- Hubert Walas
Fragile economy.
The Russian Ministry of Finance announced that tax revenues from oil and gas in January this year were down 46% compared to last year. In addition, there was a 59% increase in budget expenses due to the war effort. This combined produced a deficit of US$25 billion for the first month of this year alone. Maintaining this trend, Moscow would have reached a deficit of $300 billion by the end of 2023.
The embargo on Russian petroleum products, which has been in place since February, adds yet another black cloud hanging over the Russian economy. In the long term, Moscow is threatened with the collapse of the entire oil sector, as the Russians are running out of deposits that are profitable to extract.
All this comes at a time when Vladimir Putin is boasting of a surprisingly low decline in Russian GDP in 2022.
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"The current dynamics of the Russian economy has turned out to be much better than many experts predicted" - these were the words recently uttered by Vladimir Putin. The Russian president added that, contrary to the claims of many experts who predicted a 10, 15 or even 20 per cent decline in GDP, the Russian economy has contracted by a mere 2.1 %
Also, anecdotic reports from Russia say that shop shelves are not empty at all and that the Russian rouble, after the initial shock when it sharply lost value, became stronger than before the war.
These arguments underpin the narrative that sanctions do not affect Moscow as much as they were supposed to. Moreover, some European politicians who look more favourably towards the Kremlin, e.g. Hungarian prime minister Viktor Orban, argue that sanctions imposed on Moscow hurt the countries imposing them more than the recipient.
So what is going on? As usual, the issue is far more nuanced than the populist pronouncements of policymakers who care about lifting sanctions try to portray.
Let us start from the foundations. For those who follow the international situation, this is no news, but for the sake of order, it should be noted that for the Russian economy, such a foundation is the sale of hydrocarbons, i.e. natural gas and oil, including processed products. For example, by refineries.
The object of debate, however, remains what specific share of Russian budget revenues the raw materials sector is responsible for. A big one - that’s for sure. But big is a relative term. Mikhail Krutikhin, one of Russia's top, and at the same time independent, experts on raw material markets - a rare combination - estimates that oil and gas revenues account for around 40 per cent of budget receipts. Moreover, taking into account related factors such as dividends from state-owned raw material companies, taxes on employees of such companies and the industry as a whole, this share rises to as much as 60%.
In this light, the words of former US Senator John McCain, who called Russia a "gas station masquerading as a country", do not seem excessive.
When 60% of your budget comes from one sector, this has an obvious double effect. When the market situation is favourable, prices are rising, and you are gaining new customers, your budget also increases significantly. However, when prices collapse, and you have an outflow of customers, you are extremely vulnerable. Nassim Nicholas Taleb would call the Russian economy very 'fragile'. Almost all the eggs are put into one basket, and when the basket collapses, with a domino effect, everything else falls too.
Since Vladimir Putin took power at the beginning of the 21st century, the Russian Federation has experienced many benefits from the monostructure of its economy. Commodity prices, especially oil, were essentially rising, and Moscow was deepening its economic ties with its most important markets. Above all, with Europe, which was by far its most key customer. Two decades of sales prosperity allowed Moscow to build up massive foreign exchange reserves, which reached nearly $650 billion at their peak before the war. This, as we now know, was intended as an economic hedge against financial distress once aggression against Ukraine began.
The Russian monostructure, albeit short-term, also had a paradoxically positive effect immediately after the invasion began. Why? Because the markets reacted panic-stricken to the aggression of, after all, the world's key producer of natural resources. Especially in Europe, the price shock was very painful.
Although European countries, quite unanimously but to varying degrees, declared a shift away from Russian fuel imports, they did not do so overnight for obvious reasons. As a result, Moscow, despite having just triggered a major armed conflict, recorded record peaks in revenue from raw material sales.
If the war had ended in the anticipated three days, or even three months, or even half a year, Russia would have emerged from it not only achieving remarkable strategic success but also unscathed economically, as a budget surplus from the sale of raw materials would have covered the entire war expenditure.
However, the war did not end in three days, and Russia's hitherto most important customers began to cut their trade ties with Russia at an accelerated pace. This included a key partner - Germany.
What scale of connections are we talking about? Before Europe began rapidly diversifying its sources, Russia supplied Europe with 75% of all its natural gas exports and 55% of its oil exports.
So the Russian monostructure was doubly vulnerable. Not only is its budget based 60% on hydrocarbons, but their sales were similarly concentrated in one area - Europe. It is, therefore not without truth to say that Moscow indirectly attacked its most important customer, on which the majority of its budget rests. This says a lot about the strategic calculation and cognitive errors made by the Kremlin.
