Tag: Oil

Sanctions on Russia: Getting the Facts Right

Posted on March 14, 2024 | Policy Brief

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The important strategic role that sanctions play in the efforts to constrain Russia’s geopolitical ambitions and end its brutal war on Ukraine is often questioned and diminished in the public debate. This policy brief, authored by a collective of experts from various countries, shares insights on the complexities surrounding the use of sanctions against Russia, in light of its illegal aggression towards Ukraine. The aim is to facilitate a public discussion based on facts and reduce the risk that the debate falls prey to the information war.

Sanctions are a pivotal component in the array of strategies deployed to address the threat posed by Russia to the rule-based international order. Contrary to views minimizing their impact, evidence and research suggest that sanctions, particularly those targeting Russian energy exports, have significantly affected Russia’s macroeconomic stability [1,2,3]. Between 2022 and 2023:

  • merchandise exports fell by 28 percent,
  • the trade surplus decreased by 62 percent,
  • and the current account surplus dropped by 79 percent (see the Bank of Russia’s external sector statistics here).

Although 2022 represents an extraordinarily high baseline due to the delayed impacts of energy sanctions, the $190 billion decrease in foreign currency inflows during this time has already made a significant difference for Russia. This amount is equivalent to about two years of Russia’s current military spending, or around 10 percent of Russia’s yearly GDP, depending on the figures. Our estimates suggest that Russia’s losses due to the oil price cap and import embargo alone amount to several percent of its GDP [3,4]. These losses have contributed to the ruble’s continued weakness and have forced Russian authorities to sharply increase interest rates, which will have painful ripple effects throughout the economy in the coming months and years. Furthermore, the international sanctions coalition’s freezing of about $300 billion of the Bank of Russia’s reserves has significantly curtailed the central bank’s ability to manage the Russian economy in this era of war and sanctions.

Sanctions Enforcement

Addressing the enforcement of sanctions, it is crucial to acknowledge the extensive and continuous work undertaken by governments, think tanks, and the private sector to identify and close loopholes that facilitate sanctions evasion. Suggesting that such efforts are futile, often with arguments that lack solid evidence, potentially undermines these contributions, and furthermore provides (perhaps unintended) support to those advocating for a dismantling of the sanctions regime. We do not deny that several key aspects are facing challenges, from the oil price cap to export controls on military and dual-use goods. However, the path forward is to step up efforts and strengthen the implementation and enforcement – not to abandon the strategy altogether. Yes, Russia’s shadow fleet threatens the fundamental mechanism of the oil sanctions and, namely its reliance on Western services [4,5,6]. However, recent actions by the U.S. Treasury Department have shown that the sanctioning coalition can in fact weaken Russia’s ability to work around the energy sanctions. Specifically, the approach to designate (i.e., sanction) individual tankers has effectively removed them from the Russian oil trade. More vessels could be targeted in a similar way to gradually step-up the pressure on Russia [7]. While Russia continues to have access to many products identified as critical for the military industry (for instance semiconductors) [8], it has been shown that Russia pays significant mark-ups for these goods to compensate for the many layers of intermediaries involved in circumvention schemes. Sanctions, even when imperfect, thus still work as trade barriers. In addition to existing efforts and undertakings, companies which help Russia evade export controls can be sanctioned, even when registered in countries outside of the sanctioning coalition. Furthermore, compliance efforts within, and against, western companies, who remain extremely important for Russia, can be stepped up.

The Russian Economy

Many recent newspaper articles have been centered around the theme of Russia’s surprisingly resilient economy. We find these articles to generally be superficial and missing a key point: Russia is transitioning to a war economy, driven by massive and unsustainable public spending. In 2024, military spending is projected to boost Russia’s GDP growth by at least 2.5 percentage points, driven by a planned $100 billion in defense expenditures [9]. However, seeing this for what it is, namely war-spending, raises significant concerns about the sustainability of this growth, as it eats into existing reserves and crowds out investments in areas with a larger long-term growth potential. The massive spending also feeds inflation in consumer prices and wages, in particular as private investment levels are low and the labor market is short on competent labor. This puts pressure on monetary policy causing the central bank to increase interest rates even further, to compensate for the overly stimulating fiscal policy.

Further, it is important to bear in mind that, beyond this stimulus, the Russian economy is characterised by fundamental weaknesses. Russia has for many years dealt with anaemic growth due to low productivity gains and unfavourable demographics. Since the first round of sanctions was imposed on Russia, following its illegal annexation of Crimea in 2014, growth has hovered at around 1 percent per year on average – abysmal for an emerging market with catch-up potential. More recently, current sanctions and war expenditures have made Russia dramatically underperform compared to other oil-exporting countries [10]. Moreover, none of the normal (non-war related) growth fundamentals is likely to improve. Rather, the military aggression and the ensuing sanctions have made things worse. Hundreds of thousands of Russians have been killed or wounded in the war; many more have left the country to either escape the Putin regime or mobilization. Those leaving are often the younger and better educated, worsening the already dire demographic situation, and reinforcing the labor market inefficiencies. Additionally, with the country largely cut off from the world’s most important financial markets, investments in the Russian economy are completely insufficient [11].

As a result, Russia will be increasingly dependent on fossil fuel extraction and exports, a strategy that holds limited promise as considerations related to climate change continue to gain importance. With the loss of the European market, either due to sanctions or Putin’s failed attempt to weaponize gas flows to Europe, Russia finds itself dependent on a limited number of buyers for its oil and gas. Such dependency compels Russia to accept painful discounts and increases its exposure to market risks and price fluctuations [12].

The Cost of Sanctions

Sanctions have not been without costs for the countries imposing them. Nonetheless, the sanctioning countries are in a much better position than Russia. Any sanction strategy is necessarily a tradeoff between maximizing the sanctioned country’s economic loss while minimizing the loss to the sanctioning countries [9], but there are at least two qualifications to bear in mind. The first is that some sanctions imply very low losses – if any – while others may carry limited short term losses but longer term gains. This includes the oil-price cap that allows many importing countries to buy Russian oil at a discount [3], and policies to reduce energy demand, which squeezes Russia’s oil-income [13]. These policies may also initially hurt sanctioning countries, but in the long term facilitate an investment in energy self-sufficiency. Similarly, trade sanctions also imply some protection of one’s own industry, meaning that such sanctions may in fact bring benefits to the sanctioning countries – at least in the short run. The second qualification is that, in cases where sanctions do imply a cost to the sanctioning countries, the question is what cost is reasonable. Russia’s economy is many times smaller than, for instance, the EU’s economy. This gives the EU a strategic advantage akin to that in Texas hold’em poker: going dollar for dollar and euro for euro, Russia is bound to go bankrupt. Currently, Russia allocates a significantly larger portion of its GDP to its war machine than most sanctioning countries spend on their defense. That alone suggests sanctioning countries may want to go beyond dollar for dollar as it is cheaper to stop Russia economically today than on a future battlefield. This points to the bigger question: what would be the future cost of not sanctioning Russia today? Many accredit the weak response from the West to the annexation of Crimea in 2014 as part of the explanation behind Putin’s decision to pursue the current full-scale invasion of Ukraine. Similarly, an unwillingness to bear limited costs today may entail much more substantial costs tomorrow.

When discussing the cost of sanctions, one must also take into account Russia’s counter moves and whether they are credible [14]. Often, they are not [3, 15]. Fear-inducing platitudes, such that China and Russia will reshape the global financial system to insulate themselves from the West’s economic statecraft tools, circulate broadly. We do not deny that these countries are undertaking measures in this direction, but it is much harder to do so in practice than in political speeches. For instance, moving away from the U.S. dollar (and the Euro) in international trade (aside from in bilateral trade relations that are roughly balanced) is highly challenging. In such a trade, conducted without the U.S. dollar, one side of the bargain will end up with a large amount of currency that it does not need and cannot exchange, at scale, for hard currency. As long as a transaction is conducted in U.S. dollar, the U.S. financial system is involved via corresponding accounts, and the threat of secondary sanctions remains powerful. We have seen examples of this in recent months, following President Biden’s executive order on December 22, 2023.

One of Many Tools

Finally, we and other proponents of sanctions do not view them as a panacea, or an alternative to the essential military and financial support that Ukraine requires. Rather, we maintain that sanctions are a critical component of a multi-pronged strategy aimed at halting Putin’s unlawful and aggressive war against Ukraine, a war that threatens not only Ukraine, but peace, liberty, and prosperity across Europe. The necessity for sanctions becomes clear when considering the alternative: a Russian regime with access to $300 billion in the central bank’s reserves, the ability to earn billions more from fossil fuel exports, and to freely acquire advanced Western technology for its military operations against Ukrainian civilians. In fact, the less successful the economic statecraft measures are, the greater the need for military and financial aid to Ukraine becomes, alongside broader indirect costs such as increased defense spending, higher interest rates, and inflation in sanctioning countries. A case in point is the West’s provision of vital – yet expensive – air defense systems to Ukraine, required to counteract Russian missiles and drones, which in turn are enabled by access to Western technology. Abandoning sanctions would only exacerbate this type of challenges.

Conclusion

The discourse on sanctions against Russia necessitates a nuanced understanding of their role within the context of the broader strategy against Russia. It is critical to understand that shallow statements and misinformed opinions become part of the information war, and that the effectiveness of sanctions also depends on all stakeholders’ perceptions about the sanctioning regime’s effectiveness and long run sustainability. Supporting Ukraine in its struggle against the Russian aggression is not a matter of choosing between material support and sanctions; rather, Ukraine’s allies must employ all available tools to ensure Ukraine’s victory. While sanctions alone are not a cure-all, they are indispensable in the concerted effort to support Ukraine and restore peace and stability in the region. The way forward is thus to make the sanctions even more effective and to strengthen the enforcement, not to abandon them.

References

[1] “Russia Chartbook”. KSE Institute, February 2024

[2] “One year of sanctions: Russia’s oil export revenues cut by EUR 34 bn”. Center for Research on Energy and Clean Air, December 2023

[3] “The Price Cap on Russian Oil: A Quantitative Analysis”. Wachtmeister, H., Gars, J. and Spiro, D, July 2023

[4] Spiro, D. Gars, J, and Wachtmeister, H. (2023). “The effects of an EU import and shipping embargo on Russian oil income,” mimeo

[5] “Energy Sanctions: Four Key Steps to Constrain Russia in 2024 and Beyond”. International Working Group on Russian Sanctions & KSE Institute, February 2024

[6] “Tracking the impacts of G7 & EU’s sanctions on Russian oil”. Center for Research on Energy and Clean Air

[7] “Russia Oil Tracker”. KSE Institute, February 2024

[8] “Challenges of Export Controls Enforcement: How Russia Continues to Import Components for Its Military Production”. International Working Group on Russian Sanctions & KSE Institute, January 2024

[9] “Russia Plans Huge Defense Spending Hike in 2024 as War Drags”. Bloomberg, September 2023

[10] “Sanctions and Russia’s War: Limiting Putin’s Capabilities”. U.S. Department of the Treasury, December 2023

[11] “World Investment Report 2023”. UNCTAD

[12] “Russia-China energy relations since 24 February: Consequences and options for Europe”. Swedish Institute of International Affairs, June 2023

[13] Gars, J., Spiro, D. and Wachtmeister, H. (2022). “The effect of European fuel-tax cuts on the oil income of Russia”. Nature Energy, 7(10), pp.989-997

[14] Spiro, D. (2023). “Economic Warfare”. Available at SSRN 4445359

[15] Gars, J., Spiro, D. and Wachtmeister, H., (2023). “Were Russia’s threats of reduced oil exports credible?”. Working paper

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

How to Undermine Russia’s War Capacity: Insights from Development Day 2023

Posted on January 15, 2024 | Policy Brief

Image from SITE Development Day conference

As Russia’s full-scale invasion of Ukraine continues, the future of the country is challenged by wavering Western financial and military support and weak implementation of the sanction’s regime. At the same time, Russia fights an information war, affecting sentiments for Western powers and values across the world. With these challenges in mind, the Stockholm Institute for Transition Economics (SITE) invited researchers and stakeholders to the 2023 Development Day Conference to discuss how to undermine Russia’s capacity to wage war. This policy brief shortly summarizes the featured presentations and discussions.

