efficiently transferred to local management and activity is uninterrupted.
So far, and in a majority of important cases (major employers or important suppliers), the approach has been successful and has also helped stabilise the economy.
There was/is no effort to engage with or substitute the activities of, for example, discretionary consumer goods supplier such as clothing fashion brands. In most cases, new Russian owners have emerged in profitable areas (such as Starbucks or McDonalds) or consumers are able to access goods via parallel imports.
Much less positive from here. To a large extent, that (the list above) is the “good new”. There is also an emerging and growing list of “bad news” or more worrying news for the economy.
Oil sanctions now in place: As mentioned, Russia made windfall export earnings in 2022 because A) importers scrambled to buy as much volume as they could ahead of sanctions and B) imports collapsed throughout Q2 and most of Q3 until new parallel trade routes became more efficient.
The EU ban on the import of most Russian oil and products is now in place, as is a ban on the import of most materials from Russia. Gas exports are only 20% of previous levels. It means that export receipts will be a lot less from now than was earned in 2022. Imports will also be higher this year so the current account surplus will also be less.
How much less is a big question. The export data for December and January cannot be used, nor the budget report for January. It is incorrect to extrapolate this data to the end of this year because:
There was a big change in the tax collection and reporting system from January and this led to a lot of receipts, which would have been reported in January, being delayed to the next month. The Finance Ministry warned about this in advance (see our recent Russia Macro Monthly for details). The impact of the changes should be smoothed out by the end of 1Q23 but maybe not until then.
There was another change in the taxation of the oil industry, the so-called “tax manoeuvre”. This is a multi-year process of shifting the tax point away from export duties a production tax (MET). This also lowered the export duties in January, but the production tax will appear in 1Q23.
The MinFin also warned of a change in spending allocations from January 2023. Previously most major spending allocations were booked in December each year. From this year that will change to more of a monthly allocation – a long talked about move to smooth out budget reporting.
There was a big drop in oil export volumes in December. This was expected given the huge volumes sold in the previous six months. Buyers in Europe were full. It was expected there would be a disruption for a “couple of months” as new export procedures were sorted out and tanker owners waited to see how the “oil price cap” restrictions would be applied in practice.
In January, we see the effect of the switch to so-called “friendly country” buyers and get a better sense of how much oil export volumes will be lost. It appears the figure is minus 0.5mn bpd, so far. But it is far too early to get a proper fix on volumes. The oil products ban – Russia had exported an average of 2.8mn bpd of refined product in recent months – may have a bigger impact on production and export volumes. It all depends on how much oil Russia can physically shift to other buyers.
There is also uncertainty over the price of exports. It was reported in January that Russian exporters had significantly cut the price of Urals crude to keep exports flowing. But, currently, exporters are saying that the price discount has returned to previous levels. We will only know this by the end 1Q23 (probably).
US Treasury targets routes: It is reported that the US Treasury Department is actively warning and trying to dissuade countries from allowing the so-called parallel imports to Russia across their territory. It is also far too early to say how effective these warnings (and in some reported instances, incentives) may be. What is clear is that all countries involved in hosting export routes to Russia are making a lot of money because of it. So these exports are not easily stopped or slowed.
The same applies to oil products. Europe will be an eager buyer of diesel and other products, previously supplied from Russia, because alternative sourcing will not be as easy as finding new suppliers of crude oil. Outside India, there is not much spare refinery capacity. But the EU, probably mindful of this, has allowed an exemption which says that Russian products which are “blended” with products from another country may be imported to the EU. But the exemption does not specify how much content is permitted from Russia, i.e., what percentage of the cargo. QED, a clear route for Russian product to still get to EU markets via a third country with even a small volume of additional product to mix.
Tighter budget: No matter what will be the eventual “settling” of export trade, it is 100% clear that the size of last year’s export and budget receipts will not be replicated for “many years”. It means that the government will have to focus its financial resources on the military, on supporting key industries and employers and on the maintenance of social programmes. There will be very little remaining to pay for economic development, new industry supports, infrastructure improvements, etc.
Several ministers are frequently quoted as saying there will be enough money to fund national projects and to develop the economy. Maybe. But the critical factor will be the value of exports (especially hydrocarbons) and what new sanctions, and existing sanctions enforcement, are imposed.
Technology sanctions: Sanctions banning the supply of almost all technology to Russia (the dual-use technology ban is all embracing) is probably the most damaging of all. The economy can survive and show modest growth with “base case scenario” expected trade flows and budget spending. But the economy cannot develop without access to technology.
At the very minimum, the loss of access to Western technology will mean a growing development and efficiency gap between Russia and the West. Russia will stay in economic and industrial stagnation until either sanctions start to ease or localisation efforts are successful.
The Trade Minister is very optimistic that localisation may also occur in this area, as it has in agriculture and food supply (for example). But he also admits that the process of training and adaption will take at least five years, and probably longer.
Exodus of talent: The other issue is the exodus of IT specialists and other educated young people (mostly men) since February 24, and especially when mobilisation was announced in September. It is unclear exactly how many left the country (estimates of 1.5mn seem reasonable based on reports from other countries where Russians moved to) and, critically, how many will stay out permanently. The government is keen to make clear it wants as many as possible to return and has refused several attempts in the Duma to punish those who have left.
What does it mean?
There are several obvious reasons why the economy survived 2022 in better shape than had been expected in the spring and in the weeks after February 24.
But conditions have materially changed (e.g., the EU oil sanctions) since early December and that will have a significant impact on government revenues and on economic activity. How much those receipts will decline and what will be the impact on the economy is very unclear at this stage. Very likely we will only have a clearer picture in late 2Q23.
No collapse, but possible degradation: There is no danger, under any plausible scenario, of an economic collapse or financial crisis affecting Russia. The real impact of the accumulation of over 11,000 separate sanctions will be a steady erosion of economic activity and efficiency and, almost certainly, a steady decline in the real incomes and lifestyles that Russian people (especially those in the cities) have enjoyed since 2000. The gap in technology with the rest of the world is more likely to widen and become more damaging, but over several years rather than several months.