Russia has caught a bad case of the Dutch Disease, an economic ailment that sends the value of a currency soaring well beyond what it should be and smothers the rest of the economy.

Symptoms include: a flood of cheap imports that drive your domestic producers out of business and the falling competitiveness of exports that leads to a ballooning currency account deficit. Listless economic growth and falling tax revenues cause balance of payment problems and big budget deficits.

The term was coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of the large Groningen natural gas field in 1959. The gas field – which has just been taken offline because it started to cause earthquakes and empty gas pockets collapsed – earned so much money for the country that it drove the value of the guilder up too fast and made the rest of the economy unproductive.

In Russia’s case it is the windfall the Kremlin is earning from sky-high oil prices, exacerbated by sanctions on Russia’s ability to use dollars. At the start of the war in Ukraine the value of the ruble crashed to a nadir of RUB133 to the dollar. US President Joe Biden boasted in March that sanctions were “crushing the Russian economy” and that “the ruble is reduced to rubble.” But then it quickly rallied as the petrodollars flooded in and traded at an astonishing RUB53.2 to the dollar as of June 28 – its strongest level in seven years.

“Russia’s financial system is back to business as usual after a few weeks of severe bank runs,” Elina Ribakova, deputy chief economist at the Institute of International Finance, wrote on Twitter last week, adding that those who thought “that cutting Russia from financing for a few weeks at the beginning of the (operation) would stop the (operation) have proven naive.”

Artificial ruble rate

Russia’s version of the Dutch disease is extra painful but it’s a slow-moving disaster that could take years to inflict its full damage. For example, thanks to a quirk of Russian budget accounting, while budget spending is set in rubles, a big part of its income is based on the dollar price expectation of revenues from oil exports, denominated in the budget in dollars. That means the Kremlin is one of the biggest winners from devaluations, as it has more rubles to spend, even if they are worth less, but when the ruble strengthens its budget spending gets squeezed. Russia ran a large surplus in the first four months of this year, but the budget will eventually go into deficit as a result of the squeeze, but that won’t happen until late this year or maybe next year.

However, the strong ruble is largely artificial say economists. The Central Bank of Russia (CBR) immediately slapped strict currency controls on the exchange of rubles in the first days after the war on Ukraine started. As the pressure has come off the economy, the CBR has started to ease those restrictions. For instance, the amount of time hard currency earning companies have to surrender their earnings to the central bank has been increased from three days to 120, and the amount they have to give up has been reduced from 80% to 50%.

But many restrictions remain. Foreign investors into Russian stocks and bonds remain trapped in the country and the CBR is micromanaging international transfers. Elina Ribakova, deputy chief economists at IIF says that the regulator is afraid of massive capital flight, as if it eases the restrictions too far that could top $200bn by her estimates. In the last big crisis in 2008 some $350bn fled the country as capital flight in the aftermath of the crisis – as much money as returned during the boom years in the noughties, as bne IntelliNews reported in an opinion piece, “Capital flight to make your eyes water”.

The ruble has also been artificially inflated by the almost total collapse of imports. Figures show a 40% drop in imports to Russia in April compared to the same month in 2021. German exports to Russia in particular, Russia's biggest trade partner in Europe, slumped in March 2022 by €1bn, a decrease of 58.7% compared with March 2021, according to the German Federal Statistical Office (Destatis), adding to earlier analysis that found Russian imports had fallen to a two-decade low. In particular machinery exports from Germany to Russia were down 73.6% to €165.8mn compared with March 2021, and for exports of chemical products fell by 40.9% to €158.7mn.

On the flip side, imports from the Russian Federation to Germany rose by 77.7% to €4.4bn in March 2022 from March 2021. Crude oil and natural gas were the most important goods imported from Russia with an increase in value terms of 56.5% to €2.4bn. As a consequence, imports exceeded exports in trade with Russia by a record €3.4bn in March 2022. In February 2022, the excess of imports over exports had been €1.4bn. despite the sanctions regime, Russia is still raking in cash from Europe. And even with the energy embargo and self-sanctioning, Russia's oil exports were up 12% in the first five months of this year, as the fall in volumes was more than compensated by the increase in prices. Gazprom Neft CEO Alexander Dyukov said last week that Russia is already shipping 50% of its oil to Asia.

“At the beginning of the year, basically, three-quarters of our oil went to Europe, now more than 50% is supplied to the Asian market,” he said, during SPIEF.

Normally, a strong ruble would suck in a boom in imports, especially machinery which has made up about half of Russia’s imports since President Vladimir Putin took office in 2000. But Western sanctions on machines and technology, and the informal self-sanctions that have seen hundreds of foreign retailers exit, have seen imports collapse that would otherwise automatically bring down the value of the ruble.

The cancellation of virtually all European flights to Russia has also hit the tourism industry, which also stops “imports” of tourist services; Russians love to travel and spend at least $5bn a year on just holidays in Turkey, which counts as imports in the national accounts, because Russians take cash out of the country.