Holes in the Net of Sanctions

In one of the conference’s initial presentations Aage Borchgrevink (see list at the end of the brief for all presenters’ titles and affiliations) painted a rather dark picture of the current sanctions’ situation. According to Borchgrevink, Europe continuously exports war-critical goods to Russia either via neighboring countries (through re-rerouting), or by tampering with goods’ declaration forms. This claim was supported by Benjamin Hilgenstock who not only showed that technology from multinational companies is found in Russian military equipment but also illustrated (Figure 1) the challenges to export control that come from lengthy production and logistics chains and the various jurisdictions this entails.

Figure 1. Trade flows of war-critical goods, Q1-Q3, 2023.

Source: Benjamin Hilgenstock, Kyiv School of Economics Institute.

Offering a central Asian perspective, Eric Livny highlighted how several of the region’s economies have been booming since the enforcement of sanctions against Russia. According to Livny, European exports to Central Asian countries have in many cases skyrocketed (German exports to the Kyrgyzs Republic have for instance increased by 1000 percent since the invasion), just like exports from Central Asian countries to Russia. Further, most of the export increase from central Asian countries to Russia consists of manufactured goods (such as telephones and computers), machinery and transport equipment – some of which are critical for Russia’s war efforts. Russia has evidently made a major pivot towards Asia, Livny concluded.

This narrative was seconded by Michael Koch, Director at the Swedish National Board of Trade, who pointed to data indicating that several European countries have increased their trade with Russia’s neighboring countries in the wake of the decreased direct exports to Russia. It should be noted, though, that data presented by Borchgrevink showed that the increase in trade from neighboring countries to Russia was substantially smaller than the drop in direct trade with Russia from Europe. This suggests that sanctions still have a substantial impact, albeit smaller than its potential.

According to Koch, a key question is how to make companies more responsible for their business? This was a key theme in the discussion that followed. Offering a Swedish government perspective, Håkan Jevrell emphasized the upcoming adoption of a twelfth sanctions package in the EU, and the importance of previous adopted sanctions’ packages. Jevrell also continued by highlighting the urgency of deferring sanctions circumvention – including analyzing the effect of current sanctions. In the subsequent panel Jevrell, alongside Adrian Sadikovic, Anders Leissner, and Nataliia Shapoval keyed in on sanctions circumvention. The panel discussion brought up the challenges associated with typically complicated sanctions legislation and company ownership structures, urging for more streamlined regulation. Another aspect discussed related to the importance of enforcement of sanctions regulation and the fact that we are yet to see any rulings in relation to sanctions jurisdiction. The panelists agreed that the latter is crucial to deter sanctions violations and to legitimize sanctions and reduce Russian government revenues. Although sanctions have not yet worked as well as hoped for, they still have a bite, (for instance, oil sanctions have decreased Russian oil revenues by 30 percent).

Reducing Russia’s Government Revenues

As was emphasized throughout the conference, fossil fuel export revenues form the backbone of the Russian economy, ultimately allowing for the continuation of the war. Accounting for 40 percent of the federal budget, Russian fossil fuels are currently mainly exported to China and India. However, as presented by Petras Katinas, the EU has since the invasion on the 24th of February, paid 182 billion EUR to Russia for oil and gas imports despite the sanctions. In his presentation, Katinas also highlighted the fact that Liquified Natural Gas (LNG) imports for EU have in fact increased since the invasion – due to sanctions not being in place. The EU/G7 imposed price cap on Russian oil at $60 per barrel was initially effective in reducing Russian export revenues, but its effectiveness has over time being eroded through the emergence of a Russia controlled shadow fleet of tankers and sales documentation fraud. In order to further reduce the Russian government’s income from fossil fuels, Katinas concluded that the whitewashing of Russian oil (i.e., third countries import crude oil, refine it and sell it to sanctioning countries) must be halted, and the price cap on Russian oil needs to be lowered from the current $60 to $30 per barrel.

In his research presentation, Daniel Spiro also focused on oil sanctions targeted towards Russia – what he referred to as the “Energy-economic warfare”. According to Spiro, the sanctions regime should aim at minimizing Russia’s revenues, while at the same time minimizing sanctioning countries’ own costs, keeping in mind that the enemy (i.e. Russia) will act in the exact same way. The sanctions on Russian oil pushes Russia to sell oil to China and India and the effects from this are two-fold: firstly, selling to China and India rather than to the EU implies longer shipping routes and secondly, China and India both get a stronger bargaining position for the price they pay for the Russian oil. As such, the profit margins for Russia have decreased due to the price cap and the longer routes, while India and China are winners – buying at low prices. Considering the potential countermoves, Spiro – much like Katinas – emphasized the need to take control of the tanker market, including insurance, sales and repairs. While the oil price cap has proven potential to be an effective sanction, it has to be coupled with an embargo on LNG and preferrable halted access for Russian ships into European ports – potentially shutting down the Danish strait – Spiro concluded.

Chloé Le Coq presented work on Russian nuclear energy, another energy market where Russia is a dominant player. Russia is currently supplying 12 percent of the United States’ uranium, and accounting for as much as 70 percent on the European market. On top of this, several European countries have Russian-built reactors. While the nuclear-related revenues for Russia today are quite small, the associated political and economic influence is much more prominent. The Russian nuclear energy agency, Rosatom, is building reactors in several countries, locking in technology and offering loans (e.g., Bangladesh has a 20-year commitment in which Rosatom lends 70 percent of the production cost). In this way Russia exerts political influence on the rest of the world. Le Coq argued that energy sanctions should not only be about reducing today’s revenues but also about reducing Russian political and economic influence in the long run.

The notion of choke points for Russian vessels, for instance in the Danish strait, was discussed also in the following panel comprising of Yuliia Pavytska, Iikka Korhonen, Aage Borchgrevink, and Lars Schmidt. The panelists largely agreed that while choke points are potentially a good idea, the focus should be on ensuring that existing sanctions are enforced – noting that sanctions don’t work overnight and the need to avoid sanctions fatigue. Further, the panel discussed the fact that although fossil fuels account for a large chunk of federal revenues, a substantial part of the Russian budget come from profit taxes as well as windfall taxes on select companies, and that Russian state-owned companies should in some form be targeted by sanctions in the future. In line with the previous discussion, the panelists also emphasized the importance of getting banks and companies to cooperate when it comes to sanctions and stay out of the Russian market. Aage Borchgrevink highlighted that for companies to adhere to sanctions legislation they could potentially be criminally charged if they are found violating the sanctions, as it can accrue to human rights violations. For instance, if companies’ parts are used for war crimes, these companies may also be part of such war crimes. As such, sanctions can be regarded as a human rights instrument and companies committing sanctions violations can be prosecuted under criminal law.

Frozen Assets and Disinformation

The topic of Russian influence was discussed also in the conference’s last panel, composed of Anders Ahnlid, Kata Fredheim, Torbjörn Becker, Martin Kragh, and Andrii Plakhotniuk. The panelists discussed Russia’s strong presence on social media platforms and how Russia is posting propaganda at a speed unmet by legislators and left unchecked by tech companies. The strategic narrative televised by Russia claims that Ukraine is not a democracy, and that corruption is rampant – despite the major anti-corruption reforms undertaken since 2014. If the facts are not set straight, the propaganda risks undermining popular support for Ukraine, playing into the hands of Russia. Further, the panelists also discussed the aspect of frozen assets and how the these can be used for rebuilding Ukraine. Thinking long-term, the aim is to modify international law, allowing for confiscation, as there are currently about 200 billion EUR in Russian state-owned assets and about 20 billion EUR worth of private-owned assets, currently frozen.

The panel discussion resonated also in the presentation by Vladyslav Vlasiuk who gave an account of the Ukrainian government’s perspective of the situation. Vlasiuk, much like other speakers, pointed out sanctions as one of the main avenues to stop Russia’s continued war, while also emphasizing the need for research to ensure the implications from sanctions are analyzed and subsequently presented to the public and policy makers alike. Understanding the effects of the sanctions on both Russia’s and the sanctioning countries’ economies is crucial to ensure sustained support for the sanction’s regime, Vlasiuk emphasized.

Joining on video-link from Kyiv, Tymofiy Mylovanov, rounded off the conference by again emphasizing the need for continued pressure on Russia in forms of sanctions and sanctions compliance. According to Mylovanov, the Russian narrative off Ukraine struggling must be countered as the truth is rather that Ukraine is holding up with well-trained troops and high morale. However, Mylovanov continued, future funding of Ukraine’s efforts against Russia must be ensured – reminding the audience how Russia poses a threat not only to Ukraine, but to Europe and the world.

Concluding Remarks

The Russian attack on Ukraine is military and deadly, but the wider attack on the liberal world order, through cyber-attacks, migration flows, propaganda, and disinformation, must also be combatted. As discussed throughout the conference, sanctions have the potential for success, but it hinges on the beliefs and the compliance of citizens, companies, and governments around the world. To have sanctions deliver on their long-term potential it is key to include not only more countries but also the banking sector, and to instill a principled behavior among companies – having them refrain from trading with Russia. Varying degrees of enforcement undermine sanctions compliant countries and companies, ultimately making sanctions less effective. Thus, prosecuting those who breach or purposedly evade sanctions should be a top priority, as well as imposing control over the global tanker market, to regain the initial bite of the oil price cap. Lastly, it is crucial that the global community does not forget about Ukraine in the presence of other conflicts and competing agendas. And to ensure success for Ukraine we need to restrain the Russian war effort through stronger enforcement of sanctions, and by winning the information war.

List of Participants

Anders Ahnlid, Director General at the National Board of Trade
Aage Borchgrevink, Senior Advisor at The Norwegian Helsinki Committee
Torbjörn Becker, Director at the Stockholm Institute of Transition Economics
Chloé Le Coq, Professor of Economics, University of Paris-Panthéon-Assas, Economics and Law Research Center (CRED)
Benjamin Hilgenstock, Senior Economist at Kyiv School of Economics Institute
Håkan Jevrell, State Secretary to the Minister for International Development Cooperation and Foreign Trade
Michael Koch, Director at Swedish National Board of Trade
Iikka Korhonen, Head of the Bank of Finland Institute for Emerging Economies (BOFIT)
Martin Kragh, Deputy Centre Director at Stockholm Centre for Eastern European Studies (SCEEUS)
Eric Livny, Lead Regional Economist for Central Asia at European Bank for Reconstruction and Development (EBRD)
Anders Leissner, Lawyer and Expert on sanctions at Advokatfirman Vinge
Tymofiy Mylovanov, President of the Kyiv School of Economics
Vladyslav Vlasiuk, Sanctions Advisor to the Office of the President of Ukraine
Nataliia Shapoval, Chairman of the Kyiv School of Economics Institute
Yuliia Pavytska, Manager of the Sanctions Programme at KSE Institute
Andrii Plakhotniuk, Ambassador Extraordinary and Plenipotentiary of Ukraine to the Kingdom of Sweden
Daniel Spiro, Associate Professor, Uppsala University
Adrian Sadikovic, Journalist at Dagens Nyheter
Kata Fredheim, Executive Vice President of Partnership and Strategy and Associate Professor at SSE Riga
Lars Schmidt, Director and Sanctions Coordinator at the Ministry for Foreign Affairs, Sweden

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Cognitive Dissonance on Belarus: Recovery and Adaptation or Stalemate?

Posted on January 8, 2024 | Policy Brief

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A closer look at the Belarusian economy over the recent year, produces two initially competing narratives. The first one emphasizes that tough sanctions have led to a deadlock for the Belarusian economy. The second one stresses that output losses have turned out to be much lower than expected, and that the economy has displayed a rather high degree of adaptability – securing an early and rapid recovery. This policy brief shows that these narratives are not mutually exclusive but rather elements of the same bigger picture. A short-term focus gives the impression that the current stance is ‘more good than bad’. This reflects the fact that output has recovered and almost reached historically high levels, made possible due to a combination of exports protection mechanisms and compensatory effects on output. However, this does not eliminate the disappointing medium- and long-term prospects for the country. On the flip side of the immediate survival of the Belarusian economy is the country’s economic and political stalemate. This includes the lack of opportunities for future sustainable growth and Belarus’ enormous and continuously growing dependence on Russia. Within this stalemate, stagnation is the best plausible scenario. At the same time, much worse scenarios, both economically and politically, are also highly likely. Ultimately, breaking the deadlock is the only way to a better future for Belarus.

