The Conservation Effect

How Sanctions Do and Don’t Work Against Russia

Western sanctions against Russia are not working — this has been a widely discussed topic in recent weeks. Sanctions policy has hit a ceiling, and further expansion threatens to do too much damage to the rest of the world and Western countries themselves. At the same time, Western analysts and politicians almost unanimously agree that sanctions probably won't change the behaviour of the Russian dictator.

But in Russia, too, the perception that the sanctions have had an insignificant overall impact has become almost dominant in the last month and a half. Apart from the optimism of officials and heads of large companies, a positive attitude is widespread among the population and a significant part of the business community: “horrible, but not too horrible”, meaning that things are not that bad overall.

The purpose of this review is to provide a fuller picture of how economic sanctions in general, and sanctions against the Russian economy in particular, work and do not work. The review consists of three parts:

• A brief review of the global experience of sanctions policies, their short- and long-term impact on the economics and politics of sanctioned countries;

• assessment of the functionality and scope of various parts of the sanctions package with regard to the Russian economy;

• assessment of the actual effect of sanctions and the state of the Russian economy by June 2022 and the prospects for the developments of the situation.

The review was prepared by Re: Russia. Expertise, Analysis and Policy Network in cooperation with The Bell, a Russian independent economics, management and finance publication. Edited by Kirill Rogov

English version translated by Oliver Jones.

KEY POINTS AND CONCLUSIONS

The fact that sanctions tend to "fail" is well known to experts. The implication is that the objectives of the countries that imposed the sanctions are not achieved — the sanctions do not succeed in changing the decisions or specific policies of the sanctioned country and are rarely able to provoke "regime collapse". Yet there is relative consensus that non-unilateral (i.e. imposed by a broad coalition) and unrestricted (literally “non-pointed”) sanctions ultimately do lead to large and long-term losses for the economy and society of the sanctioned nation.

If the planned effect is not achieved, long-term broad sanctions reinforce a whole range of negative trends in social development of the sanctioned country: they lead to further autocracy, deterioration in human rights, isolation and the reduction of external partners to a narrow number of "mediators" with the outside world. In other words, they lead to a multifaceted preservation of "non-development" and, as a result, to a long-term loss of competitiveness and international influence. Thus, a country's ability to withstand sanctions ultimately leads to significant losses in the long run.

The perception that the impact of sanctions on the Russian economy is limited is down to an incorrect assessment of the inertia of the economic system, and the success of the Central Bank in fighting the first wave of the crisis. This assessment creates an "illusion of normality" that will become, and is already becoming, a source of problems in the future.

At the same time, the timing and nature of effects on the economy vary between the different parts of the sanctions package. Financial sanctions proved to be ineffective in the short term, but their medium- and long-term effects will still reveal themselves in the future. The effect of trade and logistics sanctions can only be fully assessed a few months after their introduction. Finally, sanctions on technological imports have hardly had an effect yet, but they will have the most serious consequences in the medium and long term.

The authorities’ plan to uproot the ties that have formed over decades between Russian business and Western suppliers and replace them with partners from Asian countries is not feasible due to the lack of appropriate infrastructure and motivation of these partners to take into account Russia's non-resource interests. And the relative success of the process of "structural transformation" — adapting the economy to new and worse conditions — will depend on the extent to which this process relies on the free redistribution of resources in the economy and market incentives, and in some cases — on political priorities, coercive restrictions and pressure.

The mechanisms of development of the current crisis are different from those to which Russia has become accustomed over the previous 25 years. However, the notion that the sanctions have so far had little effect on the economy is not true: the rate of GDP contraction is higher than that of the 2015 crisis, and the decline in output in basic activity areas compared to December 2021 peaks is more than 7%.

The impact of the crisis differs by sector: while some are feeling relatively normal or even showing growth, others are experiencing a total collapse. Shrinking household incomes are the second factor behind the crisis dynamics: the economy is experiencing supply and demand constraints at the same time. The war and geopolitical confrontation will also not allow the government to effectively use the budget and Russia’s Sovereign Wealth Fund (FNB) to provide the economy with real support.

The sanctions-related crisis is structural in nature and will lead to large scale changes in the economy, the essence of which can be defined as "technologically regressive import substitution". Having lost access to Western technologies and components, the economy will substitute the relevant goods in cooperation with less developed countries, obtaining from them lower-quality technologies and components at higher prices.

In parallel, due to the primitivization of the economy, some of the human capital, the high-tech sector that has been developing in recent years and the already achieved level of digitalization of the economy will be lost. However, even after this setback in development, the Russian economy is unlikely to take a new trajectory, but will enter the mode of long-term conservation typical of countries under sanctions, thereby losing competition for profit share and markets due to restrictions of access to technological imports and social stagnation.

I. THE SANCTIONS TRAP: HOW SANCTIONS WORK AND DON'T WORK AND WHAT IT MEANS FOR RUSSIA

Global Experience: How Sanctions Actually (Don't) Work

This paradox is well-known to scholars, sanctions experts and even policymakers: while sanctions are becoming an increasingly common tool of international relations and U.S. foreign policy, there is less and less evidence of their effectiveness.

Academic literature suggests that the average effectiveness of sanctions is 35-40%, and that’s not even full success of their stated objectives, but a partial one. But some calculations show that this level of efficiency of sanctions was typical of the 1980s-1990s, when the economic and political power of the West was at its highest, and by 2016 the average level of sanctions efficiency had dropped below 20%. Previously, the success of developing economies directly depended on their interaction with the developed economies and the flow of capital from them. This increased the effectiveness of sanctions; now the dependence has become much more blurred.

