How the Russian Economy is Learning to Live Under Sanctions
May 10, 2023
  • Nikolai Kulbaka
    Independent expert
Nikolai Kulbaka provides examples of Russian companies adapting to operating without Western partners and competitors and explains why business-to-business is doing better than the business-to-consumer market.
Over the past year of the Russa-Ukraine conflict, the economic outlook has changed many times, swinging from pessimism – the Russian economy is about to collapse – to optimism – these sanctions cannot hurt Russia.

The truth is that the sanctions are in effect, but the Russian economy is learning to live under them. It is not so clear how much one can trust Rosstat data, though in 2022 the reported fall in Russia's real GDP was 2.1% versus the 2021 level. This marked a much smaller decline than during previous crises.

Back in the spring of 2022, the Russian economy was in dire straits. The crisis had come unexpectedly, and few were truly ready. Nevertheless, thanks to the efforts of the Central Bank and favorable global commodity prices, the slide was stopped. In addition, Russian companies had built up a lot of experience in overcoming crises.

Now, with the economy having avoided collapse, Russian companies are much more optimistic and are beginning to build strategies that take into account the new realities. Meanwhile, the companies find themselves in different shape, and their plans for development also vary. Many of them had started looking for new ways to operate long before February 24, 2022. Let’s look at a few examples.
The production of railroad cranes is almost fully localized in Russia. The small number of imported parts can be brought from abroad in a suitcase. Source: Wiki Commons
Example 1. A Russian crane manufacturer

Some foreign companies had begun to reduce their investment in Russia from 2014, for example, the German company Kirow Ardelt AG, a manufacturer of railway cranes. As a result, the Russian company that serviced this equipment – let's call it A – was forced to start manufacturing Russian versions.

It took four years to develop the design documentation and start production. Of course, the Russian company could not pull off high volumes, though the Russian market does not need many cranes. Now, production is 4-5 units per year. Localization – production within the country – is about 95%. The remaining, small number of imported parts can be brought from abroad in a suitcase. Meanwhile, сompany A is not so afraid of competition with Chinese companies, since Russian railways have their own standards, and it can be very difficult to enter the market from the outside. Bearings for wheelsets of railway cars are an example: Chinese bearing manufacturers were allowed into Russia only after it became clear that European manufacturers had left the Russian market for a long time.

Example 2. A Russian company that manufactures electric drive technology

Over its 22 years of existence, a company we will name N, has become a serious manufacturer of electrical drive technology, which includes all kinds of industrial electrical devices, serving a huge number of Russian companies in various industries. Last year brought about major changes. The company lost European suppliers whose products had to be replaced either by Chinese or domestic ones.
As it turned out,
“Many Russian suppliers had only pretended to produce their own products, though in fact they were buying ready-made products abroad, changing the labeling and passing it off as domestic production.
Thus, the severing of relations with many countries led to a situation when there was no one to buy from, and these firms stopped “producing” products. For N, this led to a lot of challenges with acquiring components, which had to be solved on the fly. However, the company received some benefits from the sanctions.

Several Russian industries, for political reasons, were forced to completely switch to domestic production. As a rule, it was energy industries, transport engineering and the military-industrial complex. Thus, Russian companies, including the one we designated as NN, were able to expand their sales within Russia and even raise prices.

However, the company could not completely switch to domestic components. The maximum level of localization in drive technology is currently no more than 70% for the top products, falling to 60% for mass production. This particular company is not yet required to fully localize, though they are being pushed in that direction. Meanwhile, in the face of rather tough competition with Chinese producers, N is managing to keep its market share.

As mentioned above, there are Russian industries that are ready to buy only domestic products, even to the detriment of quality and at a higher price. In addition, there had been segments where original products were needed and the specific requirements of a particular project had to be taken into account, meaning that mass production, in which China is so strong, were not suitable. In this case, it is important for the buyer that the manufacturer is located next door. Finally, the smaller the output, the more the advantage of Chinese producers falls.
The demand for imported components can be met through so-called “parallel imports” legalized by the Russian government in response to Western sanctions. Source: Wiki Commons
N is successfully competing with foreign companies, primarily Chinese, in those segments where small-order products are required, without trying to master mass production. Of course, in terms of the price/quality ratio, Russian products are inferior to those of European manufacturers, but compared to China, Russian companies win out due to their proximity to clients and willingness to flexibly adapt to their requirements. And since production remains small-order, the demand for imported components can still be met through so-called “parallel imports.”

