Russia’s war on Ukraine is set to wipe out 15 years of economic development, undoing three quarters of all the progress President Vladimir Putin made in rebuilding Russia’s economy after he took office in 2000, the Institute of International Finance (IIF) said in a note released on March 23.
“In this Macro Notes, we attempt a preliminary assessment of the impact on the Russian economy from international sanctions and other developments following the country’s invasion of Ukraine,” economists Benjamin Hilgenstock and Elina Ribakova wrote. “Altogether, our projections mean that current developments are set to wipe out the economic gains of roughly fifteen years.”
The numbers are still coming in and IIF says that the true impact of the sanctions and the economic shock they have caused will not be visible until the second quarter of this year, but a recent survey by the Central Bank of Russia (CBR) of professional independent economists estimated that Russia was on course for between an 8% to 15% contraction in 2022.
IIF’s Hilgenstock and Ribakova put their own estimate at the long end of the scale, predicting a 15% contraction, but go on to say some of the damage done will have very long-term consequences that will hobble Russia’s ability to recover. As bne IntelliNews has reported, over the last 20 years each crisis has done progressively less damage but that is not going to be true this time; the harsh sanction regime will weigh the economy down significantly and very likely doom Russia to stagnation for the foreseeable future.
“At this point in time, we expect the Russian economy to contract by 15% in 2022 as domestic demand drops substantially, while a collapse in imports will outweigh a sharp decline of exports and keep the contribution from net foreign demand in positive territory,” IIF said.
Different parts of Russia’s economy will be affected differently. Imports will be worst affected thanks to the deep devaluation of the ruble, which should decline by about 35% quarter on quarter. Exports will be equally badly affected, dropping by some 30%.
Consumption, which accounts for about half of Russia’s economic activity, will decline by just under 25% but having such a large share of the economy will be one of the biggest negative growth factors. Likewise, investment will fall by circa 22% in the second quarter, but the slow-down on investment will take more time to gather momentum, but it will also have more long-lasting effects.
“We believe that the impact on imports will be largest, as the significantly weaker ruble drives up prices and both households and corporates are struggling to acquire sufficient foreign exchange,” Hilgenstock and Ribakova said. “At the same time, foreign companies will reduce their acquisition of Russian goods considerably even in cases where they are not required to do so legally, a dynamic that can be described as “self-sanctioning”. With economic prospects dimming, both in the short as well as medium and long term, a dramatic decline in gross fixed capital formation is likely. However, this will play out over a longer time period since investments are usually adjusting to the overall economic outlook at a slower pace. Finally, while consumption is also set to decline markedly, it should stay somewhat more robust as households retain access to ruble liquidity, and thus purchasing power.”
IIF says that in 2023 there could be a mild bounce-back from the pit that Russia will fall into this year, however, as there will be a -8% negative growth carry over from this year, due to lingering problems, the net growth in 2023 will end up being a 3% contraction. All in all, the effects of this sanctions shock will return Russia’s economy to the size it was in 2007, just before the end of Putin’s second term in office, undoing a large part of the progress that he engineered that is the basis of his sky-high approval ratings.
Long-term effects are worse
The short- and medium-term impact from the current shock are going to be dire but even more debilitating will be the long-term effects of the damage done that have appeared in just a few short weeks.
Top of the list is probably the brain drain. Tens of thousands of Russia’s best IT workers have already packed their bags and left the country. These highly skilled workers have been building state-of-the-art websites and e-commerce businesses. The reputation of Russian software engineers is world-wide and highly respected. A leading IT company such as EPAM, founded in Minsk, but now listed on Nasdaq and with its headquarters in New York, still maintains about two thirds of its staff in Russia and Belarus. These engineers will have no trouble finding a well-paid job wherever they go, but until now Russia offered both well-paid work and interesting challenges. But as the future fades, tens of thousands have voted with their feet and left, gutting what was probably Russia’s most vibrant industry.
“Russia is also affected by emigration, especially among the educated middle class which has the necessary financial means. Some observers estimate that around 200-300k have left just in the last three and a half weeks,” IIF said.
