Economists say Moscow and Putin will not be emptying the conflict chest any time quickly

Men in military uniforms walk in Red Square in front of St. Basil’s Cathedral in central Moscow on February 13, 2023.

Alexander Nemenov | AFP | Getty Images

The coming months will be crucial in determining how the Russian economy fares in the face of a new set of sanctions and how long it can keep pumping money into its military onslaught on Ukraine.

Russia’s budget deficit hit a record 1.8 trillion Russian rubles ($24.4 million) in January, with spending up 58% year-on-year while revenue fell by more than a third.

Industrial production and retail sales fell in December to their worst year-on-year declines since the start of the Covid-19 pandemic in early 2020, with retail sales falling 10.5% year-on-year while industrial production contracted 4.3%. compared to a 1.8% contraction in November.

Russia is yet to report its December GDP growth numbers, which are expected to feed into the full-year 2022 data scheduled for this Friday.

According to the World Bank, International Monetary Fund and OECD, Russia’s GDP fell by at least 2.2% and up to 3.9% in 2022 at best, and is widely expected to contract again in 2023.

However, both the Russian Ministry of Finance and the Central Bank claim that all of this is in their models.

According to Chris Weafer, CEO of Moscow-based Macro Advisory, several unique circumstances and accounting formalities explain the magnitude of the January deficit figure.

The sharp drop in tax revenue was mainly due to changes in the tax system that went into effect in early January, the Treasury Department claimed. Businesses previously paid taxes twice a month, but now make a consolidated payment on the 28th of each month.

The Treasury suggested that most tax payments from January through January 31 had not yet been accounted for and would instead be included in the February and March numbers.

Weafer also highlighted a change in Russia’s oil tax manoeuvre, which went into effect in January and is expected to iron out in the coming months, while the nature of Russia’s public spending allocation means it is highly concentrated and widening towards the year-end budget deficit.

Christopher Granville, managing director of global policy research at TS Lombard, identified two other factors skewing recent deficit figures.

First, this was the first pressure since the sanctioning states’ embargo on Russian crude oil imports went into effect on December 5th.

“Before that date, Europe had loaded Ural crude, then straight to zero, so Russian sea export trade had to be diverted overnight,” Granville told CNBC.

“Obviously, a lot of preparations have been made for this diversion (Russia buys up tankers, gains more access to the ‘shadow’ or ‘dark’ fleet, etc.), but the transition had to be bumpy.”

The real price of the Urals then fell, averaging just $46.8 per barrel from mid-December to mid-January, according to the Russian Ministry of Finance. This was the tax base for much of January’s oil and gas-related federal budget revenue, which also suffered from a easing of fourth-quarter revenue windfalls from an increase in natural gas royalty payments.

The Treasury also announced massive advance payments for government procurement in January, five times that of January 2022.

“Although they don’t say what that is, the answer is perfectly obvious: prepayment to the military-industrial complex to produce weapons for war,” Granville said.

How long will the reserves last?

For the month of January as a whole, the average Urals price rose back to $50 a barrel and both Granville and Weafer said it was important to gauge the impact on the Urals price and Russian exports as the full impact of the last round of Sanctions become clearer.

Sanctions countries extended bans prohibiting ships from transporting Russian-origin petroleum products from Feb. 5, and the International Energy Agency expects Russian exports to fall as it struggles to find alternative trading partners.

The export price of Russian crude is seen as a key factor in how quickly Russia’s National Wealth Fund is drawn down, particularly its key reserve buffer of 310 billion Chinese yuan ($45.5 billion) from Jan. 1.

Russia has ramped up sales of Chinese yuan as energy earnings have fallen and plans to sell another 160.2 billion rubles worth of foreign currency between Feb. 7 and March 6, almost three times the previous month’s figure.

However, Russia still has a lot in the tank, and Granville said the Kremlin will stop depleting its yuan reserves long before they are fully depleted and will instead resort to other means.

