Russia Risks ‘Economic Oblivion’ Without Europe This Winter

Summary

• Yale University researchers, whistle-blowers and Russian insiders have teamed up to provide one of the first comprehensive analyses of Russia’s current economic activity six months into the invasion of Ukraine.
• The paper’s view contrasts the ‘resilient’ and even ‘prosperous’ picture of the Russian economy that the Kremlin and many Western media outlets, such as Bloomberg, are painting.
• Hidden by Russian officials and smoothed over by unsustainable fiscal and monetary spending, the data shows crippling supply-chain issues, a lack of import substitution to combat dwindling imports, and an overwhelming brain, business and capital drain.
• These short-term impacts will be amplified over the long run, especially given Russia’s dependence on world commodity markets. The good news is that Russia may be reluctant to turn off Europe’s gas supply this winter.

Introduction

Russia invaded Ukraine nearly six months ago – a considerable amount of time even for low-frequency macroeconomic data. Early signs suggested Russia was winning the ‘war of economic attrition’ with the West. Data released by Russia showed President Vladimir Putin’s coffers were overflowing with revenues from commodities.

But this narrative of economic resilience is ‘untrue’, according to a Yale School of Management working paper. Rosstat, Russia’s official statistics office, is no longer free of political influence, and the country has been withholding key economic indicators under the guise of ‘minimising the risk of the imposition of additional sanctions’.

The data it has released has biased future projections, making Russia’s outlook seem overly optimistic. So instead, the authors use Russian language and unconventional data sources, alongside company insiders and whistle-blowers, to undertake an uncorrupted analysis of Russia’s economy.

The results paint a grim picture in the short term. But they also help us unravel the long-term challenges facing Russia’s economy. What follows is a very diluted summary of their 70-page report.

Data on Russia’s Economy

Imports

Russian imports make up 20% of GDP, with the domestic manufacturing economy largely reliant on imports across the value chain. Consumer sectors, such as non-food consumer goods and telecom equipment, are especially dependent on imports, meaning domestic consumption also relies heavily on imports.

Rosstat has ceased releasing timely import data, and Russia no longer releases any subcomponents of trade data either. Instead, the authors turn to Russia’s trade partners to get the best estimate of imports. This data shows that the flow of imports into Russia has drastically slowed in recent months (Chart 1).

A review of trade data from Russia’s top trade partners suggests Russian imports fell by upwards of 50% in the initial months following the invasion. Even the Central Bank of Russia acknowledges as much. The knock-on effect is huge, with Russian manufacturing companies struggling to source imported components.

Suggestions were that Chinese firms would fill the gap. But recent monthly releases from the Customs General Administration of China, which maintains detailed Chinese trade data with breakdowns of exports to individual trade partners, shows Chinese exports to Russia plummeted by 50% from the start of the year to April (Chart 2).

This is part of a common theme, with Asian countries reluctant to increase trade with Russia for fear of running afoul of sanctions. One analysis found non-sanctioning countries saw exports to Russia fall by an average of 40%, compared with 60% for sanctioning ones.

Domestic Consumption and Production

Without imports, consumption and production in Russia has been hit hard. In an effort to allay supply issues, Putin has legalised grey market and intellectual property infringement and exempt certain goods from trademark laws.

Despite this, domestic producers have had to resort to cannibalising parts of existing goods. One such example is Pobeda, a Russian airline that has grounded up to 40% of its fleet to provide parts to service and operate the remaining fleet.

Official CPI figures broken down by sector show the sectors most dependent on international supply chains are seeing the largest price rises (Chart 3). Tech, hospitality, electrical appliances, and western automobiles are all experiencing 30-60% YoY inflation.

On automobiles, around 100,000 were sold every month pre-war. The most recent data indicates only 27,000 were sold in June, with a 90% YoY fall in foreign vehicles sales. The sharp decline highlights both rising prices and supply-chain issues for producers and deteriorating demand on behalf of consumers.

High frequency data, such as e-commerce sales within Yandex and same-store traffic at retail sites across Moscow, reinforces steep declines in consumer spending and sales in automobiles (Chart 4).

To combat the issue, Putin has prioritised import substitution to ramp up domestic manufacturing. This, according to the paper, has so far been unsuccessful. For example, production of motor vehicles fell 75% YoY in May, with parts manufacturing falling 54%. In the aviation industry, reports are that Russian companies are struggling to produce anything beyond minor cabin items, with sensitive flight-critical components still far off.

Across all industries, gross value added has fallen, with services, manufacturing, and essential services all seeing their value-added drop in Q1 2022 by over 20% QoQ. Industrial production volumes in crucial industries such as appliances, railways, steel, textiles, batteries, apparel, and rubber have also all fallen by well over 20% (Chart 5).

