A year into the war, the sanctions on Russia are just starting to bite

In his speech to the Russian parliament on Tuesday, Vladimir Putin said the Russian economy had turned out to be much stronger than the West had expected. He was right. But will he be able to say the same in a year’s time, or three years’ time, or five years hence?

A year after the invasion of Ukraine, there are some scars on Russia’s economy, but, as yet, not the deep wounds some expected when the West announced sanctions unprecedented in their scope and co-ordination, signed up to by more than half the world’s economy.

Russia’s economy is a bit smaller – it shrank 2.1 per cent last year. Its budget is now in deficit, and it has begun drawing down on its rainy day fund, the $US187 billion ($275 billion) National Wealth Fund it had built over previous years to insulate it from external pressures and sanctions.

Vladimir Putin says Russia’s economy has turned out to be much stronger than the West had expected.Credit: AP

Record oil revenues last year, stringent capital controls and a steep decline in imports (as a result of the sanctions) produced a record $US227 billion trade surplus for Russia, which meant that, superficially at least, its economy got through the first year of the war largely unscathed.

Beneath the apparently healthy numbers, however, the economy is a very different one to that which pre-dated the war, and the way in which the West’s most significant sanctions were implemented means that they really only started to bite at the very end of last year.

The initial round of mainly financial and trade sanctions – the freezing of about half Russia’s $US640 billion of central bank reserves, shutting Russia out of the SWIFT international financial messaging system that is critical to accessing the global financial system, and the sanctioning of Russian financial institutions and individuals – did have a dramatic and immediate impact on Russia’s currency and financial markets.

But with quick responses from Russia’s central bank and policymakers, those settings soon stabilised.

The financial sanctions did, however, mean that Russia lost access to international financial markets, debt markets in particular. Foreign direct investment also evaporated, and more than 1000 multinational companies that had operated within, or with, Russia fled.

It also lost access to Western technology and talent, and experienced an exodus of its own intellectual capital.

Brain drain

Between the brain drain in the early months of the war and a second wave as the Kremlin implemented conscription, the best part of a million of Russia’s best and brightest have fled the country, diminishing not just the population, but Russia’s long-term economic capacity and capabilities.

As Russia diverts an ever-larger proportion of government spending to the floundering campaign in Ukraine, its industrial base and military capabilities, starved of that western capital, expertise and technology, are being – and will continue to be – degraded.

The sanctions are having a particular impact on the high-tech components that can be repurposed for military usage, and on the more complex oil fields in challenging environments that require western technology and expertise. The recent announcement that Russia would cut oil production by 500,000 barrels a day is being interpreted by the industry as an attempt to spin what is actually a deterioration in its production capacity.

Those aren’t the sorts of changes that show up quickly, but they will profoundly impact both the size and nature of Russia’s economy in the medium to longer term. It will be a smaller, poorer and less sophisticated economy than it might otherwise have been – a reversion to the insular economy and closed and repressed society of the Soviet era.

More damaging in the near term, albeit with some very significant long-term impacts, will be the actions the West (the G7 economies and Australia) have taken to restrict Russia’s oil and gas revenues.

Before the war, Russia’s revenue from oil and gas accounted for nearly half of all government revenue, and so they were an obvious target for western sanctions.

The problem with attacking them directly and immediately was that Europe was dependent on Russian energy and the world was reliant on Russia’s oil. About 40 per cent of Europe’s gas and 25 per cent of its oil was sourced from Russia, which produced about 10 per cent of the world’s oil.

The invasion saw the prices of oil and gas soar and, with Putin threatening to cut off the supply of gas to Europe, gave Russia a massive windfall. At the same time, it generated an energy crisis within Europe that, as its countries scrambled to find alternate supply, spilled over into the global market for gas.

The Europeans and the Biden administration in the US were acutely aware that their inaction was allowing Russia to build its war chest, but confronted with the prospect of $US100-a-barrel-plus oil prices, even higher inflation rates and a severe global recession bought time to adapt and come up with a strategy that would keep Russia’s oil flowing into the global market, while reducing its oil income.

Price caps

It was only in December that Europe finally stopped buying Russian oil and, within the G7 framework, imposed a $US60-a-barrel price cap on it, backed by the withdrawal of insurance and funding from anyone shipping that oil at prices above that price. From this month, there are also price caps on sales of Russia’s refined products, such as diesel.

Even before the price caps were in place, embargoes, whether formal or informal, meant that Russia’s oil was being sold almost exclusively to China, India and Turkey, and its customers were using the leverage of the looming caps to extract $US30-a-barrel-plus discounts on international oil.

Europe is no longer buying any meaningful volumes of Russian gas. Helped by a warmish winter, it has sufficient gas reserves to get through at least another year or two without a crisis and has also both reduced demand and accelerated its build-out of renewable energy technologies.

So, in effect, Russia has lost – permanently – the major market for its gas, with no practical near-term alternate market, and is now heavily reliant on China and India to buy its oil at discounted prices.

The caps on refined products will be even more effective because China and India are both net exporters – they have no need for Russia’s diesel or lower-value-added products. It will lose volume as well as value.

The risk for Russia is that reliance on China, in particular for its income and the goods and technology that it can no longer obtain from the West, will effectively turn it into a client state of China; a supplier of resources and agricultural products within a highly unequal relationship.

Dependent on China

That’s not quite what Putin would have foreseen from the “no limits” friendship he and Xi Jinping declared just ahead of the invasion.

Last year, as noted, Russia’s economy shrank 2.1 per cent, far less than many in the West expected. From December, however, its budget started to shift from strong surpluses into deficits. In January, the deficit was about $36 billion, with oil and gas revenues almost halving and expenses surging almost 60 per cent.

The price caps on oil and the costs of sustaining the war in Ukraine are starting to show up in a big way and will eat into Putin’s rainy day fund. At the end of last year, that was a $US187 billion fund, yet by the end of January, it had already gone down to $US148.4 billion. At this rate of depletion, there might be nothing in the fund by mid-year.

Russia is targeting a budget deficit of 2 per cent this year, and there are forecasts for its economy that range from positive growth of 0.3 per cent (the International Monetary Fund) to minus 3 per cent (the World Bank).

As the energy price caps really bite, the outcomes could either be a lot worse than even the more pessimistic assumptions, and/or the balance of activity will shift even more towards that of a wartime economy.

Russia’s economy is slowly being asphyxiated, with the West’s efforts to throttle its income only really becoming effective from December.

Those efforts won’t destroy Russia’s economy, just as they haven’t destroyed Iran’s or North Korea’s, but they will increasingly diminish it, reducing the living standards of its people and its stature and influence within geopolitics in the process.

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