Tag: Russia

Between East and West: Regional Trade Policy for Ukraine

Posted on September 12, 2011 | Policy Brief

Policy Brief Building in Kyiv, Ukraine and Globe

Given Ukraine’s geographical location between Europe and Russia, the country often has to make difficult choices in its foreign policy. Trade policy is not an exception. In particular, Ukraine is currently negotiating a comprehensive free trade agreement with the EU, which is fostering hopes of joining it in the near future. However, at the same time, Russia is ‘inviting’ Ukraine to join the Customs Union it has created together with two other former Soviet Republics; Belarus and Kazakhstan. Since Ukraine cannot be part of both regional agreements simultaneously, it will again have to choose between the EU and Russia.

Over the last decade, the European Union has become the most important trading partner of Ukraine. The share of Ukraine’s exports of goods to the EU is now around 25-30 percent, while its share in Ukraine’s exports of services has increased twofold from 17 percent in 1994 to 34 percent in 2008. The share of Ukraine’s imports from the EU is even larger: around 35 percent in goods and more than 50 percent in services. This growth in trade shares has occurred despite the fact that there are still substantial barriers, both tariff and non-tariff, to free trade between Ukraine and the EU. The Free Trade Agreement (FTA) which Ukraine and the EU are currently negotiating is intended to remove many of these barriers.

The EU-Ukraine FTA is part of the so-called New Enhanced Agreement between the EU and Ukraine and consists of a set of provisions stipulating the liberalization of trade in goods and services, capital movement and payments, and government procurement.

A big part of the agreement is devoted to the trade in goods. This is perhaps not surprisingly so given that trade in goods accounts for 80 percent of their total bilateral trade in goods and services. Tariffs that Ukraine currently applies to the EU non-agricultural imports vary from 0 to around 20 percent. Under the new agreement, the tariffs on many of these goods will be reduced.

Apart from tariffs, the agreement stipulates an elimination of many non-tariff barriers to trade. This will be achieved by harmonization and simplification of the procedures related to customs and licensing, capital movement, government procurement, and intellectual property rights (IPR) protection, as well as competition policy, energy security and others. Ukrainian legislation must be standardized to conform to the respective European laws, with some procedures becoming more transparent (tenders), while others becoming more stringent (IPR). For example, Ukrainian producers will have to abide by the legislation on trademarks and geographical names. According to the Ukrainian deputy minister of Economy, the EU has offered a grace period of 5-10 years to Ukrainian producers to re-brand their products.

The FTA negotiation process between the EU and Ukraine started on February 18, 2008. Since then, more than fifteen rounds have taken place. Initially, there were hopes that the agreement would be signed before the end of 2010. However, in the fall of 2010, it became clear that this was not going to happen. Currently, the more pessimistic experts expect the agreement to be signed only in 2013.

In parallel with the EU integration processes, Russia, Belarus and Kazakhstan have created a customs union and are actively trying to involve Ukraine in their union. On the one hand, the Customs Union is attractive for Ukraine since it offers free trade with Russia, which is still one of Ukraine’s biggest trading partners, both in terms of imports and exports.

This union promises access to cheaper energy resources, which would be beneficial for Ukraine given its high energy dependence, especially in the exporting sectors like metals and chemicals. However, joining this Customs Union would jeopardize the FTA negotiations with the EU and would even endanger the WTO membership of Ukraine.

So far, the Ukrainian government has not taken a clear stance on whether Ukraine is going to become a full member of the Customs Union. Instead, it has cautiously offered a “3+1” arrangement.

In the light of the above discussion, the natural question to ask is then: what integration strategy would Ukraine benefit the most from?

Regional Trade Agreements

The idea that regional trade agreements (RTA) are beneficial to a country is best supported by the fact that such agreements have become increasingly popular over the last twenty years. As of July 31, 2010, there were around 400 RTAs reported to the WTO with 193 being in force. According to the World Bank, on average, a WTO member has regional agreements with more than 15 partner countries. RTAs exist predominantly as free trade agreements (FTA) and customs unions (CU). The former removes barriers to trade in goods and services among member countries but allows individual members to set their own tariffs against third parties. The latter type is a stricter arrangement since customs unions act as a single agent in the world markets and have a unified external tariff regime.

The analysis of RTAs and customs unions in particular, dates back to Viner in 1950 who introduced the terms trade creation versus trade diversion. Trade creation refers to a situation where member countries begin to trade goods and services with each other after the creation of an RTA, whereas previously they produced them domestically. Trade diversion, on the other hand, occurs when member countries shift their imports from outside partners to inside partners. Obviously, while trade creation is viewed as a good consequence of a RTA, trade diversion is undesirable. This, since the lower tariffs, make member countries shift away from the most efficient outside producer to an RTA partner.

