What is the current state of the Russian economy under sanctions?

Economic sanctions have done considerable damage to Russia’s economy. The country’s economic situation will improve slowly as supply chains are re-oriented towards other markets, especially in Asia. But perseverance with the measures by Western nations remains crucial.

Measuring the impact of Western sanctions on Russia’s economy is not an exact science. The companion piece to this article suggests that by early 2023, the country’s real GDP was 7-10% below what it would have been had sanctions not been applied following the invasion of Ukraine. This calculation relies on comparing forecasts of Russia’s GDP growth before and after the invasion. There are other ways of doing this ‘counterfactual’ calculation that give a similar answer.

This reduction in GDP growth is likely to continue through 2023 and early 2024. What happens thereafter will depend on the evolution of Russia’s military activities and Western sanctions. But Russia will be able to develop alternative trading patterns that will dampen any future impact of these measures.

It is worth noting that real GDP is a measure of the output of goods and services deflated by a price index. The fall in expected GDP growth in Russia is likely to understate considerably the cost to Russia in terms of real personal disposable income – the fraction of GDP that is available to households to spend on goods and services.

Economic prospects for Russia therefore hinge on what happens to oil and gas exports, and on the extent to which the country can find new markets for exports and new suppliers of essential imports, and reduce its reliance on Western supply chains. Financial flows will also depend on measures taken against Russian financial institutions and individuals, some of which involve complex offshore arrangements, and the ever-present threat of legal appeals.

How have sanctions affected Russia’s GDP?

There are many ways of measuring the impact of sanctions on Russia’s GDP.

First, there is a comparison of forecasts of Russia’s GDP growth for 2022 and beyond before and after the imposition of sanctions. This calculation gives a figure in the range of 7-10% of lost GDP by early 2023.

Second, real GDP growth in Russia has historically been closely correlated with the real price of its oil exports. As Figure 1 shows, there is a strong positive relationship pre-war between the two variables (other than during the period around the global recession in 2009-10).

Russian growth performed poorly in the period when oil prices fell after 2015, but it was higher in the earlier period when oil prices typically averaged around $80-100 per barrel and the country’s real GDP averaged around 4% a year – coincidentally, the level that oil prices reached at the end of 2021, several months before the invasion of Ukraine took place.

So, 4% growth is a crude benchmark of where Russia’s GDP growth might have been in 2022 had the invasion not occurred. Given reported negative growth in 2022 of around -2% to -4.5%, and the low forecast for 2023, this very simple calculation again suggests a minimum GDP cost of 7-9% of GDP by early 2023.

Figure 1: Russian GDP growth (%) versus Urals oil price ($/barrel), 2005-2020

Source: Authors' calculations

Third, we can look at similar episodes of policies that inhibit trade with existing trading partners. For example, the UK’s decision to leave the European Union (EU) has caused problems for the economy arising from the erection of trade barriers with Europe, costs of trade diversion, reductions in foreign investment and so on. In economic terms, these are equivalent to limited self-imposed economic sanctions.

Counterfactual estimates of the costs of Brexit to the UK economy place the cost to GDP by late 2022 at from 4% of GDP to 5.5% of GDP. These figures estimate scenarios, based largely on historic data, of ‘what would have been’ UK GDP growth in the absence of Brexit. They do not do this by looking at current GDP estimates for the UK.

It is hard to believe that the costs of an explicit regime of sanctions imposed on Russia as a share of GDP is going to be less than the Brexit cost as a share of GDP; indeed, it is likely to be considerably greater.

What do GDP statistics mean for Russian living standards?

GDP is made up of the sum of goods and services produced, valued at market prices, or deflated to ‘real’ terms where an accurate price index is available. In markets, goods and services can be valued at sale prices. GDP calculation is not an exact science at the best of times, but where there are no markets for output (notably for services, and especially for publicly-provided services), valuation is especially problematic. And without data-intensive decomposition techniques, it is hard to measure output quality.

Several characteristics of post-sanctions Russian economic activity are important to consider. Since the start of 2022, there has been a shift to a ‘command economy’, with a greater share of GDP produced directly or indirectly by the state. This share will increase still further if, as Putin promises, production of war materials is accelerated in 2023.

