Russia Country Report Aug22 - August, 2022

August 5, 2022

Russia Inc is doing better than expected despite sanctions. International Monetary Fund Chief Economist Pierre-Olivier Gourinchas told AFP in an interview that higher energy prices are keeping Russia afloat despite Western sanctions. The IMF has upgraded Russia's GDP estimate by 2.5 percentage points, but says that its economy is expected to shrink by 6% this year.

That is still a much better result than the 15% contraction that was predicted at the start of the war and the 8% contraction most economists were predicting only a month ago. The Central Bank of Russia (CBR) is even more optimistic, saying it now expects the economy to contract by only 5% this year.

Nevertheless the sanctions shock has delivered a lot of pain. Russia’s GDP contracted 4.9% y/y in June with the main support coming from a 2.3% growth in mining sector. But other sectors have fared far worst, depending on how dependent they are on imports – and it turns out nearly every sector in the Russian economy depends on imports to come extent.

Car-making has been worst hit, with production down in May to around 3,000 cars for the entire sector, six factories in total. Production recovered somewhat in June to 13,700 cars, but normally between 100,000 and 150,000 cars roll off production lines each month.

On the trade front Russia is doing much better. The production of oil and gas are both down but thanks to the high prices they are both earning record levels of money. China and India have stepped in and taken up most of the oil and that was exported to Europe, allowing production to grow again in June. The leakage to the sanction’s regime, as bne IntelliNews predicted at the start of the war, is significant. That is not to say that India and China are actively working to support Russia. More that both countries are taking advantage of the situation to make money.

The upshot is Russia is running an all-time high current account surplus that is on course to end the year around the $300bn mark - roughly equivalent to the amount of CBR reserves frozen by EU at the start of the war.

Russia reported a current account surplus of $136bn for the first half of this year, $100bn more than in the same period a year earlier, says Elina Ribakova, deputy chief economist at IIF. The budget is also in profit, although it is expected to go into deficit later this year.

The West floated a plan to introduce oil price cap to cut Russia off from these super profits, but it has fallen at the first fence as again it appears the idea is impossible to implement due the non-cooperation in the scheme by the nonaligned world.

The sanctions on technology and equipment are by far the most effective with the vast majority of machines and electronics barred from reaching Europe. This will force Russia to go back several generations of equipment and machinery and severely limit its access to modern technology. That will impair productivity growth and dooms the country to slowly fall behind the rest of the world, unless it can source equivalent technology from its partners in the east, which is currently unavailable.

On the macroeconomic front things are going well too. The CBR put through an emergency rate hike taking interest rates to 20%, but that, and strict capital controls, successfully stabilised the economy and since then the CBR has cut rates four times, bring interest back to 8% - below the pre-war levels. Inflation peaked in April and Russia is now the only country in Europe where inflation is falling, albeit still at a very high level above 15% as of the end of July.

The politics of getting the West to remove or ease sanction has started in earnest. At the end of July the Kremlin singed off on a deal to allow Ukraine to restart its grain exports in exchange for easing sanctions on its own exports.

In a similar vein, Russia restarted flows of gas through Nord Stream 1 pipeline in July after it was feared this would not happen, but it reduced the flows for a second time from the already low 40% of capacity to 20% in order to maintain the pressure on Europe. Gazprom is asking for sanctions on all its imports of equipment to be lifted in exchange for expanding flows again.

The impact of the sanctions on most Russians are minimal and life in the cities continues as normal. While many imported foreign brands have disappeared entirely there are no shortages and more than half of Russia’s business report they have found new suppliers but only about 5% say they cannot find any alternatives to products they previously imported from the west. Although the CBR is expecting real incomes to fall by about 5% this year, the soaring value of the ruble means that in dollar terms wages slumped to $550 at the start of the war but have since doubled to close to $1,000 after the ruble appreciated to the mid 50s against the dollar – a fact not lost on the FX-savvy Russian population.

The war in Ukraine grinds on with Russia now having taken complete control of the Luhansk region and controlling more than half of the Donetsk region. Russia continues to massively outgun Ukraine and is slowly winding its forces down with artillery bombardment.

Ukraine has launched a counter act on the Russian held city of Kherson – the only asset Russia holds west of the Dnieper, but the outcome of that battle remains undecided at the time of writing.

At this stage no one is predisposed to restart peace talks and it appears that all players are waiting for a resolution of some sort on the battlefield.

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