Is Russia in for a Hard Fall?

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Rudra Sil and Brenda Shaffer discuss the economic climate in Russia.

Russia is reeling under the double attack of Western sanctions and low oil prices hurting its revenues. Its currency has been devalued. Unemployment is rising. Inflation is running high. Wages are falling, benefits are being cut and pensions are getting eroded.

But Western powers may be overestimating the impact of all those factors to force Russian President Vladimir Putin into submission, according to experts. They note that several factors work in Russia’s favor: chiefly, strong currency reserves to ride out low oil prices; a continued, long-term growth in oil demand in the foreseeable future; the likelihood of oil prices strengthening, and the limited impact of Western sanctions on the lives of ordinary Russians. However, even as Putin seems set to wait out the crisis until oil prices pick up, Russia’s best long-term interests are in a rapprochement with the West, they add.

“[Russia] was flying high two or three years ago with a lot of surplus cash, and many opportunities to do dramatic programs in terms of geopolitical ambitions and new economic forays,” said Rudra Sil, professor of political science at the Penn School of Arts and Sciences (SAS) and co-director of the Huntsman Program in International Studies & Business. The drop in oil prices has forced the country to scale all of that back dramatically, he added.

“In hurting Russia we also hurt ourselves,” said Brenda Shaffer, a professor at Georgetown University’s Center for Eurasian, Russian and East European Studies, and an expert on energy and foreign policy. She noted that the Russian sanctions have cost the European Union one-half of a percentage point in GDP growth, citing recent EU statistics. Germany, as Russia’s second-biggest trading partner in Europe, is “bearing the brunt of the sanctions,” she added. (Sil and Shaffer discussed the impact of oil prices and sanctions on Russia and the global economy on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. Listen to the podcast at the top of this page.)

Russia will have “a hard fall,” predicted Mitchell A. Orenstein, professor in the department of Slavic languages and literatures at the Penn School of Arts & Sciences. Orenstein’s specialties include the political economies of Central and Eastern Europe.

Orenstein noted that the fall in oil prices prevents Russia from making large investments in industrial modernization. That will be further constrained “under the shadow of Western sanctions that prevent investment in key sectors and cut Russia off from Western finance,” he added. “Russia will be forced into austerity and to spend down its substantial reserves in order to protect public consumption … or to continue or accelerate foreign military adventures.”

“Russia is in a bit of a bind,” said Wharton professor of legal studies and business ethics Philip Nichols. He noted that the country was forced to change when the Soviet Union dissolved. While Boris Yeltsin faced difficulties in steering the country after the dissolution, “Putin brought much-needed stability,” he added. “One of the ways he did so was by using incentives outside of the formal, market economy. That is not very efficient, but Russia could get away with it because of the high price of oil. Well, the crutch of the high price of oil is gone.”

Impact of Sanctions and Cheap Oil

Sil said the oil price fall has made the sanctions important for Russia. “It has cut off opportunities to cushion the blow from the drop in oil prices,” he explained. “[Yet], they are not on a scale so dramatic within Russia that we can afford to expect sanctions alone to bring about regime change and pressure administrative change in Moscow. It’s a much more complex and nuanced issue.”

According to Nichols, the sanctions have selective and limited impact on Russians. “When I walk around Moscow or St. Petersburg, I do not see shuttered store windows or people lined up outside of food distribution centers,” he said. “More accurately, Western sanctions and Russia’s counter-sanctions in response have constrained the country.”

Nichols pointed out that for the most part, the sanctions targeted the actions and assets of individual Russians and were not meant to have an effect on the broader economy. It was only in the third round of sanctions that limits were imposed in the financial and extractive sectors, he noted. “For most Russians whom I speak with, it is actually the Russian counter-sanctions that have had a greater effect on daily life,” he added. “In particular, they really miss parmesan cheese.”

Financial sanctions have hurt Russia the most, according to Nichols. The impact goes beyond irritants Russians initially faced in using credit cards, he said. “Far more deleterious to the Russian economy, it is difficult to structure transactions that require international financing,” he added. “Foreign investors are worried about financing and payments, and there is increased uncertainty.”

