By Eric Vandenbroeck and co-workers

On 1 September, the US-based foreignpolicy.com wondered why Putin dodged the draft. Mentioning that SitRep has heard from numerous U.S. and Western officials who say they are puzzled by Putin’s reluctance to call for mass conscription at this point in the war. Despite its smaller size, Ukraine’s military seems to have all the advantages in the war—better training, higher morale, and a steady supply of high-end Western military equipment—except in sheer numbers. And that Putin signed off on a plan to expand the number of active-duty Russian military service members by 137,000. Still, he appears intent on doing so through new recruitment drives—and even possibly recruiting convicted criminals to join the fight—rather than mass conscription. The Kremlin has a much larger pool of young men to draft into service to try to turn the tide of the war in its favor. So why hasn’t Putin called for a draft yet?

While next speculating that:

- One working theory is that the Russian leader realizes how precarious public support for the war is, especially now that it has spiraled into a much longer and costlier operation than Putin initially planned. A draft could expose broader public backlash to the war. Many young Russian men are reportedly seeking to avoid military service altogether.

- Another theory is that Russia’s military simply doesn’t have enough equipment to support large-scale conscription, given how much military equipment it has already lost in Ukraine and sweeping international sanctions hampering Russia’s defense industry from making up for the losses.

- All this has led to a strange political phenomenon in Russia: For most people, openly criticizing the government is as dangerous as ever, but hard-line nationalist politicians and pro-war commentators have started openly criticizing Putin for not going far enough to bring victory in Ukraine by avoiding the draft.

                                                                   

We follow up by looking at the effect of sanctions.

For example, in April, just weeks after he launched the invasion of Ukraine, Russian President Vladimir Putin maintained that the West could never strangle Russia’s economy. The barrage of American and European sanctions had not succeeded and would not succeed in bringing his country to its knees. 

Such defiant posturing can be expected of Putin and other Russian leaders. But now, six months after the beginning of the war and the imposition of sanctions, many observers are questioning whether Western sanctions have had the challenging effects their architects promised. International observers such as the International Monetary Fund have revised their projections of Russian GDP upward from earlier this year. Compared with initial forecasts made right after the imposition of sanctions, Russia’s economy has done better than expected, partly because of deft technocratic Russian policymaking and partly because of tight global energy markets, which have kept the price of oil and gas high.

Russia’s economic overperformance must be placed in context, however. Few observers and policymakers expected sanctions to cause enough pain to force Russia out of the conflict in months, so Russia’s ongoing war shouldn’t be a surprise. Earlier, we suggested that the 2008 financial crisis hit Russia hard, but GDP growth recovered—until 2014. Since the onset of the Ukraine crisis, GDP growth has been sluggish, below 2 percent. Hence Russia’s economy is still hurting; it is suffering a steeper growth slowdown than was seen during the 2008 financial crisis and is unlikely to be followed by a post-crisis rebound. Living standards are being supported by social spending that will be difficult to sustain and will likely force tough decisions about the government budget over the coming year. Thus far, Putin has promised Russians that he’s fighting a “special military operation,” not a war that could impose tough sacrifices on the population. However, as time passes, the war's cost and sanctions' effects on ordinary Russians will only grow.

Start with macroeconomic data for a health check on the Russian economy. Russia’s GDP has shrunk by around five percent compared with last year, with the rate of decline increasing each month since the war began. Industrial production, which includes Russia’s oil and gas industries, has fallen by only about two percent compared with last year (a reflection of high energy prices). However, the manufacturing segment of the Russian industry has fallen by 4.5 percent. Inflation stands at just over 15 percent, down somewhat from the nearly 18 percent peak after the ruble slumped and recovered in March. Adjusted for inflation, monthly wages are down by about six percent compared with last year. (Some analysts have expressed skepticism about Russia’s official data, yet there is no evidence that the state statistics agency is engaged in large-scale manipulation.)

Russia’s inflation statistics may not fully capture the reality that buying certain products is now occasionally tricky (in the case of iPhones) or nearly impossible (in the case of Lexus automobiles). Similarly, inflation data struggle to quantify the impact of reduced quality. Russia’s government, for example, is changing regulations to allow the sale of vehicles without airbags or antilock brakes, which are now challenging to produce because of sanctions-induced supply chain problems. This degradation in quality won’t show up in inflation data. Still, it will eventually be felt by Russians, especially the urban, wealthier Russians who consume more of the imported goods that are now harder to access.

Even accounting for the inflation captured by government statistics, wages are trending sharply downward, around six percent lower than last year. Social welfare payments such as pensions, the primary income source for older Russians, have been eroded by inflation since the war began. The government increased pension payouts by over eight percent in June to compensate. Still, without more such expensive social spending increases in the coming months, the typical Russian’s income will decline in the year's second half. The fact that retail sales are down by nearly ten percent suggests consumers have already started saving in anticipation of tighter budgets.

                                                                                           

The oil keeps flowing

Although households are only beginning to feel the impact of lower living standards, some industries have already been hit hard. Rather than looking at aggregate industrial production data, which includes raw materials and manufacturing firms, it is more insightful to analyze each sector separately. The raw materials sector has been only slightly affected, which is no surprise given that prices are high and Western sanctions have been designed to keep most commodities, thus far, including oil, flowing freely.

