By Eric Vandenbroeck and co-workers

For The Russian Economy To Grow

After Russia invaded Ukraine in February, the Russian economy seemed destined for a nosedive. International sanctions threatened to strangle the economy, leading to a plunge in the value of the ruble and Russian financial markets. Every day Russians appeared poised for privation.

More than eight months into the war, this scenario has yet to come to pass. Indeed, some data suggest that the opposite is accurate, and the Russian economy is doing fine. The ruble has strengthened against the dollar, and although the Russian GDP has shrunk, the contraction may be limited to less than three percent in 2022.

However, look behind the moderate GDP contraction and inflation figures, and it becomes evident that the damage is severe: the Russian economy is destined for an extended period of stagnation. The state was already interfering in the private sector before the war. That tendency has become more pronounced and threatens to stifle innovation and market efficiency further. The only way to preserve the viability of the Russian economy is either through significant reforms—which are not in the offing—or an institutional disruption similar to the one that occurred with the fall of the Soviet Union.

The misapprehension of what sanctions against Russia would accomplish can be partly explained by unrealistic expectations of what economic measures can do. Simply put, they are not the equivalent of a missile strike. In the long run, sanctions can weaken the economy and lower GDP. But in the short run, the most one can reasonably hope for is a massive fall in Russia's imports. It is only natural that the ruble strengthens rather than weakens as the demand for dollars and euros drops. And as the money that would have been spent on imports is redirected toward domestic production, GDP should rise rather than fall. The effects of sanctions on consumption and quality of life take longer to work through the economy.

 

At the beginning of the war, in February and early March, Russians rushed to buy dollars and euros to protect themselves against a potential plunge in the ruble. Over the next eight months, with Russian losses in Ukraine mounting, they bought even more. Usually, this would have caused a significant devaluation of the ruble because when people buy foreign currency, the ruble plunges. Because of sanctions, however, companies that imported goods before the war stopped purchasing currency to finance these imports.  As a result, imports fell by 40 percent in the spring. One consequence was that the ruble strengthened against the dollar. In short, it was not that sanctions did not work.

On the contrary, their short-term effect on imports was unexpectedly strong. Such a fall in imports was not expected. If Russia's central bank had anticipated such a massive fall, it would not have introduced severe restrictions on dollar deposits in March to prevent a collapse in the ruble's value.

Economic sanctions did, of course, have other immediate effects. Curbing Russia's access to microelectronics, chips, and semiconductors made the production of cars and aircraft almost impossible. From March to August, Russian car manufacturing fell by an astonishing 90 percent, and the drop in aircraft production was similar. The same holds for the production of weapons, which is understandably a top priority for the government. Expectations that new trade routes through China, Turkey, and other countries not part of the sanctions regime would compensate for the loss of Western imports have been proved wrong. The abnormally strong ruble signals that back-door import channels are not working. If imports flowed into Russia through hidden channels, importers would have bought dollars, sending the ruble down. Without these critical imports, the long-term health of Russia's high-tech industry is dire.

Even more consequential than Western technology sanctions is that Russia is unmistakably entering a period in which political cronies are solidifying their hold over the private sector. This has been a long time in the making. After the 2008 global financial crisis hit Russia harder than any other G20 country, Russian President Vladimir Putin essentially nationalized large enterprises. In some cases, he placed them under direct government control; in other cases, he put them under the purview of state banks. To stay in the government's good graces, these companies have been expected to maintain a surplus of workers on their payrolls. Even enterprises that remained private have, in essence, been prohibited from firing employees. This did provide the Russian people with economic security—at least for the time being—and that stability is a critical part of Putin's compact with his constituents. But an economy where enterprises cannot modernize, restructure, and fire employees to boost profits will stagnate. Not surprisingly, Russia's GDP growth from 2009 to 2021 averaged 0.8 percent per year, lower than the period in the 1970s and 1980s that preceded the collapse of the Soviet Union.

Even before the war, Russian businesses faced regulations that deprived them of investment. Advanced industries such as energy, transportation, and communication—those that would have benefited the most from foreign technology and investment—faced the most significant restrictions. Companies operating in this space were forced to maintain close ties with government officials and bureaucrats to survive. In exchange, these government protectors ensured that these businesses faced no competition. They outlawed foreign investment, passed laws that put onerous burdens on foreigners doing business in Russia, and opened investigations against companies operating without government protection. The result was that government officials, military generals, and high-ranking bureaucrats—many of them Putin's friends—became multimillionaires. In contrast, ordinary Russians' living standards have not improved in the past decade.

Since the beginning of the war, the government has tightened its grip on the private sector even further. Starting in March, the Kremlin rolled out laws and regulations that allowed the government to shut down businesses, dictate production decisions, and set prices for manufactured goods. The mass mobilization of military recruits in September provides Putin with another cudgel to wield over Russian businesses to preserve their workforces. Company leaders must bargain with government officials to ensure their employees are exempt from conscription.

To be sure, the Russian economy has long operated under a government stranglehold. But Putin's most recent moves are taking this control to a new level. As the economists Andrei Shleifer and Robert Vishny have argued, decentralized corruption is the one thing worse than corruption. It's bad enough when a corrupt central government demands bribes; it is even worse when several different government offices compete for handouts. Indeed, the high growth rates of Putin's first office decade were partly due to how he centralized power in the Kremlin, snuffing out competing predators such as oligarchs operating outside the government's fold. However, the emphasis on creating private armies and regional volunteer battalions for his war against Ukraine is building new power centers. That means that decentralized corruption will almost certainly resurface in Russia.

That could create a dynamic reminiscent of the 1990s when Russian business owners relied on private security, mafia ties, and corrupt officials to maintain control of newly privatized enterprises. Criminal gangs employing veterans of the Russian war in Afghanistan offered "protection" to the highest bidder or plundered profitable businesses. The mercenary groups that Putin created to fight in Ukraine will play the same role.

 

A Long Road Ahead

Russia could still eke out a victory in Ukraine. It's unclear what winning would look like; perhaps permanent occupation of a few ruined Ukrainian cities would be packaged as a triumph. Alternatively, Russia could lose the war, an outcome that would make it more likely that Putin would lose power. A new reformist government could take over and withdraw troops, consider reparations, and negotiate a  lifting of trade sanctions.

No matter the outcome, however, Russia will emerge from the war, with its government exercising authority over the private sector to an extent that is unprecedented anywhere in the world aside from Cuba and North Korea. The Russian government will be omnipresent yet simultaneously not strong enough to protect businesses from mafia groups consisting of demobilized soldiers armed with weapons they acquired during the war. Particularly at first, they will target the most profitable enterprises, both at the national and local levels.

For the Russian economy to grow, it will need major institutional reforms and the kind of clean slate Russia left in 1991. The collapse of the Soviet state made institutions of that era irrelevant. A long and painful process of building new institutions, increasing state capacity, and reducing corruption followed—until Putin came to power and eventually dismantled market institutions and built his system of patronage. The lesson is grim: even if Putin loses control and a successor ushers in significant reforms, it will take at least a decade for Russia to return to the levels of private-sector production and quality of life the country experienced just a year ago. Such are the consequences of a disastrous, misguided war.

 

 

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