The Belarusian Economy and the Changing Narratives

About 1.5 years ago, Western countries introduced tough sanctions against Belarus, punishing the Lukashenka regime for its role in Russia’s invasion of Ukraine. This gave rise to a huge uncertainty regarding Belarus’ economic prospects. A FREE policy brief published about a year ago (Kruk & Lvovskiy, 2022) presented a model-based estimate of a potential rock-bottom for the Belarusian economy in the new environment, which amounted to 20 percent of output losses. The authors however argued that actual output losses might be significantly lower given Russia’s support and policy responses, which were unaccounted for in the model. At the same time, downside risks and a lack of output consistency seem to have become permanent traits of the Belarusian economy.

Expectations of a large and prolonged recession in Belarus prevailed into mid-2023. International institutions (IMF, World Bank) and rating agencies (S&P, Fitch Ratings) mainly expected a recession in Belarus up to 10 percent 2022-2023.  The reality has however turned out to be quite different with the recession being relatively contained and short-lived. The output losses between the peak (Q2-2021) trough Q3-2022 amounted to 6.8 percent. In Q4-2022 a recovery began, and in Q3-2023 the economy had almost fully recovered, reaching nearly the same levels as in Q2-2021 (see Figure 1). Further, in terms of average real wages and household consumption, the situation appears to be even more positive. The real average wage reached its pre-war level in Q1-2023 and has since displayed record high levels, and household consumption follow a similar trend (see Figure 1).

These dynamics have given rise to a new narrative. As of lately, the Belarusian economic situation is at times treated as ‘more good than bad’. Further, most international financial institutions currently forecast a continued weak recovery growth in the coming years (EBRD, 2023; IMF, 2023; Izvorski et al., 2023).

Figure 1. Real GDP, Average Real Wages, and Real Household Consumption (index, seasonally adjusted, 2018=100).

Source: Author’s estimations based on Belstat data.

Factors Behind the Recent Recovery Growth

The underlying reasons for the recovery growth can be divided into two groups: (i) export protection mechanisms under sanctions and (ii) positive shocks and compensatory effects on output.

Export protection mechanisms under sanctions are twofold. Firstly, the Belarusian regime turned out to be somewhat successful in adjusting to the new sanctions-environment. This partly due to a somewhat geographical U-turn of Belarusian exports, underpinned by new logistics and payment schemes. The best example of this turn is the re-orientation of oil product exports from the EU and Ukraine to Russia (Kharitonchik, 2023). Moreover, some exports to traditional markets, which were challenged by logistics and payment barriers rather than sanctions, were secured by crossing these barriers. The best such example is the recovery of potash fertilizer exports to China, Brazil and India. Since early 2023 these displayed a rapid recovery due to Belarus finding logistic solutions through Russian sea ports instead of EU ports, and by using railway transportation.

Secondly, the practices of sanctions evasion may also have played a significant role. The scope of sanctions evasion is however difficult to assess due to its secretive nature. Moreover, the difference between avoiding and evading sanctions is not always clear.

Export protection mechanisms allowed Belarus to cushion actual export losses, making them transitory (see Figure 2). Actual losses in exports were close to the rock-bottom scenario estimates for only a couple of months. Instead of an expected level shift in exports by roughly 40 percent (from the pre-war level), exports displayed a recovery trajectory. Hence, what was modelled as a permanent shock in Kruk & Lvovskiy (2022), turned out to be transitory.

Figure 2. Physical Volume of Exports (index, seasonally adjusted, 2018=100).

Source: Author’s estimations based on Belstat data.

One important aspect to mention is that part of this recovery is due to oil-product exports taking place already in 2022 (Kharitonchik, 2023). In Kruk & Panasevich (2023) the authors show that the oil-refinery industry is of extreme importance for the entire Belarusian economy. Due to inter-industrial linkages, the oil-refinery industry indirectly accounts for about 11 percent of Belarus’ output, despite its modest direct contribution to the GDP (slightly more than 1 percent). Hence, due to protecting these exports (and the corresponding production of oil products), a large amount of output losses was avoided. A similar situation unfolded also for potash fertilizer exports and the chemical industry producing them (although inter-industrial linkages and effects on output are much weaker for that industry).

Besides export protection mechanisms, the recovery of exports and output stem largely from various positive and compensatory effects on output Some of them arose from Belarus’ and Russia’s respective regimes responses to sanctions, and from Russia’s readiness to support Belarus. Others are classical external positive shocks (to no degree related to sanctions) while some are a combination of both. They include: (i) increasing energy (gas) subsidies from Russia, (ii) a prolonged period of extra-high price competitiveness, especially in the Russian market, (iii) expanded access to the Russian market, (iv) other forms of Russian support (debt restructuring, budget transfers, new loans), (v) favorable trade conditions and export prices (apart from on the Russian market), (vi) a (macro)economic environment that allow for more  room for domestic economic policy interventions.

Taken together, these positive output drivers largely contributed to curbing the recession in 2022 and to the output recovery in 2023. A straightforward decomposition of the actual output growth path is unfeasible (due to the close interconnection of export protection mechanisms and output drivers, and the lack of available statistics). However, approximating the actual path in a model environment results in the following: between Q2-2021 and Q3-2022, about 12 percent of losses due to sanctions (taking into account the export protection mechanisms) and a deprivation of the Ukrainian market, and 5.2 percent of gains due to output shocks, resulted in actual output losses of 6.8 percent. Later in 2023, due to increasing effects from the export protection mechanisms, the sanctions-related output losses shrank to about 6.6 percent, while output shocks expanded output by roughly the same level. This allowed output losses to be zeroed out, i.e. the level of output in Q3-2023 was almost identical to Q3-2021.

An Economic Stalemate

Is the ‘more good than bad’ economic situation sustainable? Does the recent recovery mean that Belarus has overcome the major challenges to the economy? The short answer is no. Even with short-term thinking, there are still numerous downside risks. Sanctions still form a permanently challenging environment for the Belarusian economy, putting exports and output in jeopardy. The export protection mechanisms are not persistent, and they largely depend on Russia’s political will to support them. Moreover, the updated logistics and payment chains may also be vulnerable and sensitive to changes in the sanctions’ environment, and short-term trends in external prices. The aforementioned positive output effects are short-term by their nature and there are indications of them starting to fade already in 2023 (BEROC, 2023). Hence, even short-term projections for 2024 are challenging: the output growth is expected to weaken significantly or even fade away, while inflation spikes and financial destabilization risks are high (BEROC, 2023). Therefore, a return to a stagnant economic environment appears to be the most plausible short-term outlook.

The medium-term outlook seems even worse. According to Kruk (2023), the Belarusian macroeconomic balance (a) is very fragile, (b) is subject to numerous and huge downside risks, and (c) cannot be secured by macroeconomic policies because of the structural weaknesses in their design and the lack of room for maneuver. This means that even the existing weak long-term growth potential cannot be realized in the medium term, while the likelihood of recessions, inflation spikes and financial destabilization is high.

Re-shifting focus to a long-term and international perspective makes the viewpoint ‘more good than bad’ appear inconsistent. First, the long-term growth potential for Belarus, which was very weak even before the sanctions, keeps on worsening. This as adverse supply shocks and a deterioration of the productivity determinants continue eroding it (Kruk & Lvovskiy, 2022). Estimations of the growth potential (that rely on historical time series) are mainly within the range of 0-1 percent per annum. However, even such disappointing estimates might be optimistic bearing in mind the current political and sanctions-related risks and uncertainty (absent in the historical data). This makes stagnation the best possible long-term outlook, although it cannot be guaranteed.

Second, despite the milder recession and rapid recovery, the well-being gap between Belarus and its EU neighbors keeps on expanding (see Figure 3).

Figure 3. Well-being in Belarus vs the average among its EU neighbors (Latvia, Lithuania, Poland), 1990-2022, in percent.

Note: The GDP per capita PPP in 2017 constant international dollars is considered as well-being. The average well-being for EU Neighbors is the simple average in GDP in Latvia, Lithuania, and Poland.
Source: Author’s estimations based on World Bank data.

The average well-being in Belarus (measured in GDP per capita in constant international dollars) vs. that among its EU neighbors reached an (almost) historically low level in 2022. After attaining a level of well-being of roughly 75 percent of the average in Latvia, Lithuania, and Poland in the early 2010s, the well-being in Belarus has fall to about 52.5 percent, almost as low as in the mid-1990s. Given the economic stagnation as the most likely outlook, this means that the country will, in relative terms, keep on getting poorer in comparison to its EU neighbors.

A Political Stalemate

The hypothetical way out of the economic stalemate is more or less obvious. For instance, there is somewhat of a consensus among Belarusian economists about strengthening the long-term growth and securing macroeconomic stability (see Daneyko & Kruk, 2021; Kruk, 2023, for an overview of a collective view from a group of Belarusian economists). This vision, however, clashes with the views of the Lukashenka regime, which has inhibited its implementation throughout decades. Hence, democratic transition, or at least deprival of power of the Lukashenka regime has long appeared to be a highly likely precondition for moving away from the stalemate.

This, however, has changed in the last couple of years. The Belarusian economy’s dependence on Russia has moved from large to absolute. Prior to 2022, Russia was an important market for Belarusian exports (about 40 percent), the single energy supplier, and de facto the lender of last resort. To date, Russia’s role has expanded dramatically. The share of exports to Russia has increased up to about 65 percent. Moreover, the majority of the remaining 35 percent is exported with the assistance of or through Russia, using Russian infrastructure. Therefore, it would be fair to argue that Russia in some form “controls” roughly 90 percent of Belarusian exports. Further, being Belarus’ sole energy supplier, Russia has increased its significance for Belarus through expanded energy subsidies. The size of the energy subsidies reached a historical high in 2022, and the mechanism of the energy subsidies has become a cornerstone for macroeconomic stability in Belarus. Furthermore, Russia has turned out to be the only effective creditor for Belarus. Overall, Russia has accumulated a significant number of tools to undermine Belarus at any given moment.

A democratic transition or at least deprival of power of the Lukashenka regime might therefore not be sufficient preconditions for breaking the economic deadlock. Even if domestic political will to do so should emerge, the risk that Russia will successfully suppress it using the above outlined economic tools is very high. Hence, apart from a democratic transition, the way out of the economic stalemate requires a way out of the political stalemate. This seems to only be possible through either a politically weakened Russia, and/or an external political force, allied to the Belarusian democratic forces, and strong enough to suppress Russia.

Conclusions

Recently, the narrative on the Belarusian economy has changed. The prevailing expectations of a large and prolonged recession has been substituted by expectations of a gradual recovery. The narrative ‘the jig is up’ has somehow been crowded out by the ‘more good than bad’ viewpoint on the Belarusian economy. However, these narratives are not mutually exclusive. Behind the current ‘more good than bad’ viewpoint on the Belarusian economy, a severe economic and political deadlock prevails. Moreover, future economic and political deadlocks are the actual price being paid for the recent survival and recovery of the Belarusian economy.

From a positive perspective, the economic and political deadlock means that the country is likely to, at least, be bogged down in stagnation. Belarus’ total dependency on Russia makes the country hostage to Russia’s political preferences and country-specific risks. Should Russia decide to exert further economic and/or political influence over Belarus, it is likely to succeed. Consequently, any economic downturn faced by Russia would automatically impact Belarus.

From a normative perspective, breaking the economic and political deadlock might be the only solution, and for this, the order might matter. Prior to 2020 there was a widespread opinion that breaking the economic deadlock must be prioritized, and that it could – in turn – break the political deadlock. As of now, the tables have turned. The current order postulates the political deadlock comes first, as it seems to be the only way of breaking the economic stalemate. However, breaking the political deadlock appears to require external political will.

With these conclusions in mind, the recent Belarusian democratic forces’ manifest regarding Belarus’ EU membership aspiration, deserves attention (BDF, 2023). At first, such aspiration might appear schizophrenic given the actual political situation inside of the country. However, taking a Belarusian EU membership serious (within the EU and among Belarusians) might be the answer to Belarus’ political and economic deadlock. From this perspective, the task for the Belarusian society is thus to convince EU counterparts that this is not madness, but rather a feasible solution. It is rather evident why this solution is both desirable and feasible for the Belarusian society. The main question to be answered is therefore whether, and why it would be desirable and feasible for the EU.