Analysis of Russia’s 2023 public budget suggests that relative to 2022, there will be a 50% increase in spending on ‘security’ (including not just military activity but also prisons and the prosecutor’s office), a 9% reduction in spending on health, a 2% reduction in education spending, a 24% reduction in infrastructure spending and a 19% fall in industrial spending. All of this is in the context of a sharply increasing budget deficit. The higher public budget share of GDP and, within it, of spending on security, squeezes private consumption.

But public outputs are typically not valued at market prices. Instead, they are typically measured at input costs. This means that the evolution of GDP figures in Russia reflects in part the greater share of cost-based rather than market-based sectoral measures. While this may seem like a technicality, it is vital for our understanding of the true economic effects of Western sanctions on the Russian economy.

In general, greater public spending (‘inputs’) may not translate into higher ‘output’ as measured by performance. A productivity decline is likely to be occurring in Russia, but it will be concealed if a large share of GDP is calculated on a cost basis. In particular, accelerated diversion of resources into state spending on military production is almost certain to induce substantial inefficiency and hence a reduction in the amount of output for a given level of inputs (‘productivity’).

In fact, when statisticians attempt to value public sector output by measures that are not wholly cost-based, for example, by ‘activity analysis’, measures of GDP change look very different (as in the education sector in the UK’s GDP). For these reasons, GDP figures on a cost basis are likely to be inflated relative to a market-based approach.

Sanctions also affect measured value even when looking at goods that are suitable for final consumption or as industrial inputs outside the government sector. If normal channels of import of machinery or essential goods (or indeed luxury consumer items) are closed off, replacement will be costly (by smuggling) or inferior (by diversion to other sources of lower quality). The costs arising from these activities are considerable but they will not be reflected in an adjustment to measured GDP.

Channels for imports that are opened can also be closed if Western countries respond with further sanctions or trade restrictions inducing further costs in the search for new suppliers and construction of supply chains. But in the absence of sophisticated and detailed measurement of quality and market prices – data that are unlikely to be available to Russian statisticians, let alone to international institutions such as the International Monetary Fund (IMF) and the World Bank – it is hard to know by how much values for products of a given quality will be inflated.

So, it is virtually impossible to compare the current nominal value of GDP in Russia with past values. There is a strong likelihood that Russia’s nominal GDP values are inflated relative to past estimates. The diversion of resources to activities that are measured on a cost basis and not an output basis, that are not available for final consumption and the failure to measures the additional mark-up to consumer prices of diverting to lower quality or more expensive suppliers, are likely to continue well into 2023 and beyond.

A cumulative impact of 20-25% on personal disposable income by the end of 2023 is plausible, but this burden is likely to fall disproportionately on the urban middle class rather than rural areas where incomes are lower.

What about the complexity of the oil and gas industry?

Russia’s economic fortunes are closely linked to the prospects for its oil and gas exports. The benchmark ‘Urals price’ of Russia’s oil is currently around $30-40 per barrel lower than the price of Brent crude. And Western sanctions include a cap of $60 per barrel on the price of Russian oil traded with sanctioning nations, compared with Russia’s costs of production ranging from $20-50 per barrel. Russia is therefore vulnerable both to a fall in world oil prices (as happened in late 2022) and to further cuts in the sanctioned cap on prices.

But, as ever under a regime of sanctions, the situation is more opaque than is illustrated by these numbers. Evidence suggests that Russian oil companies are receiving more revenue per barrel than is indicated by the Urals price from their sales in various countries, albeit still at a discounted price relative to the Brent oil benchmark.

It is thought that since Russian oil companies were in effect paying a ‘windfall tax’ to the Russian government on prices above a fixed price, they have an incentive to under-report their revenues to the authorities – a form of ‘transfer pricing’. The difference is held by refiners in non-transparent offshore accounts. This is why reported revenue from oil exports remains high while the Russian government has recently faced serious budgetary problems.

