By Antonio Graceffo
During the first eleven months of the Ukraine War, it appeared that sanctions were having very little effect on the Russian economy. In December, however, the Russian economy did a U-turn and it became apparent that Moscow was under incredible economic pressure, much of which came from the oil-cap price of $60 imposed by the EU and its allies. In truth, however, Russia’s economy is even worse off than Western media reports indicate.
The reason why many media professionals and politicians got it wrong in 2022 — and why they are underestimating the damage the Russian economy has suffered in 2023 — is because they tend to look at a limited number of easily understood factors, namely GDP growth rate, trade balance/balance of payments, currency strength, unemployment, and industrial output. Given the fact that Russia is at war, these figures cannot be taken at surface value and require a deeper analysis to form an accurate picture of the health of Russia’s economy.
Last year, when Western sanctions were first announced, the value of the ruble plummeted. But when it became clear that Europe had no way of weaning itself off Russian oil, the ruble recovered. High oil prices actually caused Russia’s imports to increase, and the ruble reached a peak of around 50 to the dollar in June. GDP also grew, as did Russia’s trade surplus. Unemployment was low, and by all of the common measures, Russia was weathering the sanctions.
Russia had a trade surplus last year, meaning that they exported more than they imported. And they had a current accountssurplus of $227 billion, meaning the value of their exports was much greater than the value of their imports. Normally, this would suggest that a country’s economy is doing well. But as soon as the war started, export bans went into effect in other countries and Russia’s imports dropped off significantly. At the same time, oil exports remained high and the price of oil was high. It was no surprise that the total amount of money coming in exceeded the money flowing out.
Oil stood at about $120 in May 2022, and has been trending steadily down since then, hitting around $77 in April of this year. This caused the Russian currency to drop to a rate of 81 rubles to the dollar. For most of last year, when the price of oil was high, Russia’s GDP appeared to be growing. By the end of the year, however, everything changed and GDP growth was -2.1% for the year 2022. In February, growth was -3.1% compared to the same period last year, with Russia’s budget deficit hitting $29 billion in the first quarter of 2023.
Russia’s GDP figures were distorted last year and this year by inflation, which in 2022 reached 13.7%. Inflation causes the nominal size of the GDP, the number most media report on, to increase, regardless of whether more products were made and sold. And yet even the nominal GDP declined — and this was despite increased government spending on military equipment. This means that the economic well-being of the people declined more than the nominal drop in GDP.
Similarly, unemployment in Russia, 3.7% as of December, was lower than in most of Europe. But this high employment rate was not the result of economic health, but rather because of the war. Last year 318,000 men were drafted and as many as 500,000 may have volunteered to join the army, removing them from the labor pool. Hundreds of thousands of others have fled the country, either to avoid the draft or because of worsening economic conditions. As a result, most of the people who have stayed in Russia were able to get jobs. In fact, this year, Russia is suffering from a labor shortage.
Putin announced plans for additional rounds of conscription for this year, with a target of 400,000 additional troops. Not only will this take more young men out of the labor pool, but it will also inspire more people to leave. As is often the case, some of the first to go are the best and brightest, those who are confident they can find jobs overseas. For example 30% of Russia’s IT specialists are believed to have emigrated. It is expected that, in addition to a general labor shortage, Russia is suffering a shortage of trained professionals in many areas.
Overall manufacturing output figures have been trending downward for the past 11 months, because of the sanctions and because of a labor shortage. Russia’s overall industrial production only fell by .6% in 2022. For a healthy economy, this number would be expected to rise each year. Still, a .6% reduction, after nearly a year of sanctions, makes it seem like Russia was holding up well. But, there was a decline of 4.3% in December of last year, which marked the turning point in Russia’s economy. Production was down 2.4% in January and 1.7% in February year-on-year.
While overall production in 2022 was down only by a small percentage, much of this production was military equipment, not consumer goods. The percentage of manufacturing dedicated to arms and ammunition grew by 7%, taking away from consumer goods. At the same time, natural gas extraction decreased by 14.6% year-on-year and metal ores by 8.6%, meaning that there will be less gas and metals to work with.
