‘Floundering, Not Drowning': Russia's Economy Is Withstanding Sanctions Onslaught — for Now

• Moscow is working to recalibrate its economy in the face of a barrage of international sanctions imposed by Western powers in response to the war.
• The Russian economy shrunk by 4% year-on-year over the second quarter, although this was less sharp than the 5% expected by analysts.
• Although many economists are focusing on the long-term structural threats to the Russian economy – which the government and central bank are scrambling to counter – the more immediate collapse predicted by some has not come to fruition.

Russia's economy contracted in the second quarter – the first full three months since the country's invasion of Ukraine – and economists are divided over whether it can continue to weather the onslaught of international sanctions in the long term.

The Russian economy shrunk by 4% year-on-year over the second quarter, although this was less sharp than the 5% expected by analysts. The Central Bank of Russia expects the downturn to deepen in the quarters ahead, reaching its lowest point in the first half of 2023.

It comes as Moscow scrambles to recalibrate its economy in the face of a barrage of sanctions imposed by Western powers in response to the war, which have disrupted trade and all but ostracized Russia from the global financial system.

"There have been signs of stabilization in many sectors over the past month or two but we don't expect the downturn to bottom out until Q2 2023 and think the economy will stagnate at best thereafter," said Liam Peach, senior emerging markets economist at Capital Economics.

The immediate impact of sanctions was mitigated by swift action from the CBR to deploy capital control measures and hike interest rates sharply. The measures stabilized domestic markets and even saw the ruble become one of the top performing currencies in the world so far this year.

Subsequently, fiscal stimulus measures and substantial cuts to interest rates have also taken effect, blunting the short-term impact of sanctions. Late last month, the central bank shocked with a 150 basis point reduction in Russia's key rate, taking it to 8% and marking the fifth consecutive cut since it launched an emergency hike from 9.5% to 20% in late February.

"The downturn could have been much deeper but the central bank took immediate measures to prevent a financial crisis from taking hold. It also seems that the resilience of Russia's energy sector cushioned the impact of Western sanctions," Peach added.

However, many economists consider the long-term damage to Russia's economy to be much more severe, as a flight of business and talent gradually compresses economic activity, along with a lack of access to critical technologies.

Meanwhile, sanctions have hit some areas of the economy hard, with manufacturing output falling 4% quarter-on-quarter, and production in import-dependent sectors slumping more than 10%.

Consumer demand has also weakened sharply; retail sales slid 11% quarter-on-quarter following March's brutal inflation shock, while consumer confidence collapsed and monetary conditions tightened.

"Q3 is likely to be another weak quarter, albeit a smaller contraction than in Q2. The downturns in retail sales and manufacturing have softened, inflation has eased and monetary conditions have loosened," Peach said.

"Even so, the economy still faces severe headwinds, including limited access to Western technology and a looming ban on the provision of insurance for shipping Russian oil, which we think will cause output to fall 10% next year."

Capital Economics does not expect Russian GDP to bottom out for another year or so.

Floundering, not drowning

Aug. 24 will mark six months since global sanctions were first imposed on Russia in response to its invasion of Ukraine on Feb. 20. There are now over 11,000 international sanctions on the country.

Although many economists are focusing on the long-term structural threats to the Russian economy – which the government and central bank are scrambling to counter – the more immediate collapse predicted by some has not come to fruition.

"Despite the onslaught of sanctions, and the predictions of many observers, Russia's economy has not imploded and, although facing a contraction of 5-6% this year, is in no danger of collapse or likely to experience any form of an economic or financial crisis," said Chris Weafer, CEO of Moscow-based Macro-Advisory.

"It is, however, facing 5 to 7 quarters of low single-digit decline and a lengthy list of challenges which, if not addressed effectively, will keep growth near stagnation for many years."

In a research note Friday, Weafer suggested that the Russian economy is "floundering, not drowning."

Macro-Advisory estimates that the Russian state accounts for more than 60% of GDP, while small- and medium-sized enterprises make up less than 25%. This imbalance restricts growth during normal times but also insulates the economy during times of crisis, he added.

"The government, companies, and people are used to economic crises (this is the fifth since 1991), and support structures, for employers and in the social spheres, are well developed," Weafer said.

Meanwhile, business confidence, having dropped sharply in March and April, has returned to the long-term averages for both manufacturing and services.

Weafer also disagreed with recent assessments that the economy is on a long road to "oblivion," arguing that the mass exodus of Western companies from Russia would not be as detrimental to activity as widely assumed.

"Most of those exiting are either small companies (such as in retail fashion) or have sold to local buyers. Of the Top 50 foreign-controlled companies, only three have shut down completely," he said.

"Another three have sold to local buyers and 10 others have said they plan to sell to a local buyer. The others are staying. We calculate the hit to GDP at less than 1% because operational assets will remain in the country."

This stands in stark contrast to the "catastrophic" hit projected by a Yale University study published last month, which analyzed high-frequency consumer, trade and shipping data. The study's authors argue that sanctions and an exodus of more than 1,000 global companies are "crippling" the Russian economy.

But Weafer is far from convinced. "There is a great deal of skepticism about Russia's so-called resilience and ability, even willingness, to invest in localization, especially given how little has been done in such areas as technology, engineering, and specialist services over the past twenty years," Weafer added.

"But as previous crises have shown, Russia usually addresses such problems when left with no other choice, and usually only then."