Price shock and reduced consumption

To claim that international sanctions had zero effect on Russia’s economy would be incorrect. Putin's recognition of the self-proclaimed Donetsk and Luhansk republics, followed by the invasion of Ukraine, drove a collapse in the Russian stock and foreign-currency markets. The sharp response from the West exacerbated worries. The dollar exchange rate soared from 80 to 170 rubles, while the RTS index (Russia's main stock index) more than halved in a matter of a few days.

The sanctions were designed to cut off the Russian government from reserves it had accumulated (by freezing assets) and the international debt market (by restricting purchases of Russian debt), and to make international trade as difficult as possible and curb export earnings (by sanctioning the banking and financial sectors).

In addition, the sanctions were supposed to deprive Russian industry of modern equipment and the high-tech products needed to make cutting-edge weapons and “dual-use” items. Later, the EU introduced restrictions on transportation over land, which seriously hampered the physical delivery of goods from Europe to Russia.

Parallel to the actions of governments across the world, most global companies announced that they were either leaving Russia or freezing all operations in the country. The Russian consumer market immediately reacted with a spike in prices, especially for imports and industrial durable goods.

The effect on the food market and the fast-moving consumer goods market was less evident, as in recent years the Russian government sought and made efforts to achieve “food security.” Russian companies are fully capable of supplying the domestic market with food (excluding delicacies), hygiene products and household chemicals.

Importers ran into bans on importing a number of goods into the country, along with refusals on the part of counterparties to trade with Russia. As a result, import volumes plummeted in the first months of the war. To avoid a panic, first the Bank of Russia and then the Federal Customs Service stopped publishing data on exports and imports. According to Putin aide Maxim Oreshkin, who formerly headed up the Economic Development Ministry, imports dropped by “dozens of percentage points” in March. A fuller picture can be gleaned from analysis of container traffic and the foreign trade data of Russia's biggest partners. For example, imports from Germany tumbled in March, shrinking 2.5 times.

Even China, about which the Russian authorities had been quite hopeful (recall that a few days before the war, Vladimir Putin flew to Beijing for the opening of the Olympics and met with Xi Jinping), reduced exports to Russia. Overall imports fell by about a third in the first month of the war.

However, two factors helped prevent a collapse in the Russian consumer market. First, having gone through the bitter experience of the pandemic in 2020 – when one or another product disappeared due to supply chain disruptions – both industry and retail built up considerable stocks in the second half of 2021.

Second, the price shock (along with other shocks) drove a clear change in Russian consumer behavior, as people simply stopped buying nonessential goods. Effective demand for durable goods collapsed. This was particularly noticeable in the car market, where sales of new cars plunged by two thirds back in March and still haven’t recovered (in October, they were off 63% year-over-year).

‘Excess’ money

To prevent a financial collapse, the central bank sharply hiked rates – essentially putting the brakes on consumer lending – halted trading in the stock market, froze the assets and money in foreign investors’ brokerage accounts, and introduced a number of restrictions on foreign-currency transactions, many of which are still in effect. Exporters were obligated to sell all their foreign-currency earnings inside Russia. Meanwhile, the Finance Ministry abandoned its so-called fiscal rule under which all “excess” federal budget revenue from oil exports was sent to the foreign-exchange market and used to replenish the country’s international reserves and the National Welfare Fund.

The combined effect of these measures was a reversed "skew" in Russia’s foreign-exchange market. Exporters, which used to leave a significant part of the foreign currency (FX) they received from the sale of commodities on their foreign accounts, have ceased to do so – both because of the directive prescribing the transfer of 100% of FX earnings back to Russia and because of the threat of the companies’ accounts at foreign banks being blocked and frozen.

At the same time, demand for FX dropped off. Foreign investors who had been active participants in the dollar and euro markets on the Moscow Exchange before the war were barred from trading, and they can no longer take money out of Russia. Meanwhile, amid the collapse in imports, demand for FX from importers tailed off. Still, exports jumped 30% in money terms due to the rise in prices for oil, gas and other commodities.

