From, April 6, 2022, Condensed text:)

As the US and the EU discuss new sanctions against Russia after the horrific images from Bucha, it feels weird to speculate about the prospects of the Russian economy once this war, which we are required to call a “special operation,” is over. Yet peace always comes, one way or another. Even the Hundred Years’ War came to an end. The Ukrainian president understands this when he says that peace talks must continue. So we would do well to take stock of what we have irrevocably lost and what we may still be able to salvage.

US President Joe Biden says Russia’s economy has been crushed. People are panic-buying things like sugar and sanitary pads. Yet, according to a recent Public Opinion Foundation poll, many Russians are feeling optimistic: When asked whether they expected the situation in Russia to get better, get worse or remain the same in the next six to 12 months, 33% said they expected an improvement. When people were asked the same question about the situation in three to five years, an even higher number – 49% – said they expected things to get better.

My conversations with friends who stayed in Russia seem to corroborate the polling results. Of course, they are anxious, but their everyday lives have not changed much. “Things will get back to normal soon,” many of them keep saying. Some hope that the hostilities will soon be over, and then sanctions will be lifted, and Western companies will come back. Others hope that Russia will be able to manufacture everything it needs on its own, or that China might step in and help.

Natalya Zubarevich, an expert on socioeconomic development trends in Russia’s regions, thinks that most people have yet to feel the bite of the sanctions: Aircraft and trains are not in need of repairs just yet, retailers still have consumer goods in stock, and Western companies leaving Russia continue to pay salaries to their employees. Few people realize how complicated value chains are today, and all the countries, including Russia, are so deeply involved in the global division of labor that there is not a single high-tech product that does not have imported components.

So, does this mean that the Russian economy is doomed?

Not exactly, says economist Yakov Mirkin. Even from 1917 to 1920, when the economy dropped as low as 15% to 20% [of its former level], some things still continued to work amid the complete ruin. [Russia had] a “gray” sector of the economy, and off-the-books agricultural production. “Yes, we are about to suffer a major setback with advanced technologies. Yes, our manufacturers will be hard-pressed to find replacements for imported parts that are no longer available. Yes, sanctions target the critical sectors of the economy (technology, microelectronics, aviation, etc.). But the future of Russia will be decided by the speed with which our economy can reorient itself toward the East to a much greater degree than before,” Mirkin says.

The Sinicization of the Russian economy has been under way since 2014, the economist explains. With Western imports ebbing, Russia has been increasingly importing from the East.

Until 2014, Russia was building a “bridge” to connect itself with the European Union. After 2014, it started working on a “bridge” connecting with China. “Nobody knows how this may pan out. There are too many unknowns. In any case, the example of Iran has demonstrated that Eastern nations are at times reluctant to join Western sanctions. There are too many other interested parties and too many players,” Mirkin says.

On the other hand, the US has warned Beijing that helping Russia evade Western sanctions will cost China dearly [see the article under China in this issue]. For example, China’s exports to Russia may face sanctions if anything American was used in the manufacturing process – components, tools, equipment, technology or software. Sergei Khestanov, a macroeconomics advisor to the CEO of the Otkrytiye Investitsii [Open Investments] brokerage firm, points out that China has only three processor brands manufactured domestically, and only one of these three is not subject to these restrictions. “And as for chip-making equipment, there is only one company in the world that makes that, and it is in the Netherlands,” he says.

Nevertheless, Mirkin estimates the likelihood of an Iranian scenario for Russia at 60% to 65%. “In this scenario, the government will control 80% to 85% of the economy, while the job of the private sector will be to provide people with food, clothing and entertainment. The door to Europe will be slightly more open than in the case of Iran, but cross-border mobility for people and cash will be very limited, both to Russia and to the outside world. Russia will use its energy export revenue to buy whatever it is allowed to buy in the West. The exchange rate will either be fixed or heavily regulated by the government,” Mirkin predicts.

The Iranian scenario is not the worst case, Khestanov says. It would be much worse if Russia makes an attempt to bring back the Soviet command economy model. “I was thoroughly shocked when I saw an op-ed in Kommersant advocating indicative planning. I guess we now have a new generation of economists who are too young to remember Gosplan [the State Planning Committee in the Soviet Union]. But I remember how terrible it was. There was always a shortage of some things and an excess of others. Equipment nobody needed would sit idle, getting rusty – all because it is always easier for a factory to manufacture the same product forever,” the expert laments. It is possible to recreate the Soviet Union, Khestanov explains, but living standards would plummet in such a dramatic fashion that it would probably trigger major social unrest. Mirkin estimates the likelihood of such a scenario at 25% to 30%, leaving the remaining 10% for a black swan scenario.