Whether the Russian government can obtain access to such offshore funds depends both on the willingness of the companies to reveal information and the success or otherwise of sanctions on Russian assets held abroad by Russian nationals and by the government itself. The extent of Russia’s capacity to mobilise cash reserves held abroad – despite financial sanctions – remains largely unknown.

There are also additional costs in keeping Russian oil exports moving as pipeline exports to Western Europe are closed off. Russia has purchased a large fleet of elderly tankers, but it is not thought that this suffices to compensate for the loss of pipeline exports in volume terms. Shipping oil by tanker, according to industry estimates, costs between two and five times as much as by pipeline, even ignoring additional marine insurance and other costs.

Indeed, the uncertainty in oil markets, the risks of collateral damage adjacent to the war zone, and the sudden demand for extra shipping have raised transport costs considerably. So, while Russian companies have had some success in diverting exports of oil to countries that are not implementing sanctions, the exercise is costly for both Russia and recipient countries – and the latter have strong incentives to purchase oil from less risky sources.

While reported revenues from the sale of oil and gas have remained buoyant, there are problems: Russian oil is now more costly to export than before and it is sold at a discounted price below oil from other sources. The Russian government is also struggling to collect revenues from oil companies to alleviate its budgetary problems.

Tightening sanctions at the end of 2022 has worsened these problems. As before, it is the willingness of Western countries to maintain and enforce sanctions into 2023 and beyond that will determine whether Russia can continue to finance its activities in Ukraine.

What are the longer-run prospects for Russia?

Those who have been sceptical of the short-run impact of sanctions on Russia have nevertheless tended to take a more sanguine view of the long term, arguing that sanctions will have an impact through a number of channels:

The collapse of foreign investment incentives.
The continued freezing of overseas assets of Russian parastatals and companies.
The ‘brain drain’ of skilled young Russians.
Action against oligarchs.

Such an assessment relies on the assumption that Western nations can continue to enforce existing sanctions and potentially extend measures where clear breaches are apparent. There are plenty of uncertainties here, including the possible election of a more isolationist president in the United States, and the willingness of Western nations to continue to supply weapons and other assistance to allow the Ukrainian military to resist Russian offensives.

But the focus here is on the long-run economic issues. There is little doubt that the collapse of Western foreign investment and the brain drain of skilled Russians have caused serious short-run damage to the Russian economy. But there are other potential partners, especially in Asia, looking for outlets for both investment opportunities and employment for skilled workers.

China is facing restrictions on investment opportunities in Europe and North America, and India, which has stayed broadly ‘neutral’ in the conflict, has a skilled young workforce in information technology and similar occupations. Over time, these nations may be the sources of replacement in physical and human capital. Other supply chains for machine tools, information technology and essential hardware will gradually develop and reduce reliance on imports from Europe.

The issue of freezing overseas assets becomes crucial to Russia as its domestic assets dry up. But the question of which assets are frozen and whether the Russian government can gain access to assets held overseas is complex. In addition, sanctions on oligarchs were often implemented hastily and sometimes targeted badly.

It is clear that some assets held abroad by Russian oligarchs that are close to Putin remain untouched due to layered and complex offshore companies. Conversely, some oligarchs have complained that they have little connection with the Putin regime and yet have seen their assets frozen. It is likely that several cases will end up in court, and that the justification for sanctions on particular individuals will be explored in much greater detail in future.

The consequence is that the impact of sanctions will gradually weaken over time. The history of sanctions is precisely this: that they may be effective in the short run but that this effectiveness declines in the long run. But this is the reverse of what has sometimes been asserted concerning the sanctions regime imposed on Russia in 2022.

The evidence presented here suggests that these measures have been highly effective since, perhaps, mid-2022 and that the Russian economy by the end of 2023 will be in serious difficulties. By this time, it may become clear whether the war on Ukraine can be maintained militarily and whether the Russian regime in its current form will survive.

Where can I find out more?

The Centre for Economic Policy Research (CEPR) has a series of reports on the effects of the invasion and subsequent sanctions, available here.
Assessing the impact of international sanctions on Russian oil exports: VoxEU column by Tania Babina, Benjamin Hilgenstock, Oleg Itskhoki, Maxim Mironov and Elina Ribakova.