Russia’s economy faces death by a thousand cuts

Russia Putin Economy
Russia Putin Economy

Economic pressure was one of the ways in which the West hoped Russia would be brought to heel after its invasion of Ukraine. Yet last year the Russian economy grew by 3.6pc, far faster than most countries in Europe.

What’s more, this year Russia is likely to grow by about 3pc What on earth has happened? At the risk of being accused of teaching grandmothers to suck eggs, let me go back to basics. Extra expenditure unleashed by a war can give a boost to the economy.

This is what happened to Germany in the 1930s. There was also a huge increase in war production in the US, initially to meet export orders including from the UK, and subsequently to equip its own massively expanded armed forces.

This expenditure was a key factor in lifting those economies out of the Great Depression. If an economy enters a war with unemployed resources, including labour, then the extra production of war materiel is effectively free. It employs resources which would otherwise be unused.

Moreover, such a boost to demand can deliver an increase in non-war production as the recipients of extra income from war production spend their money. But these gains are limited. They can only occur in economies with unemployed resources and they end when the unemployed resources are exhausted.

One way of escaping from this constraint is to draw in extra resources by importing more from abroad or exporting less, thereby causing the current account of the balance of payments to deteriorate. But that too has its limits. Once they are reached, extra production for war purposes must come at the expense of reduced production for something else – ordinary consumption or investment.

When the Ukraine war began, Russia did have a margin of unemployed productive capacity, including labour. Extra demand was therefore able to draw forth increased production. But this margin of unemployed resources was quickly used up.

After that point, with resources fully employed, extra demand brings inflationary pressure. Last year, the Russian inflation rate averaged 5.9pc. This year it is likely to be about 7.5pc. So much for Economics 101. Now for the West’s policy stance.

It hoped to exert economic pressure on Russia through three channels. First, by stopping Russian exports to the West – especially oil and gas – it hoped to bring major financial pressure on the Russian government and make it difficult to build up and resupply the Russian military.

Second, it hoped that an embargo on financial dealings with Russia would make it extremely difficult for the Russian system to transact with the outside world. Third, it hoped that cutting Russia off from the supply of key industrial inputs would gradually grind down Moscow’s supply capacity of both war materiel and goods for ordinary domestic use.

The first of these channels has definitely not worked. Russia’s main exports, namely oil and gas and some minerals and metals, are the most fungible of all.

It is relatively easy to divert these from one set of markets to another. In Russia’s case, this has been facilitated by China and India replacing the West as a source of imports and a market for Russia’s exports, and by some other countries acting as intermediaries between Russia and third parties.

Indeed, higher prices for energy meant that in the early stages of the war, Russia’s export earnings, and hence the revenues flowing to the country’s government, soared. More recently, both prices and energy revenues flowing to the treasury have fallen back. Financial pressure has failed for similar reasons.

The Russian government has been preparing for this since the annexation of Crimea in 2014. It has reduced financial dependence on the West and has increased use of the Chinese system to facilitate international payments. The effectiveness of the third channel is unclear.

As with so many other countries, there are serious doubts about the validity of official statistics – particularly so in the Russian case. On the face of it, though, there doesn’t seem to have been a major impact on Russia’s productive capacity.

What is the outlook? It seems likely that the damage to Russia’s productive capacity from the loss of western technology and key supplies will increase over time. Moreover, the medium-term outlook for its supply capacity has been severely dented by the loss of so many soldiers in the Ukraine war – and more importantly, by the exodus of so many well-qualified young people who wished to escape both the Putin regime and the prospect of call-up.

The extent of troop losses is extremely uncertain. One US estimate puts the number of Russians killed and wounded at over 350,000. Emigration because of the war is unofficially estimated at over 1 million. This amounts to a combined total of about 1pc of Russia’s population.

These losses are especially important because of Russia’s pre-existing demographic time-bomb. Its birth rate has been running at about 1.5, well below the replacement level of 2.1. Not only are the majority of casualties and emigrants young, but they are also disproportionately male, threatening a gender imbalance in Russia which will undermine overall fertility.

Meanwhile, the immediate economic outlook remains fragile. The latest Russian budget envisages a 70pc increase in defence spending this year, taking it to 6pc of GDP (The UK Government should kindly take note).

Given this, despite surging tax revenues, the budget deficit is likely to be about 3pc of GDP this year. Admittedly, the current account is likely to record a surplus of about 4pc. But this is less impressive than it sounds because Russia needs a surplus of about 2pc to finance the continuing flight of capital.

The big vulnerability is energy prices. If they were to fall sharply then the budget deficit would balloon and the current account surplus would dwindle, putting pressure on the rouble and causing inflation to rise further.  If that were to happen, then the economic screw would really tighten.

Roger Bootle is senior independent adviser to Capital Economics.

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