Russia’s Economy Is Starting to Come Undone

From a Wall Street Journal story by Georgi Kantchev and Evan Gershkovich headlined “Russia’s Economy Is Starting to Come Undone”:

MOSCOW—The opening months of Russia’s invasion of Ukraine last year drove an increase in oil and natural-gas prices that brought a windfall for Moscow. Those days are over.

As the war continues into its second year and Western sanctions bite harder, Russia’s government revenue is being squeezed and its economy has shifted to a lower-growth trajectory, likely for the long term.

The country’s biggest exports, gas and oil, have lost major customers. Government finances are strained. The ruble is down over 20% since November against the dollar. The labor force has shrunk as young people are sent to the front or flee the country over fears of being drafted. Uncertainty has curbed business investment.

“Russia’s economy is entering a long-term regression,” predicted Alexandra Prokopenko, a former Russian Central Bank official who left the country shortly after the invasion.

There is no sign the economic difficulties are bad enough to pose a short-term threat to Russia’s ability to wage war. But state revenue shortfalls suggest an intensifying dilemma over how to reconcile ballooning military expenditures with the subsidies and social spending that have helped President Vladimir Putin shield civilians from hardship.

Russian billionaire Oleg Deripaska warned this month that Russia is running out of cash. “There will be no money next year, we need foreign investors,” the raw-materials magnate said at an economic conference.

Having largely lost its European market next door, and with other Western investors pulling out, Moscow is becoming ever more reliant on China, threatening to realize long-simmering fears in Moscow of becoming an economic colony of its dominant southern neighbor.

“Despite Russia’s resilience in the short term, the long-term picture is bleak: Moscow will be much more inward-looking and overly dependent on China,” said Maria Shagina, a senior fellow at the International Institute for Strategic Studies think tank in London.

A big part of the dimming outlook stems from a bad bet by Mr. Putin last year that he could use Russian energy supplies to limit Western Europe’s support for Ukraine.

European governments, instead of tempering their support for Kyiv, moved rapidly to find new sources of natural gas and oil. Most Russian gas flows to Europe stopped, and after an initial jump, global gas prices fell sharply. Moscow now says it will cut its oil production by 5% until June from its previous level. It is selling its oil at a discount to global prices.

As a result, the government’s energy revenue fell by nearly half in the first two months of this year compared with last year, while the budget deficit deepened. The fiscal gap hit $34 billion in those first two months, the equivalent of more than 1.5% of the country’s total economic output. That is forcing Moscow to dip deeper into its sovereign-wealth fund, one of its main anti-crisis buffers.

The government can still borrow domestically, and the sovereign-wealth fund still has $147 billion, even after shrinking by $28 billion since before the invasion. Russia has found ways to sell its oil to China and India. China has stepped in to provide many parts Russia used to get from the West.

Russian officials have acknowledged the difficulties but say the economy has been quick to adapt. Mr. Putin has said his government has been effective in countering the threats to the economy.

“You know, there is a maxim, guns versus butter,” Mr. Putin said in a state-of-the-nation address last month. “Of course, national defense is the top priority, but in resolving strategic tasks in this area, we should not repeat the mistakes of the past and should not destroy our own economy.”

For much of Mr. Putin’s more than 20 years in charge, high oil and gas revenue underpinned a social contract that saw most Russians largely staying out of opposition politics and protests in exchange for rising living standards.

The International Monetary Fund has estimated that Russia’s potential growth rate—the rate at which it could grow without courting inflation—was around 3.5% before 2014, the year it seized Crimea from Ukraine. That has now fallen to around 1%, some economists say, as productivity declines and the economy becomes technologically backward and more isolated.

“For an economy like Russia, 1% is nothing; it’s not even a maintenance level,” said Ms. Prokopenko, the former central bank official.

The fall in exports, tight labor market and increased government spending are worsening inflation risks, the central bank said this month. Russia’s inflation was running at around 11% in February compared with that month last year. That rate will temporarily fall below 4% in the coming months, the central bank said, though that is because of the high comparison base of the post-invasion surge in prices last year. A number of other economic indicators will also temporarily improve in the coming months due to such base effects, economists say.

The country’s industry is in its worst labor crunch since records began in 1993, the Moscow-based Gaidar Institute for Economic Policy has said. The post-invasion brain drain and last fall’s 300,000-man military mobilization have resulted in around half of businesses facing worker shortages, according to the central bank. Locksmiths, welders and machine operators are in high demand.

On a recent visit to an aircraft factory, Mr. Putin said the labor shortage is hampering military production. He said the government has prepared a list of priority professions for deferment from service.

Before the war, Oleg Mansurov dreamed of competing with Elon Musk’s SpaceX. After the invasion, investors in Mr. Mansurov’s Moscow-based SR Space pulled their funds.

By April 2022, the private company, which he launched in 2020 with venture-capital funding, was facing bankruptcy. To save it, he turned it into an IT business, providing services from web design to analyzing satellite imagery.

Western satellite-imaging-service companies had left the Russian market over the war, and Mr. Mansurov secured interest from large state-controlled enterprises that previously rejected his approaches, such as Gazprom PJSC and the nuclear-engineering company Rosatom.