The toothpaste is out of the tube.

. . . “Speculating about the prospects of the Russian economy once hostilities are over is useless at this point. We don’t know when and how they will end. We don’t know what the terms of a future peace deal will be. We don’t know whether there will be more sanctions imposed, or what they might look like,” says economist Maksim Mironov. As far as sanctions are concerned, theoretically speaking, any sanction can be lifted at some point, he says. This is true even of the most painful sanction so far – the freeze on Russia’s international reserves kept in the West. “As far as Russia’s frozen international reserves are concerned, I’d like to remind you about Libya’s case: Once Muammar Gaddafi paid all the court-ordered compensation, Libya’s assets were released. So, it is quite possible that the same thing will happen with Russia,” Mironov says.

Russia’s postwar economic performance will largely depend on geopolitical dynamics, says Yevsei Gurvich, research director of the Economic Expert Group think tank. “If hostilities cease in Ukraine, sanctions may be eased a bit, but Western countries will only agree to significant easing if they decide that the terms of the ceasefire sufficiently take Ukraine’s interests into account,” he says. In any case, the expert says, the toughest sanctions, like the freeze on some of Russia’s international reserves, are unlikely to be lifted any time soon. “I would venture to make a prediction: As a first step, we will see some Western countries returning to Russia; as a second step, we will see Russian banks reconnected to SWIFT (which will make things easier for the international partners of our companies and banks). All the other steps will take a pretty long time and definitely won’t happen this year,” Gurvich says.

So far, the US has been introducing sanctions through presidential executive orders, which means the president can lift them in the same manner, through an executive order. But once they pass Congress and are signed into law, it will be practically impossible to waive them.

The Jackson-Vanik amendment is a good example in this regard. It took decades to be repealed. By that time, the Soviet Union, against which it was introduced, had long ceased to exist. At the same time, Khestanov is positive that it will take the US Congress, as well as the EU Parliament, a very short time to pass the corresponding bills and make sanctions part of their legislation. “Given all these images people see on TV and the influx of Ukrainian refugees to Europe, politicians can’t afford to disappoint their voters and fail to introduce tougher sanctions, especially considering that many Western countries have elections coming up,” Khestanov says.

No matter what the terms of the peace deal are (that is, if there is a peace deal), sanctions won’t be lifted, Mirkin says. At most, the West might waive some of the easiest sanctions, like the ban on Russian airlines.

“We will all have to learn to live in a tight cocoon, military-style, in a situation of extensive surveillance, conformity and a stifled economy. This will last for many years, if not decades. This means that we may have reached the same kind of turning point as in 1917,” Mirkin warns.

In addition, it is not even clear at this point what this hypothetical peace deal might look like, Khestanov points out. And this may continue for a very long time. We have clearly reached a stalemate where neither of the parties can achieve a clear victory. “We can use South Ossetia as an example. Can we really say that the conflict is over? I’m not even sure if they actually have a peace treaty on paper. Northern Cyprus and Taiwan are other similar examples,” Khestanov says.

Don’t count your chickens before fall.

Khestanov said we will have to wait until fall before we can get at least a general idea of what the Russian economy might look like going forward. The problem is, there are basically two forecasting methods, and neither of them is applicable in the current situation, he explains. The first method is called linear extrapolation. You just project current trends into the future, which does not work with the current situation. The second one is pattern recognition: You find a similar situation in the past and use your prior experience to make predictions about the future. But we have never had anything similar to the current events, Khestanov says.

“I only need to know one number to be able to make predictions – and that is, I need to know how much money Russia will make in export revenues. And I need to know with certainty that this number will stay roughly the same, give or take 20%,” Khestanov explains.

