08.02 Expertise

Worse Than a Crisis. The 2022 Russian economic anomaly: how it works, and where it is headed

Oleg Vyugin
Professor at the Higher School of Economics, in 1996–1999 — Deputy Minister of Finance of Russia, in 2002–2004 — First Deputy Chairman of the Bank of Russia
Evsei Gurvich
Head of the Economic Expert Group
Oleg Itskhoki
Professor at the University of California, Los Angeles
Andrei Yakovlev
Visiting researcher, Davis Centre, Harvard University
Re: Russia report edited by Kirill Rogov

In an unexpected turn of events, Russia's economy did not significantly contract in 2022. What caused this economic anomaly? Is the Russian economy truly resistant to sanctions? On the one hand, the answer to these questions is obvious, but on the other it requires a thorough substantive examination. In this report for Re: Russia, four eminent Russian economists examine the causes and mechanisms behind the Russian economy's atypical reaction to the sanctions shock, as well as its consequences, and they make predictions for what is to come. 

Russia’s unusually high revenues from energy exports were the main factor allowing the country’s economy to avoid the typical course of an economic crisis. Indeed, these revenues were the highest in the country's history. Sanctions augmented the size of the trade surplus. As a result, despite massive capital outflows, there was an excess of money circulating in the economy. This was a major contributor to the unusual development of the crisis. This money helped to mitigate the effects of crisis factors, particularly capital outflows, and stimulated certain sectors of the economy through various channels (a strong ruble, benefits, credit, fiscal stimulus). As a result, while some industries experienced a twofold contraction, others expanded by up to 20%. 

However, this does not imply that the economy is ‘resilient’ and has weathered the sanctions storm. These seemingly upbeat figures do not reflect the reaction of the economy to the incurred imbalances, but rather the effect of super-income mobilisation. Nonetheless, the imbalances caused by the sanctions and the war remain. As revenues fall, the economy will continue to face the same set of problems that are characteristic of a standard economic crisis: investment hunger, devaluation, chronic budget deficits and contraction in demand.

An atypical crisis: mechanisms, consequences, scenarios

The Russian economy contracted much less in 2022 than was predicted by virtually all economists and experts, including those from the Russian central bank and international organisations. However, contrary to popular belief, the Russian economy's actual losses, as a result of the country’s invasion of Ukrainian and unprecedented international sanctions, amounted to 5.5-6% of GDP in 2022. By the end of 2021, the economy had reached a post-COVID growth rate of more than 5%, and while growth was expected to slow in 2022, it appeared perfectly feasible that the country would achieve a 3% annual growth rate. Thus, an accurate estimate of the country’s economic losses should be calculated using the difference between expected and actual growth (2.5-3%). However, the resulting loss is still two to two and a half times less than the expected 8 to 12% contraction in GDP for 2022. Against the backdrop of increasingly optimistic data on the state of the Russian economy, the IMF's latest forecast predicts a symbolic 0.3% recovery growth in 2023. 

The current situation is paradoxical in that the better-than-expected performance by the Russian economy does not indicate the economy’s resilience in the face of crisis factors. Rather, this performance implies that there are other factors influencing the economy's natural response. In 2022, one such circumstance was the abnormally high revenues from energy exports. We might assert that the economy did not 'cope with the sanctions,' but rather their impact was attenuated due to the circumstances. And there is a significant distinction between these two interpretations of events. 

In our previous report on the effects of the sweeping international sanctions, we contended that countries that are able to withstand such sanctions ultimately suffer far greater losses in the long term. Their economic (and political) system has been preserved and mobilised in preparation for the task of resisting sanctions (‘resistance economy’). Society adapts to its long-term state of anti-sanctions mobilisation, but as a result, it is indelibly deprived of the potential and tools for development. This is because it assumes the existence of important constraints for economic development. For example, Iran, which has been subject to sanctions since 1979, has yet to achieve the level of per capita GDP that it had 50 years ago, in the early 1970s. 

