Crimea’s annexation by Russia, the severe opposition of Moscow to the rest of the world and most of all to USA and EU and the subsequent sanctions, raise the question would these sanctions affect in any way the main parties in the conflict? Considering the isolation that Russian fell into as well as the fact that the above sanctions aim at exerting pressure on the regime of Vladimir Putin and his government to adhere to international law and put an end to Ukraine’s destabilization, raise the question whether such sanctions would have any effect on Russian and what would their possible adverse consequences be on the very states that impose such sanctions.
This analysis studies the initial consequences of the conflict in Ukraine on the main interested parties. A comparison is drawn between the main economic and social indicators in Russia and in the states with which it is involved in the conflict. Russia’s economy to a great deal depends on its oil and gas export. This dependency is also reflected in the country’s budget; 50% of the budget revenues come from receipts of taxes and fees related to extraction and export of mineral resources. Thereupon comes the question at what level of international prices of oil would Russia’s budget be balanced? On the other hand, it is important to know whether the massive-scale outflow of capitals from the country would continue and what levels would it reach. The question what costs would Russia incur for the inclusion of the new territories is also pretty important. Ultimately, the main question, raised by the imposed sanctions, is whether they are going to be successful and how they would affect the economic and political situation in Russia.
І. First consequences of the Ukrainian conflict and Crimea’s annexation
From the very beginning it is important to say that the sanctions imposed on Russia are directed mainly to highest-level people and to particular people and politicians from the closest circles of the president, Mr. Putin. In their essence, the imposed sanctions, at least the ones for the time being, are not directed to particular sectors of Russian economy, the only exception being the prohibition of export to Russia of modern military technologies from USA. The objective is to affect Putin’s close associates, who own their financial status to their Kremlin’s contacts and patronage. On the other hand, the imposed sanctions put pressure on foreign investors in Russia, who, in an attempt to prevent financial losses, have started to withdraw their investments from the country. Certain Russian players also started to transfer resources outside Russia out of fear of a financial crisis and possible Russian Ruble devaluation. According to information provided by the Central Bank of Russia (CBR), for the first quarter of the year, the capital that has left the country amounts to USD 50.6 billion, marking an increase of 84% as compared to the same period from the previous year.
Chart 1. Change in RUB/USD exchange rate during the last 6 months
Thus, sanctions already began to influence the main macroeconomic indicators in Russia and this is most strongly felt by the Russian currency growing weaker as compared to the USD and EUR. As shown in Chart 1, since the beginning of the year, RUB has depreciated with 12.5% and the process has considerably speeded up in mid-January, with the growth of tension in Ukraine. Such weakening of the Russian currency is also accompanied by the intensified interventions of CBR, which daily currency sales in support of RUB have considerably grown and from an average of USD 350 million they have reached several billion USD per day in March; on the 4th of March, an absolute record of USD 11.2 billion has been registered. Thus, from the beginning of the year until the end of April, the total amount, spent by CBR for interventions on the foreign exchange market in support of RUB, has reached USD 40 billion.
Chart 2. Dynamics of the MICEX index and the Crude Oil Brent future prices
Stock market indicators of Moscow Exchange have also been affected by the political events and since the beginning of the year, RTS Index marks a drop of 12%, while the other stock market index, MICEX, marks a drop of 13%. It is worth mentioning that stock market indices fluctuations in Russia are strongly related to oil price fluctuations at the world stock exchanges. As shows in Chart 2, in March, MICEX index has drastically dropped (down to 1237.40 t.) and such a drop has not been caused by any adequate drop in the price of oil, which only reflects the intensification of the political crisis in Ukraine during Crimea’s annexation, and the index movement continues to lag behind the movement of the price of oil, despite the recovery in April.
ІІ. Comparison between the economic specifics of the main parties, involved in the conflict
Chart 3. Comparison between the levels of GDP of the main parties, involved in the conflict
It should be taken into account that Russian economy is incomparably smaller than the total economic power of the states, involved in the conflict. As Chart 3 shows, the main opposing countries in the conflict display a very strong disproportion with regard to their economic specifics. Although currently Russia is the sixth largest economy in the world, its GDP is only 7.4% as compared to the one of the group of countries (EU, USA, Canada and Norway), shown in the above chart.
Chart 4. Comparison between the levels of GDP per capita
At the same time, the average per capita income in Russia is 60% of the one in the compared countries, measured under the Purchasing Power Parity (PPP) method, considering the fact that Russia is specific for its strong disproportion in population’s incomes. According to the Global Wealth Report of Credit Suisse (Switzerland’s investment bank) from 2013, 110 physical bodies possess 35% of the total wealth of the population, which is the strongest inequality in income distribution in the world, except in several small Caribbean islands. In Russia, for each USD 11 billion of the total nation’s wealth, there is one billionaire, while the rest of the world is characterized with one millionaire for each USD 170 million.