The reason why sanctions do not work well has to do with two effects. First, sanctions tend to be imposed on authoritarian countries, which are better able to resist external pressures than democratic ones, writes one of the chief experts on sanctions, Dursun Peksen. Authoritarian rulers are able to redistribute the costs of sanctions by rewarding loyal groups at the expense of disloyal ones and maintaining a repressive apparatus. Second, the logic of sanctions is, in a sense, the opposite of the logic of globalization. For thirty years, barriers to the flow of goods, technology and capital have been consistently lowered, and new barriers, created even by a sufficiently broad coalition of countries, cannot compensate for this overarching effect on which the modern global economic infrastructure relies. The same effect leads to the fact that sanctions against a particular economy have more and more spillover effects — the damage they cause is broadcast (or "spilt over") down the chain to other countries and the world economy as a whole.

Numerous side effects of sanctions are important to understand their main effect. A summary of the experience of sanctions, for example, suggests that sanctions have a negative effect on the development of democracy in sanctioned countries, i.e., these countries become less democratic, both immediately after sanctions have been introduced and in the long term, and the stronger the sanctions, the stronger the effect. In the short term, sanctions often help dictators to consolidate their regime, take advantage of a "rally around the flag" effect and mobilise support groups. A similar effect is seen in the field of human rights: if sanctions fail to weaken the security forces of a sanctioned regime, they lead to its consolidation and the strengthening of repressions. In fact, sanctions have not infrequently led to regime change (this effect was stronger during the classical Cold War era), especially in personalised autocracies.

Sanctions have, in fact, not infrequently led to regime change (this effect was stronger in the classical Cold War era), especially in personalist autocracies. However, in this case, too, a transition to a new autocracy rather than democracy has been more likely. Sanctions are least likely to destabilise the leaders of oil producing nations.

However, there is no doubt that the sanctions have a widespread negative effect on the economy of the country where they are imposed. Only the assessment of the scale of their effect is disputable: in order to adequately assess the economic losses, it is necessary to take into account the "lost growth", and different methodologies lead to different results in such assessments.

Some estimates suggest an initial effect averaging 2.3–3.5% of GDP, with a declining scale over a decade or so if imposed by a "broad coalition" (such as the UN); if imposed unilaterally by the United States, the lost growth is estimated at 0.5–0.9% over seven years. A fairly authoritative estimate is that Iran lost 17% of its potential GDP as a result of sanctions in 2011–2014 alone. Russian economist and former Deputy Chairman of the Central Bank Sergey Aleksashenko believes that the sanctions imposed on Russia in 2014–2015 resulted in a loss of 16% of potential GDP by 2021 (the difference between potential economic growth and actual growth — see below).

However, the increasingly widespread perception of the ineffectiveness of sanctions (based on extensive data) is to some extent a statistical artifact. The fact is that sanctions policy as such consists of two parts: the threat of imposing sanctions and the imposition of sanctions proper in case the threat does not lead to changes in the policy of the target country. However, in a large number of cases, the threat of sanctions has a significant effect, forcing governments to adjust their policies, limit repression of the opposition, comply with minimum human rights standards, and refuse external aggression or particularly unfriendly actions in politics and economics. But there is virtually no research that calculates the preventive effect of the threat of sanctions. Thus, existing research that does calculate the effect of sanctions only deals with a fraction of the total panel of cases.

The same underestimation of the "threat of sanctions" factor, according to some researchers, leads to an underestimation of their economic effect. It is more likely that countries for which the economic effect of sanctions looks too significant tend not to bring the situation forward, while "persistent" countries, on the contrary, tend to prepare their economies for sanctions in advance to minimise their effect. Their missed growth may precede the actual moment of imposing sanctions.

So, in summary, we can say the following. Sanctions policies are an important tool in international relations that has a significant effect, but it is most potent in case of a "threat" of sanctions rather than the sanctions themselves. Generally, if a country perceives the likely economic damage of sanctions to be very significant, and if a government anticipates that this effect will have political consequences, it will try to adjust its policies to avoid sanctions.

If, on the other hand, the damage is believed to be less significant or to have no political consequences for the government, then the policy will not change and the sanctions imposed will also have no positive effect on the change of course. It is only when this pre-calculation of consequences is wrong that sanctions "work", i.e. they are considered to be politically successful.

However, sanctions ultimately imposed on a country do not work in the sense that they are unlikely to lead to a change in the policy of the sanctioned country or the fall of its regime. At the same time, if sanctions are imposed by a broad enough coalition, they will hit the sanctioned economy hard and almost certainly reduce its long-term competitiveness very substantially. They will intensify "negative" trends in domestic political dynamics aimed at restricting domestic competition (authoritarian consolidation, suppression of the opposition, repression) and contribute to a kind of ossification and conservation of the regime, which provoked the imposition of sanctions. In the medium term, they lead to a reduction in external partnerships and a weakening of the country's negotiating position and thus, in the long term, to its economic and political marginalisation globally, without posing critical threats to the political regime inside. This "canning effect" is clearly seen in the example of global sanctions champions such as North Korea, Cuba and Iran.

In other words, paradoxically, a country's ability to withstand internationally broad sanctions leads to much greater losses for itself in the long run.