With domestic production down, imports contracting and consumer demand deteriorating, the latest readings of Russian PMI’s are glum. New domestic and foreign product orders have dropped significantly, as have inventories, with delivery times increasing.

Brain-, Business-, and Capital-Drain

The Yale School of Management has been tracking the business flight from Russia since February. This proprietary dataset contains detailed information across nearly 1,500 public and private global companies that traded in Russia. It is continually updated and compiled using public sources, e.g., Bloomberg, and non-public sources, including a global wiki-style network of 250+ company insiders, whistle-blowers and executive contacts.

Based on this list, well over 1,000 companies have now publicly announced they are voluntarily curtailing operations in Russia to some degree. According to the authors’ calculations, these firms add as much as $600bn to Russia’s economy, or roughly 40% of GDP. They also employ well over 1mn local Russian staff, and their investments in Russia represent the lion’s share of all active foreign investment in the country.

Most of the 1,000 firms are phasing out their trade in Russia over many months if not years. But the business retreat over the last three months has, in the words of the paper, ‘almost single-handedly reversed three decades’ worth of Russian economic integration’. Once fully divested, this loss of FDI will devastate Russia’s economy, including via a significant ‘brain-drain’.

So far, no less than 500,000 people have left Russia since the war began. The vast majority are assumed to be highly educated and highly skilled workers in competitive industries such as tech. The forcible expulsion of Western expats and the exodus of 1-in-5 ultra-high-net-worth individuals (around 15,000 people) has amplified this. Many of wealthy have moved to Dubai where real estate sales to Russian buyers has doubled YoY.

Putin Is Masking Economic Weakness

Much of why the Russian economy has appeared stable since the war concerns the unprecedented and unsustainable fiscal and monetary response initiated by the Kremlin (Table 1).

Escalating waves of fiscal and monetary stimulus have, by the Central Bank of Russia’s own data release, increased M2 by two times from the start of the year through June. And even though the infrastructure spending program has just begun, the Russian government has already increased its infrastructure investment budget by 35% in Q1 alone. Furthermore, the Finance Minister has already acknowledged the Russian government may face a deficit of 2% of GDP by the end of year, far different from the previously rosy surplus projections.

Official figures show unprecedented spending, but the true scale may be impossible to determine, according to the authors. The challenge, however, will be in sustaining it. Oil and gas revenue will decline for years to come due to difficulties re-orienting piped gas supplies toward Asia and facing potential oil and gas embargoes by the west.

Russia’s ‘rainy-day’ fund, comprising its formidable foreign exchange reserves and National Wealth Fund, is also weaker now. Around half of the $600bn in reserves are frozen in allied countries, and $75bn has already been spent since the start of the war (Chart 6). Putin has also become more selective over how and where the National Wealth Fund can be spent – not the actions of a leader swimming in surplus funds.

Long-Term Commodity Market Outlook

The short-term economic strain is likely to be exacerbated in the long run. Russia’s commodity exports represent 60% of government revenue, but finding new markets for these exports will prove difficult.

Natural gas, for example, is highly non-fungible, and 83% of Russian gas goes to Europe. Crucially, there is no interconnectivity between gas supplied to Europe (Western Siberia) and gas supplied to China (Eastern Siberia). Without a Trans-Siberian pipeline (a Russian national priority), it is impossible to make a full pivot to the East.

Even if they could, which would take years, China would need to be willing to accept the large increase in gas. Generally, China has been reluctant to do so, diversifying its gas supply away from Russia and negotiating the price of Russian gas down.

Russia’s dependence on revenue from its oil exports also far exceeds its trade partners’ needs for Russian oil. Nearly half of Russia’s revenue comes from oil, so pivoting to the East is a high priority. Data from China shows it has significantly increased its purchases of Russian oil.

However, Russia is now selling oil to India and China at a $35p/b discount. Not just that, it is also more expensive to export to these countries (Chart 7). Moreover, Asian countries cannot fully replace the amount Russia exports to Europe. Combined, Russia is set to lose a significant proportion of its oil revenues – total oil and gas revenues already dropped by more than half in May.

Bottom Line

The paper shows that Russia is facing severe economic hardship because of Western sanctions. While key headline export revenue figures looked healthy at the start of the war, deteriorating imports, a shortfall in domestic production capabilities, rising inflation and declining consumer demand paints a different local picture.

These short-term issues are only likely to deepen. The ‘povorot na vostok’ or ‘pivot to the East’, will be much more challenging than Russia wants to admit. Infrastructure issues and rising costs are perhaps the least of Russia’s troubles – the country is becoming less appealing to do business with as many Asian countries depend more on the West than Russia.

Overall, this may mean Russia is less likely to want to switch off Europe’s gas supply this winter. The country appears to need the EU more than the EU needs them.