References

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

The Russian economy under Putin (so far)

Posted on March 15, 2018 | Policy Brief

20121229 Accountability in Russia Image 02

Russians are heading to the polling booths on March 18, but where will the economy head after Putin has been elected president again? This brief provides an overview of the economic progress Russia has made since 2000 as well as an economic scorecard of Putin’s first three tenures in the Kremlin and uses this to discuss what can be expected for the coming six years. Although significant growth has been achieved since 2000, all of this came in the first two tenures of Putin in the Kremlin on the back of increasing oil prices. In order to generate growth in his upcoming presidential term, Putin and his team will need to address the significant needs for reforms in the institutions that form the basis for modern market economies. Otherwise, Russia will continue to be hostage to the whims of the international oil market and eventually lose most of its exports and government revenues as the world moves towards a carbon free future. Perhaps this is beyond the scope of Putin as president, but not beyond the horizon of young Russians that will be casting their votes on Sunday and in future elections.

Let’s assume that Putin will be elected president again on March 18 (for once a very realistic assumption made by an economist). What will this mean for the Russian economy in the coming six years given what happened during his previous and current tenures in the Kremlin? To assess the future as well as to understand Putin’s power and popularity, this brief starts by looking back at the economic developments in Russia since Putin first became president.

Although many different factors enter the power and popularity function of Putin, economic developments have a special role in providing the budget constrain within which the president can operate. A higher income level means more resources to devote to any particular sector, project, voting group or power base. This is not unique to Russia, but sometimes forgotten in discussions about Russia, that often instead only focus on military power or control of the security apparatus and media. These are of course highly relevant dimensions to understand power and popularity in Russia, but so is economic development, particularly in the longer run.

Russia’s economy in the world

The economic greatness and progress of a country is usually assessed in terms of the size of the economy, how much growth that has been generated, and how well off the citizens are relative to the citizens of other countries. So, by our common indicator gross domestic product (GDP), has Russia become a greater and more powerful country since Putin first became president? Table 1 shows two things, the absolute level of GDP measured in USD at market exchange rates and the rank this gives a country in a sample of 192 countries in the world that the IMF collects data on (this brief is too short for a long discussion of the most relevant GDP measure, but GDP at market exchange rates makes sense when comparing the economic strength of countries in a global context, Becker 2017 provides a discussion of alternative measures as well). When Putin become president for the first time in 2000, the value of domestic production was estimated at $279 billion, which implied a 19th place in the world rankings of countries’ GDP. In 2016, almost three presidential terms of Putin later, Russia’s GDP had increased by 4½ times to $1281 billion and its ranking improved to 12th place in the world. This clearly is an impressive record by most standards. However, the Russian economy is still the smallest economy of the BRIC countries and corresponds to only 7 percent of the US economy in 2016. In other words, impressive progress by Russia but the country is (still) not a global superpower in the economic arena.

Table 1. Russia in the world (GDP in USD bn)

Source: IMF (2017)

For the average Russian, income per capita is a measure more closely connected to consumption and investment opportunities or ‘welfare’. Progress in this area is also more likely to affect how individuals assess the performance of its political leaders. Of course, progress in terms of overall GDP and GDP per capita is closely linked unless something unusual is happening to population growth. Therefore, it is not surprising that GDP per capita also increased by around 4½ times between 2000 and 2016 (Table 2). This is the first order effect of the economic development in Russia, but in addition, citizens of Russia moved up from a world income rank of 92nd to 71st. This has implications when Russian’s compare themselves with other countries and can in itself provide a boost of national pride.

It also directly affects opportunities and status for Russians visiting other countries. Being at place 71 may not be fully satisfactory to many, but we should remember that due to the rather uneven income distribution in Russia, many of the people that travel abroad are far higher up on the global income ranking than what this table indicate. Nevertheless, Russia is far behind the Western and Asian high-income countries in terms of GDP per capita. And although the picture would look less severe if purchasing power parity measures are used, the basic message is the same; Russia has still a lot of catching up to do before its (average) citizens enjoy the economic standards of high-income countries.

Table 2. Russian’s in the world (GDP/capita)

Source: IMF (2017)

The macro scorecard of Putin

So what generated the impressive 4½ times increase in income in USD terms from 2000 to 2016 and can we expect high growth during Putin’s next six years in office? The short answer to the first question is the rise in international oil prices and to the second question, we don’t know. Table 3 provides a comparison of different economic indicators for Putin’s two first terms in office compared with his current term (where GDP data ends in 2016 so the sample is cut short by a year). It is evident that the impressive growth over the full period is entirely due to the strong growth performance in the first two presidential tenures. Rather than generating growth in the most recent period, the economy has shrunk. This is explained by the evolution of international oil prices, which quadrupled in the first eight years and instead halved in the more recent period. These swings in oil prices have also been accompanied by significant shifts in foreign exchange reserves, the exchange rate, and the value of the stock market.

In Becker (2017) I discuss in more detail the importance of international oil prices in understanding the macro economic development in Russia. In particular, it is important to note that it is changes in oil prices that correlate with GDP growth and other macro variables and that the problems with predicting oil prices makes it very hard to make good predictions of Russian growth.

Table 3. A macro scorecard of Putin in office

Source: Becker (forthcoming)

Policy conclusions

To break the oil dependence and take control of the economic future of Russia, the president will need to implement serious institutional reforms that constitute the basis for a modern, well-functioning market economy in his next term. Otherwise, Russia will continue to be hostage to unpredictable swing in international oil prices and nobody—including the president, the central bank, the IMF and financial markets—will be able to predict where the Russian economy is heading in the next couple of years.

Figure 1. Reforms (still) needed

Source: World Bank (2017)

In the longer run, the prediction is much easier. With the world moving towards a green economy, the price of oil will see a structural decline that will rob Russia (and other oil exporters) of most of its export and government revenues. The reforms which basically every economist agree are needed are related to market institutions and Figure 1 provides a clear illustration of key reform areas. The progress during Putin’s years in office has been modest at best. Swedish institutions in 2016 have been added to the figure as a comparison and it is clear that the institutional gap between Russia and Sweden is significant. Of course, all countries are different, but Russian policy makers that are interested in reforming its economy are most welcome to Sweden for a discussion of what we have done to build our institutions.

References

  • Becker, T. (2017). ‘Macroeconomic Challenges’, in Rosefielde, S., Kuboniwa, M., Mizobata, S. and Haba K. (eds.) The Unwinding of the Globalist Dream: EU, Russia and China, Singapore: World Scientific Publishing.
  • Becker, T. (forthcoming), ‘Russia’s economy under Putin and its impact on the CIS region’, Chapter 2 in T. Becker and S. Oxenstierna (eds.) Perspectives on the Russian Economy under Putin, London: Routledge.
  • IMF (2017), World Economic Outlook database, April 2017 edition available at http://www.imf.org/external/pubs/ft/weo/2017/01/weodata/index.aspx
  • World Bank (2017), Worldwide Governance Indicators (WGI), 2017 update available at http://info.worldbank.org/governance/wgi/index.aspx#home

The Determinants of Renewables Investment

Posted on November 13, 2017 | Policy Brief

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On the 24th of October, SITE held the first of its series of Energy Talks, replacing what for one decade had been known as SITE Energy Day. For this first edition, SITE invited Thomas Sterner, Professor of Environmental Economics at the University of Gothenburg to give a presentation under the headline of “Technological Development, Geopolitical and Environmental Issues in our Energy Future”. To comment on the presentation, Leonid Neganov, Minister of Energy of Moscow Region, and Karl Hallding, Senior Research Fellow at the Stockholm Environment Institute (SEI), had been invited. This policy brief reports on the important subjects presented by our guests as well as the discussion that took place during the event.

From climate change concerns to climate change targets

Thomas Sterner began his presentation by addressing the well-known issue of climate change, a constantly current topic.

Different versions of Figure 1 (below) have been used extensively by those discussing climate change over the last decades, most notably by the previous US President Al Gore in his 2006 documentary “An Inconvenient Truth”. It shows the concentration of CO2 (carbon-dioxide) in the atmosphere over the past 400,000 years. There is wide agreement within the scientific community that the emissions of greenhouse gases (GHG), such as CO2, methane and nitrous oxides, have led to the shifting weather patterns and increased temperature over the past century (NASA, 2017).

Figure 1. Level of CO2 in the Atmosphere

Notes: The vertical red line is the Keeling curve, showing how the concentration has changed since 1958. Source: Allmendinger, 2007.

Predicting the impact of these emissions is far from an exact science: the temperature increases are likely to be unevenly spread across the world as shown in Figure 2. Some areas are likely to be particularly afflicted, especially coastal lowlands susceptible to flooding and semi-arid areas where droughts can become more likely. Unless current emission levels start to decrease, we are likely to observe severe results of climate change within 20 years, such as displacement and increased migration in the wake of extreme weather (NIC, 2016). For instance, adverse health effects in China, or decreasing productivity in South-East Asia, have already become apparent due to current increased temperatures (Kan, 2011; Kjellstrom, 2016).

Figure 2. Predicted Temperature Increase

Source: IPCC, 2013.

To tackle this issue and its negative economic impacts, many policy makers have agreed to replace fossil fuels with renewables. Renewables is the collective term of energy sources that have a neutral or negative net-effect of GHG emissions and are extracted through resources that are continuously replenished, e.g. solar, wind and hydro power, and biomass energy.

As the issue of climate change is a global one, the transition to renewables needs to be global too. International climate agreements have hence long been the accepted norm to approach climate change issues. The Paris Agreement is currently the guiding principle, in spite of the announcement of the Trump administration to withdraw the United States. Though instrumental in creating a momentum in the transition to lower levels of GHG emissions, it comes with many flaws. Its goal of a maximum average temperature increase of 2°C might be considered radical given current levels. However, the policy instruments that the target depends on – the Intended Nationally Determined Commitments (INDCs) – shift the responsibility to individual nations and remove the global responsibility. As Thomas Sterner pointed out, the first three words of this acronym remove indeed any binding force, and elementary game theory tells us that it will be hard, not to say unlikely, for all signatories to remain cooperative in achieving the target of 2°C.

Investing in renewables: from political choice to competitive choice

As stated above, investing in renewables is a necessary condition to achieve climate change targets. Indeed, there are some countries that have pushed the development of renewables with the aim to reduce the fossil fuel dependency to a minimum level in a very near future (see Figure 3). However, most of these investments are currently driven by political will. A natural question is whether renewables technologies can be competitive.

It is a fact that costs of renewables have been severely decreased in the last decade (Timmons et al., 2014). However, as Thomas Sterner mentioned, the cost of renewables and of fossil fuels are still very place and time specific and depends on the scale. Investments in renewables are growing and solar and wind power have both seen production capacities increasing markedly yearly over the last years (GWEC, 2016; IEA, 2017a). However, coming from an initial low level, it will take some time before we will be able to rely on them.

Even with massive investments and decreasing generation costs, the intermittent nature of most renewable energies will still impede the competitiveness of renewables. Solar and wind power are the technologies where most of the development has been centred (Frankfurt School-UNEP Centre/BNEF, 2017). They are highly weather dependent and electricity production from these sources cannot be secured all of the time. This makes countries dependent on backup technologies. In some countries, the obvious answers to these challenges have been hydro and nuclear power. Both technologies have their respective drawbacks though.

Figure 3. World’s Top 10 Investors in Renewable Energy in 2016

Notes: New Investments $BN, Growth on 2015. Source: Frankfurt School-UNEP Centre/BNEF, 2017.

Hydro power requires a geography that allows for dams, which in turn change the nature markedly around them and may not be available during drought periods. Nuclear energy has surrounding safety aspects that most recently came to light with the 2011 Fukushima Daaiichi nuclear disaster, leading Germany to decide to shut down all of its 17 reactors by 2022 (25 % of the country’s electricity production). Moreover, it may also be technically difficult to have nuclear as a backup technology given the associated ramping and start-up constraints.

Two further remarks on the intermittency problem can be made. First, this problem is likely to become more severe when policymakers push for large-scale electrification (c.f. EU Energy Roadmap established in 2011). For example, the full electrification of transport or heating sector will drive up the demand for and consumption of electricity. As this happens, the need for something to secure constant energy access will increase.

Second, only the development of technologies that allow electricity storage could solve this issue permanently. However, the current technological progress regarding batteries’ capacity cannot yet offer the solution (J. Dizard, 2017).

Oil price, a reference price

Another important aspect stressed by Thomas Sterner was to take into account the significant role of fossil fuel prices. Although identifying an optimal oil price for a fossil-free future is not a straightforward procedure, as discussed during the event.

