Economic constraints

The Bell

Hello! In this week’s newsletter, we’ll review the  economic impact of the first two months of fighting in Ukraine, and discuss two key questions: how long can the Kremlin continue to afford its ‘special military operation’ and can the Russian economy hold out? The Russian Ministry of Defense recently announced new military goals that suggest the so-called ‘special military operation’ could go on for much longer than many first thought.

Not just Donbas

The acting commander of Russia’s Central Military District Rustam Minnekayev laid out Friday the aims of the second stage of Russia’s ‘special military operation’. His words amounted to the first official confirmation that Russian forces are seeking to take direct control of land outside the eastern Ukrainian region of Donbas. The ‘new aims’ include:

  • Full control over Donbas;
  • A land corridor to Crimea;
  • A possible land bridge to Transnistria, a breakaway region of Moldova.

The second and third points from Minnekayev’s statement are significant. “This [control over Donbas] makes it possible to establish a land corridor to Crimea, and also to influence Ukraine’s vital [military] facilities and the Black Sea ports where agricultural and metallurgical products are delivered,” Minnekayev said, according to state-owned news agency ТАSS.

Up until Minnekayev, Russian officials have said nothing publicly about seeking a land corridor to Crimea – something that means taking permanent control over the city of Kherson and the southern part of Ukraine’s Zaporozhye region. During March peace talks in Istanbul, the question of a “land corridor” (as opposed to the status of Donbas) was not raised, a source close to the negotiations told The Bell at the time.

The third point is even more radical. “Control over southern Ukraine opens another route to Transnistria, where we are also aware of the oppression of the Russian-speaking population,” Minnkayev said. President Vladimir Putin’s press secretary Dmitry Peskov refused to comment on Minnkayev’s words, referring journalists to the Defense Ministry.

Russian control of a route to Transnistria would leave Ukraine completely cut off from the Black Sea. Economically, it would close Ukraine’s main export channel and cut off all maritime trade. From an operational point of view, it’s impossible for Russia to achieve this without taking Mykolaiv and Odesa (Ukraine’s biggest port city with 1 million inhabitants). It implies that Russia wants control of the entire Ukrainian coastline: from the Dnieper estuary in the East to the Dniester in the West (on the border with Moldova).

What do we know about the current situation?

Statements by officials and publicly available data means we can state the following:

Donbas. Currently, Russia’s most significant public goal is the “complete liberation of Donbas”. In pursuit of this, Russian troops are fighting alongside units from the separatist People’s Republics of Donetsk and Luhansk. Russia formally sees these areas as independent nations. In the open countryside around Luhansk, Russian forces have taken control of Izyum. However, in the more urban landscape of the Donetsk Region, which has been fortified by the Ukrainian military since 2014, progress is less clear: at present, barely 50 percent of the region is controlled by Russian forces. For the moment, the main hot spots appear to be Popasna, Severodonetsk and Lysychansk, which block Russia’s path to the Ukrainian strongholds of Kramatorsk and Slavyansk.

The thinking behind Russia’s current deployment is clearly informed by the major encirclements of the Second World War: Russian forces want to surround some of the largest and best-trained units of the Ukrainian army by striking from north and south. State-owned news agency Sputnik, for example, reported this plan with reference to Ministry of Defense information. The problem, of course, is that Ukraine (which is starting to take delivery of heavy weaponry) is well aware of Russian intentions.

At the start of this week, Ukrainian President Volodymyr Zelenskyy announced that the “battle for Donbas” was already underway. However, the operational reports from both sides suggest that a large-scale Russian offensive has yet to properly begin.

Southern Ukraine. At present there is a de facto land corridor linking the annexed Crimea peninsula with Russia’s southern Rostov region. Since the start of March, Russian forces have held the Ukrainian city of Kherson and strategic points in the lower Dnieper at Kakhovka (Kherson Region) and Enerhodar (Zaporozhye Region). The battle for control of the eastern part of this corridor led to the fierce fighting around Volnovakha in March, and there is on-going fighting at Polohy and Huliaipole. The corridor includes Mariupol, Ukraine’s largest port on the Azov Sea, which is almost entirely under Russian control.

There was growing discussion last week in Russia about the political future of these acquisitions. In particular, there was extensive coverage in Russian state-owned media of a “people’s gathering” calling for the small Rozovsky district of Ukraine’s Zaporozhye region to be added to the Donetsk People’s Republic. The deputy head of the Russian parliament’s committee on CIS affairs Konstantin Zatulin suggested Thursday the creation of a new “Tavriya province” and this idea – recreating Tavriya from Kherson region and parts of Zaporozhye and Crimea – was subsequently backed bySergei Tsekov, senator for Crimea and a member of the committee for international affairs. Ukrainian officials claim that plans are in place to stage a May referendum on the creation of a ‘People’s Republic of Kherson’.

Does Russia have the money to continue the ‘special military operation’?

Yes. Under the current sanctions, Russia has the funds to continue the ‘special military operation’ for at least two years without any cuts to social spending, economists told The Bell. Speaking on condition of anonymity, an economic analyst at one foreign bank said: “We have plenty of direct financial resources to continue [the special military operation], the only question is how much people are willing to endure.”

