Impact of sanctions. December 2022

Fortress Russia is showing signs of financial stress. In Q4 22, as oil and gas revenues fell and mobilisation increased the cost of the war, the Russian Ministry of Finance has started to draw heavily on the oil fund to finance the budget, tapped Gazprom’s gas windfall with a special tax and unexpectedly started large-scale domestic bond issuance, mostly at a floating rate. On the external side, despite the strong current account, Russia has lost reserves this year. More generally, “Fortress Russia” has been eroded through the freezing of CBR assets and financial sanctions which shut Russia off from external markets and put the banking system under pressure. Russia is now in a potentially fragile financial position with high-quality reserves in convertible currencies only covering one month of imports, and sanctions obstructing conversion of Russia’s foreign assets into liquid reserves.

Up to now during the war, Russia’s economy and financial system performed better than expected. Largely as a result of buoyant oil and gas revenues which surged to a record of over $350 bn (20% of GDP), Russia’s economy and budget have been disappointingly robust during the war so far. Instead of the double-digit contraction projected in the immediate aftermath of Russia’s invasion, consensus has now revised up its estimates to a 3-4% GDP decline in 2022. Given Q2 and Q3 outcomes, we broadly concur – but see some downside to consensus estimates from the impact of mobilisation and falling commodity prices. Russia’s outperformance reflects an improved trade balance, higher government spending, and a slow phase in of sanctions, which largely offset weaker domestic demand. This is disappointing, particularly when compared with the 30-35% contraction which Russia’s invasion has driven in the Ukrainian economy.

But we are now at a turning point for Russia’s economy and budget, as oil and gas earnings collapse. We expect Russia’s earnings to fall below the critical level of $40 billion per quarter as the oil price cap and loss of access to the European gas market bite, eroding macro buffers further. As a result, Russia will face substantial difficulties in financing the war and experience renewed financial instability. At the same time, with Europe pledging €18 bn and the US $13 bn in support, Ukraine in 2023 is now in a much stronger position to finance its budget.

To exacerbate the pressure, we urge Ukraine’s allies to impose additional sanctions and vigorously enforce existing measures. Lowering the oil price cap to $35/bbl and extending financial sector sanctions to non-sanctioned institutions, particularly Gazprombank, are of critical importance.

Why Russia’s economy proved more resilient than initially expected this year:

1. Most importantly, Russia’s trade surplus expanded strongly this year due to high oil and gas prices and record oil and gas export earnings, shielding the economy and financial system. For oil, volumes have fallen very modestly, with the EU embargo on crude oil only taking effect in December and a significant redirection of exports to China, India and Turkey, while higher global prices have until recently more than offset the discount on Russian oil. Similarly, lower gas export volumes due to Russia’s squeeze on gas flows to Europe have until recently been compensated by a dramatic increase in the price. This was reinforced by the EU’s commitment to fill its gas storage, leading to inelastic demand. As a result, Russian oil and gas earnings are on track to reach a record $350-360 bn in 2022. Total exports in Q1-Q3 were 27% higher than during the same period in 2021, while a 10% decline in imports over this period also widened the trade surplus. As a result, net exports largely offset the drag from weak domestic demand due to sanctions and overall uncertainty.

2. Despite sanctions, Russia financed additional government spending this year thanks to strong oil and gas revenues – but now, as these revenues fall, it is starting to eat through its oil and gas savings. After the invasion, the NWF was used to support a wide range of companies which were in distress after the initial imposition of sanctions. Now, with oil and gas revenues weakening, Russia is consuming saved oil and gas revenues more intensively. Starting in October, Russia started heavy monthly withdrawals form the NWF – in the 250-300 bn RUB range- to finance the budget. Additionally, Russia has is extracting 1.2 trillion Ruble (or ~$20 bn) from Gazprom in 4Q-22 through a special tax.

3. Another factor is that, in practice, sanctions have been phased in only gradually. For example, the crucial EU oil embargo, while agreed in July, has only just come into force and similar restrictions on petroleum products kick in in February 2023. Other sanctions have not materialised at all, e.g., the EU embargo on metal slabs which takes effect two years from now. Importantly, some countries such as China and Turkey stepped in and increased trade with Russia, thereby mitigating the impact of sanctions. In addition, many restrictions have significant exemptions for large producers, undermining the effectiveness of the sanctions regime.

