The Russian economy ended 2022 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 RUB65. Even the Western ban on high-tech
imports, although challenging, has proved manageable as imports of
semiconductors from China in particular soared in the second half of the year

Trade was down by 15% y/y and retail sales fell 10% y/y, but a doubling of
investment by the state held economic growth up as the Kremlin puts the
economy on a war footing.

None of this means that Russia’s economy is out of the woods: many risks still
remain and several serious problems caused by the sanctions were starting
make themselves felt as the year wound down.

Oil and gas revenues started to fall sharply in November. Oil and gas
revenues contributed RUB866bn ($13bn) to the state budget — down 2.1%
y/y. This is not a critical fall in revenues. However, in reality, almost half of that
sum ($6.4bn) 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. The
federal budget ended the year with about a 2% of GDP deficit but reserves and
a flurry of Russian Finance Ministry’s OFZ treasury bill issues in the last
quarter covered the shortfall.

Part of the hole is 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
analyst say.

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 ($22bn) for the ministry from a total planned borrowing of
around RUB2.5 trillion for the whole year. 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 state-owned banks, which previously
borrowed RUB1.39 trillion ($21bn) through REPO transactions. This
mechanism is in effect the CBR printing money to cover the deficit.

This has obvious consequences: it will likely increase inflationary pressure,
forcing the central bank to raise interest rates and sacrifice economic growth,
although the CBR has kept rates on hold at 7.5% at the last few meetings of
the year.

Just how inflationary this borrowing is remains a matter for debate. Economist
Viktor Tunev calls these loans “Russian QE”: the CBR 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.

The quality of life in Russia slipped somewhat in 2022 but not by a large
amount and not by enough to cause social unrest.

Unemployment levels in Russia remains 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 mobilization amid this “compressed”
labour market. The loss of approximately 1-1.5mn people from the labour
market due to war-related mobilization 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 specializing in Russia and Central & Eastern
Europe at Bloomberg Economics. Because there are no spare resources in the
economy, mobilization 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 program 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 announced in December that the
program would continue, albeit at a slightly higher rate of 8% as construction is
a way of boosting economic growth and employment. 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 as 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, analysts say.

The sanctions leakage remains significant, but is impacting everything, and the
productive industries that rely on western inputs, technology and equipment
most.

Consumer goods have largely rerouted to enter Russia via “friendly” countries,
with Turkey playing the leading role.

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.

A few EU buyers (Hungary, Czech Republic and Slovakia) will at least
temporarily continue to import Russian pipeline oil. 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. The
import ban on Russian petroleum products enters into force in February 2023.

Russian oil exports were halved in the second half of December as shippers
paused to assess the risks, but analysts expect the volumes to pick up in the
first quarter of 2023 as new routes are found. In addition, Greek shipping that
increased its share of transporting Russia oil from 35% pre-war to 55% in the
second half of 2022 have been selling old tankers to Russia, which is building
up an unsanctioned fleet of its own that will aid this process.

Under the G7 sanctions 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 downwards 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 and have threatened to cut production by half a million
barrels a day or about 7% that could send oil price up over $100 in the first
quarter of 2023. A similar price cap for petroleum products should enter into
force in February 2023 and will further unsettle the market.

The European Commission also proposed its ninth package of Russia
sanctions in December, but they contain nothing of particular note, consisting
largely of an expanded list of people added to the Specially Designated
Nationals and Blocked Persons (SDN) List.

Gas production in Russia in January-November 2022 decreased by 11.6%
compared to the same period last year and amounted to 612.9bcm. The
main contribution to the overall dynamics was made by the decline in
production at Gazprom. The largest independent gas producers - Rosneft and
Novatek - showed an increase in production.

While there has been a lot of talk of peace talks starting in September no
concrete action has been taken. Kyiv is calling for a UN sponsored peace
summit in February, while the Kremlin has said it is willing to talk peace “at any
time”. However, the positions of the two sides is so far apart that no talks are
likely. Kyiv is insisting that Russia quit Ukraine completely before talks can
start whereas the Kremlin is insisting that Kyiv recognise the annexation of four
Ukrainian regions on September 30 before it is willing to talk. Neither side will
recognise the other’s demands.

In the meantime, both sides are running low on ammunition and their
manpower is stretched. Following the partial mobilisation that started on
September 21 the new General Sergey Surovikin has reorganised and
adopted a more defensive stance. Russian troops are dug in in multilayer
defensive lines in Donbas and from the 300,000 men mobilised, 120,000 are in
reserve in the rear allowing for rotation of troops to keep those at the frontline
fresh. At the same the rate of artillery fire has been reduced to preserve
resources.

Analysts were widely speculating that Russia will mount a major counter
offensive in the winter, sometime between January and May, with the goal of
taking the whole of the greater Donbas region.