The economic crisis, which is evident in a significant decrease in gross product and citizen income, is a manifestation of the economic imbalances that have developed. It is a painful effect that forces economic actors and society as a whole to seek ways to correct such imbalances. In the long run, the presence of circumstances that allow, for a time, for the mitigation of the most evident symptoms of the crisis without correcting the underlying imbalances is the worst-case scenario. If you have a stomach ache caused by appendicitis and take large amounts of pain relievers, the pain may go away, but your chances of dying increase dramatically. While an appendectomy might be unpleasant, it is a simple and standard procedure.

GDP per capita globally and in Iran, Cuba, Mexico and Turkey, 1972-2021, US dollars

In the early 1970s, Iran and Mexico were at the same level of development, with a slightly higher per capita GDP than the global average. Despite Iran's oil export advantage, 50 years later Mexico has a per capita GDP that is slightly lower than the global average but nearly twice that of Iran, which has yet to achieve the prosperity it experienced in the early 1970s since the imposition of sanctions in 1979. A similar trend can be observed if we look at figures from Turkey and Cuba, which had similar GDP per capita in the early 1970s. Although Cuba has managed to double its GDP per capita in the 50 years it has been under sanctions,it has barely narrowed the gap on the global average GDP per capita. Over the same period, Turkey's GDP per capita increased by a factor of 3.8, exceeding the global average by 20%.

An atypical crisis scenario

Oleg Itskohi has outlined how a typical economic crisis develops, and why this did not occur in Russia in 2022. Typically, the adverse events that precipitate a crisis result in a large outflow of capital from a country and a depreciation of the national currency. In response, residents make a ‘bank run’ in an attempt to save their money, resulting in a financial crisis. A severe credit crunch causes production to halt and businesses to be unable to fulfil contracts. Furthermore, current account deficits compel governments and economic agents to reduce their financial obligations and cut their spending, resulting in a further contraction of economic activity, a drop in demand, and a growth in unemployment. 

However, if we look at Russia in 2022, the main factor preventing such a scenario was the country’s exceptionally high income from energy exports. Moreover, the negative shock of sanctions (collapse of imports, reduction of ties to Western economies, and capital outflow) was accompanied by an increase in these revenues, as energy prices continued to rise. This was the primary factor allowing the Russian economy to avoid a crisis.

As Oleg Itskhoki has demonstrated, the combination of fundamental factors — a large trade surplus and the administrative measures introduced by the central bank, which essentially just temporarily shut down the country’s banking system — prevented a ‘bank run’ and financial system collapse. Because of the sharp decrease in imports, the trade surplus grew to gargantuan proportions: export revenues increased while import costs decreased sharply. The economy consumed far less than it ‘produced’ (in value terms).

In effect, money was pumped into the economy, which had become semi-isolated from the outside world. As such, the government did not need to impose austerity measures; instead, it provided incentives to businesses and increased spending. As such other economic agents did not feel the pressure of the crisis; they were able to continue to fulfil contracts and pay salaries despite a sharp drop in output, etc. 

Despite this, it would be incorrect to claim that the sanctions are not working. Rather, different sanctions policy blocks can operate in different directions. As a result, for example, it has been found that the imposition of sanctions against imports do not strengthen, but mitigate the effects of any financial sanctions imposed at the same time. Crucially, in a situation where there is abundant external financing, even powerful shocks that would normally cause a negative chain reaction are attenuated, and the mechanisms that would typically bring about a crisis are suppressed. Aside from the interruption of imports, the most powerful shock experienced by Russia was capital flight, but the incredible inflows of export financing helped the economy to bypass the effects of this shock.

Revenues, stockpiles, a strong ruble, and fiscal stimulus

Oleg Vyugin demonstrates how this unusual crisis scenario has played out in the realities of the Russian economy. According to Vyugin, four major factors have combined to significantly reduce the impact of the sanctions shock. 

To begin with, as has already been described, high oil and gas export revenues have been a crucial factor: in value terms, they have nearly doubled (from $245 billion in 2021 to around $345 billion). According to FCS officials, the value of Russia's commodity exports grew  by 18% in 2022. Thus, it was on track to reach an all-time high of $580 billion: In the 2000s, Russia's average annual export revenue from its commodities trade was $225 billion; in the 2010s, this was $430 billion. 