4. Also, financial sector sanctions did not trigger a systemic crisis and, thus, did not spill over into the real economy as expected in the spring. Despite their unprecedented nature, which included freezing of CBR assets and cutting off most large Russian banks from the U.S. and European financial systems, a combination of significant loopholes—to which fungible finance flows—and the strong external account helped Russia to weather the initial storm. The central bank played a key role in stabilising the situation through the provision of additional Ruble liquidity to the banking system, while also underpinning confidence in the Ruble and fighting inflation through aggressive interest rate hikes. However, this balancing act—the simultaneous pursuit of financial stability by providing liquidity and monetary stability by tightening policy —was supported by the country’s strong external position.

5. While the dramatic collapse of car manufacturing and the withdrawal of Western firms is often the focus of media coverage, so far the overall impact on industry has been less dramatic. Industrial production is down a relatively modest 2.6% YoY on October 2021, while industrial production in January-October 2022 is flat on the same period of 2021. On the latest data, Russian industry looks stable, with industrial output and investment both continuing to recover modestly.

Why sanctions nonetheless are working, and Russia is starting to lose the economic war:

1. Sanctions have clearly hurt Russia this year and its economy has dramatically underperformed both pre-invasion expectations as well as its oil-producing peers. The 3-4% contraction that is now expected for 2022 represents an 8-10 pp of GDP change compared to pre-war forecasts and a 10-12 p.p. of GDP growth differential vs. Saudi Arabia, an oil exporter of similar scale.

2. Russia is undoubtedly showing signs of financing stress. On the budget side, as oil and gas revenues started to decline in the second half of this year — reflecting falling global prices, the strong Ruble and the collapse in European gas exports — the budget has shifted into deficit. Russian authorities expect it to reach 2% of GDP in 2022. The Ministry of Finance responded by tapping Gazprom’s gas windfall in Q4 22 through a 1.2 trillion Ruble (0.9% of 2021 GDP) special tax, using 1 trillion Ruble from the NWF for financing the budget, while also launching large-scale unplanned issuances of domestic debt, raising over 2.2 trillion Rubles (1.7% of 2021 GDP) in recent weeks, mostly at floating rates. On the external side, reserves have fallen despite the strong current account. In fact, Russia faces a substantial challenge from lack of access to “proper” foreign currency reserves—i.e., liquid assets in convertible reserve currencies (G10 currencies) which are widely accepted to make payments and settle obligations.

Looking ahead, we are optimistic about the sanction coalition’s success on the economic front:

1. The crucial factor, in our view, is trade. In particular, we expect a collapse in oil and gas export earnings by more than 50% in 2023. This reflects several developments, including the impact of the European embargo on crude oil (in effect since December) and petroleum products (taking effect in February), the G7 oil price cap, and the collapse in natural gas flows to Europe. Every time oil and gas earnings, which account for 60% of exports and 40% of federal budget revenues, have fallen sharply — e.g., after 1986, in 1998, in 2008, in 2014, and in 2020 — the country has faced an economic crisis. Without the protective shield of high hydrocarbon exports, we expect that in 2023, as in previous episode, Russia’s underlying financial fragilities will resurface, with an enhanced risk of bank runs and a potential Ruble collapse. This should significantly constrain Russia’s ability to continue financing the war. Specifically, based on recent experience, we see oil and gas export earnings of $40 bn or less per quarter as a critical benchmark, beyond which Russia will struggle to finance imports and government spending. To maximise the impact, we urge the sanctions coalition to lower the oil price cap to $35/bbl at the earliest opportunity — a level which reduces oil and gas earnings below the critical level while remaining well above average production costs of $10-15/bbl and so maintaining Russia’s incentive to supply.