The high price of oil during the late 00s and early 10s stimulated the development of alternative technologies. As awareness of climate change and its effects increased among policy makers and the general public, there was a momentum to push for the development of renewables.

As investments in renewables went up, so did investments in another less green technology: hydraulic fracturing, or fracking. In the 10 years between 2005 and 2015, the United States alone saw the extraction of shale gas and oil to increase six-fold. (EIA, 2016) In part to maintain a market share, OPEC countries exceeded their own set production limits and oil prices tumbled from around $100 per barrel to around $50 (Economist, 2014).

With roughly three years behind us of somewhat stable and low oil prices, the question is what the implications of this are. It makes it more difficult to phase out fossil fuels as demand for them goes up, depressing efforts put into the research and deployment of renewables. Energy efficiency also becomes less important, driving up waste and stopping investments in energy conservation.

On the other hand, with low oil prices, investments in the fossil-fuels industry are also less likely to take place. Keeping resources in the ground becomes more palatable as profit margins are pushed down. This, in turn, is likely to have a positive effect on environment by decreasing the level of GHG emissions.

The invited guests, Leonid Neganov and Karl Hallding spoke more in depth about two central countries that contribute in shaping global environmental policy.

The local conditions, Russia and China examples

As the world’s fourth largest supplier of primary energy and the largest supplier of natural gas to the EU (IEA, 2017b), Russia presents an interesting case to observe as a country supplying fossil fuels. Leonid Neganov, Minister of Energy of Moscow Region, commented on the current policy direction of the country. He explained that non-renewable, GHG emitting energy sources make up a majority, roughly 60% of the Russian energy balance. The rest is provided by more or less equal shares of nuclear and hydro power. New renewable technologies make up a miniscule share of an estimate 0.2% of the current total.

According to Neganov, in the coming 20 years, we should not expect to see too much of a change. Though total output is expected to increase, the share of GHG-neutral energy will remain more or less constant, though the share of renewables are set to increase to 3% according to the current drafts of Russian energy policy. A more pronounced transition to other energy sources are more likely in a longer perspective towards 2050, even though circumstances may naturally change over the coming decades.

Other available information also points to that Russia has decided to tackle the shift in consumption of its major market in Europe by widening its geographic reach. Massive infrastructure investments, such as the Altai and TurkStream gas pipelines, will enable Russia to more easily reach markets that are currently beyond any practical reach.

With the Altai pipeline, Russia will be able to provide China with natural gas at a much greater level than before. China being by far the largest producer of coal sees an opportunity to shift away from the consumption of a resource that during winters causes its major cities to periodically become enveloped in clouds of smog and at the same time also decrease its GHG emissions. The environmental benefits of natural gas as opposed to coal should not be exaggerated though. Thomas Sterner pointed out that methane, the main compound of natural gas, is a considerably more potent GHG than CO2. A total leakage of an estimated 1% negates the environmental benefits, he said.

Karl Hallding, Senior Research Fellow at SEI, particularly stressed the need to look at China. It is the supplier of half of the world’s coal, extraction levels remain high. (BP, 2017) Domestic consumption is decreasing but consumption of Chinese coal is, however, more likely to shift geographic location rather than to be left in the ground, said Hallding. Through massive infrastructure investments, such as the New Silk Road, and in energy production in Sub-Saharan Africa, China spreads its influence (IEA, 2016). By exporting emissions, the impact at the global level will not change.

References

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Russia and Oil — Out of Control

Posted on October 31, 2016 | Policy Brief

Free Policy Brief Image - Russia and Oil — Out of Control

Russia’s dependence on oil and other natural resources is well known, but what does it actually mean for policy makers’ ability to control the economic fate of the country? This brief provides a more precise analysis of the depth of Russia’s oil dependence. This is based on a careful statistical analysis of the immediate correlation between international oil prices — that Russia does not control — and Russian GDP, which policy makers would like to control. I then look at how IMF’s forecast errors in oil prices spillover to forecast errors of Russian GDP. These numerical exercises are striking; over the last 25 years oil price changes explain on average two thirds of the variation in Russian GDP growth and in the last 15 years up to 80 percent of the one-year ahead forecast errors. Instead of controlling the economic fate of the country, the best policy makers can hope for is to dampen the short-run impact of oil price shocks. A flexible exchange rate and fiscal reserves are key volatility dampers, but not sufficient to protect long-term growth. The latter will always require serious structural reforms and the question is what needs to happen for policy makers to take action to get control over the long-term fate of the economy.

In a recent working paper (Becker, 2016), I take a careful look at the statistical relationship between Russian GDP and international oil prices. This brief summarizes this analysis and its policy conclusions.

Russia and oil, the basics

Although Russia’s oil dependence is discussed every time international oil prices drop, it is not uncommon to hear that oil is not really so important for the Russian economy. The argument is that the oil and natural resource sector only accounts for some 10 percent of Russian production. This is indeed consistent with the official sectoral breakdown of GDP that is shown in Figure 1 where the minerals sector indeed only has a 10 percent share.

Figure 1. Structure of GDP in 2015

slide1Source: Federal State Statistics Service, 2016

However, this static picture of production shares does not translate into a dynamic macro economic model that allows us to understand what is driving Russian growth. Instead a careful analysis of the time series of Russian GDP is required to understand how important oil is for growth.

Russian GDP can be measured in many different ways: nominal rubles, real rubles, U.S. dollars, or in purchasing power parity (PPP) terms to mention the most common. Here we focus on GDP measured in real rubles and U.S. dollars since we want to get rid of Russian inflation, which has been quite high for most of the studied time period. The PPP measure generates figures and numerical estimates that are in between the real ruble and U.S. dollar measures and are not included here to conserve space.

The first evidence of the importance of international oil prices as a major determinant of Russian income at the macro level is presented in Figures 2 and 3 where the first figure shows dollar income and the second real ruble income. In both cases it is obvious that there is a strong correlation and that the correlation is higher for income measured in dollars.

Figure 2. U.S. dollar GDP and the oil price

slide2Source: IMF, 2016

Figure 3. Real ruble GDP and the oil price

slide3Source: IMF, 2016

However, it is also clear that all the time series have some type of trends or in econometric language, are non-stationary. This means that simple correlations of the time series shown in Figure 2 and 3 may not be statistically valid (or “spurious” as it is called in the literature). This is not a critical issue but can be handled by regular econometric methods.

Russia and oil, the econometrics

When time series are non-stationary they need to be transformed to some stationary form before we can do regular regressions (in Becker, 2016 I also address the issue of using a framework that allows for co-integration).

Two transformations that make the variables stationary are to use first differences or percent growth rates. Both are used before we run simple regressions of growth or first differences of GDP on growth or first difference in international oil prices. The full sample starts in 1993, but since the early years of transition were subject to many different shocks at the same time, a shorter sample starting in 2000 is also used.

A number of observations come from the estimates that are presented in Table 1: Oil prices are always statistically significant; the adjusted R-squared is higher for dollar income than real rubles (with one exception due to a large outlier in 1993); overall the explanatory power of these simple regressions are very high (42-92 percent) and the explanatory power increases in all specifications when going from the full sample (1993-2015) to the more recent sample (2000-2015). Note that the latter sample perfectly overlaps with the current political leadership so contrary to some wishes; the oil dependence has not been reduced under Putin/Medvedev.

Table 1. Russian macro “models”

slide4Source: Becker 2016

Russia and oil, the forecasts

The strong correlation between international oil prices and Russian GDP provides a very simple econometric model for explaining past variations in Russian GDP. Unfortunately it does not imply that it is easy to forecast Russian GDP since international oil prices are very hard to predict. There are many models that have been used to forecast oil prices, but the IMF and many others now use the market for oil futures to generate its central forecast of oil prices.

The IMF also provides confidence intervals around the central forecast, and the uncertainty surrounding the forecast is substantial: In the latest forecast the 68 percent confidence interval goes from around 20 dollars per barrel to 60 one year ahead, while the 98 percent interval ranges from 10 dollar per barrel to around 85. With oil currently around 45 dollars per barrel, these variations imply that oil prices could either halve or double in the next year, not a very precise prediction to base economic policy on for Russia since the estimates for real ruble growth in the later sample in Table 1 imply that Russian GDP growth in real ruble terms could be anywhere from minus 5 to plus 10 percent, or a fifteen percentage point difference!

If we look at past IMF forecasts of oil prices and Russian GDP and see how much they deviate from actual values a year later we can compute one year ahead forecast errors. We can do this calculation for the last 16 years for which the IMF data is available. Figures 4 and 5 show how the forecast errors in oil prices correlate with the forecast errors for dollar income and real ruble income, respectively. Similar to the regressions presented in Table 1, the correlations are very high for both measures of GDP: 82 percent for dollar GDP, and 65 percent for real ruble GDP.

In other words, a very large share of the uncertainty surrounding Russian GDP forecasts can be directly attributed to variations in international oil prices, a variable that (again) Russia does not control. The fact that the variations in oil prices explain somewhat more of the variation in dollar income compared to real ruble income is a result of a policy change that in later years allowed the exchange rate to depreciate much more rapidly when oil prices fall.

Figure 4. Forecast errors

slide5Source: Becker 2016

Figure 5. Forecast errors

slide6Source: Becker 2016

Policy conclusions

The depth of Russia’s oil dependence is much greater than what casual observers of the mineral sectors share of GDP would suggest. At the macro level, variations in international oil prices explain at least two thirds of actual Russian growth and even more of the one-year ahead forecasts errors.

The experience of the 2008/09 global financial crisis provided an important lesson to Russian policy makers, which is that exchange rate flexibility is required to dampen the real impact of falling oil prices and to protect both international reserves and the fiscal position. In the more recent years, the currency has been allowed to depreciate in tandem with falling oil prices and the drop in real ruble income was therefore less severe in 2015 than in 2009. Income in dollar terms, instead, took a greater hit, but this was a necessary corollary to protecting reserves and the budget. A flexible exchange rate and gradual move to inflation targeting in combination with accumulating fiscal reserves in times of high oil prices are key to Russia’s macro economic stability.

Nevertheless, these policies are not sufficient to remove the long-run impact that low or declining oil prices will have on growth, measured both in real ruble terms or dollar terms. It is nice to have fire insurance when your house burns down, but when you rebuild the house you may want to consider not building another straw house. For Russia to build a strong economy that is not completely hostage to variations in international oil prices, fundamental reforms that encourage the development of alternative, internationally competitive, companies are needed. This includes reforms that initially will reduce policy makers control over the economy and legal system, but over time it will provide the much needed diversification away from exporting oil that puts the fate of the Russian economy squarely in the hands of international oil traders. Losing some control today may provide a lot more control in the future for the country as a whole, but perhaps at the expense of less control for the ruling elite.

References

Natural Resources, Intangible Capital and Sustainable Development in a Small, Oil-Rich Region

Posted on December 3, 2012 | Policy Brief

20121203 Natural Resources, Intangible Capital and Sustainable Development Image 01

“Where scientific enquiry is stunted, the intellectual life of a nation dries up, which means the withering of many possibilities of future development.” – Albert Einstein, 1934 The rampant unemployment rates and the general contraction of economic activity in many western countries rekindled the fear of emigration and brain drain, which for a while seemed to be exclusively a developing-world problem. This brief illustrates a potential new approach to the issue, through a recent experience in a small but oil-rich region of Southern Italy. 

Economic Growth and Brain Drain

Since the times of Solow, economic theory represents growth as the result of a process not unlike some sort of portfolio management. Just like any individual investor, countries own and need to manage certain assets, characterized by different properties and returns: some are exhaustible, others are renewable or living, and ensure a sustained stream of income.  In the original formulations, the economy’s productive assets were identified in land, capital and labor, to which human capital was soon added. In 2006, the World Bank published estimates of 120 countries’ total wealth, in an attempt to introduce a broader view of what these assets really are [1]. The report classified a country’s capital into three main types: natural, produced (physical) and intangible. A striking pattern emerged. While the share of produced assets in total wealth is virtually constant across income groups of countries, the share of natural capital tends to fall with income, and the share of intangible capital rises. This means that rich countries are largely rich because of the skills of their populations and the quality of the institutions supporting economic activity.