There are two approaches in the literature to evaluate the impact of the RTAs: gravity models and general equilibrium (GE) models. Gravity models are estimated on the actual trade data while GE models are used for simulations. The typical findings on the effect of RTA’s are that: (a) excluded countries almost always lose, (b) there is a trade creation effect but it is rather small, and (c) the effect of the RTAs differs across their members, in particular, smaller countries tend to experience a larger increase in their exports (World Bank, 2005; Berthelon, 2004).

In addition, the so-called South-North RTAs (agreements between developed and developing countries), are found to be more beneficial for the latter than South-South agreements. Finally, the literature shows that on average FTAs are associated with lower levels of tariffs compared to customs unions.

Ukraine’s Choice of Trade Policy

The above presented empirical findings on existing RTAs, can offer guidance in which of the regional agreements Ukraine would benefit the most from. First, on the one hand, both of the FTA with the EU and the Customs Union with Russia are likely to lead to higher trade volumes (trade creation). On the other hand, the FTA with the EU can be regarded as a South-North agreement and could, therefore, be expected to have larger benefits for Ukraine than the Customs Union with Russia. Another argument in favor of the EU-FTA, is that Ukraine’s other trading partners are likely to face higher tariffs if Ukraine became a member of the Customs Union, than if she signed an FTA with the EU.

A recent study by Shepotylo (2010) addresses this issue and can be used as a benchmark for the analysis. Shepotylo uses a gravity model to compare potential export gains from deeper integration with the CIS countries to those from integration with the EU. Shepotylo’s analysis evaluates whether integration would be trade creating or not, leaving aside the issue of trade diversion.

Based on past experiences of Eastern European and CIS countries, Shepotylo builds two thought experiments. The first one is based on the scenario in which Ukraine would have become more deeply integrated into the CIS structure. That is, the experiment allows us to see what would have happened to Ukrainian foreign trade over the period 2004-2007 if Ukraine had developed closer ties with the CIS countries. The second experiment envisages what would have happened if Ukraine would have joined the EU in 2004.

According to the results, Ukraine would have benefited under both integration scenarios relative to the current situation of no integration. However, the benefits would have been twice as high under the EU integration strategy. Shepotylo’s results suggest that the EU integration could have increased Ukrainian exports in 2004-2007 by 10 percent, while the deeper CIS integration would only have increased exports by about 4 percent.

The highest expected benefits of Ukraine’s integration into the EU would have come from a substantial increase in export of various types of machinery and equipment, road vehicles and transport equipment, as well as apparel and closing accessories. These gains would have been virtually uniformly positive and economically large across all groups of countries regardless of the membership in EU. For example, export of road vehicles to the CIS countries would have been 88 percent higher under the EU integration scenario than under the CIS integration scenario, while their exports to the Western Europe would have been 82 percent higher. The export of raw materials, on the other hand, would have either declined (nonferrous metals), or remained relatively stable (iron and steel).

More importantly, gains under the EU scenario would also have come from a more diversified trade structure. A higher export diversification would be achieved because of the rapid expansion of manufactured exports, the share of which in total export would have been 26 percent under the EU scenario and only 16 percent under the CIS scenario.

In our view, diversification of trade flows is very important since a more diversified export structure with a high share of manufactured products can better protect a country from negative terms-of-trade shocks. For example, export diversification reduces the effect of idiosyncratic shocks. This was found by Koren and Tenreyro (2007). According to their findings, low-income countries which specialize in fewer and more volatile sectors, experience higher aggregate volatility in terms of GDP growth rates and trade volumes, etc. Another reason to why a more diversified trade flow (i.e. moving away from exports of primary goods to exports of manufactured products) is desirable, is the general trend of declining prices of primary commodities relative to the prices of manufactured goods. Also, a diversified export structure with a higher share of technologically advanced products has been found to be conducive for higher economic growth (Hausmann et al., 2007).

Conclusion

The above analysis suggests that signing a deep FTA with the EU would benefit Ukraine the most. This, given that it is likely to lead to a substantial increase in total exports and a favorable change in export composition towards a more diversified structure with a higher share of technologically advanced goods. These developments could in turn lower macroeconomic volatility and boost economic growth. Also, the EU integration scenario considered by Shepotylo (2010) did not allow for a substantial liberalization of trade in agriculture – an area where the large EU market is most protected. If the Ukrainian government manages to negotiate more open trade in agriculture, Ukraine may potentially gain much more than predicted in Shepotylo’s experiment.