The second factor was the stockpiles and financial reserves that Russia has accumulated by the end of 2021. As noted previously, the economy's post-crisis recovery and rising energy commodity prices enabled it to reach a growth rate of around 5% by the end of 2021. Economic agents built up their reserves in anticipation of future growth. Companies' net financial results by the end of 2021 were roughly three times higher than the results of the previous year. This increased their resilience to shocks. The sharp decline in corporate sector profits did not become apparent until the third quarter of 2022. 

The third factor was the active reorientation of foreign trade towards countries not participating in the sanctions regime against Russia (primarily Asian countries). The availability of financial resources and a strong ruble allowed for a rapid increase in imports through these new channels. The strengthening of the ruble, as a result of the growing trade surplus, increased the corporate sector's financial resources in dollar terms, which was the primary reason for the rapid recovery of imports. The fourth and final factor was a significant increase in public spending, which increased by 25% year on year: the country’s economic authorities mobilised and injected some 5.5 trillion rubles (4% of GDP at 2021 prices) into the economy. This acted as a fiscal stimulus of unprecedented magnitude.

Output sustainability and hidden redistribution

Explaining the mechanisms for mitigating the shock associated with the collapse of imports and the improvement in industrial output, Evsei Gurvich highlights how these figures conceal decreasing standards of living. 

The inventory factor played a significant role in the initial phase of the crisis; as a result, the increase in inventories in the second quarter of 2022 was 1.1 trillion rubles smaller than a year earlier. This enabled businesses to cope with the initial shock. Furthermore, the sharp drop in imports accelerated the processes of import substitution. This is reflected in the economic data as an increase in output in the respective industries, but at the expense of citizens' well-being: they are forced to substitute imported goods that have disappeared from Russian shelves with other products, which had previously been considered suboptimal in terms of price and quality. Standard economic statistics do not account for such losses, but calculations show that they are significant when considered in aggregate. It is important to remember that this drop in standards will grow over time due to the limited competition from available import supply.

A third factor contributing to the decline in output was an increase in production in the defence industry, which inflated figures from the manufacturing sector by the end of the year (-4.6% overall, compared to the 15-50% decline in some other sectors). However, as in the previous case, we are talking about shortfalls in citizens' standards of living: a sharp output drop in the industries producing the goods they consume (cars, household appliances, medicines) was offset by an increase in the output of products unrelated to consumption (primarily the defence industry). Again, economic statistics obscure the process of cost redistribution between different sectors and economic agents. As a result, citizens are unaware that the seemingly optimistic economic figures being published are not a reflection of its ‘health’ but rather a symptom of long-term losses in their quality of living. 

Furthermore, in a democracy or a more balanced and pluralistic political system, questions about whether these losses in citizens' well-being make sense, and whether such a scenario should be adopted, would inevitably be the subject of intense debate. However, in a repressive authoritarian regime, citizens have no way to influence public policy goals and strategies, or to protect themselves from this kind of cost redistribution. 

In any case, the variation in the dynamics of various sectors of the economy illustrates both the effect of 'redistribution' and the atypical nature of the Russian crisis. In a normal situation, responding to macroeconomic conditions, different industries and sectors move in the same direction, albeit at different speeds. In the case of Russian industry in 2022, we are able to observe both a collapse in some sectors, and significant growth in others, which compensates for the decline in aggregate statistics.

Maximum growth/decline in manufacturing output in 2022, output as % of December for the previous year

Survival Model: Crisis Adaptability and Long-Term Stagnation 

Andrei Yakovlev examines the micro-level — the anti-crisis strategies of enterprises and regulatory bodies — and contends that the crisis has become a kind of routine and modus vivendi for Russian businesses. They have to be constantly prepared to make decisions in response to the irrational and unpleasant conditions created by the authorities, to sudden changes in macroeconomic conditions related to oil price volatility, and so on. The willingness to respond in this way requires them to behave in an economically inefficient manner, for example by maintaining unsustainable stock levels, or keeping workers who are not currently needed. This economically suboptimal behaviour, however, allows them to survive another bout of crisis or turbulence. As a result, there is a specific ‘natural selection’ of enterprises, with the choice between a survival strategy and a development strategy being a prerequisite for success. 