2. As the external balance worsens, Russia’s reserves will come under additional pressure. We see the lack of high-quality reserves — liquid reserves in G10 currencies which can be used to make external payments and settle liabilities—as a key weakness. While Russia continues to hold substantial foreign assets — $570 bn in reserves as of mid-December — a significant share has been sanctioned (~50%) and holdings in gold (~$130 bn) and yuan-denominated assets (~$100 bn) cannot easily be converted at scale into high-quality reserves. Consequently, a key focus of further sanctions action and enforcement efforts should be measures to prevent Russia from replenishing its high-quality liquid reserves. In this context, we propose to address loopholes by application of secondary sanctions on any financial hubs and third-country institutions that facilitate financial flows with Russia. In this context, we see jurisdictions such as Turkey or UAE whch have recently seen substantial inflows of Russian capital as particularly high-risk.

3. As oil and gas revenues fall and reserves come under further pressure, the Ruble will likely weaken, increasing financial instability and threatening monetary stability via pass-through to inflation. This will put policy makers in a challenging position. As in 2022, the CBR will have to provide liquidity to the financial system to support banks and mitigate the risk of bank runs. At the same time, the central bank will have to hike interest rates to retain deposits in the banking system, support the currency, and respond to rising inflation — which will then hit the economy and compromise bank asset quality over time. Without a strong external balance, the CBR will find it much harder to reconcile these objectives. To accelerate these developments, we propose that sanctions are extended to currently non-sanctioned financial institutions. In particular, with the EU embargo on Russian oil fully in effect from February and gas flows down dramatically, we believe that Gazprombank’s exemption from sanctions to facilitate energy transactions with Europe will no longer be justified.

4. On the budget, the advantage is also moving to Ukraine. Up until now, Russia has had a much stronger fiscal position. Ukraine’s revenues were heavily hit by the war, including a contraction of around one third in the economy and the destruction of many cities and enterprises, while Russia’s revenues have been boosted by strong oil and gas revenues. Next year, Russia’s budget allocates 30% of spending to defence, while Ukraine is allocating around 50% of its budget to finance the war. But now the tables are turning. Russia’s oil and gas revenues will fall next year, and it will struggle to finance the resulting deficit, with external markets closed, and a banking system under pressure. By contrast, Ukraine with €18 bn in funding now agreed from the EU and $13 bn in funding agreed from the US, now has the resources in place — supplemented by some additional donor support — to finance its 2023 budget.

5. The sharp decline in foreign investment, access to high-tech imports and loss of skilled labour will have a marked effect over time on Russia’s productivity and potential growth. In fact, this has already started in certain sectors, e.g., car manufacturing and aviation. While Ukraine, and those countries that Russia is targeting with the weaponization of energy exports, will experience an economic recovery in 2023 and beyond, Russia itself is set to remain stalled for the foreseeable future. To maximise this effect, we propose to target circumvention of sanctions and enhance export controls. The sharp rise in imports from alternative suppliers, including Turkey, likely reflects a diversion of trade to circumvent restrictions.

In summary, we see Russia back in a crisis situation in the near term as the oil embargo and price cap bite. This will help to shorten the war. The country has seen weak growth since annexation of Crimea in 2014 as Putin has pursued foreign aggression over the domestic economy. Now, cut off from critical markets, foreign investment and Western technology, trend growth — already running at an anaemic 1-1.5% — is likely to decline further. At the same time, macro buffers are being eaten up, squeezing resources that are critical to support the financial system and finance public services and pensions. Russia will be more dependent than ever on oil and gas, which are likely to be shrinking sectors as the energy transition progresses, and in the precarious role of raw material supplier to China and other emerging markets. While Russia faces economic twilight, Ukraine is set to bounce back, with support from allies, access to Western markets, and the prospect of EU membership. Over the medium run, catching up with Poland — Ukraine’s peer at the time of the Soviet Union’s breakup and a similar economy in many ways, but currently three times richer — appears a feasible objective, which would imply a decade of strong growth. With the first half of 2023 a turning point for Russia’s economy, we urge Ukraine’s allies to urgently impose further measures — particularly by lowering the oil price cap to reduce oil and gas earnings, by imposing full sanctions on remaining systemic financial institutions and addressing third-country loopholes, and by eliminating sanction exemptions for large producers in key industries.