There is an important relation between the different types of assets. In order to avoid illusory and temporary growth based on consuming the readily available natural capital, efficient management through saving and investment can transform one type of asset into another, achieving sustainability over time. Although this may sound as no big news, the analysis of the actual savings and rates of growth in the different form of capital reveals far from ideal situations all over the world. In many resource-rich developing countries, savings rates have been negative for many decades, meaning that resource rents have been at best used for consumption. In the worst cases, they have fueled corruption and private enrichment of small elites, as highlighted by the extensive literature on the “resource curse”.

Also, renewable natural resources are often exploited in an unsustainable fashion. One case in point is the thorny issue of fish stocks, but many more examples are discussed in the literature on ecosystem services. Even the intangible capital is under stress in many places. In the wording of the 2006 World Bank report, “intangible assets include the skills and know-how embodied in the labor force; social capital, that is, the trust among people in a society and their ability to work together for a common purpose; all those governance elements that boost the productivity of labor: an efficient judicial system, clear property rights, and an effective government.” Probably the first component in the list, what is traditionally indicated with the term human capital, is the most tangible, observable and relatively controllable part of it.

Controlling the Brain Drain?

Although there are many arguments in favor of international careers and general workforce mobility,[2] some regions experienced negative and prolonged net outflows – emigrants minus immigrants – to the extent that they now face a real risk of hold ups in their economic development. This, due to shortages of vitally needed high-skilled personnel. Even the economic sustainability of many basic services and businesses is in doubt due to the shrinking customer base.

Southern Italy is one of these regions. The net outflow of people with a bachelor or higher degree is negative[3] even at the national level,   -2% over the latest ten years. In southern Italy, with a population of just above 13 million, the net balance of emigrants and immigrants over the same period amounts to -630,000. 70% of these people are aged between 15 and 34, and 25% hold at least a bachelor degree. To this figure, which is based on changes in official residence and therefore grossly underestimates the real size of the phenomenon, must be added the 150,000 that on average every year join the flow of internal migrants or long-distance commuters from the south to Northern Italy. Among these people, 47% are aged between 15 and 34, and almost 30% hold a bachelor or higher degree. The reason for these massive outflows can be identified in the labor market dynamics. If we break down the average 22% decline in job creation for youth between 2008 and 2011, new hires declined by 30% for youth with a bachelor degree and 14% for higher degrees, against 11% decline for youth with only secondary education.[4]

As opposed to physical capital, recent research shows that loss of human capital can have long lasting crippling consequences for economic growth (Waldinger, 2012). Among the policies that have been tried in order to stop or counterbalance the brain drain, a first set targets human capital as embodied in the workforce, i.e. tries to attract highly trained people. Probably the most popular are economic incentives in the form of tax rebates, higher wages or other job-related benefits and amenities. This kind of incentive regime exists in Italy since December 2010, though only targeting Italian nationals. However, for many high-skilled professionals, the important factors are others, such as a generally innovative and creative environment, a network with a critical mass, a transparent and competitive labor market not contaminated by politics, high quality support services, and other conditions that are not as easy and cheap to modify. Some countries have played the card of instead attracting prestigious foreign schools to their national territory to prevent their brilliant youth from leaving in the first place. Many famous western universities have already initiated partnerships with or lent their names to schools and universities in these countries and even built replicas of themselves – mostly in Asia – so as to get a toehold in the world’s largest education market, or in the Gulf States, where financial resources abound. There are successful examples of such partnerships in Italy, too.

A different approach has been taken by the new government, with the realization that the country can benefit from the pool of expatriated talents without moving them permanently back. A program of facilitation for visiting scholars and exchange students was thus launched in September 2012. But a step even further is actually possible. A network of scholars and high-skilled professionals that want to contribute to the development of a particular country or region, for example their place of origin, does not require physical presence on the territory, and not even any formal or institutional bond. The only needed ingredient is the Internet. Not removed from the environment and the conditions where they achieved success, these people can actually contribute even more. This is the idea behind, for example, Innovitalia.net and other smaller independent initiatives inspired by the concept of crowd-sourcing.[5]

The Experience of Basilicata

I recently witnessed (what I hope is) the birth of one such network in the region where I am from. Basilicata, also known as Lucania, is a small, poor region of less than 600,000 inhabitants scattered across 131 different municipalities on a territory of barely 10,000 squared kilometers, between the heel and the toe of the boot that the Italian peninsula resembles. Here, the crisis hit especially hard and migration outflows are since then even stronger, especially among youths.  According to SVIMEZ (a think tank focused on entrepreneurship and economic activity in Southern Italy), Basilicata has lost 10% of its regional GDP since 2007, much more than the national average of -4.6%. Compared to other large European economies, Spain is currently at -2.7, while Germany and France, notwithstanding the low annual growth rates, are now back at the same level as in 2007. The youth employment rate (with the generous definition of 15-34) is alarmingly low at 30%, down by 15% since 2007, and only 24% for women. As a result, the consumption level of 27.5% of families is now below the poverty threshold, compared with 11% of families at the country level.[6]

Enter Europe’s largest onshore oil and gas reservoir; about 150,000 oil barrels are extracted in Basilicata every day, covering 12% of the national oil demand. The exploitation started in the late 1990s, although the reservoir has been known since at least the 1970s. It is expected that these oil fields will be operational until 2022, but at least one more reservoir with about the same estimated capacity remains unexploited. The regional government has for the time being blocked any new concession, hoping perhaps to negotiate better conditions. The truth is, there have been strong concerns – related to lack of transparency and in some cases to alleged corruption – voiced at the actual quantities of extracted oil and what is a fair distribution of revenues. After more than 10 years, it is hard to claim any major social impact of the project:  there is a clear lack of funds to invest in local small and medium size businesses and, as observed above, unemployment in the area remains a problem while the regional population has plummeted.

Is this a case of “resource curse”? Not really. There is no clear evidence of corruption, or elite capture – the problem seems to be mostly poor management and a lack of ideas, mixed with the deeply rooted penchant of local politics for populism and the clientela system (patronage). To give an idea, creativity in using the oil money did not go much beyond the restoration of many of the small town’s pavements and facades. In 2009, in line with the so called “Development Action Plan” of the Berlusconi government, an 80 euro lump sum was distributed to all residents. After the crisis hit harder, the royalties have also been used to cover holes here and there in the current account. Data from the Ministry for Economic Development shows that capital investment in the region went down by 8.5% per year between 2008 and 2011, while current expenditure went up by 3%. Going back to the importance from the growth perspective of savings and investment versus consumption, it is worth remarking that current expenditure is (in most part) consumption.

Can this bounty instead become an answer to Basilicata’s troubles? This was the question driving the first Sustainable Development School, held at the end of October in Viggiano, a small town in the center of the oil field, hosting 23 oil wells. Sponsored by a number of institutions and associations, local or national,[7] the event attracted a group of 45 economists, sociologists, managers and entrepreneurs, engineers and culture sector specialists, in most part born in Basilicata and working or studying abroad. Seven of these participants were instead citizens of various countries in the Middle East and North Africa region, working or studying in Basilicata. This heterogeneous group worked together for two days on concrete proposals to be put on the administrator’s tables, in five main areas: Regional Economy in the new Euro-Mediterranean context, Energy and natural resources, Environmental protection, Infrastructure for environmental protection, Promotion of the historical, cultural and social heritage. Given the context, most projects focused on alternative proposals for how to use the royalties. The keyword was, however, sustainability. Everybody was well aware of the fact that for them to last longer than oil itself, these resources must be saved and earmarked to some productive use that, leveraging on other locally abundant resources, can start off a process of self-sustained development. The projects highlighted the stimulation of local small-scale entrepreneurship and the creation of employment opportunities as necessary ingredients for a fairer sharing of the revenues but most importantly for long-term sustainability.

Many local resources, not fully utilized at present, were brought in as examples: the abundant wood, the underexploited waterways, even the wastewater from bigger agricultural and animal farms, connected to the potential for small-scale generation of energy from renewable sources. On a slightly different note, the list continued with the historical and cultural heritage, natural beauty and the religious and culinary traditions that could support a much more developed tourism industry than what it does today. All of this, in the proposals of the participants, has the potential to support profitable businesses that bring employment to the community. This ingredient is considered crucial, in the perspective that the long-term survival of any (business) initiative requires tying its success to the welfare of the local communities. The focus was thus overwhelmingly on private initiative, with the public confined to the role of investing partner and provider of supportive infrastructure (material and immaterial) and services.

Overarching is undeniably the question of institutional quality, needed as the underlying canvas to support whatever initiative we hope to see blooming.  A proposal that did not make it to the finals, though, involved the creation of a stable watchdog, either on local policies in general (and in particular on the use of the royalties) or more specifically focused on the environmental and health impact of the extractive activity. According to the more politically experienced participants, no administration would agree to finance an independent body with the explicit mandate to criticize them. Never mind that this type of institutions is common in other places. In Italy, the one body that currently operates with a watchdog function on the public administration, although limited to the financial aspect,[8] is facing threats of limitations of its powers. A lot remains to be learned. However, the perhaps most valuable outcome of this experience was, if not yet policy change at least a promising method to produce change, by mobilizing a latent ‘local’ resource and really transform oil rents in durable intangible capital.

References

  • Where Is the Wealth of Nations? Measuring Capital for the 21st Century. Washington, DC: The World Bank, 2006
  • The brain drain in Spain is mainly to Spain’s gain, The Economist, April 2012
  • The Inclusive Wealth Report 2012, Cambridge University Press, 2012
  • Rapporto sull’economia del Mezzogiorno, SVIMEZ, 2012
  • Peer effects in science: evidence from the dismissal of scientists in Nazi Germany, Waldinger, F., The Review of Economic Studies, 2012

[1] Updates on these figures for a subset of 20 countries can be found in the newly released Inclusive Wealth Report 2012 , sponsored by a number of UN agencies, the first of what is intended to be an annual report looking at a broad measure of wealth. From the report: “Wealth is the social worth of an economy’s assets: reproducible capital; human capital; knowledge; natural capital; population; institutions; and time.”

[2] The Economist recently pointed out that “[w]hat some call “brain-drain” may in fact be a win-win situation for Europe’s economies. […I]n the short run, migration takes away pressure from budgets as the unemployed don’t claim benefits but move [abroad] instead. In the long run, there is a pool of highly skilled workers who have not fallen victim to hysteresis effects and can be re-activated for the [home] economy once the crisis is over.”  However, it is not at all obvious that this migration is short-run, i.e. that these high-skilled workers will eventually go back. A survey of Italian scientists working aboard reveals, for instance, that the overwhelming majority excludes ever going back to Italy.

[3] The “import” of such people generally more than compensates the “export” in other big European countries.

[4] Source: SVIMEZ, 2012.

[5] A recent paper analyzing the experience of New Zealand (Davenport, 2040) reviews the waves of brain-drain response policies and calls this latest generation diaspora policies: “Diaspora policies are based on an assumption that many expatriates are not likely to return, at least in the short term, but represent a significant resource wherever they are located. This resource is not just embodied in the individual expatriate but also potentially includes their socio-professional networks. A key advantage of any diaspora option is that such connectivity initiatives do not require a large infrastructural investment in order to potentially mobilize this latent ‘national’ resource.”

[6] Source: ISTAT.

[7] Sponsors and partners included the municipal and regional administration, the Italian Institute for Asia and Mediterranean (ISIAMED) and its local branch, CeBasMed, the Val d’Agri National Park, the Regional Environmental Protection Agency, SVIMEZ and the University of Basilicata.

[8] The Corte dei Conti tribunal.

What Does Modern Political Economics Tell Us About the Fate of Russia’s Reforms?

Posted on September 5, 2011 | Policy Brief

20110905 Policy Brief Image Russia Kremlin Saint Basil Cathedral

After the 2008-09 crisis, Russia is facing a new set of challenges. The pre-crisis sources of growth have been exhausted. In order to implement its growth potential and catch up with OECD countries, Russia must improve its investment and business climate. Although the reform agenda has been repeatedly discussed, it is not being implemented. The explanation is provided by modern political economics: what is good policy (in terms of social welfare and growth) is not necessarily good politics (for a country’s rulers). In this sense, modern Russia is a perfect example of the non-existence of a political Coase theorem. Although everybody understands that the status quo is suboptimal, the most likely outcome is further postponement of reforms.

Whither Russia?