The comparison of the indicators that report investment activity of the two groups of countries is no less symptomatic; foreign direct investments, invested in Russia, are only 4.2% of the total investments in the other countries. On an annual basis, the flow of foreign direct investments to Russia is 7.5% as compared to the one to the compared countries. With regard to foreign trade, the total trade activity of Russia holds a share of about 4% of the respective import and export of the other compared counties.
Chart 5. Comparison between population’s life expectancy
With regard to the main social indicators, Russia also performs much worse that the other countries in the studied group. Russia’s population is only 17.3% of the population of the groupand the most adverse comparison is the comparison between the main specifics of the population of the two communities. In Russia, the average life expectancy is a bit less than 69 and nominally, it is shorter with over 11 years as compared to the other countries. At the same time, the difference between infant mortality rates is drastic. While this index for Western countries is about 4.2 per thousand, for Russia, infant mortality is 9.8 per thousand, or almost 2.5 times more.
An index, according to which Russia performs comparatively well, is budget deficit, which for 2013 is 1.3% as compared to 3.3% at the average for the European Union. The government debt is also low, about 14%. At the same time, the huge export of energy resources makes it possible to sustain surplus under the current Russia’s account and in 2013, the surplus is 1.6% of GDP. Nevertheless, as compared to 2012, this surplus marks a drop of more than 50%.
Thanks to the serous export of natural resources, Russia also has considerable monetary reserves, which at the end of April amount to USD 442,8 billion (the total amount of Russia’s international reserves, which, apart from the monetary reserves, also include monetary gold, at the end of April is USD 486 billion), and considering this indicator, Russia holds the fifth place in the world. Nevertheless, since the beginning of the year, monetary reserves have dropped with about USD 27 billion and the main reason for this drop are the mentioned central bank’s interventions to maintain RUB exchange rate.
ІІІ. Risk for Russia’s budget due to a drop in the price of oil
Russia’s economy largely depends on the export of oil and gas. Russia holds 12% of oil’s world production. The daily oil extraction is 10 million barrels, out of which it exports 5 million. Russia holds a share of 20% in the world production of gas. Currently, oil and gas export is 70% of the total export of the country and revenues from export of oil alone form 50% of all export revenues. At the same time, mineral resources extraction is 30% of Russia’s GDP and half of the economic growth in the years from 2000 until the beginning of the financial crisis is due to it. The huge influence of this sector on Russia’s economy could be estimated by the serious drop in GDP in 2009, when the price of oil collapsed from USD 147 per barrel in August 2008 to USD 34. This drastic drop in the price of oil was the main reason for Russia’s GDP shrinkage with almost 8% in 2009, marking the biggest economic drop among the G-20 group. Considering this fact, it is important to find an answer to the question how much Russia’s state budget depends on the price of oil on the international markets and how changes in this price could affect the amount of the budget deficit.
Table 1. Russia’s budget for 2013 (actual implementation) and 2014 (according to the Budget Act)
|Federal budget of Russia (RUR bn)
|O/w oil and gas
|W/o oil and gas
Source: Ministry of Finance of the Russian Federation
As shown in Table 1, revenues from oil and gas in Russia’s federal budget represent 50% (for 2014 – 48%) of the total budget revenues. In Table 2, revenues from oil and gas are presented according to their main sources. It is worth mentioning that the main budget items, used to collect revenues from oil and gas, are the Mineral Resources Tax and the Oil, Gas and Oil Products Export Tax. These two taxes form totally about and over 95% of the total revenues from oil and gas. Apart from those, revenues from oil and gas also include Income Tax of the companies, occupied in the sector for extraction and processing of oil and gas as well as the dividends of the state from its ownership in such companies. Due to the lack of detailed breakdown of these taxes, in this case they are not taken into account, with the assumption that all revenues in the budget from oil and gas are formed from the first two taxes, which does not affect significantly the accuracy of the calculations made.
Table 2. Mains sources of revenues from oil and gas for the Russian budget
|Mineral resource tax
|Expoirt duties on oil, gas and oil products
| Oil products
Source: Ministry of Finance of the Russian Federation, personal calculations
Mineral resources tax is based on the market price of oil and gas and it is a neutral tax in its essence, i.e. the loss of budget revenues will be proportional to the drop in international price of oil. This allows a relatively easy assessment of the loss from this tax at different prices of oil. A more significant effect has the tax on oil and gas export. It is also neutral but it is strongly progressive, which means that revenues increase much faster at a rise in the price of oil but losses are also accumulated as fast at a drop in this price. With regard to the tax on oil products, we will assume that the loss from this tax is proportional to the drop in the price of oil, since revenues from this tax are much less and such assumption will not affect the calculations.
