Russia’s Economy After the War with Ukraine: Where Is It Heading?

Even a year ago, Russia’s economic prospects did not look very rosy: the GDP growth slowed down (from 4.9 percent in the 1st quarter of 2012 to 0.9 percent in the 4th quarter of 2013), most industries were affected by a noticeable drop in investments, while inflation-adjusted personal incomes increased by just 3.2 percent in 2013—a 2.2 times slower pace than in 2000s on average. But even the most skeptical analysts have not talked about a recession that may be comparable to the crisis of 2009, when Russia’s GDP declined by 7.8 percent. That all changed in February 2014, when it became clear that Russia would interfere in Ukraine’s domestic affairs, and this policy may have serious longterm consequences.

Today it seems obvious that Russia already conducted a series of de facto military operations against Ukraine: first were its actions during the annexation of Crimea, then it orchestrated the destabilization of Ukraine’s eastern regions, and later Moscow sent its regular troops into Ukraine’s sovereign territory. Since the last spring I reiterated several times that Russia will inevitably start a full-scale military operation in Ukraine, and now I’m convinced that its actions will deprive Ukraine not only of Crimea, but also of a number of territories in the south-eastern part of the country. The political climate in Europe, apparently, will not return to normal over the next several years— but what will happen during this time to Russia’s economy? To answer this question one should evaluate at least four factors that today have the biggest impact on the economic life of the country.

First, there will be a sharp increase of the government’s grip on the economy, the rise in budget outlays, and, as a result, the tax burden will grow and the financial reserves will decrease. The fundamental reason is the need to fund the Crimean adventure, to finance the operations in eastern Ukraine (and in the future to pay the bills of the newly established quasi-independent states in the region), and to increase spending both on the military and on the security services. If one looks on Ukraine’s budget for FY2014, the Autonomous Republic of Crimea was entitled to receive subsidies amounting to about UAH 3.2 billion, or roughly of US $380 million using the exchange rates effective by December, 2013. According to current Russian projections, the “development of Crimea” till 2020 will cost around RUB 1.1 trillion, or US $30 billion (or about US $5 billion annually). Simple arithmetic shows that the expected amount of Russian costs exceeds Ukraine’s levels by up to 12–14 times. In the case of Donetsk and Lugansk regions the situation is much more complicated. These regions received from Kiev much bigger subsidies—for social needs, for protecting the coal industry and for purchasing Russian natural gas at affordable prices. The central authorities allocated around US $4.2 billion annually for both eastern regions (figures are average for 2012–2013). Even if one multiplies this amount at least 3–4 times (that figure reflects the difference for example in average pension standards between Russia and Ukraine), she or he gets the amount in between US $12 and US $17 billion annually. And I’m not talking about the need to rebuild the war-ravaged infrastructure of the region. To sum it up, I would say that the Ukrainian adventure will cost Russia up to RUB 600–700 billion per year, or 4.5–4.7 percent of overall federal budget outlays. Russian authorities already responded by announcing their plans to increase the VAT from 18 to 20 percent, the flat income tax from 13 to 15 percent and to introduce a sales tax on regional level that may be as high as 3 percent of any goods’ face value. All this will lead to a further decline in economic growth. I would say that the direct impact of the war in Ukraine may cost the Russian economy 1.2–1.5 percent of annual growth from 2015 to 2017 onward, if not more.

Secondly, starting the aggression against Ukraine, Russia faced sanctions from several Western countries, and in response introduced its own restrictions on trade with the EU and the United States. Western sanctions are still primarily financial in nature, limiting the ability to raise funds from abroad. Meanwhile, this source of capital has been a key engine of growth for the Russian economy for many years, compensating for the meager expansion of domestic money aggregates. As a result, the combined foreign debt of Russian companies and banks at the start of sanctions campaign (April 1, 2014) stood at $646.9 billion, of which $134.2 billion were due before December 31, 2015. Therefore the sanctions may result in “squeezing” money from the domestic interbank market, as well as in urgent allocation of funds from both the Reserve Fund and the National Welfare Fund. To realize how huge the needs of ineffective state-owned companies may be, it is enough to remind that just one company (Rosneft) has already applied for RUB 1.5 trillion (US $41 billion)—a sum that roughly amounts to the whole capital accumulated in the National Welfare Fund. All this means that interest rates on the domestic market will go up (the Central Bank already has raised its refinancing rate from 5.5 percent p.a. in February, 2014 to 8.0 percent p.a. effective from July 28, 2014), and this may lead to both higher inflation and costs. The consequence of this—taking into consideration the stagnant personal incomes—will be a decline in consumer activity and subsequent production cuts. At the same time it should be noted that the government introduced some “anti-sanctions” of its own, in particular banning the import of agricultural products from the EU, the United States and some other Western countries. These measures have already led not only to higher prices, but also to bankruptcy of several retail chains and processing companies using imported raw materials. I would assess the impact of financial sanctions at 2.0–2.5 percent of Russia’s GDP, and the effect of the reciprocal trade embargo at 0.3–0.5 percent of GDP.