On the other hand, joining the Customs Union with Russia would enhance the trade with its members and secure a lower price for energy resources. However, the benefits are likely to be outweighed by the potential losses of other markets and complications with the WTO due to the increased level of protectionism – an inevitable consequence of joining the Customs Union. In addition, the Ukrainian trade structure would become even more concentrated and skewed towards primary commodities, making the country even more vulnerable to shocks and slowing down its economic development.

Recommended Further Reading

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.

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.

The Bleak Economic Future of Russia (audio test)

Policy Brief

20221031 Economic Future of Russia Image 01

Is the Russian economy “surprisingly resilient” to sanctions and actions of the West? The short answer is no. On the contrary, the impact on Russian growth is already very clear while the economic downturn in the EU is small. The main effects from the sanctions are yet to be realized, and the coming sanctions will be even more consequential for the Russian economy. The biggest impacts are however those in the longer run, beyond the sanctions. Mr. Putin’s actions have led to a fundamental shift in the perception of Russia as a market for doing business. The West and especially EU countries are on a track of divesting their economic ties to Russia (in particular in, but not only, energy markets) and the country is simultaneously losing significant shares of its human capital. All these effects mean that the long-term economic outlook for Russia is not just a business cycle type recession but a lasting downward shift.

Introduction

The global economic outlook at the moment seems rather bleak. According to the International Monetary Fund’s (IMF) most recent World Economic Outlook, global growth is expected to slow from above 6 percent in 2021, to 3.2 percent this year, and 2.7 percent in 2023. For the US and the Euro area the corresponding numbers are slightly above a 5 percent growth in 2021, between 2 and 3 percent in 2022, while barely reaching 1 percent in 2023. At the same time inflation is up and central banks are trying to curb this by raising interest rates.

From an EU perspective it is an open question what proportion of the lower growth is caused by the economic consequences of the Russian invasion of Ukraine. Certainly, energy prices are affected as well as issues relating to natural resources and agricultural products (though the consequences of shortages in these goods are far larger for Middle Eastern, North African and Sub-Saharan countries). But it is not the case that all of the economic problems in the EU are due to the changed economic relations with Russia.

In assessing the economic impact of Russia’s war, and in particular the impact of sanctions, it is important to focus on both expectations as well as proportions. A widespread narrative portrays Russia’s relative economic resilience (compared to the expectations of some in March/ April 2022) as the Russian economy being surprisingly unaffected, while the EU is depicted as being badly hit, especially by high energy prices. In a European context, the Swedish daily newspaper Dagens Nyheter claims that “experts are surprised over Russia’s resilience” and the Economist, a British weekly newspaper, recently portrayed recession prospects for Europe as “Russia climbs out”. We argue that such point of view is misleading. To get a more balanced image of what is unfolding it is important to think both about the expected consequences of sanctions, including how long some of them take to have an effect, but also (and maybe most important when thinking about the long run), what economic consequences are now unfolding beyond the impact of sanctions.

Sanctions Against Russia

Let us start with what sanctions are in place, what types of impact these have had so far and what can be expected in the future. There are three types of sanctions currently in place. First, and most impactful in the short run, are limitations on financial transactions, especially those imposed on the Central Bank. In this category there are also the restrictions on other Russian banks disconnecting them from a key part of the global payment system, SWIFT, as well as measures targeting other assets: divestments from funds, investment withdrawals, asset freezes, and other impediments to financial flows. The main short-term aim of these actions was to reduce the Russian government’s alternatives to finance the army and their military operations. Second there are sanctions on trade in goods and services. At the moment these target particularly technology imports and energy and metals exports. These take a longer time to be felt and are potentially more costly to the sanctioning countries as well. They also contribute, in principle, to reduced resources for war. Besides affecting the government’s budget, both financial and trade sanctions disturb ordinary people’s lives as well and might create discontent and protests. A third group of sanctions are so-called sanctions of inconvenience such as limitations to air traffic, closure of air space, exclusion form sport and cultural events, restrictions of movement for both officials and tourists, and others, which aim at disconnecting the target country from the rest of the world. These are partly symbolic in nature, but can also impact popular opinion, including among the elites. However, a potential problem is that such sanctions can push opinion in either of two opposite directions: against the target regime in sympathy with the sanctioning parties; or against what is now perceived as an external enemy in a so-called rally-around-the-flag effect.

