RUSSIA´S ECONOMIC REBOUND NEARS ITS LIMITS / GEOPOLITICAL FUTURES

Russia’s Economic Rebound Nears Its Limits

The rapid recovery could give way to an equally sudden crash.

By: Ekaterina Zolotova

Despite unprecedented sanctions and massive expenses in the war in Ukraine, the Russian economy has managed to stay afloat for more than a year and a half. 

Even slight growth is not out of the question. 

The economy’s resilience can be explained by the revival of consumer demand, greater private investment, import substitution policies and government spending on defense. 

However, rosy rhetoric notwithstanding, serious internal and external challenges remain for the Russian economy.

Growth Factors

No strangers to economic strife, Russia’s policymakers could rely on a familiar playbook when confronted with Western sanctions following the invasion of Ukraine in February 2022. 

In the 1990s, large budget deficits financed by short-term government borrowing quickly caught up with Russia, forcing the country to devalue the ruble and submit to an International Monetary Fund rescue in 1998. 

By contrast, savings from oil export revenues enabled the Kremlin to withstand the 2008 global financial shock comparatively well. 

Today, Moscow puts a premium on maintaining large reserves and avoiding high levels of external debt. 

The economy suffered another setback in 2014-15, coinciding with the imposition of Western sanctions related to Russia’s annexation of Crimea, but the primary cause of the slowdown was a sharp fall in oil prices – partially analogous to the situation today. 

A floating exchange rate enabled the Russian central bank to save foreign exchange reserves and focus on fighting inflation caused by the ruble’s depreciation.

Russia is currently focused on mitigating downward pressure on the ruble, monitoring the federal budget and plugging gaps with the National Wealth Fund, which consists of about 12 trillion rubles ($125 billion) from oil and natural gas revenues. 

Last year’s windfall from oil and gas exports reduced the government’s need to tap the NWF, but revenues from energy are down significantly this year. 

But thanks to higher domestic production and imports, the non-oil tax take is much higher. 

For example, in June it was above even pre-pandemic levels – ironically supporting the Kremlin in its long-standing goal of diversifying its revenue streams. 

(However, industries that rely on imported goods run the risk of price increases.) 

Additionally, the Kremlin plans a 10 percent one-time excess profit tax on large businesses. 

It could use that money to cover the budget deficit, or it could reinvest it in new import-substituting production, which would have positive effects down the road. 

The ruble’s recent decline also indicates that the central bank is allowing the exchange rate to fluctuate. 

A weaker ruble comes with some advantages. 

For example, the state receives more revenue in the national currency as exporters convert their increased oil and gas forex earnings on the Moscow Exchange into rubles so they can pay taxes and expenses. 

(The Russian government prefers an exchange rate of between 80 and 90 rubles to the U.S. dollar.) 

To relieve some pressure on the ruble, the Russian Finance Ministry decided not to buy foreign currency with its oil and gas windfall in the coming months, as prescribed by budget rules. 

(According to the rule, the ministry, with the help of the central bank, buys yuan and gold when revenues exceed a specific threshold.)

 

Other positive factors for the Kremlin include rising oil prices, improving business sentiment and relatively low inflation. 

Specifically, Russian crude and petroleum products have recently begun selling above the G-7’s price caps. 

The central bank’s business climate indicator remains close to the highs of the last decade, and estimates of overall current conditions are above the 10-year average. 

And inflation in the first half of the year was just 2.76 percent. 

Further, after falling by 1.8 percent in the first three months of the year, the economy grew by 4.8 percent in the second quarter compared with the same period in 2022. 

(However, much of this can be attributed to base effects.) 

Lending and business investment remain high; small and midsized private businesses in a few sectors have benefited from liberalization; and weapons production is a major boon for growth.

Reasons for Concern

Still, Russia’s economy faces two important, interconnected challenges. 

First is the risk of overheating, which could destabilize the economy without improvements in spending or Russia’s economic isolation from the West. 

Second, Russia’s exports could suffer from a potential slowdown in the global economy.

The central bank has been warning about potential overheating. 

Though it hailed the economy’s nearly completed return to pre-war levels of activity, the bank noted that this suggests Russia has almost exhausted its capacity for sustainable growth. 

Unexpectedly strong domestic demand (public and private) fueled Russia’s rapid recovery, but soon the country will need to increase either its own production or its imports to keep pace. 

The former will be difficult. Many firms are already operating at capacity, and companies have noted a shortage of workers.

At the same time, it is hard to ramp up imports given the higher costs and delays imposed by Western sanctions. 

By volume, Russian imports were already 16 percent lower in 2022, and although Moscow has made progress on redirecting trade toward “friendly” countries, it is still heavily dependent on foreign trade. 

The Ministry of Economic Development estimates that “unfriendly” countries now account for 35 percent of Russian merchandise exports, down from 58 percent at the start of 2022. 

Direct imports from the European Union fell to about 55 billion euros ($60 billion) from 89 billion euros. 

However, China’s share in Russian imports has grown to 34 percent from 25 percent. 

Neither has Russia weaned itself off foreign currencies, which are still used to settle about 70 percent of the country’s goods trade.

An even more serious challenge could come from an economic slowdown in Russia’s key trading partners. 

For example, Turkey has become a major buyer of Russian energy and a supplier of Western goods, but its economy is fragile. 

Turkish imports of Russian goods were 43 percent lower in June 2023 than a year earlier. 

Similarly, China, a crucial buyer of Russian energy, imported less oil by volume in June than it has at any point this year except January. 

Global demand is gradually weakening, and other countries in Africa, Latin America and Asia cannot always supply Russia with the goods it can no longer secure from the West.

The Kremlin’s optimistic assessments of the economy are not entirely misplaced. 

But the rapid recovery could give way to an equally sudden crash. 

Despite sanctions, Russia remains deeply embedded in international trade – only now with a smaller, less wealthy pool of partners. 

Import difficulties and maxed-out domestic production have already started to push inflation higher. 

A new round of overheating and recession may be just around the corner.