The Russian economy owes much of its resilience to its trade in natural resources. With quiet diplomatic support from the United States, the United Kingdom and the EU have been watering down sanctions that were supposed to take effect against Russian oil exports later this year. To keep energy prices from spiking, the West has backed away from some efforts to stop Russia from redirecting oil exports to other customers, such as China and India. Under recent sanctions, European firms will now be allowed to ship Russian oil to third parties.

Because the West has implemented few significant sanctions on Russia’s oil and gas exports, and because the EU’s oil import ban doesn’t take effect until December, the volume of Russian oil exports has been unchanged since the sanctions were imposed. Sanctions force Russia to sell oil at around a $20 per barrel discount to global benchmark prices. Still, the latest monthly data that Russia’s government released on its revenue from taxing oil suggests the country is making roughly as much export revenue as it did in January. By contrast, revenues from the export of natural gas—far less necessary to Russia than oil exports—have slumped after the Kremlin restricted its sale to Europe.

 

Industrial woes

Unlike Russia’s energy industry, the rest of Russia’s industrial sector has been hit hard. Among the worst affected sectors have been cars, trucks, locomotives, and fiber optic cables, each of which has seen production fall by over half. In other sectors less exposed to foreign ownership or complex supply chains, such as textiles or food processing, production is flat or, in some cases, has increased relative to last year.

One cause of this industrial disruption is the withdrawal of Japanese, U.S., and European firms that had factories in Russia. Some of these factories will reopen under new Russian ownership, but operating them independently may prove difficult. Manufacturers are also struggling to source necessary materials. Accessing components from abroad is now far trickier because even products not under formal restrictions are harder to access, ship, and pay for. “I cannot say we’re facing a total blockade,” the CEO of Transmashholding, a Moscow-based railroad equipment firm, told Russian media, referring to his firm's difficulties in shipping and paying for imported components. “But we face increased friction.”

A key question over the coming months is whether these industrial disruptions intensify or are resolved. On the one hand, Russia has now had nearly half a year to establish alternative payments and logistics networks, which should allow some crucial nonsanctioned imports to reach the country. On the other hand, when surveyed, Russian firms say they continue to draw from existing inventories, implying that they are still struggling to source necessary components. Monthly data show that Russian industrial goods and parts imports remain far below prewar levels.

The fate of Russia’s industrial sector matters for several reasons. The industry is a crucial source of employment, especially in what Russia calls monogorods, or towns that depend on a single factory or industry, often in the Urals or Siberia. Past layoffs in such cities have caused major protests and social upheavals that have proved politically destabilizing. Recent research by a Russian think tank found that half of all monogorods will face a direct negative impact due to sanctions. Russia’s government will struggle to find funds to support beleaguered industries given the government’s own tightened budget.

Russia’s government finances have gotten harder to parse now that the Kremlin has stopped releasing details about spending, presumably to hide the costs of the war. In April last month, Russia released detailed data that defense spending had increased by 40 percent over the year. In addition to higher salaries and operating costs to fund the attack on Ukraine, the Kremlin will also need to allocate substantial future resources to rebuilding the vast stock of equipment damaged or destroyed on Ukrainian battlefields. The costs of the war are adding up, not only on the central government’s balance sheet but also for regional governments, which are being asked to raise volunteer battalions.

This spending spree will spur inflationary pressure over the coming year. The government isn’t bringing in as much revenue as before. The modest decline in world oil prices since June—plus the significant discounts at which Russia now must sell its oil—has brought Russia’s oil tax revenue down to more normal levels compared with the bumper revenues it was generating in the initial months after the invasion. Yet non-oil tax revenue has fallen dramatically. Adjusting for inflation, over the first seven months of 2022, non-oil revenue declined by around 15 percent, which will probably increase further over the rest of the year.

As a result, Russia’s budget is veering toward a substantial deficit if current trends continue. This situation could change in the coming months, mainly if oil prices—and thus tax revenue—increase. Yet demands for spending are unlikely to disappear so long as the war continues and living standards decline.

The Kremlin will be in a complicated position if the budget deficit grows. It entered the war with hardly any debt, but Western sanctions have blocked its ability to issue new bonds to most foreign investors. It could let the ruble decline against the dollar, which, because Russia’s government spending is all ruble-denominated, would have the effect of helping to balance the budget. But a slump in the ruble would drive up inflation and, in the process, lower living standards and undermine the Kremlin’s narrative that sanctions aren’t working and that the Russian economy is stable.

 

Mounting costs

In some sense, the Kremlin is correct in insisting that Russia’s economy has stabilized. Its banks are solvent, most industries operate like normal, and the crucial energy sector continues to pump oil. There is plenty of food on store shelves, even if luxury cars are in short supply. The production of cars and washing machines will be far lower than expected, so consumers will defer significant purchases if they can. The optimistic scenario for the Kremlin is that Russians tighten their belts and muddle through.

Nevertheless, the costs of the war and sanctions are adding up, even if the initial impact was less dramatic than the West hoped or Russia feared. For now, Russia’s leaders are happy to have survived six months of Western sanctions. Over the coming year, however, Russian industry will continue to struggle to adapt to a world without imported Western components. Barring an upswing in oil prices, Russia’s government will face tougher tradeoffs between continuing social spending and tolerating budget deficits and high inflation. Russia’s economy is not going to collapse in a way that forces a halt to the Kremlin’s war effort. However, the country faces a sharp recession, a long grind of lower living standards, and little hope for a quick rebound.

 

 

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