Another factor pushing up the value of the currency is that the so-called budget rule has been suspended, under which any excess oil tax earned from oil when price of a barrel is more than $42 was siphoned off into the National Welfare Fund (NWF) and taken out of circulation, keeping the value of the currency under control. The CBR dropped the rule after the West seized some $300bn of its reserves in March, leaving it short of dollars.

Oil prices and exports

Russia’s Dutch Disease looks like it will stay in place for a while. Oil prices fell to a low of around $25 in 2020 during the worst of the coronavirus (COVID-19) pandemic but are now back at well over $100 a barrel and are expected to rise even further as the EU attempts to wean itself of Russian imports.

Brent oil prices may rise to $135 per barrel in the second half of this year as the EU plans to cut 90% of Russian oil imports by 2023 as part of the sixth package of sanctions introduced in June, the IHS Markit consulting agency (part of S&P Global) forecasts in a recent report.

Without the ability to spend its extra month, the high value of the ruble is hurting the Russian economy, but the CBR is almost powerless to weaken the ruble without crashing the economy through unleashing massive capital flight. Denis Manturov, Minister of Trade and Industry, says that metals exports are only profitable at a RUB70/dollar exchange rate, as labour and production costs are in rubles, but the export earnings are in dollars. German Gref, head of Sberbank, called exports the economy's “poison,” while imports are the “cure.”

One of the cures to Russia’s Dutch Disease, and one of the few options open to the Kremlin, is simply to choke off the stream of those petrodollars, which may be part of the logic of reducing Russian exports of gas to the West. In the middle of June Russia’s state-owned gas behemoth Gazprom announced it was reducing flows of gas to Europe by 60% due to technical problems and the company has already cut off half a dozen countries for refusing to participate in its gas-for-rubles scheme.

Widely taken as a political attack on Europe, which still can’t do without Russian gas supplies, the Kremlin can well afford to cut them, which will reduce the inflow of un-spendable dollars and so help weaken the ruble.

“Most governments broadly miscalculated the perspectives or the worldview of the Russian elite and what Putin cares about,” said Alina Polyakova, president of the Center for European Policy Analysis. “It has been clear for a very long time that Putin and the people around him don’t care about economic growth. What Putin and the elites care about is revenue, and they’re still getting revenue from energy sales… Sanctions are certainly not deterring Russian forces from the kind of military operation they’re carrying out.”

Russia also benefits from the geopolitical knock-on effects from the oil embargo as the sanctions are allowing America’s top strategic competitor, China, to buy massive amounts of oil at heavily discounted prices, as Russia seeks willing customers to replace lost revenue. Russia has also leapt up the rankings in importance for India, which also gorging on the discounted commodity prices to massively increase its imports of Russian raw materials.

Russia is actively searching for new import partners to try and soak up some of its excess dollar liquidity. During last week’s BRICS summit, Putin said trade between the Russian Federation and the BRICS countries expanded by 38% to reach $45bn in the first three months of 2022, and trade with China and India was up by triple digits in the same period.

Just how extreme things have become was highlighted by the increase in the value of Russian imports from Belarus that has now surpassed that of goods arriving from Germany, Bloomberg reported on June 8. In March, Belarusian exports to Russia totalled $1.3bn against Germany’s $1.1bn. The trend continued into April, with Belarus ramping up sales to $1.5bn, while German imports fell to a little over $800mn in response to European Union sanctions against Russian businesses.

But boosting imports from “friendly” countries is limited and it will take a long time to build up enough to compensate for the hundreds of billions of dollars of lost imports from the West.

The government is happy for the meantime, as one of the side-effects of the strong ruble has been to reassure the devaluation-battered population that the government has a grip on the situation. But the Kremlin is already taking about ways of weakening the ruble.

Last week First Deputy Prime Minister Andrey Belousov, in an interview with Interfax, said for the first time that “both at the expert level and in government structures” there is a discussion about the transition to “ruble targeting” instead of “inflation targeting,” a policy that the CBR has been following since CBR Governor Elvia Nabiullina took over in 2013. Belousov said in this case the target value for the ruble would be RUB70-RUB80 per dollar, roughly where it was before the war started.

Nabiullina is reportedly dead set against exchange rate targeting and it was she that introduced the free-floating ruble early by dismantling the currency corridor in November 2014 in the midst of another oil-price induced shock that had existed in various forms for almost 20 years since 1995. Nabiullina repeated clearly during her speech at this year’s St Petersburg International Economic Forum (SPIEF) that the ruble must remain a floating currency.

But all the talk of switching from inflation to exchange rate targeting is academic. Without lifting the restrictions that would allow foreign investors to quit the market, the only tools available to the government to affect the exchange are extremely crude: boost imports or cut exports.

“The only option [to control the value of the ruble] seems to be to limit energy exports voluntarily,” political scientist Ilya Matveev said in a threat on Twitter. “It can very well be that the most recent reduction of gas flows to Europe is motivated by the economic, not the political logic,” Matveev added, who describes Russia as suffering from “Dutch Disease on steroids.”

In this setup, the short-term cutting oil and gas exports has become the only really effective tool the Kremlin has in its arsenal to manage the value of the ruble.