Sanctions, sliding oil prices and stagnation: Russia’s economy and the road to recovery

Russian roubles, Alexander Novikov, Flickr
Russian roubles, Alexander Novikov, Flickr

Over the past two years, the Russian economy has been buffeted from all sides: Western economic sanctions were imposed in spring 2014 as a response to Russia’s annexation of Crimea; the price of crude oil – Russia’s most valuable export – began to slide in late 2014, falling from over $100/barrel to well below $50/barrel today; and the economic slowdown of China – Russia’s largest export partner – has lead to diminished growth in demand for Russian commodity exports. The economy slid into recession in 2015, with GDP contracting by 4% and inflation running close to 15%. But by the autumn of 2015, the economic contraction began to slow and Vladimir Putin, Russia’s president, declared triumphantly that “the peak of crisis” had passed.

After spending most of last year in free-fall, the economy has stabilised somewhat in 2016: GDP growth is becoming less negative, unemployment is falling, real wages are rising, and industrial production is increasing again. However, challenges remain. Firstly, the issues of economic sanctions, low oil prices and weak demand from China have not yet abated. Secondly, and perhaps more importantly, the setbacks recently experienced by the Russian economy are merely part of a broader trend of stagnation – GDP growth began steadily declining in mid 2010, long before the turbulent events of 2014. For the situation to improve, the Russian state must first acknowledge the challenges faced by the economy, then work towards implementing deep structural reforms in order to remove the roadblocks to recovery.


The economic sanctions placed on Russia in 2014 can broadly be placed into three categories: financial sanctions, arms sanctions and oil sanctions. The financial sanctions have restricted Russian businesses’ access to credit from Western banks, which is particularly problematic in Russia because the poorly developed financial system obliges local firms to borrow from foreign – mostly European – banks. In fact, there is a double whammy effect going on here: borrowing from foreign banks has resulted in lots of non-rouble denominated debt, which means that the recent fall in the value of the rouble has dramatically increased the real value of the external debt burden; and with sanctions imposed, Russian businesses are unable to refinance their debt. This might not prove disastrous for firms with significant dollar revenues – such as oil and gas companies – but extended restriction of access to foreign capital will hinder investment in the wider economy.

There has also been a ban placed on all arms trade with Russia. However, this seems to have had little impact on arms exports since Russia has few European clients and sells almost no kit to America. Russia’s primary arms export partners – China, Algeria and India – seem not to have heeded the demands of the West on this occasion. In fact, 2015 was a record year for sales of Russian weaponry.

While the impact of sanctions has been relatively mild…, their true bite has yet to be felt.

Sanctions were also imposed on Russia’s oil and gas sector, with restrictions placed on Russian access to advanced Western drilling technology. Whilst Russian oil production has not yet suffered – 2015 was a post-Soviet record – these sanctions are intended to have a long term effect. There are only a handful of companies in the world that produce the technology required to exploit Russia’s deposits of shale and Arctic oil, and most of them are American. If sanctions remain in place, Russia’s oil production is forecast to fall in future years as current wells dry up and new ones cannot be drilled.

Sanctions have not all been one-sided though. Russia responded by imposing its own counter-sanctions and has banned the import of food from the West. Food imports were specifically targeted in the hope that protection would drag up Russia’s dire agricultural productivity. The result was a sharp increase in food prices of around 20%, further eating away at the purchasing power of Russian wage packets.

Low oil prices

Russia depends on oil and other natural resources for around ¾ of its exports and about half of government revenues, so when oil prices took a tumble in late 2014 the economy was hit hard. Furthermore, the price of oil is very closely correlated with the dollar-rouble exchange rate, meaning that the fall in the price of oil led to a corresponding depreciation of the rouble. Since Russia is heavily dependent on imports, this has had a severe impact on inflation, with the CPI index reaching 15% in 2015. Not only does this higher inflation increase prices for consumers, but Russian businesses suffer too since firms in pretty much all sectors of the economy rely heavily on inputs imported from abroad. They pass the cost onto Russian consumers either via higher prices, or through lower quality goods if firms switch their inputs to inferior domestic substitutes.

There is another, less obvious, effect of low oil prices as well. Russia’s abundance in natural resources has fostered an environment of rent-seeking, described in a model developed by Clifford Gaddy and Barry Ickes, which ensures that low oil prices have large spill over effects that are felt across the wider economy. The Russian economy chiefly consists of two sectors: the rent-generating sector, largely made up of oil and gas companies that are globally competitive and hugely profitable, and the rent-dependent sector, mostly comprised of inefficient Soviet-era firms that are globally uncompetitive and thus cannot sell their produce on global markets. Rents generated from oil and gas revenues are redistributed by the state across the rest of the economy, allowing vast swathes of inefficient Russian industry to survive in a semi-parasitic relationship. Thanks to this system of political economy, any negative shock to oil prices will not just affect exports or government revenues – it will hit the Russian economy right to its core as oil and gas firms are no longer able to sustain the inefficient rent-dependent firms to the same extent.