Russian Case: War, Spillover and Rally of Optimism

However, Nicholas Mulder, author of The Economic Weapon, a book on how the institution of sanctions evolved between World Wars I and II, writes in a recent article on the IMF website that sanctions against Russia should not be compared to those of the last fifty years. In all these cases, there were either broad sanctions in place (aimed at causing maximum damage to a country's economy) applied to relatively small economies (Iran, Venezuela) or targeted sanctions against large economies (sanctions against Russia in 2014–2015). What we are dealing with today should be seen as a separate category in the history of sanctions: broad sanctions imposed on the world's eleventh largest economy, in addition to being an important supplier of primary resources to world markets. As an analogy, Mulder recalls the case of Japan: after the outbreak of the Second Sino-Japanese War, sanctions were imposed on Japan (then the world's seventh-largest economy), but they only proved effective when the US joined in, cutting off the import of resources into the country. The result, however, was a Japanese attack on the United States.

Mulder stresses that it is the restriction of imports that is critical for a country at war to undermine its war machine. This is also what other economists have written about, arguing that effective sanctions against Russian imports are more important than sanctions against Russian exports, which would have broad spillover effects on the global economy.

The fact that sanctions against Russia would not work after its invasion of Ukraine was known in advance by scholars, informed people and even designers of these very sanctions. The issue of their ineffectiveness was discussed in the U.S. administration on the eve of the Russian invasion. In a review entitled "Do Western Sanctions Against Russia Work'' Russian economic media The Bell notes that the main architect of the current sanctions regime Daleep Singh took leave in April 2022 and did not return to his previous job.

In its review, The Bell has compiled and grouped into three areas data and statistics showing that sanctions are not working:

1. Huge Profits Despite the Embargo

In spite of the war and sanctions, Russia's revenues from oil and gas exports are only growing. The embargo blocking 90% of Russian oil imports to Europe has not yet entered into force, but the market has already built it into the price calculation, which is keeping at an absolutely comfortable level for the Kremlin. The EU is still buying Russian oil — and in practice the embargo on the purchase of Russian gas is out of the question. As a result, Russian oil production is already reaching pre-war levels. In the first 100 days of the war alone (24 February to 3 June), Russia received €93 billion in energy export revenues — and the EU imported 61% of the total amount.

2. A U-turn to the East

At the same time, China and India, subject to 25–30% discounts, turned out to be ready to buy considerably more Russian oil and almost completely compensated for Russia’s European losses. Since the beginning of the war, from March through May 2022, India's imports of “Urals” oil rose by 658% as compared to 2021 indicators. For China, the increase was 205% and for Asia as a whole — 347%. But restrictions on energy exports to Europe will still lead to a decline in physical production and exports, even taking into account the reorientation of some sales to Asia. Demand for Russian oil in the future will determine the dynamics of the global economy: if major countries go into recession, oil prices may fall significantly, which will undermine the success of Russian exports.

3. The Damage to Europe

The war in Ukraine has indeed exacerbated already accelerating inflation in the West, a consequence of generous pandemic injections of monetary aid to the economy. Annual inflation in the eurozone accelerated in May due to higher energy prices to 8.1% and the EU foreign trade deficit hit an all-time high. The UK and the US are experiencing their highest inflation rates in forty years.

All these effects are related to the paradoxes of sanctions policies described above: while the sanctions imposed and the economic damage associated with them have no direct effect (policy change or destabilisation of the regime of the sanctioned country), in a globalized world they cannot, on the one hand, block all channels of interaction between the sanctioned country and the global economy, and on the other, have significant "spillover" effects on other countries and the global market.

To the evidence of the ineffectiveness of sanctions having to do with the external perimeter and described above, one should add another ‘internal’ effect — the very optimistic mood of the Russian people and even parts of the business community at the moment. The signs of the macroeconomic shock (a surge in inflation, weakening of the ruble and an increase in interest rates) that have been quickly mitigated have created a feeling that the effect of sanctions on the Russian economy is insignificant and easily surmountable.

The sociological data available today shows that crisis expectations of the people sharply declined in May and June (thus, according to the most recent Levada Center data, in June 19% of respondents said that their financial standing had rather improved, and 34% said that it had rather worsened, while in April it was 13% and 41%, respectively). However, business surveys also indicate a rather optimistic perception of the situation. For example, for two months now the business activity index (PMI) based on surveys of managers and considered a very reliable indicator, has been slightly above the 50 point mark, which indicates a zero balance between the answers "the situation has improved" and "the situation has deteriorated". The index is no different from what we have seen over the past four years and is nowhere near what we saw at the start of the pandemic. It seems that the managers do not feel the "winds of the crisis". This is also an important effect, which can partially be explained by the "rally around the flag" phenomenon (when sanctions are perceived as external aggression and so lead to consolidation of the authoritarian regime) and partly by the specific nature of the sanctions package and the reaction of the Russian economy to it.

II. TWO PHASES OF THE CRISIS: MECHANISMS, TIMING AND IMPACT OF SANCTIONS

Types of Sanctions and Their Effects

Sergey Aleksashenko. Strong or Weak?

The effect of sanctions imposed after the Russian invasion of Ukraine was much stronger and manifested itself much faster as compared to 2014.

The sanctions imposed then targeted the financial sector (closing off of the capital market) and were accompanied by a precipitous drop in oil prices (which almost halved between July 1 and December 31), erroneous Central Bank policies and the subsequent ruble devaluation. In January 2015 consumer inflation accelerated to almost 4% per month, after which it started to decline. A gradual increase in oil prices and the Central Bank's transition to a floating exchange rate sharply reduced inflationary pressures, while a change in the US administration's stance resulted in the Russian economy's access to global financial markets being restored from mid-2016. The 2014 sanctions in the real sector were not significant.