Currently, Russia gets about $300 billion a year in energy export revenue. Approximately $100 billion of this amount gets divided between businesses, the general population and state coffers, while some ends up being moved abroad, Khestanov says. “At this point, we can’t estimate how much Russia is going to lose from the disruption of its supply chains. Obviously, Russia is going to lose some of its exports. But will it be able to compensate for these losses? And how much of the lost exports will it be able to reroute? At this point, we only have one projection from the International Energy Agency (IEA), and we have to take it with a grain of salt. The IEA says Russia has lost about 3 million barrels [of oil] a day. This may be not too far from reality. If it’s true, this is a very significant loss, considering that Russia used to export 7 million to 8 million barrels a day,” Khestanov says.

It will be very difficult to reroute energy exports, because a large portion of them goes through pipelines. “Russia has an oil pipeline and an oil terminal in the Far East, but their capacity is too low. There is the Sila Siberi [Siberian Might] gas pipeline, but, again, it has a very low throughput capacity. The Trans-Siberian Railway is already being used to capacity for coal exports to China. There are some preliminary estimates saying that building a new gas pipeline from Urengoi to China would cost about $200 billion and take roughly five years,” Khestanov says.

There is also one technical issue: By the time gas gets to Germany, roughly a quarter of it has been burned off by the compressor turbines. Gas does not flow through the pipe on its own; you have to pump it through. The distance to China is greater than to Germany, so transmission losses will be higher. “In addition, Gazprom started a gas war against Turkmenistan in 2009, and as a result Turkmenistan built four pipelines to China – and Turkmenistan is much closer to China than Russia,” the expert continues. He says oil executives admit in off-the-record conversations that Russia will only be able to reroute 25% to 28% of its energy exports to the East due to capacity limitations.

In fact, would China be interested in buying all of the oil and gas that Russia has to offer? China would not only ask for a discounted price – for example, China buys Iranian oil at a 20% to 50% discount. Instead of paying cash, China pays Iran in consumer goods.

Also, China has plenty of options available when it comes to gas suppliers. In addition to four pipelines from Turkmenistan, China has 13 major ports for oil and liquefied natural gas tankers that operate all year long.

“In other words, if Russia loses about 40% of its export revenue, it will only have about $180 billion left. But there is something the government could do in this situation. It could avoid a disaster by allowing the ruble to lose some of its value,” Khestanov says. The ruble is gaining strength at the moment, but this is an artificial phenomenon, and the government won’t be able to sustain the current exchange rate for very long, he explains. Otherwise, the exchange rate will cease to perform its key function of balancing the budget.

If the rubles depreciates, inflation will go up. . . .

“I can see several factors that will continue to push prices up. First, imported goods, as well as Russian products that use imported components and parts, will cost more. Second, Ukraine is one of the world’s largest suppliers of grain, and due to hostilities there, food prices will inevitably go up throughout the world (including Russia). Third, food import operations will be seriously impaired by disrupted supply chains,” Gurvich explains.

High inflation coupled with unemployment will have a major impact on income levels. “First, some people will lose their jobs because foreign companies are leaving Russia, because factories cannot operate without imported parts or for some other reason. Next, higher unemployment means that labor is no longer a precious resource, making it cheaper (meaning lower wages for workers). The authorities will probably further index pensions and salaries in the public sector, but while this indexation will soften the blow for retired people, doctors and teachers, those working in the private sector will see their real incomes drop,” the expert says.

While the drop in household incomes is not likely to be as bad as during the [1998] default crisis in Russia, industrial output will probably shrink even more than it did then. “The situation, of course, is highly unpredictable, but Russia’s economy shrinking by approximately 10% seems to be the most likely scenario. That would mean the largest drop-off in industrial output over the last 28 years – that is, since 1995,” Gurvich says.

Another factor that can help balance the budget, apart from the ruble’s depreciation, is a major reduction of imports – a much bigger reduction than in exports. “It is a law: When exports drop, imports drop even more,” Khestanov explains. In fact, it is not clear at this point what Russia will be able to import, as the sanctions sound tough but somewhat vague. . . .

Considering that shipping goods to Russia takes an average of at least three to four months, or maybe even more, the effects of the sanctions on economic decision-making in Russia will not become manifest until September or October, Khestanov says. “By that time, many things may happen, and the situation may be very different. Today, when every person has a smartphone with access to the Internet, the media coverage of war has become much more vivid. And considering that bloodshed often results in even more bloodshed, it is hard to make predictions about where we may be by that time,” Khestanov says. At this point, the expert says, “even the gods have no idea what might happen to the economy.”