Are sanctions really impacting the Russian economy?

 

Since Russia's gradual invasion of Ukraine starting February 2022, governments globally have imposed numerous sanctions to punish the Putin administration. Western nations placed asset freezes on Russian foreign exchange (FX) reserves which have confiscated almost half of Russia's USD 640 billion in FX and gold reserves held overseas. Russia defaulted on its overseas debt in June as sanctions have cut off the country from the global financial system. Additionally, the Russian government cannot raise financing through overseas debt issuance. 

The following sanctions were announced by sector:

Banks: The US, UK, Canada and EU have cut certain Russian banks out of the SWIFT international payments system. This will preclude those banks from making cross-border payments. Major Russian banks can no longer undertake transactions with US institutions and individuals and several have also seen asset freezes.

Airlines: Russian airlines have been banned from UK and EU (among other countries) air spaces. Russia's largest airline Aeroflot canceled several overseas flights due to sanctions. 

Energy: The US banned Russian oil company Gazprom, pipeline company Transneft, power company RusHydro as well as the largest railway, freight and telecom companies from raising debt in its local market. The UK will terminate all oil imports from Russia by the end of 2022. 

Despite the severity of these sanctions, incoming economic data suggests that the Russian economy is coping better than expected. 

The economy is holding on better than expected:

Russia's GDP has fallen 6.3% between Q4 2021 and Q2 2022 compared to -2.8% between Q3 2014 and Q2 2015 when it annexed Crimea. However, capital investment, one of the key economic drivers rose 7.8% y/y in H1-2022, led by strong manufacturing and mining activity. 

Source: Federal State Statistics 

Note: Click on the picture to zoom in 

Industrial production has held on better than during the COVID shock as well as Crimea annexation.

Source: Federal State Statistics 

The unemployment rate is at a historical low despite sanctions. However, this may be a reflection of the exodus of working age population from the country since the beginning of the war this year.

Source: Federal State Statistics 

The Ruble is definitely not in a rubble. In fact it is one of the best performing currencies in the world this year!

Following Russia's shock invasion of Ukraine in February and strict sanctions from Western nations, the Ruble depreciated ~14% against the USD. However, this depreciation was short lived given that Russia is a major exporter of oil and gas and both these commodities are benefiting from massive price rallies this year. 

The Ruble's depreciation has been much milder than its 42% collapse between Q3 2014 and Q1 2015. 

Russia's current account balance has been booming this year given oil and gas prices. Russia is the largest exporter of gas and the second largest exporter of crude oil globally. 

The Russian government estimates oil revenue to increase towards USD 337 billion in 2022, + 38% over 2021.

While several Western nations have cut back on Russian oil imports, Russia has inked deals with Brazil, China, India and South Africa, which helped the country earn USD 45 billion trade revenue in Q1 20222 through oil and fertilizer exports. 

Following the imposition of sanctions and the reactive collapse in the Ruble, the central bank of Russia (CBR) raised the policy rate to 20% to protect the currency. Policymakers implemented China-style capital control measures to prevent capital from leaving the country. Additionally, Russia is transacting in Rubles with other nations, in order to prop up the currency.  

Experience with prior sanctions has helped Russia better prepare this time around:

Several Western companies have halted their operations in Russia and McDonald's is one example. McDonald's exited Russia by selling its stores to a Siberian coal baron. These stores have now been rebranded and opened as 'Tasty and That's It'. 

Separately, Russia has been paring down its government debt over the past decades to prevent a severe financial crisis reminiscent of the 1998 sovereign debt default. 

Russia debt to GDP (%)

To put these figures into context, the World Bank defines worrisome debt to GDP at or over 77%, indicating that Russian debt is much below worrisome level.

Russian corporate debt has also been restructured to be largely local currency denominated for ease of payment.  

The Putin administration has made efforts to reduce Russia's reliance on USD financing since facing sanctions in 2014-15 during Crimea's annexation. The CBR's foreign exchange reserves have increasingly become a mix of USD (down to 16% in 2021), Chinese Yuan (CNY), Euro (EUR) and gold. 

The central bank sounded more optimistic about the economy compared to previous expectations:

Easing inflationary pressures are now allowing the CBR to loosen financial conditions and support economic growth. After raising rates to 20% in February, the CBR cut its policy rate at subsequent meetings to 8% by July. 

The central bank estimates lower GDP contraction than previously estimated, thanks to robust exports. Russia has redirected commodity exports to new markets. Gazprom raised gas sales to China by 70% y/y in the first five months of 2022. China and India overtook Germany as the largest buyers of Russian crude oil. 

New supply routes have been forged to ease import constraints. The Russia Ministry of  Industry and Trade launched a parallel import scheme to import critical goods including auto parts, electronics, household appliances and clothing among other goods without the copyright holder's permission.  

Businesses have also prudently utilized inventory in order not to exhaust inputs. 

Russia's manufacturing purchasing managers' index (indicating month on month change in the sector's output) has been in expansion territory since May after activity collapsed in March and April. Strong demand conditions are driving higher new orders. Manufacturing activity continues to be weakened by sanctions but conditions are improving. 

Russian monthly manufacturing PMI:

Source: Trading Economics, above 50 (highlighted) indicates expanding activity 

The IMF revised down its estimate of Russian GDP contraction from 8.5% to 6% in 2022.

Towards a structural transformation in Russia:

The CBR's July statement noted the need for structural economic transformation several times. Examples include:

 "Our monetary policy takes into account the need for a structural transformation of the economy"

"The transformation of the economy will be evident from changes in the labour market. We consider this to be a key indicator of the transformation process."

"As the structural transformation progresses, we will observe an increase in the transfer of manpower between companies and sectors."

By structural transformation, the central bank is referring to the need for different sectors inter-linked with external demand to either localize production lines or completely change the range of goods they currently offer. Companies that exported goods to Europe will need to seek other markets. Other sectors will open up for import substitution and boost job creation including in the technology, aviation and space sectors. 

Europe banned the export of cutting edge technology which provides Russia the opportunity to build local expertise in quantum computing, advanced semiconductors, high-end electronics and software. 

Several media articles are now reporting new entrepreneurial ventures being established in the domestic food, cosmetics, clothing, tourism and construction industries already. 

These are mere examples and theoretical ideas of economic opportunities and implementation is key to achieving structural transformation. However, there are plenty of examples where countries gathered sectoral expertise under pressure. China is steadily building local expertise in semiconductor manufacturing given tensions with the US. Israel has built immense military and technological capability in part due to pressures from the external environment in the Middle East. Therefore, good outcomes are possible, if the government and industry take opportunities seriously.   

Sources:

https://www.nytimes.com/2022/02/03/world/europe/putin-sanctions-proofing.html

https://internationalbanker.com/finance/we-are-witnessing-a-global-de-dollarisation-spree/

 https://www.cbr.ru/eng/press/event/?id=14034

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