OUTLOOK 2023: Russia

OUTLOOK 2023: Russia
President Vladimir Putin’s Fiscal Fortress has proved to be far more effective at shielding Russia from sanctions than hoped by the West. / bne IntelliNews
By Ben Aris in Berlin January 31, 2023

This outlook is part of bne IntelliNews' annual series of reports looking ahead to what 2023 holds for the countries in our region. Read the full report here or download the pdf at the bottom of this article.

The Russian economy is starting 2023 in a far better state than many had anticipated in the spring following the invasion of Ukraine and ensuing Western sanctions. The fall in GDP has only amounted to about 3% or even less, and the US dollar is still trading at less than 65 rubles. Even the Western ban on high-tech imports, although challenging, has proved manageable. But none of this means that Russia’s economy is out of the woods: many risks still remain. We asked economists from Russia’s leading investment banks to highlight the new warning signs that have emerged in recent months.

Oil and gas revenues started to fall sharply. In November, oil and gas revenues contributed RUB866 billion ($13 billion) to the state budget – down 2.1% year on year. This is not a critical fall in revenues. However, in reality, almost half of that sum ($6.4 billion) came from a one-off payment of Gazprom’s mineral extraction taxes. Without that money, oil and gas income was down 48.9% compared with 2021.

There are two possible reasons for this. First is the near-total cessation of pipeline gas exports to Gazprom’s lucrative European market following the closure and subsequent explosions on the Nord Stream gas pipeline. Second is the fall in prices for Russian oil, which led to November’s oil revenues being down 25.4% y/y.

Russia’s finance ministry is printing money to cover this deficit. Part of the hole can be filled using the National Welfare Fund, but this alone will not be enough. Relying solely on the NWF would mean the liquid part of that fund would run out by 2025, according to the projected budget deficit, central bank analysts reported

This fall, the finance ministry turned to large-scale borrowing in the federal loan bond market to cover the rest of the deficit. These internal loans raised RUB1.44 trillion ($22 billion) for the ministry. Of this sum, 77% derives from bonds floating rates, which will ultimately be tied to central bank rates. The main buyers of these bonds were leading banks, which previously borrowed RUB1.39 trillion ($21 billion) through repo transactions. Therefore we are effectively looking at hidden money emission.

This has obvious consequences: it will likely increase inflationary pressure, forcing the central bank to raise interest rates and sacrifice economic growth. However, not every economist regards this scheme as inflationary. Economist Viktor Tunev believes that, from the point of view of modern monetary theory, this borrowing algorithm will have no significant economic consequences. He calls these loans “Russian QE”: the central bank creates liquidity in the form of federal loan bonds, simultaneously improving standards in assets and enhancing money supplies to the banks’ liability without involving capital.

Unemployment levels in Russia remain close to historic lows even as foreign companies have left the market and factories have closed. The latest official figures show that 3.9% of the workforce was unemployed in October (the all-time low of 3.8% unemployment was set in August).

There are several possible explanations for this paradox. First, Russia’s labour market always responds to a crisis by cutting salaries first, not jobs. Second, the low level of benefit payments in Russia means that people who do lose their jobs are likely to grab any job they can as soon as possible.

On top of this, Russia launched its military mobilisation amid this “compressed” labour market, said Rostislav Kapelyushnikov, deputy director of the Center for Labour Market Studies at Moscow’s Higher School of Economics. The loss of approximately 1-1.5 million people from the labour market due to war-related mobilisation and emigration will exacerbate the situation with a growing pool of unfilled vacancies. 

This serves as a wake-up call that Russia’s labour resources are limited, says Alexander Isakov, an economist specialising in Russia and Central & Eastern Europe at Bloomberg Economics. Because there are no spare resources in the economy, mobilisation requires those working in “productive” industries (such as processing, construction and transport) to be diverted into the state sector. All of this impedes potential economic growth: increased defence and public sector spending have structural side-effects that will limit potential annual growth to about 0.5% over the coming five years, Isakov says.

Russia’s real estate market is currently experiencing a bubble due to cheap mortgages. The current programme of discounted mortgages at a rate of 7% was due to end in Russia at the end of this year. Both the central bank and the Accounts Chamber have repeatedly called for the scheme to be cancelled. However, President Vladimir Putin recently announced that the programme would continue, albeit at a slightly higher rate of 8%. These discounted mortgages are causing Russia’s real estate market to overheat. The primary and secondary housing markets are unbalanced (the price difference between a new apartment and a “maintained” apartment is now 40%).