Russia’s finances are being managed by capable officials, according to an oil and gas analyst from a major U.S. company. Problems, including for the military, are more likely to arise from difficulties in buying parts — rather than from a lack of money.

Oil and gas revenues. If you assume a base case scenario in which there is no Western energy embargo on Russia, then the average annual price of Russia’s Urals crude is expected to be $70-75 per barrel. This figure takes into account the ‘Urals discount’ (currently an enormous $40 per barrel as a result of a boycott of Russian crude), and a reduction in imports. That figure would enable the Kremlin to continue funding all its activities – including military activities in Ukraine and the indexation of social benefits – for at least two years without difficulty, a leading analyst at one of Russia’s biggest banks told The Bell.

Exports of oil and oil products will drop about 11 percent (to 1 million barrels a day) in 2022 and total Russian oil production will fall by up to 8 percent, according to the head of a Kremlin-connected think tank. However, the rising price of Urals crude – up at least 10 percent even allowing for the discount to Brent – means the money generated from energy exports will increase. Natural gas prices are expected to stay high for years to come, a source told The Bell, with average prices likely about double the level of 2021.

The budget. Prior to the ‘special military operation’, Russia’s finances were in good shape: there was a surplus of more than 500 billion rubles in 2021, the equivalent of about 0.4 percent of GDP. The 2022 budget is based on an extremely pessimistic  average price of $44.2 for Urals crude, and an average exchange rate of 72.1 rubles to the dollar.

Russia can even cope with a small budget deficit – if it did occur, the Finance Ministry would likely dip into the National Wealth Fund (as it did during the pandemic). At the start of this month, the fund had liquid reserves worth 9.7 trillion rubles. The Central Bank has cautioned that it won’t “mirror” spending from the fund with the sale of foreign currency, but there would be little impact on inflation from this due to currency controls, a source told The Bell.

Russia’s ability to finance its military adventures in Ukraine is determined by revenue, the structure of expenditure and the ability to deal with any deficit. But there is room for maneuver. For example, it would be possible to avoid a sharp reduction in non-military spending by increasing the deficit. “Without borrowing, Russia’s reserves are worth 6-7 percent of its GDP, an amount quite sufficient to support increased military expenditure and cushion the fall in other spending for at least two years,” one economist told The Bell.

Under a more extreme scenario (for example, a European oil embargo or oil cartel OPEC increasing production), there could be a significant drop in oil and gas revenue. If this happens, the government could cut-back on social spending (like halting pay rises for civil servants or replacing index-linked pensions with one-off payments). Alternatively, it could cut-back on investment.

As long as Russia can sell its oil and gas, there will be sufficient resources to keep the economy afloat, according to an energy analyst at a U.S. company. Despite the restrictions imposed since February, Russia increased oil supplies by tanker to Europe in April to 1.6 million barrels a day, compared with 1.3 million barrels a day the previous month.

How is the economy faring?

Central Bank chief Elvia Nabiullina warned last week that the economy will enter a period of “structural transformation” (i.e. a real crisis) in the second or third quarter of this year.

For the moment, there is little indication of a coming storm. Nationwide indicators in March showed no sign of a decline in economic activity. This is largely because manufacturers have stocks of parts and raw materials, according to analysts at the Central Banks.

Businesses will start running into problems in May or June, said Natalya Zubarevich, a regional expert at Moscow State University. “All companies are desperately seeking alternatives in terms of [suppliers] of components and markets. It is unclear how quickly they will find them, but it’s unlikely to be done in a month. May-June is the time when the reserves run out,” she told The Bell.

Nor is the macroeconomic situation disastrous: huge inflows of foreign currency from exports go hand-in-hand with a sharp reduction in imports, so the balance of payments is positive, Zubarevich explained. “Sanctions are a long play. It won’t spark a collapse tomorrow. Degradation, and the emergence of shortages, will be gradual,” she said.

Meanwhile, household incomes have fallen due to inflation, Zubarevich added. In March, annual inflation jumped to 16.7 percent from 9.2 percent in February; as of April 15, it was at 17.6 percent, its highest for 20 years.

What happens next?

A recession is likely to be of “transformational, structural character” and it’s difficult to say when it could end, according to Central Bank analysts. “The persistence of supply shocks means this recession could be very deep and the timeframe to exit extended,” they wrote.

Anything requiring high-tech goods could be particularly badly affected. Not even localization will replace many unique components (this process was described by economist Oleg Itskhoki in a March interview with The Bell). The first threats are to car manufacture and the electronics industry, Central Bank analysts believe. Indeed, the reluctance of foreign businesses to operate in Russia might prove more damaging than formal Western sanctions.

Russia’s potential for economic growth will also decrease as efficiency falls because of a partial switch to less sophisticated, lower quality and more expensive imports.

The Central Bank analysts expect a “structural transformation” of the Russian economy will come in four phases: 1) adaptation; 2) adjustment to new conditions (by the end of the year) involving a the return of “shuttle” small businesses and an increased role for intermediaries in foreign trade; 3) “reverse industrialization” of the economy, i.e. industrialization based on the development of less advanced technologies; 4) the conclusion of the structural adjustment and a new economic balance based on less sophisticated technologies.

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