26.01.23 Expertise

Crisis in Abundance: why did the Russian economy fail to collapse and is there a crisis on the horizon?

Oleg Itskhoki
Professor at the University of California, Los Angeles

For the first time in history, large-scale economic sanctions have been imposed against an economy as large as Russia’s. The consequences of this look significant, Russia’s economy had contracted by approximately 6% by the end of the year, with this figure representing the difference between potential growth and actual contraction. Ultimately, this means that the economy is in better shape than many experts had expected. The contraction of Russia’s GDP in 2022 hovered at around 3%, despite the fact that in March, most experts, including those within both the Russian Ministry of Finance and the Bank of Russia, were predicting that the decline would be around 8-12%.

An analysis of the reasons behind this turn of events is extremely important both for the development of sanctions strategies and as it sheds light on the future of Russia’s economy. Re: Russia is preparing a major review of the mechanisms and events that have helped to mitigate the sanctions-induced crisis. Today, in anticipation of its release, we are pleased to be able to publish this article by Oleg Itskhoki, one of the world's most respected economists of Russian descent.

Why did the Russian economy fail to collapse, despite the sheer number of sanctions imposed against it? To start with, different sanctions can simultaneously affect different sectors of the economy. For example, import sanctions may mitigate the effects of financial sanctions. Additionally, governmental intervention measures play a significant, albeit temporary, role. Finally, a large influx of export revenues, combined with a trade surplus, which has been aided by import restrictions, has largely absorbed many of the potential economic shocks as it suppressed the crisis’s mechanisms of transmission. This does not, however, mean that the effects of such shocks have been completely attenuated. Imbalances persist, and may become particularly prominent if the trade balance situation noticeably deteriorates. In the likely scenario that export earnings fall, the Russian economy will go through changes in 2023 far more similar in nature to a classic economic crisis than was experienced in 2022.

The Classic Crisis Model: Bank Runs

The word ‘crisis’ generally conjures images of some kind of sudden collapse, often in the form of a banking or financial crisis, or even an extremely sharp economic drop, bringing to a halt the operations of many industries at once. The Russian economy, on the other hand, is currently experiencing a rather gradual decline. The exception to this was the situation in March, the first month of the war, when it seemed as though the country was simultaneously experiencing a banking, financial and currency crisis. 

As it turned out, there were three factors at work in the Russian economy during this period. Sanctions, pre-existing economic issues, including a huge trade surplus, a budget surplus (which was the result of high energy export prices), and the fact that the Russian economy was going through de-dollarisation.

When economists wonder why, in this case, excessive bank runs did not lead to equilibrium, and a subsequent banking and financial crisis, a question to the contrary arises: can a crisis develop during a trade surplus, a budget surplus, and the absence of dollarised contracts within an economy? Had any of these factors not been present, a massive financial crisis would have been the likely scenario.

However, there is also another issue at play. When we think of bank runs as a trigger for economic crisis, as viewed through the prism of economic models, we do not generally assume that the government will be able to simply ‘shut down’ the banking system for a few weeks (see, for example, the Nobel Prize 2022 winning Diamond-Dybvig model). In economic modelling, economists do not account for this, because were the banking system to be paused, and as a result, consumption and investment financing were to be frozen, this would have a serious, negative impact on the population’s well-being. The problem, however, was that the Russian central bank really did shut down the country’s banking system. Why was it possible for the Russian banking system to be stabilised by shutting down operations for several weeks? How can it be that, on a whim, the central bank is able to raise the interest rate to 20-25%, or prohibit banksfrom issuing money to the general population? There is no doubt that this is a very powerful tool when it comes to stopping a potential banking crisis, but why is this method generally not used in other countries? This is an essential issue for those working on economic modelling to consider.

A combination of fundamental factors, most notably a huge trade surplus resulting from record export earnings and a reduction in imports, combined with an aggressive policy to stabilise the banking and financial system, worked together to avoid bank run equilibrium, which would have significantly altered the entire macroeconomic landscape of Russia in 2022. As a result, after the stabilisation of the banking system, an acute crisis was replaced by an inertial macroeconomic scenario, with gradual contraction and stagnation of the economy.