A year has passed, the West, including its most important customer, Europe, has imposed a palette of sanctions on Russia, including a price cap on oil in December and, since the beginning of February, sanctions affecting petroleum products.
Taking all this into account, what does this mean for the Russian crude industry? The RusEnergy analyst Krutikhin, quoted earlier, believes that Russia will lose....57% of its oil product exports in the coming months.
As Krutikhin points out - all major importers of petroleum products from Russia, i.e. European and North American countries, have refused to buy Russian petroleum products since February. This means that there will be overcapacity in Russia for the production of crude products.
To date, the majority - let’s recall 75 per cent, of the petroleum products produced by Russian refineries have gone for export. This means that a large proportion of refineries will be in serious trouble. Russian oil wells will also be threatened with closure or at the best, stoppage, if at all possible.
At this point one word usually comes up - 'Asia'. If not Europe, which, after all, is dying out anyway, then Asia, which is becoming the gravitational centre of the world, will pick up Russian exports. The problem, as the Carnegie Endowment analyst notes, is that countries such as India and China are themselves exporters of oil products and are in competition with Moscow in this field.
So what fate awaits the Russian budget? Krutikhin believes that Moscow has to reckon with losing half of its revenue from oil sales. Moreover, given the disappearing gas exports to Europe and the lack of prospects for a surge in sales to China and India, a very general estimate suggests a loss of 30% of the total budget revenues.
30% of budget revenue. Is this even real?
As it happens, Moscow recently presented its budget plan for 2023, and the results for the first month of the current year have also emerged. Let's take a look at these figures.
According to the Russian budget plan for the current 2023 year, federal budget expenditure is expected to be some $409 billion, while revenues are expected to be around $368 billion. Thus, the deficit would be 41 billion, a healthy 2% of GDP - given the international circumstances in which the Russian Federation finds itself. The plan was to herald an improvement after a 57 billion deficit at the end of 2022.
Where, then, is here the 30% hole Krutikhin is talking about? Let's take a peek at the financial report for the first month of this year. Here much is explained.
Compared to January last year, revenues fell by 35% to $19 billion, while expenses rose by almost 60% to $44 billion. The budget hole thus amounted to $25 billion in January alone. That is, in the first month of this year, Moscow reached 60% of the deficit planned for the whole year.
Extrapolating this figure to the whole year is perhaps not the most sensible thing. Too many variables and unexpected events can take place to trust such linear predictions. Nevertheless, these figures are a good illustration of the scale of the problem Moscow faces. For if the trend from January is maintained. The budget hole at the end of this year will be at $300 billion.
30% of the revenue loss mentioned by Krutikhin would mean that annual revenues would be $257 billion, not $368 billion. So, on this account alone, the deficit grows to $152 billion. But even this on an annualised basis is only half of the budget hole from the January trend. What about the other half? The war-ridden country is not only earning less but also spending more. And so, depending on the sources, the war is costing Russia from $130 billion, according to Russian sources, to $328 billion, according to US sources. And therein lies the rub.
However, at the beginning of the material, another big figure was mentioned - nearly $650 billion of Russian foreign exchange and gold reserves, which were supposed to be a hedge against the worst-case scenario, which, as the quoted figures show, is now underway.
The problem is that of this amount, Moscow currently only has $100-150 billion available. How is this possible?
Firstly, it should be remembered that some 80% of the reserves - some $500 billion - were foreign exchange reserves, while 20% - $130 billion - gold reserves. Shortly after the invasion, more than 60% of the foreign exchange reserves worth about $320 billion were frozen under US decision and pressure. What remained, therefore, were assets worth about $180 billion, mostly in Chinese yuan. Of this pool, Moscow has already managed to use between 60 and 100 billion over the past year. This leaves some 80-120 billion in liquid assets. There is still 130 billion left in gold, but selling it is extremely difficult, and the Kremlin would have to do so at a very steep discount. Even in a record-breaking last year, all world governments bought $70 billion worth of gold, half the value of the Russian treasury.
It is also worth noting that in July 2022, the Russian State Duma made information on reserves a national secret, and the data we get may well be inflated by the Russians.
Raw materials and reserves are among the most important variables. Yet, alongside this, Moscow is experiencing a number of other slumps that, when combined, also resonate strongly on the country's financial health. To name but a few, we need to consider the departure of 1-3 million citizens from the country and the enlistment of hundreds of thousands of young men - the engine of a healthy economy - in an activity of no economic benefit, i.e. frontline combat and death. At least 100 000 of them are now dead.