In 2009, the New Economic School joined the Russia Balance Sheet project launched by two DC-based think tanks: the Center for Strategic and International Studies and the Peterson Institute for International Economics. The aim of the project was to assess Russia’s assets and liabilities. Similarly to compiling a company’s balance sheet, the project estimated the potential for long-term development and growth, and the problems that could prevent Russia from realizing this potential.

The main output of the project in 2009-10 was the book “Russia after the Global Economic Crisis”, which was published in English in the Spring 2010 and in Russian in the fall of the same year. The book looked at a broad range of issues that could be classified as Russia’s “assets” and “liabilities”, extending from economic, political and social issues to energy, foreign relations, climate change, innovation and military reform. Interestingly, despite the breadth of the analysis, the authors of the book’s different chapters arrived at similar conclusions, which might be summarized as follows: while Russia came out of the crisis in a reasonably good shape and has nothing to fear in the near term, it has serious long-term problems that need to be addressed as soon as possible; however, it is, unfortunately, the case that Russia is unlikely to implement the required reforms, since they go against the interests of the ruling elite.

This argument is especially clear with respect to Russia’s economic problems – that Aleh Tsyvinski and I analyzed in the first chapter of the book. In the short run the Russian economy is certainly doing quite well. So long as oil prices stay high, the budget remains balanced, the economy grows, and sovereign debt is virtually non-existent (in marked contrast with debt burdens of OECD countries). Contrary to what is claimed by many critics of the government, pre-crisis growth did trickle down to all parts of Russian society, and that has ensured that the government enjoys sufficient political support.

However, in the long run, the situation is very different. The pre-crisis sources of economic growth (rising oil prices, low capacity utilization and an underemployed labor force) have all been exhausted. Oil prices are high, but are unlikely to rise much further. Production capacity and infrastructure are over-utilized. The labor market is very tight. In order to grow at the rates, which Korea and other fast-growing countries achieved when they were at Russia’s level of development, Russia needs new investment. Hence, Russia has to improve the business climate and the investment climate. This, in turn, depends on reducing corruption, improving protection of property rights, building an effective and independent judiciary, and opening the economy to competition (both domestic and international).

Good Policy, Bad Policy

The changes that are needed in order to ensure strong growth are obvious, but they are unlikely to happen. The reason is very simple: the political equilibrium is such that Russia’s political elite is not interested in change. There is nothing unusual about this. As Bueno de Mesquita et al. (2003) have argued: good policy may be bad politics and vice versa. If achievement of economic growth depends on surrendering control over the commanding heights of the economy (through privatization, strengthening the rule of law, deregulation, and encouragement of competition), the ruling elite may fear a weakening of its hold on power and ultimate loss of power as the price of achieving growth. In this case, the ruling elite will prefer to stay in charge of a stagnating economy (and enjoy a big piece of a small cake) rather than risk losing power (and having no piece of a bigger cake).

Can society somehow buy out the vested interests of the rulers? One of the most powerful theoretical results in economics, the Coase theorem, would suggest that the answer is yes. However, the conditions of the Coase theorem are not met in the instance of political economy, which we are considering. In our case the ruling elite does not merely trade goods or even assets: by allowing reforms it would lose the power to expropriate and protection from being expropriated. Unsurprisingly, there is no “political Coase theorem” (see Acemoglu, 2003).

As we discuss in Guriev et al. (2009), this problem is particularly acute in resource-rich transition economies without established political and legal institutions. In such economies, the lack of institutions means that the rulers are less accountable and can therefore appropriate a large share of the resource rents. The resource rents increase the incentives to hold on to power and provide the rulers with the resources which they need in order to maintain the status quo.

In the opening chapter of “Russia After the Global Economic Crisis”, Aleh Tsyvinski and myself argued that this is precisely Russia’s problem. We punningly defined the status quo as a “70-80 scenario”: if the oil price stayed fairly high ($70-80 per barrel) then Russia would be likely to follow the 1970-80s experience of the Soviet Union, when reforms were shelved and the economy stagnated. That period ended with the bankruptcy and disintegration of the Soviet Union.

Certainly, the differences between modern Russia and the 1970-80s Soviet Union are substantial. Although the government controls the commanding heights of the modern Russian economy, the nature of the latter is capitalist and not command. Also, Russian economic policymakers are much more competent and, unlike their Soviet predecessors, they can easily believe that if a country runs out of cash, the government is removed from office: they have seen it happen to those same Soviet predecessors.

This brings us to a conundrum: if it is clear that the status quo is a dead-end, what is the ruling elite hoping for? On the one hand, the elite understands all too well that reforms are risky – everybody remembers the last Soviet government, which initiated change and lost power as a result of that change. On the other hand, it is clear that in order to remain in power the government needs growth and that growth can only come from reforms.

Rational Overconfidence

The solution to this conundrum is to be found, not in modern political economics, but in the realm of behavioral economics and studies of leadership. In recent years, economists have been keen to integrate insights from psychology into their models of markets and organizations.

Psychologists know very well that human beings want to be happy, and are therefore disposed to forget bad news and remember only good news. They also like to persuade themselves that they are good (or at least better than others). This explains why investors always want to believe in more optimistic scenarios (hence bubbles, see Akerlof and Shiller, 2009). Furthermore, a certain degree of over-optimism on the part of leaders is actually “rational” or “optimal” (see Van den Steen, 2005, and Guriev and Suvorov, 2010). Over-optimistic leaders are more resolute, and they attract more capable and enthusiastic followers. In this sense, in an environment with weak political institutions, over-optimistic political leaders always crowd out more realistic leaders (who do not promise as much). Where there are strong political institutions that ensure political accountability (e.g. via political parties), this behavior is not sustainable. But if there is no accountability, over-optimism almost inevitably prevails as a result of political selection.

This may explain why the Russian political leadership hopes for the better. So far the model “whenever we are in trouble, the oil price goes up and saves us” has worked, and it will keep working until the oil price goes down and undermines both macroeconomic and political stability. Once again, resource abundance is important as it helps to feed the over-optimism: the fortunate leaders that rule during the period of high oil prices can easily believe that their luck is permanent and their belief (or, as the leadership literature calls it, “vision”) will be consistent with the evidence – but only until the oil price plunge.

The 70-80 Scenario: Two Years On

We started to write the 70-80 chapter in the fall of 2009, when the oil price was already back from $40 per barrel to the fiscally comfortable range of $70-80 dollars. What has happened since then to the likelihood and sustainability of our scenario?

What we find is that, although the 70-80 pun no longer works, our main argument has been reinforced. First, the oil price is no longer in the range of $70-80 per barrel, but has risen higher due to events in the Middle East and Japan, as well as increased demand for oil as a store of value reflecting diminished confidence in dollar and euro assets. Second, the Arab Spring has made the Russian government suspect that its hold on power is more tenuous than it previously believed, and it has started to spend even more aggressively. Russia’s budget is no longer in surplus at $70 per barrel: it can now only be balanced if the oil price is at $125 per barrel (!). In this sense, $70-80 per barrel is no longer a “high” price – it is both below the current market’s expectations and below the Russian government’s fiscal benchmarks.

However, our main argument has been reconfirmed. High oil prices have encouraged the Russian government to become further entrenched in the status quo scenario. While there has been a substantial increase in rhetoric about privatization, deregulation, competition, rule of law etc., actual change has been lacking. On the contrary, there is increasing reliance on government ownership and increasing probability that Russia will move further down the road to stagnation after the presidential elections of 2012.

Can There Be An Alternative to Stagnation?

In “Russia After the Global Economic Crisis” we also charted an alternative scenario based on reforms that help to realize Russia’s substantial growth potential. Is this scenario feasible? Certainly, the laws of political economy are not deterministic. Even though the status quo path is preferable for the country’s rulers, a leader (or a sub-group in the elite) may emerge who is long-term-oriented and is not over-optimistic. If this leader or group manages to create a critical mass of stakeholders for reforms, there may be a “run” on the status quo. For example, if the oil price decreases and there is fiscal pressure to privatize, then a critical mass of private owners may emerge who are interested in protection of property rights and the rule-of-law.

However, even though a positive scenario is possible, it is not very likely. Investors have already reached this conclusion: Russia has been experiencing large capital flight since the fall of 2010 (net capital outflow is about of 5% of GDP). Investors are not yet ready to bet their money on the good scenario. Nor would political economists recommend them to do so.

References

  • Acemoglu, Daron (2003). “Why Not A Political Coase Theorem? Social Conflict, Commitment, And Politics,” Journal of Comparative Economics, 31: 620-652.
  • Akerlof, George A., and Robert J. Shiller (2009). “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism”. Princeton University Press.
  • Åslund, Anders, Sergei Guriev and Andrew Kuchins (2010). Russia after the Global Economic Crisis. Peterson Institute for International Economics. Washington, D.C.
  • Bueno de Mesquita, Bruce, Alastair Smith, Randolph M. Siverson, and James D. Morrow (2003). “Logic of Political Survival”. MIT Press.
  • Gilbert, Daniel (2006). “Stumbling on Happiness”. Knopf.
  • Guriev, Sergei, Alexander Plekhanov, and Konstantin Sonin (2009). “Development Based on Commodity Revenues.” European Bank for Reconstruction and Development Working Paper No. 108. Available at SSRN: http://ssrn.com/abstract=1520630 (Also available as Chapter 4 in the Transition Report 2009).
  • Guriev, Sergei, and Anton Suvorov (2010). “Why Less Informed Managers May Be Better Leaders.” Available at SSRN: http://ssrn.com/abstract=1596673
  • Van den Steen, Eric J. (2005). “Organizational Beliefs and Managerial Vision.” Journal of Law, Economics, and Organization, 21: 256-283.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

A Multidimensional Approach to Energy Security in Belarus

Posted on September 5, 2011 | Policy Brief

20110905 Policy Brief Energy Security in Belarus Image 01

Energy security is a complex phenomenon incorporating a variety of economic, social and environmental aspects. This brief outlines fundamental aspects of energy security in Belarus that decision makers, policy analysts and the general public should be aware of when trying to understand the consequences for energy security of existing and suggested policies as well as other domestic and external factors. This brief will pay special attention to the economic dimension of energy security (such as energy intensity of the economy and diversification of energy sources), international and geopolitical dimension (diversification of energy suppliers and use of the hydrocarbon pipeline system), as well as environmental considerations (actual and prospective environmental impact of the energy consumption and production).

Energy security is an issue of primary concern for decision-makers worldwide. This is especially true in many post-Soviet countries, where the current dependency on Russian energy imports is being reinforced by the high energy intensity of these economies – a legacy of the energy inefficient Soviet technologies coupled with a lack of technological modernization over the past two decades. Belarus, a landlocked country with a population of 10 million people, is one of the countries struggling to solve an energy security puzzle in the midst of perturbations of the energy markets and important changes in regional geopolitics.

Belarus’ economy has been growing steadily in the early 2000s with an impressive 7.7% average annual GDP growth – a figure surpassing the economic performance of its closest post-Soviet neighbors, Ukraine (7.6%) and Russia (7.5%). The 2010 economic crisis resulting in substantial downturns in Ukraine (-15.0%) and Russia (-7.9%), had very mild impact on the Belarusian economy, which grew 0.2% in 2010.

Despite the apparent robustness of the Belarusian economy as compared to its neighbors, the crisis revealed a major weakness of the Belarusian economic model, the country’s utmost dependence on economic and political relations with Russia. Belarus is trying to move away from the Russia-centered economic model, in an attempt to diversify the sources of its economic growth. Not surprisingly, Russia is using a number of economic and political levers, of which oil and natural gas are the most important ones, in an attempt to tame a rebellious ex-vassal.

As a result, Belarus recently faced a variety of new energy challenges that must be successfully tackled for the country to preserve its political and economic independence.

The Belarusian Economic Growth Drivers

Belarusian economic growth in the late 1990s-early 2000s was primarily driven by the combination of three main factors: (i) privileged access to Russian markets for Belarusian industrial and agricultural exporters and energy importers; (ii) preferential support of the enterprises and sectors with a large state share, especially those producing for export, and (iii) governmental policies on wage and price control, which resulted in temporary cost advantages for traditional exports (WB 2005). These factors were reinforced by the low capacity utilization that experienced a sudden drop in the early 1990s as the Soviet Union collapsed.

