Russia has built an economy like a fortress, but the pain is real

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Western sanctions deal a serious blow to Russia’s economy. The ruble is falling, foreign companies are fleeing and significantly higher prices are imminent. Familiar products could disappear from stores and civic achievements such as vacations abroad are in question.

Short-term pain aside, Russia’s economy is likely to see a deepening of the stagnation that set in well before the invasion of Ukraine.

But a total collapse is unlikely, say several economists. Despite tough financial sanctions, Russia has “built an economy that’s built for conflict,” said Richard Connolly, an expert on Russia’s economy at the UK’s Royal United Services Institute.

The Russian government’s extensive involvement in the economy and the money it still makes from oil and gas exports – even with US and UK bans – will help pack a punch for many workers, retirees and government employees in a country mitigate that has suffered three major financial crises over the past three decades. And as economists point out, Iran, a much smaller and less diversified economy, has endured years of sanctions misery over its nuclear program without a full collapse.

Still, the Russian currency has fallen spectacularly, which will push up the prices of imported goods, when inflation was already at 9%. On February 23, the day before the invasion, it cost 80 rubles to get one US dollar. It was 119 on Thursday – even after Russia’s central bank took drastic measures to halt the slump, including doubling interest rates to 20%.

Marina Albee, owner of the vegetarian restaurant Cafe Flaschena in St. Petersburg’s Old Town, has already heard from her fruit and vegetable supplier that prices will rise by 10 to 50 percent. Other providers cannot say how much.

The café imports dried seaweed and smoked tofu from Japan, mini asparagus from Chile, broccoli from Benin, basmati rice and coconut oil from India.

“We’re waiting for the tsunami — the tsunami is the price hikes on everything we buy,” Albee said. “We need to keep an eye on the situation and, if necessary, remove these dishes from the menu.”

“We can revamp our menu to include more Russian-based dishes,” she said. ‘You have to be quick on your feet’ After surviving two years without tourists because of the COVID-19 pandemic, ‘it takes a lot to worry us,’ Albee added.

Although sanctions have frozen a large part of Russia’s foreign exchange reserves, government finances are in good shape with low levels of debt. When the government needs to borrow, its creditors are mainly domestic banks, rather than foreign investors who might abandon them in a crisis. The government this week announced support for large companies that are vital to the economy.

Estimates of the short-term impact on Russia’s economic growth vary widely given the possibility of further sanctions and the uncertainty surrounding the fallout from President Vladimir Putin’s war.

“Russians will be much poorer – they won’t have money to vacation in Turkey or send their kids to school in the West – and even then they won’t be welcome because of Putin,” said Tim Ash, Senior Emerging Markets Sovereign Analyst at BlueBay Asset Management.

He sees a 10% drop in economic growth, while other economists see a drop of just 2% or something in between.

Long-term prospects for a growing economy are not good – for enduring reasons that existed before the war: a few favored insiders control large companies and sectors, leading to a lack of competition and new investment. Russia has failed to diversify from its dominant oil and gas sector. Per capita income in 2020 was about the same as in 2014.

Foreign investment accumulated in the 30 years since the collapse of the Soviet Union, and the jobs that come with it, are pushing the door. Big corporations like Volkswagen, Ikea and Apple have shut down factories or stopped selling, while energy giants BP, Exxon and Shell have announced they will stop buying or ending partnerships in Russian oil and gas.

On Wednesday, the rating agency Fitch further lowered the country’s credit rating to junk status and warned of an imminent default on government debt.

The central bank has stepped in to strengthen the ruble and the banking system, limit foreign currency withdrawals and keep the stock market closed for nearly two weeks. The government has also announced measures to prevent foreign investors from fleeing. While such restrictions protect the financial system from an outright collapse, they also shut the economy off from trade and investment that could boost growth.

Ever since the Kremlin faced sanctions over its seizure of Ukraine’s Crimea peninsula in 2014, it assumed such measures would be the West’s main weapon in any conflict. In response, it has developed what Connolly, an associate fellow at the Royal United Services Institute and author of a book on Russia’s response to sanctions, calls “the Kalashnikov economy,” a reference to the Russian military rifle.

It’s “a permanent, somewhat primitive system,” he said, based on low levels of debt, government control of most of the banking system and a central bank able to step in and prop up the currency and banks.

While trade will fall and fewer goods will be available, the weaker ruble means the Russian government is making more of its currency on the oil it sells, as the price of oil is quoted in dollars. Given recent higher prices, Connolly estimates that Russia is getting 2.7 times the amount of rubles from oil compared to 2019, money that can cover salaries and pensions.

While US and UK officials said they would ban the relatively small amount of oil they import from Russia, Europe, much more dependent on Russian energy, has held back.

As it stands, “there are a lot of gaps here and the Russians will take advantage of that and find a way to move on,” Connolly said.

“I’m not saying they’re going to have a wonderful time. I’m saying they have the resources to deal with these issues,” he said.

The long-term effects of the Putin government on domestic politics are difficult to predict. Simon Commander, managing partner of consulting firm Altura Partners and a former World Bank official, says: “Brisk popularity of the regime, fueled by increasing wealth…seems unattainable.”

“It may not lead to open dissent, let alone revolts, but it will hardly bolster support for the autocrat,” he said.

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