“[The effects of cheap oil] are not on a scale so dramatic within Russia that we can afford to expect sanctions alone to bring about regime change and pressure administrative change in Moscow.”–Rudra Sil

Russia’s problems will no doubt hurt the world economy, but not as much as the contraction in China, said Sil. “China seems to drive so much of the global economy; relative to that, Russia’s problems are more of a domestic issue.”

Sil added that the EU as a whole might be able to survive the impact of the Russian sanctions. However, “countries like Greece, Spain and Italy are struggling a lot more, and these divisions are starting to come out this year.”

Positive Effects

“Ironically, the sanctions have to some extent had a salubrious effect on an economy that may have depended too much on imports from just a few places,” Nichols said. “The sanctions have forced businesses that sell foodstuffs and consumer products to Russian consumers to find different sources of goods, and for the most part they have.”

Nichols talked of how such local sourcing has helped McDonald’s in Russia. McDonald’s increased its profitability in Russia last year by increasing local sourcing to about 85%, he said. The fast food chain now plans to open 60 new restaurants in Russia in the coming year, to begin franchising outlets instead of owning them all, and to increase local content to 100% in the next two years, he added. “McDonalds had to look for supply sources not affected by sanctions, and that actually increased its profits.”

Options for Russia

Nichols said the options for Putin depend on how Russian citizens choose between stability on the one hand, and economic growth and global integration on the other. “If the Russian people desire economic growth and global integration, it seems that the government should wean itself from these informal structures and incentives and should promote leaner, more competitive and transparent enterprises,” he noted.

“Russia’s best strategy would be to back down from its confrontation with the West, pull out of Ukraine, and agree to turn the Ukrainian border over to Ukraine, in exchange for a face-saving lifting of the sanctions and counter-sanctions, which would also improve domestic consumption by making food, in particular, less expensive,” said Orenstein.

However, Orenstein does not expect Putin to budge. “Given the opposing logics of creating foreign adventures to distract Russians from domestic troubles and making peace with the West to lift consumption, however, it is unlikely that Putin will want to choose one or the other, but rather keep his options open and simply survive the bad times however he can,” he said.  “It was difficult dealing with Putin when he was flush with oil money; it will be equally difficult dealing with him backed into a corner.”

Meanwhile, Russia is not showing any signs of relenting. The Russian foreign minister, Sergey Lavrov, said that while he wanted to see a “reset” of Russia’s relations with the United States, Moscow would not budge on any of the issues that put it at odds with Washington, the New York Times reported. He added that Russia would not negotiate the status of Crimea, which it annexed in 2014.

According to Nichols, Russia’s best interests lie in resolving the Crimean issue. In such a scenario, “Russia may have to give up something — perhaps debt owed it by Ukraine,” he said. The benefits would be both the re-engagement of Russia with global institutions and the lifting of sanctions, he added. “In general, Russia would free itself of a damaging problem and could reclaim its position as a leading voice in global, rather than just regional, issues.”

“To think that somehow, because people are unhappy about the economy, it is going to bring down a government is often wishful thinking.”–Brenda Shaffer

Putin’s Mixed Record

Putin is unlikely to view the current trend of low oil prices as a “real crisis situation,” said Shaffer. “Putin knows a lot about oil.” She noted that when he came to power as prime minister in 1999, the oil price was $12 a barrel, or $29.5 in today’s dollars. Currency reserves in Russia at the time were about $12 billion and have since grown significantly, she noted. As of December 2015, Russia’s foreign currency reserves were more than $368 billion, according to TradingEconomics.com. In addition, Russia has rainy-day funds of another $120 billion.

Shaffer said Putin “also knows that oil works in cycles.” In fact, prevailing oil prices are setting the stage for an oil price spike, she added. “The oil price collapsing trends lead us to behavior such as non-investment in the oil sector, buying larger cars, becoming complacent about conservation, and set the stage for the oil price rise. Putin knows that.”

Sil credited Putin with some astuteness in handling Russia’s oil wealth. “He is the one who organized the reserve funds — the rainy-day funds — in 2004,” he said. “This is not a country that is simply squandering oil wealth. They have used it in a targeted fashion, and the result has been that the population more or less trusts the government to — at the moment at least — keep things together.” That said, Sil gave Putin “two or three years to get himself out of this jam” of the combined impact of weak oil prices and the sanctions.

