Deep recession

Due to the escalation of the conflict with Ukraine, with the invasion of the latter by the Russian military in late February 2022, and the resulting harsh sanctions adopted by Western countries, the Russian economy will turn again into recession after the recovery experienced last year. Sanctions include:

• Sanctioning and removing selected Russian banks from the international communication tool SWIFT.
• Freezing the Russian central bank’s foreign currency reserves (mostly held in Western accounts).
• The U.S. ban on engaging in any transaction involving Russia’s central bank.
• Prohibiting the trading of Russian sovereign debt.
• Restricting Russia’s access to foreign capital.
• Freezing assets and forbidding travel for selected Russian public officials and oligarchs.
• Sanctioning Russia’s energy and defense sectors.
• Withholding the Nord Stream 2 certification.
• Controlling exports of high-tech components to Russia.
• Closing the E.U. airspace to Russian aircraft, among other measures.

These sanctions put considerable downward pressure on the Russian rouble, which has already plummeted, and will drive a surge in consumer price inflation. The higher level of inflation will erode Russian consumers’ purchasing power, resulting in a natural decline in private consumption, the traditional growth driver (50% of GDP). In an emergency move, the Russian central bank already raised its key interest rate to 20% (from a relatively high level of 9.5%) on 28 February 2022. It could increase it further to fight the rouble depreciation and elevated inflation. Higher financing costs and deteriorated sentiment will increase inflation and limit household spending and business investment. Concomitantly, public investments have not been accelerating in recent years and are currently expected to be put on hold.

On the other hand, the Russian economy could benefit from higher commodity prices, especially for its flagship exports, i.e., natural gas and crude oil. However, E.U. countries announced their intention to limit their imports from Russia. If it were the case, this would result in weaker demand and softer prices, significantly as their immediate needs will decrease with the end of the winter season approaching. This negative trend could be reinforced should Russia reduce or stop pipeline flows to Europe as a counter-sanction. In the industrial sector, restricted access to Western-produced semiconductors, computers, telecommunications, automation, and information security equipment will be harmful, given the importance of such inputs in the Russian mining and manufacturing sectors. Moreover, even before implementing these official formal restrictions, various Western companies have decided to stop or limit their activity in the Russian Federation. 

To limit the impact, Russia may want to deepen its trade relations with China, already the primary market for its exports and imports. However, China’s purchases would not compensate (by far) for a drop in natural gas supplies delivered to Europe. Closer ties with China could lead to broader usage of the Chinese CIPS (Cross-Border Interbank Payments System) as an alternative to SWIFT, which would partially compensate for the lost access to the latter. Major Russian private and state-owned institutions (including Gazprom) have already accepted yuan payments in recent years but to a limited extent. Finally, the Russian domestic payment system SPFS (System for Transfer of Financial Messages) could see a broader use to substitute for SWIFT.

Initially, solid public accounts will not suffice to save the economy

Oil and gas revenues remain an essential source of proceeds for Russia. Their share accounted for 36% of last year’s public revenues, while crude oil, natural gas, and their by-products constituted 49% of Russia’s total exports. Compared to most other mineral-rich emerging countries, Russia has built up relatively strong financials, with a low level of public external debt, its recurrent current account surplus, and the accumulation of a fair share of its minerals revenues in the National Welfare Fund, as well as substantial foreign reserves (around USD 640 billion). However, the freeze promptly imposed by western depositary countries on the latter prevents the Russian central bank from deploying them and reduces the effectiveness of the Russian response to limit the deterioration scale, especially the rouble plunge. 

Over the last few years, Russia has been reducing its dependence on the U.S. dollar in favor of the euro. As a result, in mid-2021, reserves in USD accounted for 16% of the total, EUR 32%, and GBP 7%, while yuan (CNY) was at 13%. Gold reserves represented 22%. To offset the impact of sanctions, capital control measures have been implemented with a ban on F.X. transfers, including servicing F.X. loans outside the country. Russian exporters must also sell 80% of their foreign currency revenues. Moreover, the Bank of Russia banned coupon payments for foreign investors holding rouble-denominated sovereign debt, while Russian companies are also barred from paying dividends to their overseas shareholders. This comes on top of a temporary ban on selling Russian assets by foreign investors to reduce the money outflow out of the country. Additionally, the Russian government has ordered the finance ministry to spend 1 trillion roubles (USD 10.3 billion) from the National Wealth Fund to buy shares in Russian companies. 

 The economic deterioration could lead to wider protests

As of December 2021, polls showed that about 38% of Russians did not consider war with Ukraine a real possibility, according to Levada Center polling. Another 15% ultimately ruled out the possibility of armed conflict. In February 2022, 71% approved the activities of Vladimir Putin as the President of Russia, compared to 61% in August 2021. 

In July 2020, a nationwide vote ratified constitutional reforms proposed by President Putin. They encompassed promises of increased state support for citizens and, most importantly, an amendment allowing President Putin to run for the presidency again in 2024 and stay in power until 2036. They also included giving presidents lifetime immunity from prosecution. The parliamentary election in September 2021 preserved the constitutional majority of the ruling United Russia party (49.8% of the votes; 324 seats/450). However, the Communist Party came a strong second, with 18.9% of the votes. 

However, with the escalation of the conflict, protests took place in several cities across Russia, despite arrests. The adverse effects of sanctions, such as higher inflation, eroding purchasing power, the country’s isolation, and expected weaker consumer sentiment, added to the lack of structural reforms, could trigger further social discontent and protests.