(Bloomberg Opinion) -- For years, Russia has been preparing for a crisis of the magnitude its economy is now facing. Leading up to February’s full-scale invasion of Ukraine, Moscow built up its national champions, sought to wean itself off the U.S. dollar and filled a hefty war chest. That, along with oil and gas revenue, has helped to cushion the financial punishment imposed by the West. Clara Ferreira Marques of Bloomberg Opinion and Scott Johnson, who covers Russia for Bloomberg Economics, discuss why this resilience isn’t all it seems.
Clara Ferreira Marques: Russia’s “fortress economy” has held up, for all its cracks. Russia won’t thrive, and a deep and painful recession is inevitable, but it hasn’t crumbled either, even in the face of wide-ranging, even unprecedented, sanctions. Should we be surprised?
Scott Johnson: It’s early days when it comes to assessing the impact of sanctions on the economy. In the very short term, they’ve been able to prevent financial chaos, but there are going to be long-term effects. Why has this panic been so brief? That’s a function of the limits of the sanctions and of the strength of economic policymaking in Russia, of the amount of time that policymakers have had to prepare.
It’s a fragile stability, though. Russia still has sky-high borrowing costs, with the key rate at 17% even after a surprise 300 basis point rate cut. That’s the peak of the emergency tightening cycle that we had in 2014. And if you look at the ruble, it’s not far off from where it started the war, but largely because of capital controls. The central bank has been able to restore order in the financial system but will have to retain a tight grip, even as it starts to shift its focus to limiting damage to the economy.
The impact we’ve seen is what you’d expect when imposing sanctions on a major commodity exporter, while leaving those commodities largely untouched. It’s difficult to expect financial mayhem in Russia unless you shut down the capital flows from its energy exports, and obviously doing that would recoil on European economies.
CFM: How sustainable is this? The central bank, for one, can’t keep rates at current levels, but equally there is no way the country could tolerate financial instability. So how do Moscow’s policymakers manage this balancing act?
SJ: Early on, we outlined four elements of financial crisis that could hit Russia — a bank run, a free-falling currency, a credit crunch and debt defaults. Policymakers have been very successful at stemming the first two, but at the risk of inflaming the others.
They will need to allow rates to come down and loosen capital controls a little further. What we’re still talking about today is extending the time period for mandatory conversions of export earnings, or reducing the amount of mandatory conversions for export earnings — they're not ready to lift this altogether. The capital controls are a drag on the economy, but they’re necessary to allow adjustments to take place in an orderly way. In terms of further changes, I think the central bank does have room to ease a little bit more, probably in a couple of weeks we'll see another rate cut. But it's going to have to be gradual.
CFM: We’re seeing a gap open up between the real economy and the financial sector. The latter has been easy to manage, the former not so much, given inflation was already running at roughly 9% before the war. How serious is the threat?
SJ: Containing the financial crisis was job number one, and I think they’ve done that — but not without increasing the drag on the economy. Sanctions also have a lot of real effects, and that’s not something policymakers can do much about.
Initially, it seemed like the ruble would be the main driver of inflation, but that hasn’t been the case. Instead, we’ve seen a combination of outright shortages and panic buying, which has pushed up prices much faster than I initially expected. So you've got inflation at almost 17% in March. In April, I think we'll end up a little bit below 20%, and in the coming months further acceleration seems likely.
As inventories run down you could see more disruption to supply and it is possible the shock extends a little further. So far inflation is the main channel through which households are paying for Putin’s war, feeling the impact of sanctions. It’s crimping purchasing power, lowering real incomes. There’s not a lot of data yet on household spending, but we did see auto sales collapse in March — that’s a function of this price impact, but also of the interruptions to supply and limitations on financing. Higher-frequency, alternative data too point to a broad pullback in consumer activity.
There’s also a big blow to sentiment that will weigh on spending both for households and businesses. Uncertainty will persist as long as the war goes on, which means that private investment is probably not taking place. In the long run, we will see investment come back online, as companies find new suppliers and as they find new markets, but that's going to take time.
CFM: And the wage crunch, which is going to weigh on spending along with the impact of higher prices? It does seem like employers — and not just the departing foreign ones — are cutting back.
SJ: Russia’s labor market is unusual in that companies tend to retain headcount to the extent that they can in a downturn. Often, you’ll see wages and hours reduced before there are outright job cuts, and that will also ripple through to household spending. But unemployment is likely to rise, especially as sanctions are perceived as more permanent.
If we look at real incomes since 2014, they cratered after the collapse in oil prices as Russia suffered a long but shallow recession, and it was a very gradual recovery. That’s the kind of story we may see over the next one to two years. Even if on the surface the spike in joblessness looks fairly moderate, the adjustment will happen somewhere, and households will suffer on the income side.