Subsidies have made housing more affordable for more citizens, who have decided to take out mortgages now rather than wait. Demand has risen sharply – faster than supply can adapt – and prices are soaring. In Moscow, it is now impossible to buy a comfort-class apartment in a new building without taking out a mortgage. However, this bubble is unlikely to burst, according to independent financial analyst Sergei Skatov: developers have already sold more than 51% of the housing due to come onto the market by the end of 2023. They need to sell a further 10-20%, which is entirely achievable even if demand falls to summer levels. Defaults on mortgage portfolios could also burst the bubble, but with a failure rate of just 0.4% (and 0.15% in the primary market), this is also unlikely, Skatov said.

Economic outlook

The EU saw a €1 trillion bill for gas prices, since the beginning of the Russian war on Ukraine. The subsidies of EU states accounted for ~ €700bn. 2023 will be as difficult as prices will be above €1,000 per 1,000 cubic metres, while budget costs in 2022 were 2-7.5% of GDP.  

The cost to Russia is probably even higher. According to a bne IntelliNews back of the envelope calculation, the war has cost Russia around $200 billion, just counting the military spending plus the value of a 3% contraction, but that is equivalent to some 7%-8% of GDP. Those costs are bound to rise in 2023 as the effect of sanctions start to bite. 

Russia’s invasion of Ukraine in February has changed everything for everyone. The tragedy is that in October 2021, just before this crisis started, Russia’s economy was booming. A dozen companies had done billion-dollar IPOs. Incomes were rising. The leading companies were expanding abroad. The budget was healthy and in surplus. It appeared that Russia had finally emerged as a first world country.

Then Russian President Vladimir Putin wrecked it all by insisting on his no-Nato for Ukraine deal, a demand he backed with the threat of force and when no deal was forthcoming he followed through on his threat. The upshot is we are now living in a fractured world that is fuelling a polycrisis from which it is unlikely that we will emerge for several years.

Remarkably, Russia’s economy has had a very good year in 2022 considering the “massive package” of the sanctions inflicted on it in March about a week after it crossed the border into Ukraine.

At the start of the war the consensus was that Russia’s economy would contract by at least 15% – worse than the 8% contraction Russia suffered in both the 1998 and 2008 crises. As the year drew to an end the consensus was the contraction would be a little less than 3%.

Most of the macroeconomic results have done far better than expected. Inflation is high but as the Central Bank of Russia (CBR) was one of the first to start hiking well before the war started, it is falling now and is around 12% – far better than the circa 20% that is across Central Europe.

Everything is of course down, but only mildly. Life on the streets of Moscow is pretty much normal and although many of the international brands have left Russia, the parallel imports (mainly via Turkey, but also via Serbia, Central Asia and the Caucasus) are kicking in, so most of the international brand names are available again.

The ban on seaborne shipments of Russian crude oil to EU countries went into effect on December 5. The ban does not apply to crude oil transmitted by pipeline. Germany and Poland, the largest European buyers of Russian pipeline crude, have announced that they will also suspend their pipeline imports, which have already fallen close to zero. 

A few EU buyers (Hungary, Czech Republic and Slovakia) will at least temporarily continue to import Russian pipeline oil for about a year. Most of EU crude oil imports from Russia, however, are now ending.

Russia must find new buyers for about a quarter of its crude oil exports. A separate import ban on Russian petroleum products enters into force in February 2023, which are much more widely distributed in Europe.

The G7 countries also imposed a price cap on seaborne Russian crude. Under the agreement, maritime services related to the transport of Russian crude oil can only be offered for oil priced below the price cap.

The price cap is currently set at $60 a barrel, but could be revised later. Russian Urals-blend crude was already trading below the cap price before the cap entered into force. Russian officials have discussed countermeasures to address the price cap, but nothing has yet been decided. A similar price cap for petroleum products should enter into force in February 2023. Another price cap for gas is being discussed but no agreement amongst the fractious EU has been reached on that either. 

The European Commission proposed its ninth package of Russia sanctions in December, but Hungary says energy will not be part of it. Among other things, the latest round names a number of Russian individuals, companies and banks not previously sanctioned, as well as further export restrictions. For example, the export of drone engines to Russia or potential third-country suppliers is banned. In addition, new export controls and restrictions particularly on dual-use products are planned, including chemicals and IT components.

The shock in December was the manufacturing PMI expanded to 53.2 – its biggest increase in more than five years. Economists believe the rise was due to state spending as the Kremlin has put the Russian economy on a war footing and is pouring money into manufacturing, but the services sector, while also improving, is still in decline.

But Russians in general seem to accept the increased hardship, as they have mostly bought into Russian President Vladimir Putin’s line that Russia is fighting a proxy war and is under attack by Nato – something that is not entirely untrue.