Table3. Effect of the change in the price of oil on the federal budget (RUB billion)
|Oil price in USD/b
|Mineral resource tax
|Export duties on oil, gas and oil products
|Revenue/Loss in respect to oil prace change
|Budget balance (% of GDP)
Source: Personal calculations
Data from the calculations is presented in Table 3. It shows that Russia’s budget is balanced at a price of USD 98 – 100 per barrel.
ІV. Economic risks as a result of the political tension and the imposed sanctions
Even if we assume that the price of oil won’t drop below USD 100 per barrel for a long period of time, the risks before Russian economy remain pretty serious and include the following:
Chart 6. Net export of private capital in billion USD, 2005 – 2013
Apart from the price of oil, a serous problem for Russian economy is the withdrawal of capitals from the country, including the ones of the Russian oligarchs. As mentioned above, for the first quarter of 2014, the capital that have left Russia exceed USD 50 billion and the amount is expected to reach USD 150-160 billion at the end of the year. Expectations for outflow of such amounts of capitals are completely realistic, considering the outflow of capitals from Russia during the intervention in Georgia in August 2008. Then, negative financial flows exceeded USD 130 billion until the end of the year, although some part of the process coincided with the beginning of the world financial crisis. Yet, Russia was not subjected to any more specific pressure by the West.
This outflow will have a serious negative impact on the growth of GDP, which was already revised by IMF up to 0.2% for 2014, out of 1.3% earlier. Moreover, this growth is calculated at the relatively optimistic assumptions that the political turbulences will discontinue with Crimea’s annexation and won’t affect other parts of Ukraine – an assumption that is currently undergoing negative development. Therefore, a drop in Russia’s GDP for 2014 of 1% or even 2% could easily be expected. The outflow of capital from the country will put pressure on RUB exchange rate and thereupon on the inflation rate. The main objective of CBR’s policy is to maintain a certain stable inflation level, and for 2014, the inflation objective is 5.5%. For the purposes of maintaining this level, the central bank has increased its basic interest rate with 2.5 ppt up to 8%. Increase in the interest rate will make loans more costly, which will additionally decrease market activity and economic growth. Furthermore, holding back inflation is not possible without holding back Ruble’s devaluation. If the central bank goes on with its foreign exchange interventions, its monetary reserves will continue decreasing. Depending on the process of their decrease, at a certain time, CBR could discontinue intervening, which will lead to a serious devaluation of the Ruble and an abrupt rise of inflation. Moreover, the whole size of the monetary reserve is not available for interventions. Out of a total of USD 442,8 billion, USD 175 billion (40%) are accumulated in the two basic funds of the country – Reserve Fund (RF) and National Wealth Fund (NWF), the first one playing the role of a budget buffer and the second one for securing the pension costs for the future generations. According to information from independent sources, currently the government has redirected to Crimea all contributions to NWF for 2014, amounting to RUB 243 billion or about USD 7 billion.
V. Risks on Russia’s main macroeconomic indicators in case of intensification of the conflict
Chart 7. Dependence of the regions in Ukraine on central budget transfers
Source: Кто кого кормит, Инвест газета, 20.01.2014 г.
If Russia continues joining territories from Ukraine, the budget costs that it will have to incur for securing the financial conditions of the newly joined territories will increase the pressure on its budget. It is worth mentioning that the two new regions from Ukraine that make pretence to join Russia, i.e. Donetsk and Lugansk, as shown in the chart below, are two of the regions that most strongly depend on budget transfers from Kiev. There are estimations that joining Russia they will increase Moscow’s budget costs with about USD 60 billion up to USD 80 billion. This is between 3% and 4% of Russian GDP and at the same time 15%-20% of the Russian budget, which is already planned with a deficit of 0.5% for 2014. If expansion continues with more territories, budget costs will easily exceed USD 120 billion up to USD 160 billion, which goes far beyond the limits of the healthy budget deficit, reaching 5.5%-7.5% of Russian GDP or 30% up to 40% of the planed budget revenues.
From this point of view, the suggestion that Putin is being hesitant in recognizing the results from the referendums in Donetsk and Lugansk, out of this fear of the unbearable costs that the government will have to incur, should not be underestimated. On the other hand, the suggestion that the inclusion of the two regions will not be as quick and automatic as the one of Crimea, which on its part will cause further future problems, is also worth considering.
VІ. Efficiency of sanctions and counter sanctions
The main question, however, is whether the sanctions, imposed by the Western partners, will have effect and, at the same time, whether the counter sanctions, announced by Russia, will achieve the expected result. The answer to that question largely depends on the type of imposed sanctions. If they are limited to a list of people with a prohibition to travel or to access their financial assets in the West, the effect will be of one nature, while if the Western states impose sanctions on certain economic sectors in Russia, the results could be much more serious. It should be taken into account that Russia’s dependency on EU is much stronger with respect to trade flows. Russia’s trade revenues in EU are 22% of its GDP, while EU revenues from its business relations with Russia are only 3% of the Union’s GDP. On the other hand, Russia’s share in EU’s foreign trade is 10%.