CFM: How much support can and will the government provide? Putin saved for a crisis, sacrificed growth for a crisis, and now the crisis is here.
SJ: There’s going to be tension between cushioning the blow of sanctions and trying to rebuild fiscal buffers. As long as the government is concerned that the sanctions could get worse, they’re going to be cautious in the amount of money that they’re spending.
But clearly with energy prices where they are, even with some disruption to energy exports, even with the discount on Russian crude relative to benchmarks, they’re taking in close to a billion dollars a day in energy revenue. There’s no doubt that there will be more demands on the budget from both the war machine and the need to offset the impact on incomes, but I don’t think they’ll have trouble doing that in the near term.
CFM: Does this episode tell us anything about sanctions’ effectiveness, given the muted immediate impact and Russia’s adaptability — or is it really about the type of sanctions that have been deployed to date, and their limitations?
SJ: Clearly, sanctions have increased the pressure on the Russian economy, on Russian households and Russian businesses. In this case, the most important question is how much additional pressure they’ve placed on Vladimir Putin, and whether they are actually a factor in the decisions he makes. He will be wary of widespread instability, but it’s very hard to say whether sanctions are making any difference in the way he acts in Ukraine. On that point, it may be that what Ukraine needs is not more sanctions, but more weapons, as Russia prepares a new offensive. Sanctions won’t work fast enough to prevent that, even if there were an oil and gas embargo from Europe tomorrow.
These particular sanctions, are they effective? I actually think that the financial sanctions we’ve seen so far are about as effective as you could hope, and in some respects they’ve been probably more effective than expected thanks to the voluntary pullback of private companies from Russia, which has meant a much sharper adjustment than I would have predicted going into this. That self-sanctioning effect is adding teeth to what are otherwise partial measures. But it’s the fact that Russia’s biggest source of export revenue has not been seriously affected by the sanctions that limits their overall impact.
CFM: How should Europe structure potential limits on energy imports or even an embargo, given Europe’s vulnerabilities and Russia’s fiscal architecture? This isn’t necessarily all or nothing, so is there a way to limit revenues for Moscow while reducing the impact on European economies — say by focusing on oil, which is a more significant revenue generator for Putin?
SJ: Gas is simply a harder sell for European governments. In the long term, the economy would adjust, but where the uncertainty lies is in the immediate effects — you could have a chaotic adjustment, a sharper, cyclical downturn in Germany than forecasts imply.
European economies may try to wean themselves more quickly off Russian oil. It’ll be expensive, but the shift can take place over a shorter period of time. Going for oil is also a big deal for Russia fiscally. But while oil is an easy adjustment for European economies because it is fungible, it is also easier for Russia to work around. There will be a price effect, with Russia getting less for its oil, as it already is, but what’s easier for Europe to achieve is also easier for Russia to absorb. And Russia is still a major commodities exporter, it’s not just energy.
CFM: Putin has for years sacrificed Russia’s long-term prospects for short-term resilience. That outlook has only darkened as the regime focuses on survival. What happens next for the economy, after it weathers the coming months?
SJ: The depth of the contraction, the length of the downturn, depends on the war and how quickly it ends, but it’s hard to see a resolution that would bring sanctions down completely. Even in a negotiated settlement, most of the sanctions against Russia would probably remain in place. So we’re looking at a different kind of economic contraction than those Russia has experienced in recent decades. The Covid-19 hit was short and brief, and in the run-up to the war, Russia’s economy was actually overheating. When you look back to the global financial crisis, Russia took a very hard hit but also benefitted from the global pick up in activity. This time, I don’t see a lot of room for a rapid recovery.
We’re forecasting a 10% hit to Russian gross domestic product this year, though there’s a lot of uncertainty to that. But on the other end, there’s the question of the speed of the rebound. How much of this hit to output is going to be permanent? When you look a little further out, the drag from sanctions in place since 2014 is now dramatically amplified. You have this disruption to the flow of technology and ideas to the Russian economy, both crucial to reorienting the economy away from energy, given hydrocarbons are ultimately a losing game for Russia. Then there’s demographics.
The bottom line is that Russia was already staring down stagnation prior to the war. Isolating itself from global markets, from the flow of technology and ideas, is the absolute last thing the economy needs.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Clara Ferreira Marques is a Bloomberg Opinion columnist and member of the editorial board covering commodities and environmental, social and governance issues. Previously, she was an associate editor for Reuters Breakingviews, and editor and correspondent for Reuters in Singapore, India, the U.K., Italy and Russia.
Scott Johnson is an economist in London, covering Russia for Bloomberg Economics.
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