The Paradox of Sanctions during a Trade Surplus

The Russian economy soon found itself in a situation where, for months on end, exports were several times higher than imports. A significant trade surplus was observed as early as 2021, as energy prices rose as a result of post-Covid recovery and fears of an impending war by the end of the year grew. Since March, this surplus has multiplied, as a result of a significant spike in energy prices and also because of sanctions, which have halved Russia’s imports. According to the figures from 2022, the trade balance surplus will account for more than 10% of GDP. This is higher than the figures recorded in China at the peak of its export growth in the mid-2000s.

Since exports are a part of production and imports are a part of consumption, this situation means that the gap between production output and consumption is more than 10% of GDP. This gap is unprecedented and explains why there was no significant capital outflow during the trade deficit (economists call this a ‘sudden stop’), which would have resulted in a financial crisis. 

A crisis typically occurs during a trade deficit. Examples of this can be seen in Greece in the early 2010s, in Argentina in 2001, and in many other cases where two factors overlap: a large trade deficit and a halt in capital (credit) inflows. In Russia, the situation was fundamentally different as, on the one hand, the country still had an opportunity to borrow in international markets, but on the other, there was no need to do so. This is what set Russia apart from other countries; it had no reason to introduce the austerity measures that countries typically use when the inflow of money ends and the trade balance is in deficit. There was no need for the Russian government to pursue austerity policies (when wages and pensions are underpaid or reduced) in order to cope with either a trade deficit or a budget deficit. In Russia, the situation was reversed — there was a tremendous influx of foreign currency, yet it was impossible to buy many imported goods.

As it turns out, in the absence of export sanctions, both financial and import sanctions are not enough to grind an economy to a halt in the short term. That is not to say that sanctions do not work or are ineffective. Instead, we should ask ourselves an important question: were the sanctions effective from the point of view of the Western countries that imposed them? Unfortunately, there is no quick answer to this. But one thing is clear, the combination of import and financial sanctions (in the absence of export ones) has failed to provoke a financial crisis. On the contrary, this particular combination has actually staved it off. Exports have generated an inflow of money, but there is nowhere to spend this, and as a result, a funding deficit has not arisen. This means there is no need to introduce austerity measures, the likes of which Europe pursued with great difficulty in 2010-2012.

If export sanctions were to be imposed, then the country would need to ‘borrow’ in order to cope with these sanctions. Sources of income would be cut off, with borrowing would be the only remaining alternative. Since, as things stand, Russia does not have a reason to engage in borrowing, the effect of current financial sanctions has been limited. 

Taking into account the aforementioned situation, it seems to me that after the invasion of Ukraine, the decision to introduce certain sanctions against Russia by Western countries was politically motivated. Ultimately, the sanctions that were implemented were unable to precipitate a financial crisis. Import sanctions are slowly and systematically working to reduce Russia’s production potential, but have not led to an acute crisis. Generally speaking, we now have an understanding that import sanctions function to partially offset the effect of financial sanctions, while export sanctions, on the contrary, increase them (for a theoretical explanation of this phenomenon, refer to Dmitry Mukhin’s article). This does not mean that import sanctions do not work, but they do mitigate the potential crisis effect of financial sanctions by reducing the domestic market’s currency deficit.

The Paradoxes of Crisis Abundance

Another important question also hangs in the air: why was there no string of bankruptcies? Some breaches of contracts occurred, including, for example, defaults on leasing contracts for all Russian aircraft. But this occurred away from Russia, that is Russia defaulted on Irish firms. But why did the Russian economy not experience a wave of defaults, that would have led to companies saying: ‘Our economic circumstances have changed, we can no longer pay wages?’ In principle, there could have been a wave of contract violations — but, if some contracts were indeed breached, why did others not follow suit? 

It is not difficult to discern the answer to this question: money. There was a lot of money already circulating in the economy. Violating contracts makes sense when money is scarce or has run out; when the economy is flooded with money, it remains possible to continue ‘business as usual’, even though there were a number of contracts that did suffer as a result of the war.