Along these dimensions the sanctions have so far had mixed effects in relation to the objectives listed above. We will return to this issue below, but in short, the sanctions on the Central Bank and the financial system, albeit powerful, fell short of causing anything like a collapse of the Russian financial system. Some of the trade restrictions, together with other global economic events, created an environment where lost trade volumes for Russia were compensated by price increases in resources and energy exports. When it comes to restrictions on imports of many high-tech components, these are certainly being felt in the Russian economy although still not fully. Public perceptions in Russia are hard to judge from the outside, especially given the problems of voiced opposition in the country, while public perceptions in sanctioning countries have mainly been favorable as people want to see that their governments are “doing something”.

What Do We Know About Sanctions in General?

A key question when judging whether sanctions “work” is to study what a reasonable benchmark can be. As discussed in a previous FREE Policy Brief (2012), sanctions don’t enjoy a reputation of being very effective. This is true both in the research literature as well as in the public opinion. There are reasons for this that have to do with both how “effectiveness” is intended and the limits that empirical enquiries necessarily face in trying to answer the question of effectiveness. This does not mean, however, that sanctions have no effect. Another FREE Policy Brief (2022) summarizes a selection of the most credible research in this area. In short, a majority of studies find that sanctions affect the population in target countries through shortages of various kind (food, clean water, medicine and healthcare), resulting in lower life expectancy and increased infant mortality. The types of effects are comparable to the consequences of a military conflict. In the cases where it has been possible to credibly quantify the damage to GDP, estimates are in the range of 2 to 4 percent of reduced annual growth over a fairly long period (10 years on average and up to 3 years after the lifting of sanctions). One has to keep in mind that lower growth rates compound over time, so that the total loss at the end of an average period is quite substantial. As a comparison, the latest estimate of the total loss in global GDP from the Covid-19 crisis stands at “just” -3.4 percent. Other studies find similarly significant negative effects on other economic outcomes such as employment rate, international trade, public expenditure, the value of the country’s currency, and inequality. There is of course variation in the effects depending on the type of sanctions and also on the structure of the target economy. Trade sanctions tend to have a negative effect both in the short and long run, while smart sanctions (i.e. sanctions targeting specific individuals or groups) may even have positive effects on the target country’s economy in the long run.

Sanctions and the Current State of the Russian Economy

When it comes to the Russian economy’s performance in these dire straits, the very bleak forecasts from spring 2022 have since been partly revised upwards. Some are surprised that the collective West has not been able to deliver a “knock-out blow” to the Russian economy. In light of what we know about sanctions in general this is perhaps not very surprising. Also, one can recall that even a totally isolated Soviet economy held up for quite some time. This however does not mean that sanctions are not working. There are several explanations for this. As already mentioned, some of the restrictions imply by their very nature some time delay; large countries normally have stocks and reserves of many goods – and on top of this Mr. Putin had been preparing for a while. Also, the undecisive and delayed management of energy trade from the EU reduced the effectiveness of other measures, in particular the impact of financial restrictions. Continued trade in the most valuable resources for the Russian government together with spikes in prices (partly due to the fact that the embargo was announced several months ahead of the intended implementation) flooded the Russian state coffers. This effect was also enlarged by the domestic tax cuts on gasoline prices in many European countries in response to a higher oil price (Gars, Spiro and Wachtmeister, 2022). This is soon coming to an end, but at the moment Russia enjoys the world’s second largest current account surplus.

The phenomenal adaptability of the global economy is also playing in Russia’s favor: banned from Western markets, Russia is finding new suppliers for at least some imports. However, although they are dampening and slowing the blow at the moment, it is difficult to envision how these countries can be substitutes for Western trade partners for many years to come.

The Russian Economy Beyond Sanctions

Given all of this, the impact on the Russian economy is not nearly as small as some commentators claim. Starting with GDP, an earlier FREE Policy Brief (2016) shows how surprisingly well Russia’s GDP growth can be explained by changes in international oil prices. This is true for the most recent period as well, up until the turn of the year 2021-2022 and the start of hostilities, as shown in Figure 1. Besides the clear seasonal pattern, Russian GDP (in Rubles) closely follows the BRENT oil price. This simple model, which performs very well in explaining the GDP series historically, generates a predicted development as shown by the red dotted line. Comparing this with the figures provided by the Russian Federal State Statistics Service, Rosstat, for the first two quarters of 2022 (which might in themselves be exaggeratedly positive) indicates a loss by at least 8 percent in the first and further 9 percent in the second quarter. In other words, GDP predicted by this admittedly simple model would have been 19 percent higher than what reported by Rosstat in the first half of 2022. As a comparison, Saudi Arabia – another highly oil dependent country – saw its fastest growth in a decade during the second quarter, up by almost 12 percent.