“A foretaste of this is the idea put forward by MinFin to unify oil taxation on Brent instead of Urals (i.e. a substantial increase in the tax burden on the Russian oil industry, which is then expected to offset the blow by investing in logistics, to curb the deficit vis-à-vis Brent) or First Deputy Prime Minister Andrey Belousov’s suggestion that large companies gleaming with profits in 2022 should make a ‘voluntary contribution’ to the federal budget (disputed magnitude: Rb200-250bn), said Granville.

Several reports over the past year have suggested that Moscow could invest in another wave of yuan and other “friendly” currency reserves if oil and gas revenues allow. However, given the current fiscal situation, it may not be able to replenish its foreign exchange reserves for some time, according to Agathe Demarais, director of global forecasts at the Economist Intelligence Unit.

“Statistics are state secrets in Russia these days, particularly in relation to sovereign wealth fund reserves – it’s very, very difficult to know when that’s going to happen, but all we see from the fiscal stance is that things aren’t going very well good, and so it’s clear that Russia needs to draw on its reserves,” she told CNBC.

“Also, it has plans to issue debt, but that can only be done domestically, so it’s like a closed loop – Russian banks buy debt from the Russian state, etc. etc. It’s not exactly the most efficient way to fund itself , and obviously if something falls, then the whole system collapses.”

Initial rounds of sanctions following the invasion of Ukraine aimed to lock Russia out of the global financial system and freeze assets held in Western currencies while preventing investment in the country.

Sanctions not about the “collapse” of the Russian economy

The unique makeup of Russia’s economy — particularly the significant proportion of GDP generated by state-owned companies — is a key reason Russia’s internal workings and war effort appear relatively unaffected by sanctions, at least at face value, Weafer said.

“That means that when times are tough, the state is able to inject money into state sectors, provide stability and subsidies, and keep those industries and services running,” he said.

“This is a stabilizing factor for the economy, but of course also an anchor in good times or in times of recovery.”

There is far more volatility in the private sector, Weafer said, as evidenced by the recent slump in activity in Russia’s auto sector.

However, he suggested that the government’s ability to subsidize key industries in the state sector has kept unemployment low, while parallel trade markets through countries like India and Turkey mean the lifestyle of Russian citizens has not been significantly affected so far.

“I think it increasingly depends on how much money the government has to spend. If she has enough money to provide social support and key industry support, this situation can last for a very, very long time,” Weafer said.

“On the other hand, when the budget comes under pressure and we know the government can’t borrow money, they have to start making cuts and making decisions between military spending, key industry support, social support, etc. That may change, but for now they have enough money for the military, for supporting key industries, for job subsidies and for social programs.”

In this respect, he assumes that the pressure from the domestic economy or the population on the Kremlin to change course in Ukraine is initially low.

Restricted access to technology

Demarais, author of a book on the global impact of US sanctions, reiterated that the most significant long-term damage will come from Russia’s declining access to technology and expertise, which in turn will lead to a gradual loss of its key economic cash cow – the energy sector .

The goal of the sanctions attack, she explained, is not a much-touted “collapse of Russia’s economy” or regime change, but the slow and gradual exhaustion of Russia’s ability to wage war in Ukraine from a financial and technological perspective.

“The technology gap, particularly those sectors of the economy that depend on access to Western technology or Western expertise, will definitely narrow in many areas and the gap between them and the rest of the world will widen,” Weafer said.

The Russian government, together with companies in so-called friendly countries, has launched a localization and import substitution program to eventually create a new technological infrastructure over the next few years.

“Even the optimists say it’s probably the end of the decade before that can be done, it’s not a quick fix,” Weafer said.

“I think even government ministers are saying until you get everything set up with training, facilities etc. it’s a program of at least five years and it’s probably more like seven or eight years before you can start engaging, if you do it right.”

A spokesman for the Russian Treasury Ministry was not immediately available for comment when asked by CNBC.

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