At the same time, the Russian economic authorities, which have dealt with at least three major crises in the last 15 years, have been steadily honing their anti-crisis economic policy skills, which have evolved into an essential component of their professional orientation. Anti-crisis packages have become increasingly sophisticated and are being implemented increasingly frequently. In the spring of 2022, in addition to the extraordinary measures introduced by the central bank to stabilise the currency market, the government promptly implemented state support measures that had previously been tested and proven effective in the last economic crisis, in 2020. To this, we can add that, in the 2010s, the general economic objectives of 'stability,' i.e. preparedness for a crisis, triumphed over the objectives of 'development,' i.e. maximisation of economic growth. This was evident, in particular, in the fact that the economic authorities were wary of the inflow of external financing, fearing that its outflow would amplify the impact of any future crisis event. 

Furthermore, as Andrei Yakovlev adds, Russia has developed a specific model of anti-crisis management in which the hyper-centralised management system responds flexibly in critical situations, transferring powers to the regional level and including mechanisms of coordination between local authorities and business. In other words, the management system is designed in such a way that it limits the potential for economic development through hyper-centralisation while also accumulating significant resources for resisting and adapting to crises. Ultimately, this crisis adaptability enables the economy-restraining hyper-centralised model to endure in the long run, determining the trajectory of long-term stagnation. Russia's economy grew at a rate of approximately 1% per year over the last decade (compared to a global growth rate of 2.6%); this figure improved to 1.5% in 2021, but the 2022 crisis has returned the long-term rate to the norm of stagnation.

Has the crisis passed or does it still lie ahead?

Even normalisation of export revenues, i.e. a reduction of $100-150 billion, will begin to accelerate the crisis spiral that was suppressed last year. 

According to Oleg Itzhoki, the macroeconomic situation in 2023 will be fundamentally different to that of 2022. In the context of excessive financing and massive inflows of foreign exchange earnings, 2022 was the year of import sanctions, and the disruption and reorganisation of supply chains. 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 may more closely resemble a typical financial crisis episode (what is termed a 'sudden stop'), with the economy suffering from declining capital inflows, devaluation pressures, and growing problems with financing the entire economy — both in terms of banking and production.

According to central bank calculations, the net outflow of private capital in 2022 amounted to $250 billion, equivalent to about 12% of GDP, an all-time high. However, its impact was offset last year by a surplus in foreign trade almost equal to it in value ($280 billion), which allowed for an increase in government spending, supported the banking system and credit availability, and increased import availability at the expense of a strong ruble. The contraction of this surplus next year will likely increase tensions on all of these fronts; the only question is the magnitude of this contraction and, thus, the severity of its consequences. 

According to Oleg Vyugin, the main source of macroeconomic risk in 2023 will be the exhaustion of non-monetary sources of the country’s macroeconomic stability. Achieving the projected level of oil and gas revenues of 8 trillion in 2023 appears increasingly insurmountable. Budget revenues, for example, fell by one-third in January 2023 compared to levels of the previous year, while expenditures increased by 60%. The fiscal stimulus implemented last year, which helped to limit the recession, will be difficult to replicate this year without triggering inflation. In addition, attempts to raise domestic borrowing in excess of the planned 3 trillion rubles would require excessive use of the OFZ (federal loan bonds) refinancing pyramid in repo transactions with the Bank of Russia. 

Thus, in order to meet the plans for the financing of budget expenditures, it will be necessary to draw not just 3 trillion rubles, but 6 trillion rubles from the National Wealth Fund, which, in the current circumstances, can also be attributed as monetary financing of the budget deficit. This would increase the likelihood of rising inflation, forcing the central bank to raise its refinancing rate. There remains a chance for the country to make it through 2023 without destroying its financial stability thanks to the inertia of inflationary processes and the availability of financial resources in the public and private sectors, but this will be completely eroded over the following years unless significant cuts in public expenditure are made.