As a result, the fall of the economy turned out to be insignificant (2%), but to estimate the effect of the sanctions, one should add to it the extremely low growth rate in subsequent years: 2% on average per year without taking into account the effect of COVID. Thus, the cumulative effect of the 2014 sanctions can be estimated as the difference between the actual growth rate of the economy in 2014-2021 and the potential 3% growth rate (this is slightly lower than global economic growth over these years — accounting for the effect of falling oil prices in 2014–2015). That is, without these sanctions, Russia's GDP in 2021 would very likely be 16% higher than it was.

Following the imposition of sanctions in 2022, inflation accelerated to 10% per month almost instantaneously, and the ruble exchange rate fell by 40% in two weeks with rising oil prices. The forecasts of the Ministry of Economy and the Central Bank predict an economic decline by the end of the year of about 10%, but given the growth of January–February, more revealing is the estimate of the fall in the fourth quarter of 2022 compared to the same quarter of 2021 — according to the Central Bank forecast it is 13–15%. Although I am cautious about all forecasts, even nonspecialists can clearly see the difference in the key parameters of the two sanctions-related shocks.

Oleg Vyugin. Sanctions Typology and Their Timeframe

The effectiveness of sanctions cannot be assessed in isolation from the time frame of their impact on the economy. And from that point of view they can be divided into several groups:

• Immediate financial sanctions (partial financial isolation, and impediments and restrictions on the use of a country's foreign financial assets);

• Trade and logistics constraints;

• A ban on the import of modern technology from other countries in most sectors of the economy;

• Exit and termination of commercial activities of prominent foreign companies and investors.

The financial sanctions proved to be of limited effect due to the immediate closure of almost all channels of cross-border capital movement by the Russian Central Bank. The decision of Visa and Mastercard to stop servicing cards issued by the Russian banks along with severely limited access to account openings for Russian residents in most foreign banks also played a role. As a result, the transmission mechanism that had evolved over decades to influence domestic financial policy, based on the free flow of capital, was blocked. Therefore, the initial reaction in the form of ruble depreciation and price shock turned out to be short-lived.

Also, as a result of sharp complications in import settlements and logistics, the demand for foreign currency decreased. The Central Bank and a number of major Russian banks found themselves under sanctions, so export revenues coming into the country were in little demand from the financial system due to increased risks of freezing the still-functioning correspondent accounts of Russian banks in foreign banks. Further developments confirmed this effect, which was reflected in the unrestrained strengthening of the ruble against the dollar.

Financial sanctions proved to be ineffective in the short run as an instrument of destabilisation of the state budget due to large reserves in the federal treasury accounts and substantial growth of oil and gas tax revenues. But growing military expenditures and the need to increase social payments, along with falling non-oil and gas taxes, will sooner or later lead to a budget deficit. In the medium term, financial sanctions, together with the gradual introduction of an embargo on Russian oil, will be a serious obstacle to foreign trade and a factor in the growth of the public finance deficit, a significant drop in production and subsequent stagnation.

Trade and logistics constraints manifested themselves in a sharp fall in imports and their appreciation. The availability of two to three months of stock in industry ensured the operation of business and trade could continue with the necessary range of goods. The effect of this type of sanctions is of a delayed nature. It remains to be seen to what extent parallel imports and the creation of transit organisational structures in non-sanctioned countries will be able to cover the emerging shortages of goods and components, on which almost all sectors of the economy and most businesses depend.

The sanctions have disrupted all logistics, and many companies are forced to look for new logistical pathways. The first serious effects of this type of sanctions will be seen in the summer, when time off will be over and, in order to preserve jobs and production, the interrupted supplies of imported components will have to be replaced by alternative or counterfeit imports, leading to a significant increase in logistics costs and irrecoverable losses of individual components and the final product.

Restrictions on technological imports have both medium-term (i.e. a year or two) and longer-term prospects of negative impact on the economy. Modern technological solutions and relevant "soft and hard" goods permeate the whole Russian economy through the supply of components from abroad and mutual domestic supplies. It is safe to say that all production in Russia which meets the up-to-date standards is the result of partial or full borrowing and adaptation of global technology, equipment and knowledge. Inability to attract them further, and thus technological isolation, will have the strongest negative effect in the long run.

Illusion of Normalcy

Sergey Aleksashenko. Central Bank Policy — Short-term and Delayed Effects

It came as a great surprise to me how easily and gracefully the Russian authorities solved the problem of the Bank of Russia assets freeze — the almost complete ban on capital transactions and the ban on many current transactions reduced the effect of this measure to almost a zero level. With an exceptionally strong current account surplus, the Central Bank does not need to accumulate foreign exchange reserves: an excess supply of currency allows one to demonstrate to the public that the authorities and the economy can withstand and minimise the impact of sanctions.

At the same time, the Ministry of Finance has no problem buying foreign currency for the needs of current budget expenditures, and the Central Bank can issue limited permission to buy foreign currency for banks and companies to make payments of capital nature.

Certainly, this decision, while allowing them to cope with the tactical goal of stabilising the financial market, entails serious problems, the severity of which will increase over time. Actual inconvertibility and uncertainty of the ruble exchange rate, lack of clear rules of access to purchasing currency will pressurise economic activity and lead to irrational decisions.

I agree with the way the Central Bank experts have shown the trajectory of the Russian economy's decline — a slight downturn in the second quarter and a sharp decline towards the end of the year. In this regard, I did not expect to see significant qualitative changes in the state of the economy in the first months. In my opinion, until the end of summer the economy will be "accumulating fall potential" — with goods inventory being exhausted, suppliers disappearing, supply chains failing — but not actually falling. This might to a very small extent affect the rate of decline and create an illusion that everything is not so bad.