“We became more focused not on the development of a long-term product that would make some kind of qualitative leap but on simply becoming a classic business and generating revenue,” Mr. Mansurov said. “We understood we just had to survive.”

Companies are adapting to the West’s import bans. While Moscow has boosted imports of technologies critical to its war in Ukraine from other countries, including semiconductors and microchips from China, in many civilian sectors, parts are difficult to replace.

The central bank has said risks are rising in the airline sector, where a deficit of new aircraft and parts could lead to problems with maintenance. IT and finance firms are struggling without access to Western technologies such as software, database-management systems and analytics tools and equipment, the bank said.

Russia tried import substitution—replacing foreign goods with homemade ones—for years before the current sanctions, with limited success. A large chunk of its telecommunications equipment and advanced oil drilling software is imported.

“This is a little bit like going back to Soviet times, doing everything ourselves,” said Vasily Astrov, an economist at the Vienna Institute for International Economic Studies. “It will be nearly impossible to properly replace what’s missing.” Analysts at the central bank have called the postwar reality “reverse industrialization,” suggesting a reliance on less-sophisticated technology.

Ilya Korovenkov, director of Chili. Lab, a boutique IT company in Nizhny Novgorod developing web services and e-marketplaces, said that before the war, clients would often order new capabilities and functions. Now, the work is focused on fixing and improving existing systems.

“It’s logical,” he said. “We don’t know what will happen in a month. We need to wait it out.”

With all these changes, the Russian economy is becoming more dependent on the state.

Much industrial-production growth now comes from factories turning out missiles, artillery shells and military clothing, replacing the vast quantities used in the war. Some factories are working multiple shifts to cope with demand, Mr. Putin has said.

While official statistics don’t break out military production, the output of “finished metal goods”—a line that analysts say includes weapons and ammunition—rose by 7% last year. Production of computers, electronic and optical products, another line said to include military output, rose by 2% for the year and 41% in December compared with November. By contrast, auto output fell about 45% year-over-year.

Military production masks the problems. “This isn’t real, productive growth. This doesn’t develop the economy,” Ms. Prokopenko said.

Russia managed to avoid the worst last year, aided initially by high global energy prices. Gross domestic product fell 2.1%, according to official data, far less than some early forecasts of a 10% to 15% drop.

Gas exports to Europe didn’t start tailing off until last summer. The EU’s ban on Russian seaborne oil and a Group of Seven price cap began to take effect only in December. Sanctions on oil products such as diesel took effect last month. These delays kept energy revenue up and helped the government unleash a huge fiscal stimulus of around 4% of GDP in 2022, according to the IMF.

In January and February of this year, however, oil and gas tax revenue, which accounts for nearly half of total budget revenue, fell by 46% year-over-year, while state spending jumped more than 50%.

Analysts estimate that Russia’s fiscal break-even oil price—what it would need to balance its books—has swelled to over $100 a barrel as war spending weighs on the budget.

The country’s flagship Urals crude fetched an average of $49.56 a barrel in February, according to the Ministry of Finance, a deep discount to the benchmark Brent, which traded around $80 a barrel that month, although some analysts argue the difference is smaller. The government last month changed its oil-taxation formula in an effort to squeeze more from producers.

“Russia now has a lower bargaining power in the world oil market because they have much less choice where to ship the oil,” said Mr. Astrov, the Vienna Institute economist.

Consumers are ailing, too. Retail sales fell 6.7% in 2022, the worst showing since 2015, according to official data. New-car sales fell by 62% in February year-on-year, according to the Moscow-based Association of European Businesses.

Nearly a decade ago, Artem Temirov and his brother launched a coffee shop in central Moscow they called Kooperativ Chernyy, or the Black Cooperative. Just before the war, they opened a roaster and planned to begin selling their coffee beans in supermarkets.

The invasion halted those plans. Russia’s postwar exodus has included many who could afford to spend at a high-end shop like Kooperativ Chernyy, and sales fell. Despite a pick-up in the summer—which Mr. Temirov attributed to Russians wanting to ignore their new reality—sales cratered again after Mr. Putin’s September troop mobilization.

For this year, most analysts expect another fall in GDP, although some, including the IMF, forecast modest growth.

But the fund said that by 2027, economic output is projected to be around 7% lower than pre-war forecasts had indicated. “The loss in human capital, isolation from global financial markets, and impaired access to advanced technology will hamper the Russian economy,” the IMF said.

Rystad Energy, a consulting firm, expects investment in Russian oil and gas exploration and production to fall to $33 billion this year from a predicted $57 billion before the invasion. That would mean less output down the line. Analysts at BP PLC estimate that Russia’s total oil production, which was around 12 million barrels a day in 2019, will be down to between 7 million and 9 million a day by 2035.

“We’re not talking about a one-year or a two-year crisis,” said Mr. Astrov. “The Russian economy will be on a different trajectory.”

Georgi Kantchev is a foreign correspondent for The Wall Street Journal based in Berlin. Previously he was stationed in Moscow.

Evan Gershkovich is a Wall Street Journal reporter covering Russia, Ukraine and the former Soviet Union. He was previously a reporter for Agence France-Presse and the Moscow Times.


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