Emigration is not new to Russia. After the boom in the noughties and an end to the double-digit real income growth, emigration accelerated again following Vladimir Putin’s return to the presidency in 2012 and continued in the aftermath of Russia’s annexation of Crimea and the start of the sanctions regime, IIF notes.
“According to official statistics, almost half a million people left Russia in 2020, close to double the numbers during the economically challenging 1990s,” IIF says. “This “brain drain” is one of the reasons why we believe that productivity and potential output growth will decrease further from already-low levels. Another reason is US and EU export controls on technology, including microelectronics, which will hinder technological development for years.”
As bne IntelliNews reported, the lack of a developed domestic precision machine tools industry and the need to import almost all Russia’s advanced equipment is the country’s soft underbelly. Without access to the latest machine tool technology, mostly imported from Germany and the US, Russia’s economy is doomed to fall further and further behind the developed world.
And Russia’s productivity was already subpar even before this crisis started. Productivity soared in the noughties as some $300bn of capital flight returned from abroad in 2006 and 2007 to be invested in the Russian economy. But the crisis of 2008 saw that capital leave again almost overnight and productivity gains never recovered. A similar story is expected to play out in this crisis, only it could be even worse than in 2008.
Productivity gains will be further hurt by the departure of some 400 foreign firms that have either suspended operations, or pulled the plug entirely. Foreign investors have been an important catalyst for the economic development of Russia. In the early 1990 the foreign food maker Mars and fast moving consumer goods (FMCG) company Procter & Gamble trained a whole generation of Russians in the art of retail and its staff was poached wholesale by the new Russian retail companies.
Many of these foreign companies are now “self-sanctioning”, refusing to do business with Russia on principle. Some others that have been reluctant to leave because their business is so big, have been shamed into suspending operations. The chocolate-maker Nestle initially said it was staying; however, a social media campaign involving chocolate bars soaked in blood changed the company’s mind this week and it too has announced it will suspend services. Even the iconic McDonalds restaurant that opened on Pushkin Square in the heart of Moscow in 1990 in Soviet days has been shuttered and taken over by a local copycat burger vendor, bringing its three-decade long run to an end.
“This includes manufacturers, e.g., in the automotive sector, energy companies, large retailers, financial institutions, as well as other service providers such as law and consulting firms. While the immediate impact on economic activity will be considerable, we expect it to be even more meaningful in the medium and long term and lead to a permanent weakening of key sectors of the Russian economy,” Hilgenstock and Ribakova said. “At the same time, the retreat of foreign competitors will provide opportunities for domestic companies to fill the gap, resulting in an increasing decoupling of Russia from the global economy – “Fortress Russia” pushed to the extreme.”
Much of Russia’s oil and gas sector was already under sanction since 2014 and foreign companies prohibited from investing into new projects. But Russia’s aviation sector is going to be amongst the most badly affected by the new economic regime.
Russian aviation is very heavily reliant on foreign made planes, despite several abortive attempts to develop its own domestic aviation production business with the Sukhoi Superjet and similar projects. Following the invasion of Ukraine, Airbus and Boeing – which represent around 70% of the close to 1,000 aircraft flying for Russian carriers – cancelled maintenance contracts and stopped spare part deliveries.
“Experts believe that roughly half of all planes could be grounded by next year due to these actions. Another issue is that Bermuda recently invalidated all aircraft registrations in the country, which affects more than 70% of Russian-operated aircraft. Finally, more than 70% of all planes are leased, overwhelmingly from international leasing companies, and sanctions mandate all contracts to be terminated at the end of March,” IIF reports.
“This year, we expect output to contract by 15%, followed by a statistical carryover driven further 3% in 2023, which will wipe out economic growth achieved over the last close to fifteen years. Sharply lower domestic demand is likely to play a crucial role, while a collapse in imports should offset lower exports, leading to a marginally positive contribution from net foreign demand. However, should further sanctions in the form of trade embargos be implemented, exports might fall more than we currently forecast. In addition to the near-term implications, we believe that the negative effect on medium- and long-term economic prospects could be even more important,” Hilgenstock and Ribakova conclude.