The labour market is another apparent paradox. As can be observed from data, some companies stopped manufacturing products: for example, many engineering industries have suffered losses of 80% or more. It is difficult to explain how an entire sector of the economy can simply stop working for months on end without provoking some sort of crisis. Why did we not see any spike in unemployment data? It is evident that some companies have moved to part-time employment, yet I would like to see the scale of the problem in order to underhow how, in a situation when so many technological companies have ceased production, unemployment data has not spiked. 

The state of the labour market is somewhat of a mystery. In all likelihood there is a non-market equilibrium, which can be explained by the fact that, again, there is still money circulating within the economy; the government distributed a fair number of subsidies to companies directly from the budget in the first months of the 2022. People were able to hold onto their jobs. But, what was the impact of this on smaller businesses? If large companies are able to coordinate their employment policies with the state, then why did we not see an unemployment spike due to layoffs from smaller enterprises? There is no simple explanation for what happened in the labour market, and the mechanisms which compensated for this phenomena.

Another paradox is how this all adds up in GDP. There are a number of industries that have reduced production by 30–90%, yet GDP fell by only 3%. It is possible that these industries have a very small role to play in the bigger picture of the country’s production structures, but this seems unlikely or even unfathomable.

It is necessary, of course, to take into account that there were industries that managed to grow as a result of import restrictions and substitutions. If it is not possible to purchase imported goods and services, then the demand for domestic goods, entertainment and travel grows. It is in these industries that I would expect to observe more significant growth than the data shows. This is also astonishing. That is to say, the shocks from the large-scale drop in imports is reflected rather poorly in Russia’s economic statistics.

It would appear that what we are witnessing is a situation in which a large number of powerful shocks have occurred, but somehow, they have all combined to prevent a critical decline in GDP and employment rates. Again, this may come as no surprise if we take into account Russia’s high export earnings and the fact that, as a result, consumer demand has remained strong. Typically, when we discuss crises in Western economies, we are of the understanding that they usually arise as a result of a significant contraction in domestic demand. This is due to an increase in overall uncertainty and the subsequent tendency to save, rather than spend. It should be noted that, in Russia, there has been no dramatic decline in domestic demand as a result of all the aforementioned shocks.

We can see from data collected from other countries that imports are in the process of recovery. In May these figures had fallen by 50%, yet by August, they had recovered by more than half, that is, to 75-80% of pre-war levels. In some instances, imports increased by 3 to 4 times (from Turkey, for example). However, the structure of these imports has changed as people are faced with the dilemma of either overpaying for goods delivered via Turkey, or buying items of lower quality. Import costs may have risen largely as a result of higher prices, as well as additional logistics and transportation costs, while import volumes actually fell. Nevertheless, it can be assumed that the bulk of imports, with the exception of certain categories that are closely monitored, will recover one way or another over time.

Beginning in 2023, the main restrictions will be related to falling exports, not imports. In the long run, imports will stagnate, but not as a result of restrictions (which will exist for a narrow range of goods, but this is not particularly important for imports overall). The main issue will be falling export earnings, which, in turn, will restrict import growth. 

The Exchange Rate Paradox

Russia currently has a market exchange rate. In particular, there are strong limitations on the central bank’s ability to influence the rate. The Bank of Russia would prefer the exchange rate to be weaker, but current conditions mean it is difficult to bring this about (Dmitry Mukhin’s ‘Sanctions and the Exchange Rate’ elaborates on this issue).

At the same time, the rate is not entirely market-oriented, as it has ceased to be an investment opportunity. In other words, foreign investors can no longer invest in ruble-denominated assets. This means that the ruble and its exchange rate is no longer tied to the international financial system, and mainly reacts to current events rather than forecasts. It is possible that foreign speculative traders could have tried to spin a profit off the ruble's decline, in anticipation of export sanctions (to be introduced in December 2022 and February 2023), but they no longer have any access to the market. Russian investors have limited opportunities to engage in this kind of speculation.