For sure, Putin has also stumbled badly. Orenstein recalled how in late 2009, Russia under its then president Dmitry Medvedev made an abortive attempt to attract investments to modernize its industry. Medvedev had launched the so-called Skolkovo initiative to create a Russian version of Silicon Valley infrastructure, and succeeded in recruiting MIT and Stanford as partners.

“Putin (who was then prime minister), however, treated this program as a test balloon and at some point decided that it had failed, instead emphasizing ramping up the defense industries in addition to oil and gas,” said Orenstein. “From the perspective of today, that looks like an historic mistake. Many believe, however, that the Putin regime can never really succeed at innovation because it is too repressive and corrupt.”

Oil Demand Will Grow

Sil said that notwithstanding the current weakness, global oil demand will recover with the population growth and industrialization in developing countries. He cited Russia signing a $400 billion gas supply contract with China in late 2014 and its subsequent oil and gas deals with India. He also pointed to the untapped potential from “up and coming African countries.”

According to Shaffer, there is “nothing exceptional” about the current weakness in oil prices. She pointed out that $30 a barrel is actually the average price over the last 45 years, and that it is “not a historical low.” In fact, “what was exceptional was the high oil prices between 2012 and 2014.”

“Maybe without the prop of outrageously high oil prices, Russia will be forced to become more efficient….”–Philip Nichols

Shaffer added that the Chinese economy “is still growing,” even if it has slowed down, and that its oil demand hasn’t fallen, but is only growing at a less significant rate than earlier. This year, “not everything is set for oil prices to stay the same,” she said, alluding to a price increase. Instability in the Persian Gulf, with tensions among Saudi Arabia, Iran and Iraq, and other events “could knock off production there.”

The experts also saw some ominous signs. Instead of serving as a tool to force submission, lower oil prices “might make Russia more dangerous in some ways,” said Sil. “It can create a sense of panic that might lead to some more dangerous types of approaches than we’ve seen so far.”

Orenstein agreed. “The next few years will be the most dangerous in Russia-West relations,” he said. “Low oil prices may have to last for a long while before Russia is willing to make a serious agreement with the Europeans and Americans that will allow it to become a country in good standing in the West again, and one that is perceived as safe for investors.”

Misplaced Expectations?

Both Sil and Shaffer maintained that Western nations overstate the ability of declining oil prices to weaken Russia into submission. “When the price drop started, there was huge glee that Russia is going to pull out of Crimea and Iran is going to stop its nuclear program,” said Shaffer. “We don’t see any modifying effect on the foreign policy behavior of the oil producers.”

Orenstein noted that while devaluation will cushion the blow for Russia, it will not be enough. “Without lifting sanctions, very little new investment will flow into Russia to take advantage of lower costs,” he said. “Therefore, Russia has a strong incentive to initiate a rapprochement with the West. The West has a strong incentive to make sure that Russia gives up some of its core objectives in Ukraine and Syria.” He expected that Putin “will try to [wait] out” the current crisis.

According to Shaffer, among the factors working in Putin’s favor is that the ruble’s devaluation has helped Russia bridge its budget deficit. Also, polls in Russia show Putin’s popularity is high. She cautioned against using American foreign policy tools to analyze foreign governments in general, and especially authoritarian governments such as in Russia. “To think that somehow, because people are unhappy about the economy, it is going to bring down a government is often wishful thinking.”

Optimistic Outlook

Nichols is bullish about Russia in the long run. “Russia will be a prosperous and deeply engaged actor in the global community and economy,” he said. He added that the West has “not always been sympathetic or helpful” as Russia grappled with its problems. “Maybe without the prop of outrageously high oil prices, Russia will be forced to become more efficient, and people who can lead Russia through the next set of transitions will rise to leadership positions.”

Nichols also said that while he does not condone the seizure and annexation of Crimea, Russia and Putin have been overly demonized. “Perhaps the most damaging effect of the sanctions and the oil slump is that Russians are travelling less, and fewer people from North America are going to Russia,” he said. “The absence of human interaction and the subsequent caricaturing and demonization of each other might inflict the greatest long-term damage.”

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