while the price of oil is projected to rise steadily as global demand picks up again, Russia remains dangerously dependent on it

This system of rent distribution is not only detrimental to the efficiency of the whole economy, but it also stifles the success of Russia’s most successful companies – it’s natural resource-extracting firms. To ensure the distribution of oil rents, the Russian state exerts a high degree of control over the natural resource sector as well as imposing heavy taxes on it. The problem for Russian policymakers, regardless of the oil price, is that the current tax system discourages oil companies from investing in future production, especially in remote or geologically challenging regions where the extraction costs are high. Unless there is taxation reform, the volume of oil production will begin to fall, putting the entire system of oil rent dependency in jeopardy.

The broader trend of stagnation

Until very recently, Russian quarterly GDP growth had been persistently falling since mid-2010. On top of this, there have been persistent capital outflows, which, admittedly, is nothing unusual for a resource-rich country running a trade surplus, but capital outflows are also a proxy measure for property rights. Weak property rights discourage investment, particularly from abroad. Inflows of foreign direct investment, which were decreasing even before the imposition of sanctions, fell from a quarterly peak of $40bn in early 2013 to just $3bn by mid 2015.

Weak, and largely arbitrary, property rights have been a key institutional deficiency of Russia’s economy ever since property rights were introduced at the end of the Soviet era. The state seizure of Russian business’ assets, “reiderstvo”, is all too commonplace. Even Russia’s richest and most powerful oligarchs can fall victim to this. In 2003, Mikhail Khodorkovsky, who was the owner of Yukos, one of Russia’s largest oil companies, was arrested for tax evasion and imprisoned for nine years. Not only that, his assets and company were broken up and annexed by the state. Once the richest man in Russia, Khodorkovsky declared bankruptcy in 2006 and his dramatic downfall serves as a warning to Russian businessmen that their property rights are conditional on the consent of the state. Due this modus vivendi established between Putin and the oligarchs, Russia’s richest businessmen often prefer to stash their cash safely out of the state’s reach in the British Virgin Islands or the English Premier League than to invest in Russia.

the setbacks recently experienced by the Russian economy are merely part of a broader trend of stagnation – GDP growth began steadily declining in mid 2010, long before the turbulent events of 2014

However, according to Dr Richard Connolly of the University of Birmingham, the key driver of the decline in GDP growth is slowing private investment. The binding constraint on investment is poor financial intermediation: Russia’s poorly developed financial system simply does not provide businesses with sufficient capital to invest. There are a number of reasons for this. First, the state owns around 2/3 of all banks, meaning competition in the banking sector is low and credit is more likely to be directed to politically favoured ventures than economically efficient ones. Second, finance in Russia is highly bank-centric; with underdeveloped bond and equity markets, there are few alternate sources of funding for companies who are unable to get a loan from state-controlled banks. Third, the role for foreign organisations is diminishing – foreign banks such as Barclays and HSBC have left – leaving Russian businesses with even fewer financing options.

Stabilisation and economic reform: the road to recovery

The Russian economy may have stabilised, but it isn’t out of the woods yet. While the impact of sanctions has been relatively mild compared to the devastating effects of a low oil price, their true bite has yet to be felt. As current oil reserves dwindle, Russian oil companies will be unable to drill new ones in hard-to-reach places such as the Arctic since they are barred from accessing the vital Western drilling technology. Furthermore, while the price of oil is projected to rise steadily as global demand picks up again, Russia remains dangerously dependent on it, both for exports and government revenues, and also for the resource rents which sustain inefficient sectors of the economy.

But in order to truly reverse the recent trend of stagnation, Russia must do something to ramp up investment. Ceteris paribas, a sustained increase in private investment could be the cure to much of Russia’s economic problems. It would facilitate modernisation and diversification; it would raise productivity; it would allow Russia to rebuild its crumbling infrastructure; and it would enable the country to sustain its growing ranks of pensioners.

If it truly wishes to catch up with West economically, Russia must first acknowledge that its system of political economy is severely flawed and then it must be bold enough to enact the deep structural reforms that are necessary to ensure long term prosperity. The state must establish that property rights are not dependent on good relations with government officials; this will surely raise the rate of investment, both foreign and domestic, in the economy. Moreover, Russia must attempt to develop its financial system further. Moving banks into private ownership would remove the political aspects of capital allocation and establishing a robust legal and regulatory framework would facilitate the proliferation and growth of alternate markets for capital –  such as equity or bond markets. By providing investors with secure property rights, as well as increasing the availability of credit, Russia can revive private investment, reverse its current economic misfortunes, and finally achieve its long held ambition of becoming a successful, modern and dynamic economy.


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