In addition, Moscow is investing heavily in artificially maintaining the ruble exchange rate. The ruble has strengthened after its initial post-war collapse. However, the ruble became strong by pumping a sea of money into its stabilisation, as well as through draconian currency controls and a decline in imports. The Kremlin profoundly hampered its withdrawal and currency conversion. Russia's largest bank, Sberbank, closed 783 branches last year; including other banks, it is safe to assume that well over 1,000 bank branches across the country were closed. But, even despite these actions, it is estimated that some $250 billion dollars flowed out of Russia last year.
Take even the optimistic figures boasted by the Kremlin, according to which Russia's economy was expected to shrink by only 2.1 per cent. This figure takes everything into account, including a dramatic increase in arms spending. A freshly manufactured tank sent to the front and immediately destroyed by the Ukrainians also counts as an increase in gross domestic product.
This is why it is much better to keep an eye on the indicators that the Russian economy rests on - oil and gas, whose impact on the Russian budget is as high as 60%. Although, for the sake of fairness, there are voices of Russian analysts, similarly considered objective, that are less apocalyptic than Krutikhin's predictions. Vladislav Inozemtsev, director of the Centre for Post-Industrial Studies, estimates that the decline in production of petroleum products will reach not 57%, but at a relatively mild 12-14% relative to 2021 levels. Inozemtsev considers a decline of 50% extremely unlikely, as never before has Russia, or previously the USSR, experienced such a decline even between 1988-1998. On the other hand,, since 1945, Russia has not fought a kinetic war of this calibre.
What is certain, however, is that Russian exports are set to become even more primitive and therefore focus on unprocessed and, therefore, cheaper products. What else can Moscow do to mitigate the effects of the coming problems? In practice, it can only do one thing - raise taxes. On the one hand, increase them for oil companies, on the other hand, to burden its own society with, for example, an increase in fuel prices at gas stations. Wealth drain from poor Russian society just begins.
Inzomtsev, although he remains a bigger optimist in the short-to-medium term, agrees with Krutikhin on the long-term outlook. In a 10- to 20-year timeframe, they both forecast the near-total collapse of the Russian oil sector unless it undergoes a major modernisation.
Since the 2000s, the Russian upstream industry has shown a dramatic need for modernisation, as the share of hard-to-recover crude has steadily increased. Even before the war, in 2021, Russian Federation Energy Minister Pavel Sorokin said that by 2030 almost all Russian oil would be hard to recover. Krutikhin estimates that in 2035, only 30% of Russian deposits will be profitable to extract. Therefore, Moscow's goal in the last few pre-war years was to intensify the exploration of new deposits and open new production fields, including those on the Arctic shelf. This topic, not for the first time, was neglected, as it was more important to prepare the state for the coming war by, among other things, building up foreign currency reserves. Inevitably, the pervasive corruption and wealth-building of individual oligarchs also played a large part.
Yet, what are hard-to-recover raw materials? The Russian Ministry of Natural Resources defines them as reserves: "that are hard to recover, the cost-effective (profitable) development of which can only be carried out using methods and technologies that require increased capital investments and operating costs compared to traditionally used methods".
Two key words: capital and technology. Capital is leaving the Russian Federation at an express pace. Although this is paradoxically less of a problem. Much more critical is technology, or rather the lack of it. To maintain and, more importantly, develop its own mining sector, Moscow needs Western specialists and Western technology. With the current geopolitical conditions and the ongoing war, there is no chance of their involvement. The modernisation train has already departed. So, as Inzomtsev writes, 'a disaster in the Russian oil industry is very likely — perhaps not ‘here and now’, but within 7−12 years'.
Time will tell whether the Russian raw materials industry will collapse more quickly and drastically, as Krutikhin predicts, or more slowly, as says Inozemtsev. In either case, however, the most important part of the Russian budget is doomed to collapse, and no matter how hard the Kremlin powders the reality, that reality will sooner or later reveal itself in full force.
The final argument for the Russian case may be the far more devastating collapse of the economy of Moscow's enemy - Ukraine, which has shrunk by a third in the last year alone. It’s true that from this perspective, Kyiv’s fragility is much greater even than Moscow’s. It all rests on the West's willingness to keep Ukraine alive. Yet there are no signs that this willingness should evaporate any time soon, and the economic durability of Russia is nowhere near the economic durability of West-backed Ukraine. And when you wage a long war, in the end, there is one thing that matters - money.
Hubert Walas
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