Figure 1. Russian GDP against predictions

Source: Authors’ calculations on GDP in rubles based on figures from Rosstat and the BRENT oil price series. Note that GDP is denominated in Rubles to avoid confusion due to the USD/Rubles exchange rates being volatile (given the lack of trade post invasion) and thus hard to interpret.

Other indicators point in the same direction. According to a report published by researchers at Yale University in July this year, Russian imports, on which all sectors and industries in the economy are dependent, fell by no less than ~50 percent; consumer spending and retail sales both plunged by at least ~20 percent; sales of foreign cars – an important indicator of business cycle – plummeted by 95 percent. Further,  domestic production levels show no trace of the effort towards import substitution, a key ingredient in Mr. Putin’s proposed “solution” to the sanctions problem.

Longer Term Trends

There are many reasons to be concerned with the short run impact from sanctions on the Russian economy. Internally in Russia it matters for the public opinion, especially in parts that do not have access to reports about what goes on in the war. Economic growth has always been important for Putin’s popularity during peace time (Becker, 2019a). In Europe it matters mainly because a key objective is to make financing the war as difficult as possible, but also to ensure public support for Ukraine. A perception among Europeans that the Russian economy is doing fine despite sanctions is likely to decrease the support for these measures. However, the more important economic consequences for Russia are the long-run effects. Many large multinational firms have left and started to divest from the country. There has always been a risk premium attached to doing business in Russia, which showed up particularly in terms of reduced investment after the annexation of Crimea in 2014 (Becker, 2019b). But for a long time hopes of a gradual shift and a large market potential kept companies involved in Russia (in some time periods more, in others less). This has however ended for the foreseeable future. Many of the large companies that have left the Russian market are unlikely to return even in the medium term, regardless of what happens to sanctions. Similarly, investments into Russia have been seen as a crucial determinant of its growth and wellbeing (Becker and Olofsgård, 2017), and now this momentum is completely lost.

Energy relations have been Russia’s main leverage against the EU although warnings about this dependency have been raised for a long time. In this relationship, there has also been a hope that Russia would feel a mutual dependence and that over time it would shift its less desirable political course. With the events over the past year, this balancing act has decidedly come to an end, if not permanent, at least for many years to come. The EU will do its utmost not to rely on Russian energy in the future, and regardless of what path it chooses – LNG, more nuclear power, more electricity storage, etc. – the path forward will be to move away from Russia. Of course, there are other markets – approximately 40 percent of global GDP lies outside of the sanctioning countries – so clearly there are alternatives both for selling resources and establishing new trade relationships. However, this will in many cases take a lot of time and require very large infrastructure investments. And perhaps more important, for the most (to Russia) valuable imports in the high-tech sector it will take a very long time before other countries can replace the firms that have now pulled out.

Yet another factor that will have long-term consequences is that many of these aspects are understood by large parts of the Russian population, and those with good prospects in the West have already left or are trying to do so. It has been a long-term goal for those wanting to reform the Russian economy, at least in the past 20 years, to attract and put to fruition the high potential that have been available in terms of human capital and scientific knowledge. However, these attempts have not succeeded and the recent developments have put a permanent end to those dreams.

Conclusion

In the latest IMF forecast, countries in the Euro area will grow by 3.1 percent this year and only 0.5 percent in 2023. In January the corresponding numbers stood at 3.9 percent and 2.5 percent. This drop, caused in large part by the altered relations with Russia, is certainly non negligible, and especially painful coming on the heels of the Covid-19 crisis. However, it is an order of magnitude smaller than the “missed growth” Russia is experiencing. When judging the impact from sanctions on the Russian economy overall, the correct (and historically consistent) counterfactual displays a sizable GDP growth driven by very high energy and commodity prices. Relative to such counterfactual, the sanctions effect is already very noticeable. In the coming months, economic activity will slow down and many European household will feel the consequences. In this climate it will be important that, when assessing the situation with Russia perhaps performing better than expected, the following is kept in mind. Firstly, Russia is still doing much worse compared to the EU as well as to other oil-producing countries. Secondly, and even more important, what matters are the longer run prospects. And these are certainly even worse for the Russian economy.

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.