GDP is expected to decline by 2.5% in 2023. One of the reasons why a country needs its GDP to grow each year is because products have a finite lifespan and periodically need to be replaced or repaired. Public infrastructure like highways, damns, and power generation plants, as well as buildings like schools and hospitals, all need to be serviced. On the consumer side, cars, washing machines, refrigerators, and essentially every piece of machinery, has a fixed life, be it five years or longer. This means that each year a percentage of the country’s total economic activity is dedicated to maintaining things the country and the people already have rather than making new things and improving the quality of life. One of the infrastructure items which needs to be renewed is Russia’s 952,000 kilometers of heating, water, and sewer networks.
The sanctions are causing parts shortages, making it difficult to repair foreign cars and machines. And among the products which are no longer making their way into the country are replacement parts and chips, necessary to repair or manufacture machines, cars, and other consumer and industrial goods. Consequently, Russian companies are looking for ways to manufacture Russian brands. This is also problematic, however, because foreign components and inputs may still be needed. Russian replacement parts are also being created for foreign machines and cars, resulting in higher prices and lower quality. In some cases, factories are shutting down until further notice. Shortages of raw materials and inputs combined with the labor shortage have caused disruptions in manufacturing. Every car manufacturer in Russia halted operations at some point last year and some have not returned to work. As of October, 27.1% of auto workers were furloughed, while an additional 8.4% were reduced to part-time work. With reduced consumption and sales, companies are earning less and wages are dropping. Factory layoffs will increase unemployment, which may be absorbed into government employment. But that would increase the deficit.
War expenditure is estimated to have cost the Kremlin $43 billion last year. Russia’s foreign currency reserves stood at $630.5 billion before the war. At first, it looked like the level would remain high, in spite of Moscow’s increased spending. This was because the sanctions reduced the amount of dollars that would normally be flowing out to pay for imports. Additionally, a large number of foreign companies ceased operations in Russia, and were no longer expatriating profits in dollars. Moscow also imposed capital flight rules, limiting the amount of dollars private citizens could purchase and forcing exporters to convert 50% to 80% of foreign reserves into rubles. Despite all these measures, the reserves were dropping quickly. Since Russia was still trading with China, the Central Bank of the Russian Federation had a surplus of yuan. So, they went on the open market, trading $19.6 billion yuan for dollars, bringing the reserves back up to $593.9 billion in March 2023.
Moscow will most likely find itself in a cash crunch this year. Financial sanctions have frozen about 70% of Russian banking assets and blocked about $330 billion of Russian central bank reserves held in EU and G7 nations and Australia. Foreign energy sales collapsed at the beginning of the year as the sanctions and gas cap came fully into effect, including an intensified ban on Russian natural gas sales to Europe.
To induce countries to bypass sanctions and buy Russian oil, Moscow has to offer a 30-40% discount below market price. China and India have been two of the largest purchasers, but shipping to India adds between $10 an $12 per barrel to the cost. Consequently, falling oil prices may eliminate any benefit Russia can earn on the black market. In February, Russia’s oil revenues dropped by 40%, year-on-year.
For the Russian people, quality of life is clearly deteriorating. Inflation plus reduced working hours is making people poorer. Real incomes have fallen 8 to 9%. Electricity and other utility bills are up in some cases as much as 30-40%. Each month, as many as 6,000 blackouts are being reported countrywide. As a result, living standards are expected to fallthis year. Crime is up, including the first increase in the murder rate in 20 years, as well as a 40% increase in crimes related to drug production.
At the government level, moving forward, the central bank will be faced with a choice of either allowing the value of the ruble to drop, while maintaining foreign currency reserves, or using the dissipating reserves to prop up a falling ruble. And, with war spending set to increase this year, but revenues declining, either currency reserves will drop or the deficit and debt will continue to grow.
Antonio Graceffo, PhD, China-MBA, is a China economic analyst teaching economics at the American University in Mongolia.