Oleg Buklemishev. Premature Optimism

Perhaps for the first time we are not dealing with occasional and pinpoint sanctions, but with an all-out sanctions war, in which the admissibility and desirability of collateral damage is recognised from the outset. That is, sanctions are spread along a chain to all citizens and all businesses in the country. For much of the middle class, this marks the gradual but final loss of quality of life to which they have become accustomed to in recent years. If there is one thing that is surprising, it is their stoicism (or lack of awareness thereof).

At the same time, most domestic observers perceive the inertia of the economic system as evidence that everything may not be so terrible. The symbolic reduction of the Bank of Russia interest rate in several steps exactly to the level prior to February 24, along with the parallel strengthening of the ruble, is also intended to instil confidence in the limited effects of sanctions pressure.

However, the optimistic revision of forecasts is premature. It is obvious, in particular, that both of these 'positive' signs have exactly the opposite meaning. The Central Bank is disorienting market expectations and, given the forthcoming fiscal expansion in the coming months, risks facing increased inflationary pressure. In turn, the ruble renaissance is more indicative of a degradation of balance of payments adjustment capabilities than of the real "power" of the Russian currency. And a smoother recession curve does not at all equate to limiting its quantitative depth and, most importantly, changing its qualitative nature.

Challenges of the Crisis’ Second Phase and the Prospects for Supplier Substitution

Sergey Aleksashenko. Three Challenges: Inflation, Ruble Appreciation and Budget

The most severe challenge today is a sharp contraction in imports. In two to three months this supply squeeze will reach the corporate sector and households. The fastest consequence will be a reduction in the supply of consumer goods, which will inevitably lead to higher prices. In the medium term, falling imports of intermediate goods will break technology chains and exacerbate economic decline. However, I do not see what the authorities can do to overcome this threat — the main burden will fall on the companies, which will be struggling to survive.

The second challenge is ruble appreciation. Without easing of the currency restrictions regime, the ruble has a huge potential to strengthen, which will lead to not only a decrease in current revenues, but also a decrease in the ruble valuation of the Russian SWF.

The third challenge faced by the authorities is the need to decide on the level of indexation of pensions and salaries to budgetary employees this year. On the one hand, the Ministry of Finance has reserves for indexation, but on the other, there is complete uncertainty about budget revenues, which could collapse if the oil embargo proves to work and prices stabilise.

Oleg Vyugin. Prospects and Challenges of the "Forced Transplant"

One of the main effects of sanctions was a dramatic drop in imports. That effect seems less vivid in the backdrop of “self-imposed sanctions” of the international companies that refused to service the logistics of imports to Russia, as well as sanctions against Russian banks, which forced the compliance of their partner banks to switch to manual processing of financial transactions. The main challenges to the economy lie in the non-financial sector, namely the ability of businesses that have lost their usual trade routes to secure production, employment and financial solvency to find alternative supply channels.

At the same time, import substitution in the way the Russian authorities proposed to implement it is the most important economic and political fake of the last decade. Any sober economist, let alone business leaders, understands that an attempt to reproduce key modern technologies without global cooperation are either hopeless or require decades of massive costs for which Russian companies have no resources.

Today, the entire Russian economy is permeated by direct or indirect links with the counterparties in the global economy, somewhere — to a large extent, somewhere — via small but critical supplies. Attempts to "remove" enterprises from these systemic linkages will lead to production degradation, if not to stoppages or a significant drop in output.

The hopes of politicians for parallel imports or imports of counterparts from non-aligned countries, particularly from China, cannot be considered entirely unfounded. To a certain extent, these plans can be implemented. However, the Russian authorities’ strive to uproot the decades-long links between Russian business and companies from the developed world and replace them with companies from non-aligned countries is unlikely to be fully feasible for two reasons.

The first is lack of motivation on the part of the governments of these countries to take into account Russia's non-resource interests, as they themselves are recipients of modern technologies of developed countries. The second is sanctions restrictions. The development of the necessary import substitution scenario depends on the extent to which the governments of non-aligned countries will be ready to take risks by allowing their businesses to arrange significant alternative supplies to Russia. That is ultimately in the degree to which they recognize the authority of the US and EU sanctions policy, as well as the ability of the latter to spend significant political resources to exert pressure on the governments of non-aligned countries.

Oleg Buklemishev. New Big Brother, Forks and Scenarios of Structural Transformation

Serious doubts about "Chinese import substitution" arise not only in connection to the threat of secondary sanctions, but also to the increased market power of the counterparty, underdeveloped transport, payment and customs infrastructure. Besides, psychological and cultural unwillingness of the majority of Russian companies to work with China and other Asian countries, moreover, as a knowingly junior partner, will simply play a role. But even where a more or less adequate substitute can be acquired, such decisions will doom Russian business not only to a technological lag, but also to the well-known global non-competitiveness, as these technologies and services will be purchased at a triple price.

In my view, the main challenge of the coming months and years is the notorious "structural transformation" (a neat euphemism of the Central Bank), but simply put, the impending degradation of the Russian economy in self-isolation. This is a highly complex process from a managerial point of view and polycentric in nature. Theoretically, two extreme scenarios of such transformation are possible.