Example 3. Manufacturer of road construction equipment

Though at the beginning of 2022, another Russian company – let’s call it B, had been operating for more than 20 years and had staked out a considerable place in the market, the departure of large importers after the introduction of western sanctions, had a positive effect on its business. Now, the company has up to a third of the Russian market and is only afraid of Chinese competitors, which have a much bigger line of equipment. At the beginning of 2022, the share of imported components was 15-20% for B, with plans to bring it down to zero in a year or two.

This is not a very big market: the annual turnover barely exceeds $1 billion. However, the development of new models depends on investments that will not pay off very soon, as well as scientific research, which requires trained specialists.

Russian universities, according to businessmen, are hardly able to provide this. The problem lies not so much in the inability of university laboratories to fulfill orders, but rather in the fact that, to get high-quality and reliable results, many years of mutually beneficial cooperation between business and companies is required. Most companies, however, prefer to limit themselves to cheap, one-time orders, which are not beneficial for universities and are done by them to tick boxes.

Example 4. Door manufacturer

This is a small company (we'll call it D) that would be considered a small business. It specializes in custom-made doors for apartments – for the exterior, interior, kitchens, balconies. A few years ago, D purchased European equipment to manufacture high-quality metal exterior doors.

This year, one of its door-making machines broke down. A year ago, this would not have been an issue – they would have ordered the necessary spare part from the manufacturer in Europe. Now, that has become an extremely expensive operation, involving looking for the part from middlemen in other countries. If you try to replace the part with something similar, the expensive machine simply stops running. Now D has had to reduce its range of products, and it has no idea when it will be able to fix the broken machine.

Seemingly, many other small businesses based on high-tech European equipment will have similar problems. Take most modern Russian printing houses: whereas large printers can come up with the money to purchase needed components through complex and expensive logistics channels, small printers do not have this ability.

Some conclusions from the examples

Most Russian companies have adapted to the sanctions to one degree or another. Those in the business-to-business market have been the biggest winners.
“They now have fewer competitors, and in many cases state-owned companies are ready to buy their products at a higher price, as long as they are made locally.”
Such companies are not interested in sanctions being lifted – on the contrary, they would rather have them extended. Russian producers of agricultural and food products found themselves in a similar spot when Russia put in place “counter-sanctions” in 2014. For a long time, the agricultural lobby has been successfully pushing for extending the measures.

The business-to-consumer market is limited by consumer demand, so prices cannot rise significantly. In addition, the domestic consumer goods market is relatively large, meaning only imports can fill it with cheap mass products. It is dominated by China and Turkey, and Russian companies do not even try to compete with them. Their lot is niche products that are either unprofitable to import or simply do not exist abroad.

The relative success of companies in the business-to-business market, however, does not mean that it will last. From time to time, problems arise with the supply of individual components needed for manufacturing domestic products, as well as from the actions of the state, which is trying to increase budget revenues by extorting business.

Meanwhile, the growing budget deficit indicates that the state’s problems are growing. Sooner or later, this will either lead to devaluation or inflation, or both at the same time – with serious consequences for business. Nevertheless, for now business is trying to be hopeful about the future, counting on the fact that the hard times will end sooner or later.

Russian business will keep churning even with the conflict ongoing. Still, the most likely outlook for the economy is the creation of chaebols based on big businesses, without the introduction of a state monopoly on foreign trade and the abolition of the market. However, this outlook would mean no serious investment, as well as fluctuations in real GDP growth between -1% and 1% per year. Even these results could easily worsen should the state decide on price regulation, meaning a strong fall in the economy will be unavoidable.
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