The ongoing dispute between Ukraine and Russia over eastern Ukraine and Crimea, where many people speak Russian as their first language, has attracted global attention for the past two months. Beyond the politics, the weak and heavily indebted Ukrainian economy remains in the spotlight. In 2013, the Ukrainian economy eked out a gain of less than 1 per cent in real GDP and it could easily slip into recession this year driven by mounting uncertainty. But what about the economic consequences for Russia itself? We see little or no economic upside from being involved in the unrest in eastern Ukraine, and much to lose.
Our examination of a recent IMF assessment of Russia reveals an economy that was performing at or even beyond full capacity, but also feeling the effects of declining growth potential. The IMF noted that a period of relatively easy economic growth, driven by higher energy prices and growing energy exports largely to Western Europe, was coming to an end mainly because of a lack of private investment. Real annual growth of 2 percent or less was the most likely medium-term scenario for Russia, even prior to the dramatic events of the past two months. Russia’s real GDP expanded by a tepid 1.3 percent in 2013 and the IMF expects similar weak growth in 2014, although there are signs that the Russian economy could already be in a recession due to the fallout from Putin’s intervention in Ukraine.
Beneath the surface, Russia was and is facing a growing number of sobering economic realities. The pace of private investment growth is slowing. The public sector is steadily occupying a growing share of the economy, both through expanded core government spending and through a growing role for state-controlled enterprises, notably in the banking sector. The economic stimulus benefits of the pre-Olympic building surge have all been captured. The economy is coping with underlying inflationary forces, with core inflation having drifted upward to 6 percent annually. Due to demographics—the steady ageing of the Russian population, a shortening of life expectancy (notably for males), and falling fertility rates—the Russian workforce was projected by the IMF to shrink by around four million workers by 2018. Lastly, Russia has been experiencing significant net capital outflows, offsetting the large (but declining) trade surplus fueled by gas and oil exports.
So much for the current snapshot of the economy. The Russian leadership has shown a distinct lack of interest in the economic consequences of its adventure in Crimea and ongoing intimidation in parts of eastern Ukraine. The sanctions implemented by the West have, to date, been weak and have mainly involved travel bans and financial sanctions on some of Putin’s wealthy oligarch friends and political cronies. While the Russian stock market and ruble initially tumbled following the annexation of Crimea, they have subsequently stabilized as investors seem to view the sanctions as of little consequence.
With that said, there are some economic repercussions from Putin’s adventure in Ukraine and these could intensify if the West decides to implement tougher sanctions on Russia’s energy, banking, and military industries. The ratings agency Standard and Poor’s recently downgraded Russian government debt and the finance ministry has been forced to cancel bond auctions due to a lack of interest. The average yield on Russian corporate debt has also increased sharply. As long as oil prices remain in the $100 per barrel range, however, Russian President Putin doesn’t have to worry about raising funds in global capital markets. However, this could change over the near term given the volatility of oil prices and Russia’s stumbling economic performance.
Sanctions on Russia’s energy sector would have the most dramatic impact on both the Russian and European economies, given the symbiotic energy relationship between Russia and its western European buyers. Russia currently supplies around one-third of Europe’s natural gas, which helps to explain why EU politicians have been reluctant to impose tougher sanctions despite the Obama administration’s calls to take firmer action. Indeed, a break in Russia-EU energy trading relations would cause sharp short-term economic pain both ways. Each side would no doubt scramble to find alternatives, with upward pressure on European and global energy prices in the near term likely. Over the medium to longer term, a change in political relations with the west will likely force fundamental downward pressure to trade and investment patterns between Russia and the major western economies. Russia would need to seek out expanded trade and investment relations in the emerging world, notably with China, and would need to redirect fiscal resources to build the necessary trade infrastructure to take advantage of any new partnerships. This might be the time for the United States to lift its ban on the export of crude oil and natural gas and become an energy supplier to the global market, especially given the growth in U.S. domestic energy supplies attributable to the fracking revolution. It is possible that U.S. energy exports to Europe could eventually replace a good portion of natural gas supplies from Russia.
The bottom line? The Russian adventure in Ukraine has already had a negative impact on the Russian economy with further deterioration ahead if the West expands sanctions to include Russia’s energy industry. The most likely consequences of Russian expansionism would include ruptured international trade and investment flows, more capital flight, weaker domestic private investment, higher inflation, further expansion in the state’s role in the economy, and less scope for innovation and productivity growth. For an economy that may already be tipping into recession and projected to grow at a much slower pace in the years ahead, these consequences could result in Russia’s economic growth potential effectively being reduced to near zero. A costly political adventure, indeed.