The first, which is relatively spontaneous, is when the economy, and above all its private sector, adapts to the new physical and price parameters of the environment, resulting in a renewed state of equilibrium. The main characteristics of such an equilibrium are still unclear, but production and management factors should be combined in a different way. Complexity is rejected by such an economy, so that a substantial part of the best quality production factors (including labour) will remain unused, which is probably the main problem of the new equilibrium from the point of view of political economy.

Of course, the forces of inertia and political influence will prevent a more or less free redistribution of resources in the economy, i.e. an ideal market equilibrium, and the role of the public sector in the Russian economy is very important.

The second scenario is built for the most part not on market signals, but on the basis of a largely conservative ideology of what is necessary from the point of view of the ruling elite. There is the military-industrial complex, it should not shrink in scale and capability in a hostile environment. There are the "commanding heights" and the focal points of the Russian economy, they should remain as such, and they should remain under the management of trusted (though not necessarily skillful) persons in the new reality as well. There are representatives of unfriendly states, they should not be met with any kind of favour, but on the contrary, with strong and relentless pushback. In this scenario, redistribution of resources in strategic directions can go not only through public budgets, but also through direct orders or pressure.

The future reality is likely to be somewhere in the middle. Ultimately, the partial success of the transformation will depend on how many hurdles are put in the way of market logic (for example, prohibitions on the explicit release of labour resources or obstacles to the transfer of real management authority and resources to the regional level).

State managers traditionally treat businessmen and their efforts with a strange mixture of suspicion and disdain; they consider themselves "salt of the earth" and are not ready to transfer the reins of current and strategic management to them. In their turn, the latter see the state as weakened, unable to perform many of its functions under the new conditions, and are ready to make concessions (such as suspending inspections or bankruptcies or easing currency regulations) to fulfil them, but do not yet understand the potential limits of such retreat, although they feel its purely tactical and opportunistic.

A significant complication is also related to the problem of time inconsistency: deep in their hearts, state officials and managers do not yet believe that the reality that has come is forever and, if so, that it is necessary to really adapt to it, including promptly making far-reaching investment decisions (on import substitution for gaping holes, say, in the military industrial complex) and personal decisions (conditionally, taking children from a British boarding school and sending them to learn Mandarin). They have kept a glimmer of hope that the sanctions will soon ease, the wonderful old world will return, and British lords and German chancellors will once again crowd in their receptions. However, these hopes are based on a one-time (and, apparently, unique) post-Crimean experience.

According to those who know them, many state managers are now busy wishful thinking or are just very good at disguising the reality. Although most of the official forecasts have a "glued tail", i.e. they show a rapid economic recovery (under the assumption of continued external restrictions), in reality few have any idea how the economic (and political) system will function in the new environment in the long run. Most decisions are made on a live thread and without a decisive U-turn from the usual, as if counting on a short term after which "everything will settle down".

III. FORWARD INTO THE PAST: WHAT'S HAPPENING TO THE RUSSIAN ECONOMY AND WHERE IT'S GOING

Is There a Crisis and What’s its Scale?

As already noted, the view of the Russian people, a significant part of the business community and the elites regarding the current condition remains rather optimistic.

However, that optimism is less encouraging and more a cause of bewilderment. Although data on the GDP dynamics for the second quarter will not be available until late August, according to the tentative estimates of the Ministry of Economic Development, the decline of GDP in May has accelerated to 4.3% compared to May 2021, whereas April numbers show a decline of 2.8%. This is a stronger rate of decline than in early 2015, when the decline indicator was 1.5% in the first quarter and 3.1% in the second. However, at that time, the economic condition was definitely felt by households and businesses as a crisis (see Fig. 1-2)

Figure 1: Output Intensity Index by Basic Economic Activity, 2014-2022 (January 2013 = 100 %)

Figure 2: Levada Center Consumer Sentiment Index, 2008-2022 (March 2008 = 100 %)

However, in 2015, the contraction of the economy was a response to an external shock — the fall in oil prices, which caused a jump in the dollar exchange rate and inflation. Over the past 25 years, the Russian people, bureaucracy and businesses have experienced three of such crises (1998, 2008 and 2015) and are familiar with their signs, logic and mechanisms of normalisation after oil prices return to the upward trajectory. This spring's rapid return of macroeconomic indicators to their previous values after a brief shock in March served as just such a signal for the population and market players against the backdrop of rising oil prices.

Meanwhile, as the experts explain earlier in this study, following capital flow restrictions and macroeconomic shocks, the second and more powerful swing of the sanctions crisis is a supply shock — a sharp reduction in imports. Import contraction also occurs in case of an external shock associated with a fall in oil prices. In this case, imports are reduced as they become more expensive after the ruble has devaluated. However, as things get back to normal, imports begin to grow, following the growth of revenues from exports and solvent demand. However, in the current case the normalisation of macroeconomic indicators does not mean such a reversal. And this new reality does not seem to be fully understood by the population and economic agents.

According to the Federal Statistics Service (Rosstat), in May 2022 industrial production fell by 1.7% as compared to last May; in manufacturing the decline accelerated from 2.1% in April to 3.2% in May (also as compared to May 2021). But the real picture of the "sanctions" dynamics is not in year-on-year comparisons (throughout 2021, the economy was growing in a post-COVID recovery trend), but in estimates of the accumulated contraction to the pre-sanctions peak (see Fig. 1).