Third, the emerging economic uncertainty, of course, affects both the consumer and investment plans. In the spring of 2014 most of the companies working in the catering and retail trade have already noted a significant reduction in visitor spending, if not a decline of the number of customers. Passenger car sales in Russia fell in August, 2014 by 25.8 percent compared with the same period of the previous year. Since the beginning of 2014, suburban luxury homes and estates around Moscow and St. Petersburg, which for many years were one of the best investment destinations, are not too easy to sell, despite the much lower prices that have fallen by more than 40 percent from their 2013 post-crisis peak. In fact, all of these are the clear signals of an approaching decline in investment activity. Capital flight from Russia, which in 2013 amounted to US $62.7 billion, reached US $74.6 billion in the first half of 2014. An indirect confirmation of the sharp disappointment Russians experience in their economic future is the growing emigration: during 2008–2011, even during the transient crisis, the number of Russians leaving the country for permanent residence abroad approached on average 35.5 thousand people per year, but in 2013 it reached 182.6 thousand persons, and the first half of 2014 was estimated at around 122 thousand. One may say without exaggeration that in some sectors of the economy a genuine panic is in place—and these negative expectations will also affect economic growth, though it is very difficult to evaluate it in precise numbers.

Fourthly and finally, the consequences of the war in Ukraine and of the increase of government’s role in the economy resulted in serious disagreements within the government and the ruling elite. Economy Minister Alexei Ulyukayev disagreed with the Central Bank officials concerning the use of the Reserve Fund and allowing the budget to go into red. Finance Minister Anton Siluanov refused to support the position of Deputy Prime Minister Olga Golodets on the pension system reform (in the course of the debate President Vladimir Putin fired a Deputy Economy Minister Sergei Belyakov who openly criticized the government’s approach). After Regional Development Minister Igor Slyunyaev tried to “correct” Mr. Putin’s ideas on the methods of the development of the Russian Far East, the whole ministry was disbanded on September 8, 2014—and one may insist with confidence that the disagreements inside the government shall not vanish as the economic difficulties continue to grow. This, in turn, means that economic decisions will be made more slowly; the anti-crisis recipes will become more cautious, and therefore all the concrete steps will come late, exacerbating the economic difficulties.

What conclusions can be drawn from these trends? Today, it’s almost obvious that Russian economy is entering a recession caused primarily by domestic political factors. The overall cost of Putin’s Ukrainian adventure may be estimated at no less than 1.5 percent of the country’s GDP and the sanctions aimed at the financial sector will add to this by at least another 1.5–2 percent. Therefore I would predict contraction of the Russian economy by at least 3 percent in 2015 and a slow return back to “zero growth” in 2016–2017.

The main topic, with which the economic bloc of the government is now obsessed, concerns where to get money for injecting it into the economy to resume growth. But this seems to be a false focus since the very idea presupposes the “normality” of the Russian economy and therefore its susceptibility to such measures. The major problem, however, is that (unlike the most of the economies of the West all mechanisms for effective management and healthy competition at grassroots level of Russian economy are largely destroyed. One should realize that for example in the years following the Great Depression in the United States (from 1932 to 1938) both federal and local governments allocated around US $3.7 billion (US $152 billion in 2010 prices) to a program of building roads—primarily for promoting employment and growth—and that in Russia from 2004 to 2013 for similar purposes (i.e. for the construction of new and reconstruction of existing roads) more than RUB 3.8 trillion (US $122 billion) were spent. The difference, however, lies in the result these investments produced: in the United States more than 190 thousand km of roads were built, while in Russia less than 20 thousand km. This example shows that the state in Russia is unable to restore economic growth simply because the money it may accumulate for these purposes will be either stolen or will be used very inefficiently. And the growth of both the public sector and budget spending does not give any hope that the efficiency and competitiveness in the foreseeable future will be on the agenda of Russian authorities.

The causes of the approaching crisis of the Russian economy today are hidden not in cyclical fluctuations in market conditions, but in country’s inability to make a successful transition to a new technological cycle. Russia’s lagging behind the advanced Western nations, which was visible back in the Soviet time, looks really catastrophic nowadays. The country doesn’t produce computers, mobile phones, modern means of communication; it is by 70–80 percent dependent on imports of drugs, medical equipment, and of many crucial components for aerospace and defense industry. The history of Russian modernizations—from the time of Peter the Great till the 1960s—shows that for each new “turn” the country needs a massive borrowing of technology from the outside world. However, the major consequence of the war with Ukraine and the subsequent sanctions today is the fact that Russian economy is becoming a new autarky in nature, which prevents it from any radical technological change. In other words, the conflict with Ukraine will not only slow the economic growth in Russia and provoke an outflow of both capital and creative people, but, even more importantly, it will stop the influx of new technologies that are critical to the transition to a new stage of technological progress.

Thus, from an economist’s point of view, Russia’s prospects for the coming years look grim. Since the end of 2014 the economy will enter into recession, which will continue in 2015, with the GDP declining by 2.5–4.0 percent. This decline will be accompanied by a fall in investment and with the rise of inflation to 8.5–9.5 percent p.a. in 2014 and to more than 10 percent p.a. in 2015. The government, faced with the need to increase ruble-denominated budget outlays to meet its obligations, will allow the national currency to depreciate against the dollar from its current level of RUB 37 / $1 to RUB 39.5–40.0 / $1 by the end of 2014 and to RUB 43.0–45.0 / $1 by the end of 2015. To be precise one should also add that the population will react relatively calmly to all that for two reasons. On the one hand, the government propaganda is still very successful in its efforts to shift responsibility for the newly arising problems on the West (e.g. according to the recent polls, 85 percent of Russians believe that a ban on food imports was introduced not by Moscow, but by both the European Union and the United States). On the other hand, almost 58 percent of working Russians get their income (wages, benefits or pensions) either directly from the government or from the state-owned corporations—and the authorities may increase these payments regardless of the actual state of the economy. This situation leads to a situation where the real concern about the economic situation in the society will arise only when it will become too late to correct the mistakes. This is what allows me to assert that the conflict with Ukraine has in Russia spawned a whole range of economic, social and political processes capable to stall its economy, and to give rise to huge changes both in Russian society and in the Russian state.