Russia’s “energy blackmail” also bore fruit. The Russian government managed to get Gazprombank, to whom European buyers of energy make payments, cut out of the sanctions. Thus, FX continued to flow onto the Moscow Exchange, and in quantities that significantly exceeded the demand for it. By the end of March, the dollar had returned to the pre-war exchange rate of 80 rubles before sliding to 50 rubles in June, less than a third of the peak in early March. Still, prices that had soared in March didn’t come down at all. The strong ruble – perceived by some analysts as evidence of the ineffectiveness of the sanctions – actually spoke to the opposite: the international restrictions, combined with the voluntary boycott by global companies, drove a drop in deliveries to Russia. Whatever the reason for it, the overvalued national currency dealt a serious blow to Russian exporters and the federal budget. According to Finance Minister Anton Siluanov, the treasury loses RUB130-200 billion in revenue for each ruble that the dollar weakens. On the flip side, imports have become unbelievably profitable.

To ensure the flow of imports of goods that aren’t produced in Russia or are produced in insufficient quantities, the government legalized “parallel imports” back in April – imports without the permission of the manufacturer or intellectual property right-holder. As soon as the summer, import volumes began to recover. This included European good imports, though they were now brought not directly from Europe, but from Turkey, Armenia and Kazakhstan. In addition, Chinese exports to Russia were up 12.8% in the first 10 months of the year.

There is a caveat, however. Far from all countries are directly violating the international sanctions. For example, Kazakh presidential aide Timur Suleimenov said back in the spring that his country wouldn’t help Russia circumvent sanctions. And in early July, a draft executive order was unveiled that would ban flows of sanctioned goods to Russia and Belarus through Kazakhstan.

However, that didn’t stop Kazakhstan from significantly expanding exports to Russia of goods that aren’t on the sanctions lists. For example, in the first half of 2022, when births in Kazakhstan fell 8.4%, deliveries of breast pumps from Europe to the country skyrocketed 633%, while official exports of the product from Kazakhstan to Russia more than doubled.

Besides, there is the possibility that finding a solution to the problem could soon become irrelevant. The painstaking work of the US and the EU aimed at the international economic isolation of Russia continues. While developed countries have already adopted a record number of restrictions, now the aim is to force third countries, like China, India, Turkey, Armenia, Georgia and Kazakhstan, to comply with them through a mix of carrots and sticks (in the form of secondary sanctions). A breakthrough now seems possible thanks to changing economic conditions.

Russia was attractive as a supplier of commodities when there was a threat of commodity shortages in world markets and prices were hovering around record highs. However, as the situation in the commodity markets normalizes, the benefits of cheap resources no longer outweigh the risks of secondary sanctions. Banks that work with Russians or the Russian payment system are also at risk.

On November 28, the price of Brent oil fell below $81/barrel for the first time since early January, meaning that European oil prices have gone back to pre-war levels. Less pleasant for Russian oil companies and the federal budget is that the Russian grade Urals sells at a deep discount to other grades due to the sanctions. Prices have dropped to around $50/barrel – still below where they were in January and matching the levels of the pandemic-affected April 2021.

Needless to say, the situation has changed dramatically compared to March or June. Moreover, the falling oil price can’t be brushed off as emotion- or speculation-driven. It’s not the first week or even first month when oil has gotten cheaper. The drivers are multiple and include a slowdown in the global economy – which analysts blame, ironically, on the energy crisis – and a new wave of coronavirus in China.

What might this translate into? For the government, it stands to recall that the federal budget adopted at the end of November had been drawn up in the summer, when Brent was trading at $100-125/barrel and the price of Urals traded above $85/barrel. In addition, the budget didn’t include expenditures for the four annexed Ukrainian regions or the impact of the partial mobilization – developments that emerged later, after the budget had already been drawn up. Against this backdrop, the Ministry of Economic Development penciled in an average Urals price of $70/barrel in its 2023 macro forecasts, while the Finance Ministry used that price for the federal budget.

The Finance Ministry of course doesn’t want to be wrong and will try to collect the budgeted amount of rubles. But that doesn’t necessarily require high oil prices – they can make up for it through the exchange rate, with a sharp weakening of the ruble able to help the state meet its obligations. Based on the current price of Urals, however, an exchange rate of 70 or even 80 rubles per dollar won’t help the Finance Ministry. It must be higher. On top of the challenge of meeting the budget, the fall in oil prices creates another problem: the country needs FX to pay for legal and parallel imports of consumer goods, as well as the needs of the defense industry, whose appetite has seriously grown in recent months.