A year of sanctions

February 28, 2023

My economic overview for Al Jazeera

After Russia’s full-scale invasion of Ukraine in February 2022, Western countries imposed numerous sanctions against Russian banks and companies, significantly affecting the Russian economy. Yet the economic collapse some expected never came.

This allowed President Vladimir Putin to declare confidently at the beginning of this year: “2022 was a challenging year for us, and we managed to get through the risks that emerged … quite successfully.”

Indeed, the Western sanctions did not undermine Russia’s economic potential to the extent that the Kremlin would lose the ability to finance its war in Ukraine. The events of 2022 have confirmed that the Russian economy is inefficient but resilient and that the Kremlin can mitigate any destabilizing effect the economic downturn may have on the political front.

The impact of sanctions

The sustainability of the Russian economy is determined by its place in the global division of labor: it stands at the very beginning of technological chains as a supplier of natural resources.

Since the global economy cannot grow without increasing its consumption of natural resources, the demand for Russian raw materials is maintained. This, to a large extent, has protected the Russian economy from the impact of sanctions.

In 2021, Russia provided 17.5 percent of oil sold on the world market, 47 percent of palladium, 16.7 percent of nickel, 13 percent of aluminum (not including China), and almost a quarter of potash fertilizers.

Hypothetically, the world economy could give up Russian raw materials, but only at the cost of price hikes and potentially years of recession, which is not in the interests of Western politicians.

The United States’ attempt to close the access of Russian aluminum to the world market in 2018 led to an instant jump in the price of this metal by 20 percent, which forced the White House to abandon the announced plans.

That is why, in 2022, the West imposed some of the harshest sanctions on Russian export sectors, such as steel, coal, and processed wood, where the global economy has spare capacity. The combined share of these raw materials in Russian exports in 2021 was 11.7 percent, so restrictions on European sales did not significantly impact Russia’s economy at large.

However, they significantly affected the economies of certain regions where these sectors dominate. For example, in November-December 2022, coal mines in Kemerovo, Russia’s core coal production region, could sell just 50-60 percent of extracted coal. In Karelia and Arkhangelsk, where there are many woodworking enterprises, industrial production is contracted by 15.5 percent and 19.8 percent, respectively. In Lipetsk, industrial production collapsed by 15.4 percent due to a drop in production at the largest Russian steelmaker, Novolipetsk Steel.

Western sanctions related to the oil industry targeted revenues rather than production. As a result, Russian oil production increased by 2 percent in 2022. On February 5, an EU ban on the import of refined petroleum products from Russia came into effect, but there is no evidence yet that it has impacted the Russian economy. Since the beginning of 2023, production of gasoline and diesel fuel climbed by 7 percent compared with the previous year, which could, in part, be the result of increased demand from the Russian army.

The decline in gas exports to Europe – not so much sanctions-related but a consequence of Putin’s “freeze and split” strategy for Europe – has had a more significant impact, with production falling by 18-20 percent. If the situation does not change, gas production may shrink by an additional 7-8 percent in 2023.

Mild Recession but Somewhere…

The impact of the sanctions on the Russian economy was significant, but it was not as severe as some expected. It contracted by 2.1 percent in 2022 – much less than the predictions of 5-6-10 percent in the spring.

The high oil and gas prices cushioned the fall in GDP, which brought in windfall profits. Revenues from hydrocarbon production and exports increased by 28 percent compared with 2021, and high inflation in the first half of 2022 led to an increase in nominal revenues from taxes.

Financial sanctions, such as the freeze on the accounts and assets of the Central bank and commercial banks and the restriction on payments and access to capital markets, had the most immediate impact on the economy.

In the spring of 2022, inflation in Russia took just a week to accelerate to more than two percent per week and for the dollar to appreciate by 60 percent to the rouble. The Russian financial authorities were able to mitigate this initial fallout by imposing restrictions on current and capital transactions and refusing to convert the rouble, thus strengthening the exchange rate and suppressing inflation.

However, the gradual build-up of pressure on the balance of payments associated with restrictions on trade in Russian hydrocarbons led to a fall in the current account balance and a rouble weakening by more than 20 percent in the second half of the year.

