I have had somewhat of a morbid fascination trying to ascertain the impact of sanctions on the Russian economy and everyday life. Information hasn’t been that easy to come by. The most public evidence that Russia has been holding up comes from still robust revenues from energy exports and the surprising strength of the ruble. The Russian central bank has started to cut interest rates because the ruble has been so strong. And yet, despite this, I just couldn’t fathom how the country’s economy could not be feeling incredible pressure.
Here are the assumptions I was working from:
- Russia produces almost nothing of value other than energy and other commodities.
- Russia is extremely reliant on imports of technology and equipment to produce military equipment, automobiles, aviation, energy extraction and distribution, and other high values add products.
- Russia is a highly corrupt kleptocracy that has very little human capital to create and innovate, such that it will not be able to carry out import substitution.
- The number of firms leaving Russia will have a huge impact on the goods and services being produced in the country as well as the quality and safety.
- The brain drain and capital flight of very wealthy people will make it extremely difficult for Russia to ever return to its peak GDP even if sanctions are lifted.
Given all of this, I keep saying to myself,
“Who cares if Russia is still earning billions from energy sales? What can they buy with it since so few firms and countries are willing to do business with Russia?”Click To Tweet
I guess one thing is weapons, which should not be taken lightly, especially if it’s able to deploy drones, rockets, and artillery it is reportedly buying from Iran and North Korea. Ukraine is starting to take back territory that Russia forcibly occupied, and Russia has suffered incredible losses in personnel and equipment. Thus, anything that can help improve its fighting capability should be taken very seriously. At the same time, Putin does not want to mobilize its male population via a draft as this will prove what a disaster Russia’s “Special Military Operation” has been. Until this takes place, it will rely on mercenaries and very poorly trained and equipped “volunteers.”
I digress since the focus of this post is the impact of sanctions on Russia.
My perception is that, other than energy, which it does not have a monopoly on, Russia is quite insignificant from a business standpoint for almost every country that it imports from and exports to. And yet, it is hugely dependent on the rest of the world for access to technology, sophisticated equipment, and machinery that it needs to help its economy grow to support its war machine and Putin’s kleptocracy.
Life lesson: Always have others need much more from you than you need from them. If not, then make sure you are a very kind and considerate person so that others will want to be in a relationship with you. Putin way overplayed his hand thinking he had tremendous leverage, especially when it comes to energy. He didn’t realize countries have other options, albeit at a very high short-term cost, and are not beholden to him. And now that he has proven without a shadow of a doubt that Russian energy is just another geopolitical weapon and he can’t be trusted, there is no incentive to deepen ties with Russia. The relationship should only be opportunistic. Evidence of this is China and India buying Russian oil at a very deep discount.
Given my fascination with Russia, a country I have always found incredibly interesting, and how it is adjusting to sanctions, I have been on the prowl for information that quantifies the impact of sanctions on the country. Finally, I came across one last month that was referenced on Twitter. And wow, what a goldmine of information! It turns out that researchers at Yale University have been at the forefront of monitoring the companies that have left Russia or suspended operations there and doing their best to quantify the impact of this on the Russian economy. They also have a list of “F” companies that are still doing business in Russia, and they don’t seem to be shy about wanting to shame them into pulling out of the country.
The paper was released on July 20, 2022, called Business Retreats and Sanctions are Crippling the Russian Economy. It goes into great detail covering the Russian energy sector, Russia’s tremendous reliance on imports, the futile potential for import substitution, and the capital and brain drain that will curtail Russian economic potential for decades.
Despite reports of Russia’s energy sector doing just fine, the authors assert that its exports are dropping quite significantly. China and India are already loaded up with Russian oil and no longer need as much. And if Western countries align on capping the price paid for Russian oil, then this will produce even less revenue for Russia.
In addition, Europe, in spite of a very challenging winter ahead, especially for Germany, is already securing other sources of natural gas via liquid natural gas from the Middle East and the United States. Russia’s energy output is going to drop because it does not have the equipment and technical talent to keep its fields operating at high levels, with major oil companies and service firms having pulled out. If it truly wants to serve the Chinese market, it’s going to have to make huge investments in very complex infrastructure and distribution via pipelines which it is in no position to do. It has neither the capital nor technical talent to carry this out.
The largest market share Russia has is 10% for oil, gas, and coal, and yet energy revenues represent 60% of its budget. So who is dependent on whom? Russia exports 83% of its natural gas to Europe, whereas Russian supply represents 46% of total European natural gas. This is not ideal for Europe, but if Europe is successful in finding non-Russian sources of supply, then Russia will be hit incredibly hard.
It will no doubt be painful for Europe to get from here to there but is without question the right decision for the long run. Russia using gas as a geopolitical weapon seems to have temporarily, and that is the operative word, slowed down the Germans from losing their minds to green fantasies as they are now conceding they still need to keep their nuclear plants operating and are now taking the steps to keep them (very temporarily) to get through this winter.
The following chart shows how imports have fallen significantly since the invasion as much of the world will not sell goods and services to Russia.
Even China, which supposedly is now in the throes of developing a new “special relationship” with Russia, is not willing to risk having its firms incur western sanctions by selling to Russia and is pulling back significantly.