On top of the strength of Putin’s Fiscal Fortress that has proved to be far more effective at shielding Russia from sanctions than hoped, the effect of the partial sanctions and self-sanctioning has been to drive up commodity prices to the point where they far outweigh the reduction of volumes of commodities exported.

And instead of collapsing the economy, Russia is rolling in money. Russia should end 2022 with a current account surplus of some $250bn – more than twice the $120bn it ended 2021 with, and that was already an all-time high record.

The effect of the sanctions in the short term has been limited – and actually in many ways counterproductive – but the long-term effects will be devastating.

Cut off from technology, sophisticated equipment and many of the inputs Russia relies on – Russia imports all its seed potatoes, hatching eggs, print ink and much of its quality paper, for example – its long-term growth potential has been reduced from the already low 2% to about 1% now. With global growth regularly over 4% or more, Russia’s economy is destined to stagnate and slowly fall behind that of the rest of the world in the coming decade.

Russia’s economic health will almost certainly worsen in 2023. The federal budget is expected to end 2022 with about a 2% of GDP deficit, but was still in surplus in November, but only thanks to a special RUB450 billion ($7.1 billion) tax payment by Gazprom.

The oil embargo and related oil price cap scheme that was implemented on December 5 will also prove to be largely ineffective but will reduce Russian oil exports and/or production by about 1mn barrels per day (bpd), say analysts, bring the current account surplus down to around $100 billion in 2023 and increase the 2023 budget deficit to 3%, up from the 2% that has been pencilled in by the Ministry of Finance. While all these things are painful, none of them are devastating and both the Kremlin and the people are willing to take this pain for the moment.

Russia’s economy is likely to limp on as business tries to remake itself with relations in the Global South. While Russia will be cut off from the latest technology it is now trying to marry itself to the faster growing part of the global economy that will somewhat mitigate the pain of leaving the advanced economies. Moreover, Russia has a lot to offer the emerging world as it remains a cornucopia of raw materials and fuel, while its military and energy technology – especially nuclear power – remains advanced and attractive.

The most likely outcome for Russia’s economic development will be these relations will sustain it and allow Putin to placate the population to avoid popular unrest. At the same time, sanction leakage and the ability of regular Russians to continue to travel will mean the shops will remain full of modern creature comforts and the significant leakage in the sanctions regime will also keep business ticking over.

All of this will very likely be enough to keep Putin in office until his term expires in 2024 – and probably longer.

Political outlook

There seems little hope now that Russia can reverse the damage and undo the sanctions it has brought down on itself. All of Russia’s diplomatic efforts in the last months of 2022 were focused on reducing the sanctions, but it has made little progress. During the renewal of the Istanbul grain deal on November 17 the Kremlin pushed for a reduction of sanctions and shipping of its own agricultural products, but won few concessions. The Kremlin has little real leverage and while Kyiv was open to peace talks in March and April, despite the resurgence of talking about possible talks in November and December, Ukrainian President Volodymyr Zelenskiy and the vast majority of the Ukrainian people are committed to fighting the war to the bitter end, unless talks are forced on them by a weary Europe.

That might happen, as by November it was clear that a certain Ukraine fatigue was appearing in the West. While the US has been making a profit out of the war thanks to its capture of Russia’s share of the European gas market with its record-high LNG exports, the cost to Europe has been enormous. According to bne IntelliNews estimates Europe had committed some €550bn to support and relief for companies and consumers by December and the cost of the war to European economies was on course to top €1 trillion by the end of winter.

Moreover, as any expansion of the war will be fought in Europe, that at a minimum will unleash a flood of millions of Ukrainian refugees, Nato has made it very clear its first priority is to prevent an escalation of the war that could pull Nato members in. Ejecting Russia from Ukrainian territory is a distant second but ensuring that Russia does not conquer Ukraine is still a high priority and Nato and Brussels will continue to equip Ukraine to ensure that end.

As for the chances of either coloured revolution or a palace coup in Russia, both remain very unlikely. Putin has effectively crushed all popular opposition to his rule and at the same time run a very effective propaganda campaign that has convinced the vast majority of Russians to rally to the flag.

A palace coup remains unlikely while Putin commands the loyalty of the population – his approval rating in December had dropped only 2pp to 78% despite the humiliating success of Ukraine’s Kharkiv offences and the decision to retreat from Kherson – which makes him untouchable by the Russian elite. Moreover, as any change in guard at the top would likely be accompanied by a purge and redistribution of control of Russia’s richest assets, the majority of Russia’s ruling elite have little incentive to rock the boat.