President Vladimir Putin has spent years preparing for the worst. Since at least 2014, when Russia was buffeted by the combination of crashing oil prices and sanctions over Ukraine, the Kremlin has focused on building financial barricades, enforcing macroeconomic discipline, weaning itself off the US dollar and backing import substitution. Even as the pandemic squeezed ordinary households, Moscow held the budget purse strings tight.
As a result, Russia comes to the current crisis with its fundamentals looking healthier than most, with a relatively light debt burden, plus an impressive near-$640 billion of international reserves and a fiscal cushion equivalent to roughly 12% of its economic output in the shape of a National Wealth Fund bolstered by hydrocarbon revenues. There's improved self-sufficiency too, and in 2020, for the first time in the post-Soviet period, Russia became a net exporter of agricultural produce.
Whether the combination will be enough to shield Russia in the event of sanctions is hard to gauge. We don't know just how far Moscow will go to resolve what it sees as a security threat on its western border, or just how heavily the West will punish any attack or military incursion into Ukraine, should it come to that. Ranges of options are available to both sides. But it's easy to overestimate the benefits of Putin's armor-plated economy. Those exist, but short-term protection comes with a rising long-term cost, as productivity and growth are sacrificed for stability and regime preservation. Add in ongoing dependence on oil and gas, plus poor demographics, and the vulnerabilities become even more apparent.
The problem Putin faces can be summed up in one word: torpor.
Building a defensive structure means centralization, high savings and therefore low investment in the future, plus it involves supporting large state enterprises that hold up the state but crowd out competition and encourage the misallocation of resources. A handful of industries (oil and gas, nuclear, arms and grain) dominate exports. Genuine foreign direct investment is minimal.
Richard Connolly, director of the Eastern Advisory Group, and a veteran observer of Russian economic policy, describes it as a "Kalashnikov economy" built first for durability, not performance, where the state is not providing stimulus, but rather is acting as a drag. Research and development spending, for example, amounts to just 1% of economic output — half or a third of most market economies. Connolly estimates some two-thirds of that is accounted for by the military, and much of what's left, by oil and gas. The state, in its many forms, dominates. Not surprisingly, technological innovation activity lags OECD rivals.
The result: Though Russia largely avoided Covid-19 lockdowns to keep its economy moving, paying a high price in infections and deaths, the recovery has run its course and the future is uninspiring. Bloomberg Economics sees the pace of economic expansion slowing from above 4% last year, when Russia's lax pandemic containment helped demand, before settling around 2% for the foreseeable future.
This fortress may protect state giants, but it hits households and small businesses, who have suffered particularly badly. Russians have endured a brutal pandemic, and distrust in officialdom means inoculation rates remain low, with less than half the population fully vaccinated. Pandemic support and handouts for veterans, pensioners and mothers have lifted take-home earnings, but toward the end of last year Russians' real disposable incomes were still below where they were before Putin's Crimean adventure in 2014. A weak ruble and inflation at more than twice the central bank's target, meanwhile, are exacerbating that pain.
For now, this predicament is unlikely to trigger regime-threatening demonstrations — the cost of protest is too high. But the consistent erosion of Russia's human capital comes with consequences, in terms of demographics, competitiveness and future social stability.
Moreover, for all the sacrifices foisted on ordinary citizens in the name of autarky, Russia remains highly vulnerable through its dependence on oil and gas, which in recent years accounted for nearly 20% of GDP, roughly 40% of federal revenue and a larger portion of exports, figures that underplay the industry's real political clout. Europe is certainly in a tight spot having failed to diversify its energy supply and deal with gas storage, relying on Moscow for well over 40% of its gas imports. But Russia also needs Europe, its top trading partner and the largest market for its gas by far — no small matter, even if gas is significantly less vital to the Kremlin's budget than oil.
Here, as Maria Shagina, sanctions expert and visiting fellow at the Finnish Institute of International Affairs points out, Europe underplays its hand by focusing only on its own weakness without considering Russia's own vulnerability.
Asia could, as some argue, step in. Yet Russia's much-vaunted pivot to the east has been, in truth, a pivot to China, and this autocratic brother in arms isn't going to save the day. Any significant shift in hydrocarbon exports would be slow, and Beijing, having worked hard to diversify its energy supply, will have the upper hand. Chinese companies and in particular its banks have also shown themselves skeptical of returns in Russia and wary of getting tangled in US sanctions. They've yet to signal they could or would fill the investment gap.
Will any of these longer-term headaches be enough to dissuade Putin from taking on more? Iikka Korhonen, of the Bank of Finland Institute for Emerging Economies, who has researched the economic impact of sanctions, suggests they won't necessarily, given the Kremlin's near-term focus. Economic logic did not, after all, prevent Putin annexing Crimea, and Russia can manage for a number of years even with further punishment. Yet even what appears to be a small impact, in percentage terms, will hurt — and make it harder to get back to growth.
No barricades, in the end, can make up for autocratic myopia.
Disclaimer: This article first appeared on Bloomberg and is published by special syndication arrangement.