In addition to capital outflows, which will lead to a lack of investment funds, ‘crowding out’ (replacing these funds with government borrowing) will constrain financing in the real economy, writes Evsei Gurvich. There are several overlapping processes here: on the one hand, an increase in debt financing of the budget deficit, and, on the other, the withdrawal of foreign investors from both currency and ruble-denominated government bonds. This means that the government will not only have to provide additional net borrowing, but will also have to substitute the foreign capital leaving the government debt market with additional domestic borrowing. 

There are also a number of structural and conjunctive risks. For example, a lack of qualified labour appears to be a significant factor that has already dampened economic dynamics and increased wage costs in 2022. New waves of frontline mobilisation and resulting population flight will exacerbate this trend. Furthermore, if modern equipment imports and technology transfers remain unaffordable as a result of technological sanctions, the increasing technological dysfunctionality of Russian industry will become apparent in productivity. Finally, the country's population is concentrated in its European part, and as a result trade logistics infrastructure has historically been designed to capitalise on the country's proximity to Europe and integration with European markets. Both consumption-oriented imports and exports are now primarily routed through Asia, increasing the burden of transportation and necessitating the creation of new infrastructure and related investments. 

The certainty of uncertainty and irreversible changes

Uncertainty is another important factor that is rarely considered in economic forecasts but has a significant impact on the behaviour of economic agents and economic policy, writes Yevsey Gurvich. This factor is difficult to quantify, but high levels of uncertainty cause businesses to postpone investment and hiring decisions, banks to raise lending rates as they factor in additional risks, and citizens to save by reducing consumer spending. Moreover, uncertainty severely reduces the effectiveness of economic policy instruments, forcing the government and the central bank to employ increasingly harsh economic measures. 

The level of uncertainty in 2022 was at its highest since the 1998 debt default. This was reflected in record levels of fluctuation by the dollar and multiple revisions to the estimates for the year's decline in GDP. The effects of uncertainty will compound next year. And, this will intensify the risks associated with economic policy. It is difficult to predict whether taxes will be raised in the near future (although it seems likely that they will), what new sanctions will be imposed, or what steps the Russian authorities will be forced to take in response to the changing situation.

According to Gurvich, high uncertainty and deteriorating conditions will almost certainly provoke attempts to limit the degree of freedom available to economic agents (the introduction of planning elements, increased state regulation, and so on). Oleg Vyugin asserts that strained public finances and other risks that lead to economic decline and a drop in the real-terms incomes of the population may prompt the authorities to respond by raising taxes and increasing state influence over the private sector, which will exacerbate the decline in production efficiency.

Gurvich believes that the main trend now will be to gradually ‘Sovietise’ the economy in the hope of avoiding the potential crisis. This broad trend manifests itself in a variety of ways, including the rapid isolation of the Russian economy from the global economy, the growing formal and informal role of the public sector, increased budgetary spending on defence and security, and the expansion of military production. 

The nature of this ‘Sovietisation’ is not linked to the desire to abandon the market economy as such, but to the presence of political goals that clearly prevail over economic ones. These are the challenges of confrontation with the West and the imposition of sanctions, as well as the militarisation of the country and the economy. This path of militarisation appears to be a strategic choice that will remain among the authorities’ primary objectives even if active hostilities in Ukraine end this year. In this sense, the current Russian regime's economic policy has undergone an irreversible shift, the consequences of which have been couched in record rent-seeking behaviour over the past year. As a result, the build-up of military production has paradoxically helped the Russian economy to avoid the outward signs of a crisis. However, the conflict between political priorities and economic expediency will become glaringly obvious over the next year.

Crisis in Abundance: Why Did the Russian Economy Fail to Collapse and Is There a Crisis on the Horizon?

Itskhoki (1).jpg
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.