These tables show how China is far more important to Russia than Russia is to China. And this is the case with virtually every country with whom it does business. It also shows how rational it is to play ball with the United States at the expense of Russia, as the United States is by far the biggest purchaser of Chinese exports.
China is already in the midst of immense economic challenges resulting from its Zero Covid policies and the collapse of its enormous real estate bubble. There is no way it will prioritize supporting Russia at the expense of hurting its export markets in the United States and Europe. This will put more people out of work in an economy that is already plagued with a very high unemployment rate for young college graduates that is only projected to get worse.
Shifting to consumer trends, data tracked by Yale shows retail sales dropping quite significantly in Russia, along with overall consumer spending.
With major automobile manufacturers no longer exporting cars to Russia, sales have plummeted as supply has been reduced and buying power impacted.
And one can see from these tables that Russia currently has no practical, real-time capacity to carry out import substitution to grow its domestic automobile industry to make up for lost foreign imports.
And here are other industries that have been contracting largely because Russia cannot produce what is necessary to substitute for previously relied upon imports.
I can’t imagine that this will inspire great confidence in Russia’s aircraft fleet. The goal of the aircraft stripping is to provide spare parts for other planes so they can keep flying through at least 2025.
The Yale researchers believe that a very large percentage of the country’s economic output is at risk of meaningful contraction based on the large number of foreign companies curtailing operations in Russia. It is possible firms from China and India may fill some of the voids, but that will take a very long time. The goods and services will be of lesser quality given how long it takes to develop critical mass, effective operating knowledge of working in a new market, and overall efficiencies to deliver quality and service in a timely manner.
The brain drain that has already taken place and is expected to take place has been and will be, devastating to Russia’s ability to innovate, come up with viable import substitution, and to stop its economic output from going into freefall.
And if, for whatever reason, one believes that Yale’s report is highly biased or uses flawed methodologies, then there is this confidential report obtained by Bloomberg produced by Russian technocrats that is also pessimistic about the impact of Western sanctions on the country’s future economic output.
It projects the loss of a very large number of information technology specialists over the next three years as sanctions start to bite even harder and the quality of life diminishes for those with the buying power and skills to enjoy better and more rewarding lives elsewhere.
The report estimates as many as 200,000 IT specialists may leave the country by 2025, the first official forecast of the widening brain drain.
Because it is so rare to see such a sober and realistic analysis that draws unequivocally negative conclusions about the impact of Western sanctions on Russia produced by Russian officials, I thought it best to end this post by quoting liberally from what was covered in the Bloomberg article.
Oil Sector Hit
As a result, the output will have to be reduced, threatening Kremlin goals for expanding domestic gas supplies, the report said. The lack of technology needed for liquefied natural gas plants is “critical” and may hamper efforts to build new ones.
Europe’s plans to stop importing Russian oil products — about 55% of exports went there last year — could trigger sharp cuts in production, leaving the domestic market short of fuel, as well.
Metals producers are losing $5.7 billion a year from the restrictions, the report said.
If the world economy slips into recession, the report warns, Russia could see exports cut further as it becomes the “swing supplier” on global markets, with demand for its products disappearing first. That could trigger a plunge in the ruble and a spike in inflation.
On the import side, “the main short-term risk is the suspension of production due to lack of imported raw materials and components.” Over the longer term, the inability to repair imported equipment could permanently limit growth, the report said.
“There are simply no alternative suppliers for some critical imports,” it said.
Even in the farm sector, where the Kremlin has touted its efforts at replacing foreign supplies, dependence on key inputs could force Russians to reduce their food consumption as supplies dwindle, according to the report.
Restrictions on access to western technology may push Russia a generation or two behind current standards as it’s forced to rely on less advanced alternatives from China and Southeast Asia.
And remember the part of this post that discussed Russia’s dependence on foreign imports? Well, here are some very sobering statistics cited in the report.
On a sectoral basis, the report details the breadth of the hit from sanctions:
- Agriculture: Fully 99% of poultry production and 30% of Holstein dairy cattle output depends on imports. Seeds for staples like sugar beets and potatoes are also mostly brought in from outside the country, as are fish feeds and amino acids.
- Aviation: 95% of passenger volume is carried on foreign-made planes, and the lack of access to imported spare parts could lead the fleet to shrink as they go out of service
- Machine-building: only 30% of machine tools are Russian-made and local industry doesn’t have the capacity to cover the rising demand
- Pharmaceuticals: About 80% of domestic production relies on imported raw materials
- Transport: EU restrictions have tripled costs for road shipments
- Communications and IT: Restrictions on SIM cards could leave Russia short of them by 2025, while its telecommunications sector may fall five years behind world leaders in 2022.
And while Russia’s economy has not been nearly as impacted as Ukraine’s, which just reported that its GDP dropped by 37.2% in the second quarter, and has not had the devastating infrastructure damage, it also doesn’t have Western support like Ukraine does for sophisticated and highly effective weaponry or for future economic aid to rebuild the country.
Prior to the war, Russia had horrific demographics that were going to diminish its economic potential. And now, with a huge number of younger males killed and wounded in the war and no prospects for sanctions relief without Russia withdrawing from Ukraine and paying reparations, which I don’t see happening, Putin has expedited the economic and social demise of Russia.
I will continue to follow the impact of Western sanctions on Russia very closely. I don’t see how it doesn’t get increasingly worse for the health and well-being of millions of Russians as time goes by.