The trade balance remains in a state of equilibrium, and domestic demand for foreign currency and rubles still exists. In principle, the domestic restrictions that were introduced in the spring and which economists called ‘financial repression’ have been all but removed. In this sense, Russian households and companies can decide in which currency to hold their savings, and this remains quite stable. But one way or another, the exchange rate is currently determined, first of all, by the trade balance of exports and imports. Foreign currency inflow is generating a huge surplus.

It should be noted that the central bank has been stripped of the instrument it has traditionally used to smooth out the country’s exchange rate. That is, the Bank of Russia, after having its assets frozen and falling under sanctions, was not able to continue its usual policy of buying and selling foreign currency in order to stabilise the exchange rate. Therefore, it initially shot up to a value of 125–130 rubles per dollar (with the parallel retail rate reaching 150 rubles per dollar). Since the central bank lost this stabilising tool, it has been forced to use the rather unusual method of financial repression (restrictions on currency conversion, withdrawals from accounts, withholding foreign exchange earnings, withdrawing foreign currency abroad) instead of simply buying and selling currency. March and April were marked by a period of financial repression, plus a very high interest rate on rubles. Such measures by the Bank of Russia made it possible to stabilise the demand for foreign currencies. A trade surplus was noticeable in March, and then especially prominent in April, and this played a key part in the ruble’s strong performance. 

As of now, the central bank has very limited tools at its disposal to manipulate the exchange rate. There are now essentially only two options at hand: the first is to print more money, which translates to an easing of monetary policy, and which will eventually lead to the devaluation of the ruble. Ultimately, this measure has nothing to do with the exchange rate. In order to exert direct influence on the ruble’s exchange rate, the central bank must buy foreign currencies on the market, which it has been doing since August, as this is the only action capable of weakening the national currency.

At the same time, as I understand it, the Bank of Russia is not keen to purchase foreign currencies, as it is afraid of being slapped with additional sanctions. In this sense, its influence is fairly limited. Therefore, it appears as though the current exchange rate  is in a state of equilibrium, determined primarily by the balance of exports and imports. Over time, as further sanctions are introduced and exports decline, we will see the ruble’s devaluation.

Some Final Conclusions: a Classic Crisis in 2023?

It seems as though the key factor behind the relatively weak impact of sanctions on the Russian economy was the abnormally high export earnings, and their anti-crisis effect which was achieved, in part, as a result of import restrictions. This meant that the effect of financial sanctions on the Russian economy was neutralised, and the consequences of various other shocks were mitigated as well. There was no significant need for large capital outflows, which meant that there was also no need to introduce austerity measures. There was no crisis-induced contraction of domestic demand. These same circumstances can be observed at the company level, and as a result, businesses did not need either to terminate or urgently fulfil contracts, or make sudden and large-scale redundancies. Governmental decisions, such as the decision to arbitrarily ‘close’ the banking system for some length of time, also played a part, but only in the short term.

The ruble exchange rate has ceased to be a leading indicator of the state of the economy, since it has been largely cut off from the international investment market. Thus the ruble remains mainly market-based, primarily reflecting the current situation with the trade balance, and not the general state of the economy. The expected decline in export earnings and recovery in imports will put pressure on the ruble to weaken. The central bank may temporarily slow down this process by selling its foreign exchange reserves. At the same time, the need for inflationary financing of the budget deficit will also create pressure for the ruble to depreciate, and these two factors are likely to clash in the first half of 2023.

The macroeconomic situation in 2023 will be fundamentally different to that of 2022. 2022 was the year of import sanctions, the destruction or adjustment of existing supply chains and the construction of alternative chains in the face of excess financing and inflows of foreign exchange earnings. 2023, on the other hand, will be a year of relatively adjusted supply chains, but it will also be a year of declining export revenues and an influx of foreign exchange financing in the face of persistent budget deficits. In this sense, 2023 will more closely resemble a typical international crisis (what we call a ‘sudden stop’), with a decline in capital inflows, devaluation pressures and growing problems with financing the entire economy – both in terms of banking and production.