Thus, the output indicator for basic types of economic activity (the closest operational indicator to GDP) calculated by the HSE Development Center ("Bessonov Index") indicates a 7.3% decline by December 2021 (in May 2015, this indicator decreased by 4.4% compared to December 2014). According to experts' estimates, more than one-third of the decline was caused by a drop in wholesale trade (May's turnover was 18.7% lower than in December 2021), one-sixth of the decline was caused by a drop in mineral extraction, while retail trade, manufacturing and agriculture together caused another third of the overall downslide. The cumulative reduction in output in industry (i.e. excluding construction and services) over three months amounted, according to calculations by various think tanks, to between 4% and 7%. The Center for Macroeconomic Forecasting (CMASF) estimates it at 6.9%, Rosstat — at 4.6% and Higher School of Economics — at 4% (the difference is due to different methodologies used by the centres to minimize distortions and outliers and adjust for seasonality).

It should be noted that in May the rate of decline slowed down sharply (according to Rosstat, in May production declined by only 0.2% after a decline by 1.9% in April). The main contribution to this was made by stabilisation and even a slight growth in the extractive sector (primarily in oil production), as well as possibly in the defence industry. The decline in a number of manufacturing industries has also stopped. However, due to a large number of holidays, May is not considered the most reliable month for economic statistics and circumstantial leading indicators — reduced electricity consumption and railroad loading — suggest that the industrial contraction continues in June.

In one way or another, the economy went from dynamic growth at the end of 2021 to a rather deep recession in a few months. It is characterised by the fact that it is not frontal, varying greatly in scale across sectors. While many industries and even sectors are doing relatively well or even growing (pulling over unmet demand), others are experiencing a real collapse. Thus in Russia car production has virtually stopped: in May 2022 they produced only about 4 thousand cars instead of 112 thousand cars the year before. Production of trucks is at 60% of the May 2021 level; according to Rosstat, production of "television sets" has halved compared to May last year and production of washing machines and refrigerators is down by 60%. These collapses are obviously related to the breakdown of the supply chains of imported components, the lack of which leads to the shutdown of entire production facilities.

The second avenue for the spreading of the crisis is the decline in incomes and, consequently, demand on the part of citizens. Russians' real wages have moved to fall under the onslaught of inflation: in April they declined by 7.2% in annual terms — this is the maximum drop since 2015 (back in March they were growing by 3.6%). Real pensions decreased by 8.2% in May (in January–May the decrease amounted to 5.8%). Unscheduled indexation of pensions and the minimum wage by 10% is likely to support incomes of elderly Russians, but its impact on wages will be limited. Instead of employment reduction, output decline in many industries will cause, as it usually happens in Russia, reduction of real wages (due to cuts in various types of payments).

Data on May wages is still unknown, but the Central Bank and the Ministry of Economic Development are concerned about the contraction in consumer demand, which is clearly demonstrated by the dynamics of retail trade: in May it fell by almost 11% against December 2021 (mainly due to the non-food goods and in particular durable consumer goods). This, by the way, roughly corresponds to the reduction of this indicator in May 2015 vs. November 2014. The sharp contraction in demand is also indicated by deflation: prices in Russia have not actually been rising since late May. This is not so much a sign of economic stabilisation, as officials sometimes like to interpret a slowdown in inflation, but rather the specifics of the current crisis: while companies incur costs due to complicated logistics and the need to replace familiar suppliers, low demand for goods forces them to keep the prices down. Minister of Economic Development Maxim Reshetnikov has already warned that Russia's economy is "sliding" into a dangerous deflationary spiral.

An excessive strengthening of the ruble also does not work favourably for companies. In a normal situation, a strong ruble makes internal factors of production (labour, purchase of domestic intermediate goods) more expensive for enterprises, but makes its imported components cheaper. However, in this case the strong ruble does not translate into the availability of imports to the extent that it usually does.

Government spending in such a situation remains a key tool for rebalancing and compensating for crisis factors. So far, the Russian budget is supported by tax revenues from oil and gas: according to the Ministry of Finance, oil and gas revenues in January–May 2022 increased by 45% in annual terms (up to Rub 5.7 trillion). However, non-oil and gas revenues (VAT, income tax, profit tax, etc.) over the same period decreased by 3.1% — to Rub 6.385 trillion (in May the decline was 6.4%). The federal budget is prepared for a controlled deficit by the end of 2022 in the amount of 1.2% of GDP, which will be financed from the Sovereign Wealth Fund (officials admit that in reality the deficit could reach 2%). However, what will the additional funds be spent on?

After the publication of April budget statistics, which showed that military expenditures increased by almost 2.5 times in annual terms, and in general defence and security expenditures amounted to 26% of total expenditures, the Ministry of Finance classified the details of budget expenditures. And very recently the same Ministry of Finance proposed to sharply reduce expenditures under the state programs "Development of the Transport System", "Scientific and Technological Development" and "Ensuring the Defence Capability of the Nation". In the first and second cases, funding for the development of the civilian economy is reduced. A draft law, which appeared almost at the same time and proposed to force businesses to work under government orders in the interests of the army and special services, and the defence industry enterprises to work nights and weekends, also shows the drift of government priorities towards the wartime economic model. The draft law making military contracts mandatory for enterprises will make it possible to de facto shift the Ministry of Finance's estimated cuts in budget spending on defence programs onto businesses.

However, the main uncertainty for the budget is the unpredictability of oil and gas revenues. In the near future, they may be strongly affected by fluctuations in oil prices, sanctions aimed at limiting the rent received by Russia from their exports and, finally, counter-sanctions – preventive restriction of Russian gas supplies to Europe as part of the trade and energy war.

Thus, we can say that another factor in the development of the current crisis in the Russian economy is the war with Ukraine and geopolitical escalation that has entered a protracted stage, the costs of which will not allow the anti-crisis potential of the budget and SWF to be realised and at least to some extent reduce the costs of the sanctions crisis for business.