Chart 8. Expected chance for success of sanctions
Source: Russia’s tit for tat, Peter A.G. van Bergeijk 25 April 2014
In one of his studies from April 2014, Peter van Bergeijk, Professor of International Economics and Macroeconomics in Erasmus University, forecasted that the effect of the sanctions, imposed jointly by USA and EU, would have success of between 47% and 52% and their effect would be felt mostly during the second year after their imposing. At the same time, Russia’s counter sanctions would achieve success of about 39%, which is one of the reasons for the Western partners’ hesitation.
VІІ. Long-term consequences of the conflict
Nevertheless, we have to admit that the West is obligated to take actions as a result of Russia’s behavior, in order to protect its constitutional foundations, based on which the modern world is developed. From this point of view, escalation of sanctions is expected and most probably they will affect mainly Russia’s financial system. Suspension of credit card service support by Visa and MasterCard for some Russian banks, close to the Kremlin, already forced Moscow to initiate development of an own credit card platform.
What is yet to come, however, is related to the enactment of a new requirement of FATCA (Foreign Account Tax Complience Act) in USA, as of 01 July, which aims at terminating tax avoidance by American citizens and companies. According to that law, American banks will have to deduct 30% of tax on certain payments to foreign countries, which concern mainly dividends and interest revenues, if the countries to which the payment goes do not have an agreement with USA for information disclosure. This will render business relations with Russia extremely difficult and it will also affect mainly the country’s monetary reserves management, where the share of USD is about 50% and CBR holds such assets mainly in US government debt securities. Furthermore, all payments in oil sales are made in USD and this means that they will become more costly if Moscow and Washington fail to reach an agreement, which currently looks pretty much possible. It is worth mentioning that in 2017, the requirements of the Act are extended if no agreement is reached, and the tax will be also deducted from the gross cash outflows, and not only from interest and dividends. Thus, it is actually not the sanctions themselves, unless they are extended, but the very political pressure and international isolation that Putin’s regime is facing that will lead to an adverse pressure on Russia’s economy. The results of such a confrontation should be expected in the longer run, when the West’s dependency on Russian natural resources will be reduced to the possible minimum.
At the same time, it is highly unlikely that Russian economy will get reorganized in such a way as to change mineral resources extraction’s status of a main source of growth. Unfortunately, the economic development model, established in Russia, is based on oligarchic relations between power and economic elite. Oligarchs control huge economic conglomerates, which are vertically integrated, which on its part allows no development of competition. Actually, the share of SMEs in Russia’s GDP is estimated to about 20%-25%, which is not only lower than SMEs’ share in developed countries but it is also incomparably smaller than their share in the other developing countries too. Moreover, 90% of these companies’ business is concentrated in 4 main sectors: trade (57%), production (11.5%), construction (11%) and real estates (9.7%). Given this structure of its economy and its political system specifics, Russia will find it pretty difficult to succeed in developing innovative enterprises, able to compete at the world market. Thus, in the long run, the economic sanctions imposed by the Western partners, even if initially not so effective, will undoubtedly influence Russia’s economic development, which on its part will also have its political consequences.
The Ukrainian conflict is not simply the next conflict, raging on the international scene. It will continue to develop in time and it will also have long-term consequences for the countries involved. Currently, Russia has fallen into a serious international isolation and it faces the opposition of the Western countries, mainly in the face of USA and EU. If the positions of the main conflicting countries remain unchanged, the consequences of this confrontation will have a long-term effect on the business relations between the countries involved and the adverse consequences will be mainly suffered by Russia, Vladimir Putin’s regime respectively, although the negative effect will be definitely felt by EU states too. Nevertheless, the economic power of the Western countries gives them an advantage to this geopolitical confrontation. The next months will show the extent to which the government in Moscow realizes the future adverse development of the situation and whether it is willing to make compromises in its position. In any case, in terms of economy, Russia is not prepared to withstand such a situation too long.
On the contrary, in case of strengthening of the positions, the chance for Russia to fall, firstly, into a serious economic crisis, followed by a political crisis, will grow with time. The outcome of these crises has much more political than economic solutions. What the present crisis did was to seriously shake Russia’s international position and reveal its vulnerability with regard to the political and economic model that it has adopted. It is obvious that this model is unstable in the long run and sooner or later this system will undergo a cataclysm. However, only future will show the scale of this cataclysm and the direction of its development.
The article was initially published on 15 May 2014 at NBU’s R!SK Management Lab