Immediately prior to the 2010 economic downturn, productivity growth was the main driving force of the industrial growth in Belarus (WB 2010a). For most economies in transition, productivity growth is driven by (i) productivity increases within the firms and (ii) labor reallocation. In Belarus, most of the productivity increase occurred due to the former driving force. Recent data show that productivity growth is slowing down – a sign that productivity improvements has so far been gained through “low hanging fruit” type of investments, but these are now coming to an end. (WB 2010a).

Productivity growth in 2004-2008 was reinforced by increasing capacity utilization from approximately 45% in 1996 to 57% in 2004 to almost 70% in 2009. Yet, it is commonly perceived that most of the underused capacities are outdated and need rehabilitation or replacement. Thus, the actual figures of the unused capacities may be well inflated. Therefore, the years of reclaiming unused capacities will soon become history, and Belarus is gradually approaching a point at which output growth would require either costly capacity expansion or increase of capacity-usage efficiency. Of these two alternatives, improvements in energy efficiency are the one that does not show signs of being exhausted in the near future.

Belarusian energy efficiency increased by nearly 50% between 1996 and 2008 as the government began designing and enforcing a comprehensive energy efficiency policy. The measures included among others (i) establishing a Committee for Energy Efficiency in 1993, which evolved into Energy Efficiency Department of the Committee for Standardization with a mandate to develop and implement the energy efficiency improvement strategy; (ii) substantial financing, amounting to USD 4.2 billion in 1996-2008 and USD 1.2 billion in 2008 alone ; (iii) political commitment to energy efficiency, as illustrated by two National Energy Savings Programs approved in 1996 and 2001 respectively and the 1998 Law on Energy Savings (WB 2010b).

Currently, Belarus’ energy intensity is the lowest compared to the neighboring CIS countries (see Figure 1). Specifically, in 2008 Belarus used 1.17 tons of oil equivalents (toe) to produce USD 1,000 of its GDP – a substantial advantage compared to Ukraine’s 2.55, Russia’s 1.60 and Moldova’s 1.50 toe/USD 1,000. Yet, despite substantial recent progress and good standing in its regional sub-group, Belarus is still far from its energy efficiency potential, as showed by comparison with the closest Western neighbors: Poland and Lithuania use respectively 0.41 and 0.46 toe/USD1,000 (IEA 2010). Economic modeling suggests that a baseline scenario of 50% decline in energy intensity within the next decade would be a source of an additional annual GDP growth by 3.5-7%.

Currently, as implicit subsidies from Russia in the form of cheap oil, natural gas and electricity diminish, economic growth induced by the productivity increase, and capacity reclaiming is being exhausted, it becomes apparent that the search for new sources of economic growth must incorporate energy security considerations.

Overview of the Energy Security Dimensions in Belarus

Energy security is a multidimensional issue, which requires considerations with respect to:

  • Primary energy sources distribution
  • International trade and the geopolitical context
  • Impact of energy on the environment

I will review them in turn.

1. Primary Energy Security Dimensions in Belarus

A reasonable diversification of energy sources results in a more sustainable energy model of the economy.
Currently, Belarus’ primary energy source is natural gas, which accounts for 63% of its energy supply (see Figure 2). Natural gas is primarily used for heat production (55% of the total natural gas supply) and electricity production (20%). Over 80% of Belarusian centralized heating stations use natural gas and nearly 95% of electric energy in the country is produced with natural gas as a primary fuel.

Notes to figure 2:

  1. The percentage scores may not add up to unity due to independent rounding, other omitted uses and secondary supply sources.
  2. Net of exports.
  3. Combustible renewables and waste.
  4. Combined heat and power plants.

The second biggest share (29%) is crude oil and petroleum products, mainly used in the transport sector as well as the residential, commercial and public services sectors. All other primary energy sources account for less than 10% of the total primary energy supply. Renewable sources of energy are virtually unused in Belarus.

In sum, the analysis of the Belarusian energy balance reveals a disproportionately large share of natural gas use, especially in electricity and heat generation. It is therefore clear that, in the context of emerging tensions over the imported Russian natural gas, substantial changes in the electricity and heat generation sector will be needed.

2. International Trade Considerations and Geopolitical Context

Belarus produces only 14% (4 Mtoe per year) of its total primary energy demand and nearly 15% of its oil and gas consumption, thus being totally dependent on fossil fuels imports from Russia. Prior to the escalation of the conflict with Russia, almost the entire demand for natural gas and oil was satisfied by Russian imports at discounted prices, which was often viewed as an implicit subsidy of the Belarusian economy. Currently, Russia is reducing these implicit subsidies by narrowing the gap between prices charged to Belarus and to the EU.

An important difference between natural gas imports and oil imports is that while natural gas imports are entirely consumed by the Belarusian domestic market, a large share of crude oil imports is processed and exported as petroleum products (see Table 1). Therefore, while reducing dependency on Russian gas imports may be achieved, to a large extent, by a transition to alternative energy sources and improvements in energy, the same approach is unlikely to work for oil imports, since no transition to other sources of energy is possible for oil refineries and efficiency increase is limited to losses minimization. Thus, the only alternative to reduce dependency on Russian oil imports is diversification of oil suppliers.

In early 2010, the Belarusian government has signed an agreement with Venezuela on continuous supply of crude oil to Belarus. The first delivery was made by a railroad transfer from the Ukrainian sea port of Odessa; the following deliveries were made through the Estonian Muuga seaport and the Lithuanian Klaipeda seaport by railroad. Belarusian government has announced that it expects nearly 4 million tons of Venezuelan oil to be delivered in 2010, and the quantity is expected to grow to 10 million tons (i.e., 42.5% of the current oil imports) in 2011 and onwards. The average price for Venezuelan crude in 2010 was USD645 per ton (compared to USD 402 per ton of Russian oil), according to the national statistics committee.

Land transport of Venezuelan oil from seaports remains the most questionable issue. While railroad transfer proved to be a reasonable intermediate solution, a sustainable and cost-efficient transportation of Venezuelan oil is possible only through pipelines. Although the Lithuanian and Latvian legs of the former Soviet Druzhba pipeline system can be used, they require major investments to allow for reverse transfer from Baltic seaports to Belarus. The Ukrainian Odessa-Brody oil pipeline, in reverse direction, is the most likely route for a large share of Venezuelan oil, as Ukrainian government signed an agreement with Belarus for transfer of 9 million tons of Venezuelan crude in 2011. Yet, the deal is heavily threatened by Russia which was using the Odessa-Brody pipeline in the opposite direction until 2010 and is losing an important lever of influence over Belarus as the country diversifies its oil imports.

Another crucial energy security consideration from the geopolitical perspective for Belarus is its own pipeline systems (see Figure 3 below).

In 2009, nearly 62.2 billion cubic meters of Russian natural gas (36.9% of total Russian natural gas exports to the non-CIS countries) and 89.6 million ton of Russian oil (36.2% of total Russian crude exports) went through Belarusian pipelines. For comparison, Ukraine, another major transfer route for Russian hydrocarbons, transports 95.8 billion cubic meters of Russian gas (56.9% of Russian exports) and nearly 30 million tons of Russian crude (12.1% of Russian exports). Thus, almost the entire (93.8%) Russian natural gas exports as well as a substantial share of Russian oil exports (48.3%) are transported via Ukrainian and Belarusian pipeline systems.

Until recently, Belarusian oil and gas transit capacity has been a powerful lever in its relationships with Moscow. In an attempt to diversify its hydrocarbon export routes, however, Russia has announced the construction of an alternative Nord Stream pipeline system (see Figure 4) in 2005. The two-legged 1,200 km pipeline system will transport natural gas from Russian Vyborg to German Greifswald under the Baltic Sea, thus making it the longest sub-sea pipeline in the world. Each leg has a projected capacity of 27.5 billion cubic meters per year (55 billion cubic meters for the entire system). The first leg is projected to be in full operation by late 2011, the second by late 2012.

Although the Nord Stream transfer capacity is below the annual transfer of natural gas through Belarus, it represents an important strategic instrument in Russian foreign policy to manipulate Belarus and Ukraine as they compete for a residual share of the Russian natural gas transfer. Recent trends in European energy security policy headed towards increase of energy efficiency, diversification of hydrocarbons importers and shale gas revolution will undoubtedly lead to a decrease in the European demand for Russian gas, which, in the worst case scenario, may completely eliminate Belarus from the Russian gas transfer system, as Belarusian and most of the Ukrainian gas pipeline capacity become redundant.

3. Impact of Energy on the Environment

Belarus lies around the average, both in Europe and in the Eastern European region, when it comes to pollution intensity of its energy use, (see Figure 4 below). While there is room for improvements in terms of the impact of energy on the environment, this concern is of second order as compared to the above discussion on energy intensity. Moreover, it is believed that improvement of energy efficiency of the economy through implementation of modern technologies will bring along reduction of pollution intensity as well.

Despite the fact that current environmental implications of energy use are not especially worrisome, Belarus still remains one of the countries that suffered the most severe consequences of the 1986 Chernobyl nuclear power plant accident.

About 20% of Belarusian territory was affected by the accident and nearly 17% of its agricultural land. Costs to the economy are estimated in the order of 32 to 35 times the Belarus state budget in 1985. Nearly 22% of the national budget was spent in 1991 on remediation measures, although the figure has contracted to 6% in 2002 and 3% in 2006%. The total spending of Belarus due to consequences of the Chernobyl disaster over the period 1991-2003 exceeded USD 13 billion.

Besides the direct impacts on health, several social problems followed the worst civil nuclear accident, including the loss of rural livelihoods and outward migration of qualified workforce accompanied by inward migration of unqualified workforce and people who have economic difficulties elsewhere. A significant amount of agricultural land in the area of the radioactive fallout is still unavailable for cultivation. Development of the area remains a challenge, especially in small towns accommodating migrants from outside Eastern Europe, predominantly from Central Asia. Radioactive pollution is still a concern in the affected areas.

Not surprisingly, Belarusian population remains cautious about plans to construct the first nuclear power plant in Astravets, in the Hrodna Voblast, as nuclear power is still considered a source of substantial risks, despite extensive media campaigns and policy assurances on the exceptional nature of the Chernobyl accident.

Concluding remarks

A changing geopolitical context and gradually shifting priorities in the Belarusian foreign policy will undoubtedly affect various dimensions of the energy security of this transitional Eastern European country.

When evaluating consequences of external or internal factors for energy security, it is necessary to keep in mind that this is a complex, multifaceted issue. The main concerns to be considered about Belarusian energy security include primary energy source distribution (diversification of energy sources, especially away from natural gas, and reduction of the economy’s energy intensity), international trade and geopolitical context (with a special focus on diversification of energy suppliers and an optimal use of the country’s gas- and oil- transporting systems) and environmental considerations of the energy use (related to both actual and prospective impact of the energy production and consumption on the environment). Other dimensions of relevance include social impacts of the energy production and consumption, sustainability of the energy use another important elements beyond the scope of this brief.

The main trends that will alter energy security in Belarus within the coming decade most likely will include the shale gas and liquefied natural gas (LNG) revolution, the launch of the Nord Stream, possibly the construction of the Astravets nuclear plant as well as the effort of Belarus to diversify hydrocarbon suppliers.

In the next part of the analysis forthcoming in the FREE policy brief series I will analyze in detail these and other existing trends and will discuss their potential positive effects and challenges as well as potential measures for addressing the adverse effects in the context of energy security of Belarus.

Recommended Further Reading

  • Cherp, A, A. Antypas, V. Cheterian and M. Salnykov. 2006. Environment and security: Transforming risks into cooperation. The case of Eastern Europe: Belarus-Moldova-Ukraine. UNEP/UNDP/UNECE/OSCE/REC/NATO Report.
  • Chester, L. 2010. “Conceptualizing energy security and making explicit its polysemic nature”. Energy Policy, 38(2): 887-95.
  • CIA (Central Intelligence Agency) 2010. CIA World Factbook. (https://www.cia.gov/library/publications/the-world-factbook/fields/2003.html)
  • IEA (International Energy Agency) 2010. “Key World energy statistics”.
  • WB (World Bank) 2005. “Belarus – Window of opportunity to enhance competitiveness and sustain economic growth – a Country Economic Memorandum for the Republic of Belarus”.
  • WB (World Bank) 2010a. “Belarus – Industrial performance before and during the global crisis: Belarus economic policy notes.”
  • WB (World Bank) 2010b. “Lights out? The outlook for energy in Eastern Europe and the former Soviet Union”.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.