A more severe blow to the Russian economy came from the “moral sanctions” – the voluntary withdrawal of foreign companies from Russia. The most significant effect was the shutdown of automobile plants, which belonged to international companies. As a result, the production of new cars in Russia fell threefold, and sales – by 59 percent. The manufacturing industry in the Kaluga and Kaliningrad regions, where such plants were concentrated, shrunk by 20 percent.

When considering the drop in industrial production and services, we should consider that throughout the past year, many foreign companies sold their assets to Russian businesses. This process, especially if we are talking about large production facilities, takes several months and requires the consent of the Russian government.

During this time, current activities may stop, but after the transaction is legally formalized, the companies can resume their work. This means that, to a certain extent, the economic decline reflected in the shrinking gross domestic product (GDP) for 2022 may be partially compensated in 2023.

Budget under Pressure

The Russian government was also able to mitigate the effect of the sanctions on the general population by increasing spending. Public expenditure increased by 32 percent of the planned budget for 2022, or $113bn.

About half of the additional budget was directed to the military. Still, much of the rest was spent on new social programs, including additional indexation of pensions, increased benefits for families with children, deferment of payroll tax payments, etc.

The Russian government could cover the extra expenditure from the fiscal reserve accumulated in previous years, the National Wealth Fund (NWF). At the beginning of 2022, the liquid part of it amounted to $113.5bn or 7.3 percent of GDP. The entire budget deficit for 2022, which equaled 3.3 trillion roubles ($50bn), was financed from it. It is likely that in 2023, the fiscal reserve – which now has fallen to 4.6 percent of GDP or $87bn – will be used to cover the budget deficit again.

The pressure on the Russian government budget will inevitably increase in the coming years because the sluggish economy will not be able to generate enough revenues. As a result, the fiscal reserve may disappear completely by 2025-26, but that will not lead to a budgetary crisis. The overall Russian public debt is below 20 percent of GDP, allowing the government to borrow from the domestic market.

The long-term outlook

The past year of sanctions and economic downturn seems to be continuing a trend of stagnation in the Russian economy rather than starting a new one.

In the first eight years of Putin’s presidency (2000-2008), the Russian economy grew at an average rate of 7 percent annually due to the economic reforms of the 1990s, high oil prices, and extensive foreign borrowing.

By contrast, between 2012 and 2021, the Russian economy grew on average by 1.4 percent. This slow growth had much to do with Putin’s authoritarian approach to political and economic decision-making after he returned to the presidency in 2012.

While cracking down on political competition, he also dismantled the progressive system of arbitration courts, which had provided a much higher level of legal protection for businesses. Putin also launched a massive program to rearm the military at the expense of investment in human capital development.

After the annexation of Crimea in 2014 and the unleashing of the armed conflict in eastern Ukraine, sanctions were imposed against Russia, limiting many companies’ access to modern technology. The research and development sector was also undermined, especially by criminal cases launched against Russian scientists accused of treason. These factors severely worsened the business climate in the country and diminished economic growth.

In the short term, the Kremlin will do its best to cushion the Russian population from the effects of the economic crisis.

It is already looking to compensate for falling revenues from slumping oil and gas prices (down 43 percent for October 2022 -January 2023 compared with January-March 2022) by introducing changes to oil tax rates. Putin also declared he wants Russian businesses to contribute voluntary payments to the budget to boost revenues.

This additional revenue will be used to finance the Russian army and the families of regular and mobilized soldiers. Other social benefits and programs will also be maintained.

This will ensure that when the time comes for the presidential elections in March 2024, a considerable amount of the population would not mind seeing Putin re-elected with 70-75 percent of the votes.

In the longer term, the Russian economy is still unlikely to experience a collapse. That is because even the most onerous sanctions have a limited effect. Iran is a good example of that. The country has been under US sanctions since 1987, but its GDP grew by 3.3 percent on average between 1990 and 2020.

Like Iran, Russia will gradually lag behind the global economy and will not achieve more than 1.5-2 percent annual growth.

In the long term, the sanctions will have severe consequences for the technological development of the Russian economy. For ordinary Russians, this would mean a gradual decline in the quality of goods on store shelves and the inaccessibility of customary services until the war.

Economic stagnation, however, is unlikely to lead to social or political unrest. The decline of the standard of living will be very slow and uneven. At the same time, the repression of dissidents and the political opposition will grow, making the protest cost very high.