What are Structural Crisis and Regressive Import Substitution

So, output and consumption indicators at the beginning of summer, i.e. in the fourth month of the war, show signs of an economic crisis, apparently already surpassing the scale of the crisis in the first and second quarters of 2015. However, although the first phase of this crisis (March–April) was similar to crises caused by external shocks, in reality it has the character of a structural one. The previous structural crisis was experienced by the Russian economy in the early 1990s, and one should rather look for analogies with the development of such a crisis there.

Vladimir Gimpelson and Rostislav Kapelyushnikov were the first to write about this: “The transformational crisis of the early 1990s was accompanied by severe macroeconomic shocks, with a total breakdown of economic ties among its key features. This led to a halt in normal economic life. The current crisis is similar: although it is also accompanied by a series of macroeconomic shocks, its main feature is the widespread disruption of technological and production chains. The only difference is that then it was a disruption of ties within the country and now it is a disruption of ties with the outside world”.

The similarities and differences with the crisis of the early 1990s is that back then the economy opened up to external markets and this helped determine market prices of goods, resources and the weight of the national currency. Now there is a rapid reduction in the links between the economy and the outside world, and many price indicators (e.g. the ruble exchange rate or the price of many imports) are distorted by regulatory constraints from both sides. Thus, unlike in the early 1990s, the Russian economy is now "breaking off" from the global economy not only through reduced financial and trade links, but also at the institutional level.

Unlike a crisis associated with an external shock, which usually has a frontal character, a structural crisis spreads over the economy gradually, as the disconnection in different places reaches the reduction of output of final products, and the overall contraction begins to have a serious impact on solvent demand. This creeping nature, however, weakens its political effect — the deterioration is gradual and asynchronous across different sectors of the economy.

The main effect on the Russian economy in the medium term will be related not so much to the financial sanctions (although the growth lost due to disappearing foreign investment will also be significant in the long term), as to the sanctions against imports and the actual severance of relations with advanced Western economies. As The Bell noted in its review on the effectiveness of sanctions, 49% of Russian imports in 2021 were for machinery and equipment, and on a country-by-country basis also almost half (45%) were from countries that supported the sanctions. This is where the chain and linkages will break down, and the economy will have to somehow compensate for that in the coming years.

Having lost access to Western technologies, samples and components, the Russian economy will seek to replace the relevant goods in cooperation with less developed countries, receiving from them lower quality and more obsolete technologies, as well as samples and components at higher, noncompetitive prices (as Russian companies will not have any other alternatives). There will not be as much import substitution through domestic production, as Russian officials claim, rather one imported good shall be substituted by another, but less advanced and of lower quality. Thus, Russia's share in the value-added chains will decrease due to the increased cost of imported technologies and components.

In this sense, the term "reverse industrialisation" introduced by the Central Bank analysts describes only part of the process — replacement of the technologically simplest units with domestic analogues. The term "technologically regressive import substitution" proposed by the well known economist Branko Milanovic to describe this unique process looks more accurate. It refers to the substitution of imports with both less advanced imports and even less advanced domestic equivalents. In fact, it is a scenario where the normal model of development of any economy is reversed. "Nothing like this has happened yet in modern economic history," — Milanovic notes on this point.

The development model of the Russian economy over the last decade has been partially similar to that used by some of the Middle Eastern oil-exporting countries. Relying on sufficiently high income levels that spurred high consumption, and significant currency inflows that allowed to import the most advanced technologies and components, they stimulated the incorporation of local businesses into international production and services chains of high-tech consumption. And as a result, they not only absorbed advanced technologies and production methods (although their own share in value added chains remained small), but also made great strides towards high-tech and new digital economy.

As noted by economist Oleg Itskhoki in one of our previous reports, in Russia this sector also had significant potential for external expansion in the CIS and Eastern Europe (Yandex, Sberbank and other companies). Now the market of Russian high-tech start-ups and hightech in general, which was booming in the 2010s, is experiencing a catastrophe and is leaving Russia altogether due to the impossibility of financial and technological interaction in technological and business chains.

The paradox is that, unlike the standard scenario of "conservation" of the economy and social development under broad and long-term sanctions discussed above, Russia will first have to go through a stage of accelerated technological degradation, erasing the successes of the last ten years, which will be accompanied by a significant economic contraction. And only after that will it enter the trajectory of sanctions-related conservation.

This stage is exactly what the Russian Central Bank experts call the "reverse industrialization", noting that economic recovery will take place at a lower technological level.

However, the economy’s entering the fourth stage, described by these same experts, namely "reaching a new equilibrium, development on a new, less advanced technological basis, and a gradual return to previous technological levels" does not seem very likely.

The experience of social and political dynamics of countries under long-standing and extensive sanctions (discussed in Part I of the report) suggests that the preconditions listed by experts for such a trajectory will most likely be absent ("restoration of attractiveness of financial and direct investments", "development of human capital", "availability of social lifts"). As Branko Milanovic notes in his review of the "technologically regressive import substitution" model, it will also mean a conscious loss of part of human capital: highly skilled workforce will be out of demand in the process of structural economic regression and will have to adjust to the requirements of a more primitive technological mode.

Moreover, even having joined the group of technologically less developed countries, Russia is likely to lose in competition with them due to more expensive factors of production (labour and technological imports). This is likely to determine its further lagging behind in levels of competitiveness and, consequently, in the struggle for a share of profits and markets.

In other words, the Russian economy (as well as its social environment) will have to go through first sterilization and then mothballing.