Russia’s economy was smaller than that of Texas even before the latest and most lethal sanctions imposed by Washington.
It has diminished further to Benelux proportions after the ruble’s 10% crash this week, the steepest fall since the late Nineties.
Upon this slender economic base, Vladimir Putin’s Russia is posing as a world-class superpower, the new master of the Middle East, insisting on its ‘droit de regard’ over the old Tsarist realms as if by natural right.
What is extraordinary is than anybody should believe in such geostrategic posturing.
The harsher truth is that Mr. Putin squandered the windfall wealth of the commodity supercycle and hollowed out what remained of the Soviet industrial and engineering base, leaving Russia’s Potemkin economy in a futureless cul de sac.
He has succeeded (so far) in propping up his ally in Syria but this tells us little about the global balance of power. It is easy enough to lend air support to a regime with ground forces already in place, if you are willing to carpet bomb civilians without pity.
The West’s tortured hesitation reflects entirely valid doubts over Syria’s three-way struggle, and the Salafist alternative. It too simple to confuse this with weakness.
The Kremlin likes to dismiss Western sanctions as a flea bite. Not any longer. “The measures are turning into a tool of real economic war,” said Russian premier Dmitry Medvedev.
The US Treasury document announcing sanctions – to punish “worldwide malign activity” – is a mortal threat to the Putin oligarchy, almost intended to provoke an internal palace coup by the Siloviki in the Kremlin.
It openly alleges that Oleg Deripaska, aluminium king and head of Rusal, “ordered the murder of a businessman”. It cites claims that Suleiman Kerimov from Polyus Gold laundered hundreds of millions of euro buying villas in France, “transporting as much as 20 million euros at a time in suitcases”.
Deripaska has described the sanctions as “groundless, ridiculous and absurd”.
What is new about these sanctions is that they target pre-existing securities. The previous measures in 2014 had a perverse effect since they targeted only fresh issuance, which raised the scarcity value of pre-existing bonds and gave comfort to foreign investors. Tim Ash from Bluebay Asset Management said there was feeling that you could navigate around it.
The latest twist turns the named companies into international pariah, as Rusal is discovering. It has been blackballed from the London Metal Exchange. Its listed share price on the Hong Kong exchange has fallen 58% this week.
This is a foretaste of what lies in store for Russia’s corporate elite. No Americans can deal with sanctioned entities, and no Europeans can do so lightly without provoking the US Treasury under “secondary sanctions” clauses – if they have any commercial dealings with the US. Belgium-based Euroclear said immediately that it would comply.
The US Treasury has a very deep reach into the international dollarised payment system, and is armed with an elite commando unit skilled at what it calls “boa constrictor” methods. Chinese banks might step into the breach and lend to Russia (at a price) but even they will hesitate.
Investors must now contend with the prospect that almost any oligarch could be targeted and that any Russian asset – including sovereign bonds – could be tainted and therefore plunge in value overnight. This risks a collective rush for the exits. Nobody wants to be trapped in a firesale. Sberbank shares are down 17% over the last two days even though it is not on the list.
Russia has been the darling of emerging market funds over recent months as its economy stabilized and Brent crude prices recovered to $70 a barrel. Investors badly misread the political risk, but they were not alone.
Standard & Poor’s raised the country’s credit rating to a BBB investment grade in February, deeming the national finances strong enough to “absorb shocks that could come from tighter sanctions”. This judgment will be put to a severe test.
Russian vice-premier Arkady Dvorkovich has promised to rescue sanctioned companies, implying that the state will cover the debts of private firms and state-owned companies if need be. Now the Reserve Fund is exhausted and was shut down in December. Much of the residual $67bn Welfare Fund is committed.
The Kremlin will have to tap the central bank’s $453bn portfolio of foreign reserves. “If the sanctions go on long enough and the circle expands, the cushion may not be enough,” warned an editorial in Vedomosti.
To be clear, the country is not facing an imminent financial crisis. The floating ruble acted as a shock absorber through the oil crash.
The fiscal deficit is a modest 2% of GDP, though it is arguable that Russia will struggle to finance any deficit at all if sovereign bonds are added to the sanctions list. The country lacks a functioning domestic bond market. But all in all, Russia survived the trauma.
What it faces instead is ‘neo-stagnation’, to borrow from former British ambassador Sir Andrew Wood. It is caught in a self-feeding cycle of decline as infrastructure crumbles and young brains leave.
The deep recession of 2015 and 2016 may be over but per capita income is stuck at $8,800 and industrial wages are now lower than in eastern China – let alone Poland. The post-Soviet convergence with the West has stalled. There is no new growth model for the 21st century.
The drastic plan of autarky and import substitution launched three years ago by president Putin to break dependence on commodities – 80% of exports during the boom – has come to little. Reliance on foreign farm machinery was to be cut 56% by 2020, and engineering equipment by 34%. None of this happening. Machinery imports are rising.
Russia is still hostage to oil and gas. Energy provides a tolerable living for now but US shale has entirely changed the structure of global oil industry, capping each rise in prices with a surge of new drilling. It has become a headwind.
Russia’s own production costs are rising as the old fields decline by 3-5% a year in Western Siberia. The energy ministry warns that output could halve by 2035 unless there is a wave of investment.
The coming surge of US liquefied natural gas (LNG) has deprived Mr. Putin of his pricing power in Europe. He was able to charge $12 (MMBtu) in 2012. Today his gas fetches around $5 even if his volumes remain high. This is the long shadow of global LNG.
Mr. Putin wasted Russia’s oil bonanza from 2005 to 2014 on hubristic rearmament. The Stockholm International Peace Research Institute said the military budget rose 8.1% in real terms in 2014 and another 15% in the final mad year of 2015 when the economy was already contracting.
Finance minister Alexei Kudrin resigned with a warning that it would ruin the country, and that is exactly what it did.
The Russian military added a fleet of new Su-34 long-range combat aircraft, and batteries S-400 surface-to-air missile systems, even as pauperization spread through the Russian provinces. It coincided with the negligent disarmament of the West, made worse by Europe’s austerity overkill.
This misalignment created a window that Mr. Putin has exploited. The window is about to close again. Russia can no longer afford the military rent, and the West is rearming fast.
A nuclear-armed Sparta under a despotic leader with totalitarian propaganda tools can of course be very dangerous. But please don’t call Putinism a success.