In December the EU commissioned a secret report to assess just how badly the war in Ukraine, and the polycrisis it is fuelling, is hurting Europe’s economy. Good news: the conclusion was that the bounce-back effect of sanctions imposed on Russia has “largely spared” Europe’s own economy. In all, the EU member states have spent a total of €525bn on relief and subsidies, and given the size of the EU economy (€16.6 trillion) that is a relatively modest amount – 3.1% or less than many countries spent on stimulus during the coronacrisis.
However, the same is true of Russia. Sanctions have not badly hurt its economy either. In the first month of the war Russia’s economy was widely expected to contract by at least 15% and things like its oil production and banking sector were supposed to collapse. Not only did that not happen, but Russia is actually making more money than it has ever made before. This year the current account surplus is predicted to be $270bn by the end of the year – more than twice as much as the $120bn it had in 2021, and that was already an all-time record.
Calculating the cash cost to Russia is very difficult. The budget has earmarked a total of $75bn (RUB4.7 trillion) for military spending this year, which is planned to double to $84bn next year. However, you could include the spending on the police, which is set to be almost as much as on the military and is presumably to prevent anti-war demonstrations or make sure they are easily crushed if they happen. All-in-all as part of the new three-year budget passed in December, Russia intends to spend a total of $600bn on defence and security out to 2025.
Another way to look at the cost is the cost of the 3% contraction this year. Russia’s economy was worth $1.8 trillion in 2021, so a 3% contraction is only worth about $53bn. That is a lot less than the $267bn that a 15% contraction would have been worth.
In relative terms the sanctions war is costing Europe about 3% of GDP so far (just counting subsidies), whereas adding Russia’s contraction and budget spending and the cost is of the order of 7% of GDP, although it still remains well within Russia’s means to finance it just from the windfall $150bn extra it has earned this year from commodity exports. If you add in the spending on the police the total rises to around $200bn, but Russia can easily afford that too, as it has another approximately $180bn in the National Welfare Fund. Russia still has plenty of money.
Of course, both the EU and Russia have suffered considerable economic pain. In Russia the automotive sector has almost completely collapsed. At its low in March Russia turned out a mere 3,000 cars, as opposed the 100,000-plus a month it usually makes. Since then output has recovered somewhat but overall production remains down by about 60%. Many sectors have been deeply wounded and will not fully recover in the foreseeable future.
And long term, Russia’s growth potential has been cut from an already flaccid 2% to a mere 1% – far behind the global growth rates on the order of 4%. Russia is doomed to stagnate over the coming decades and steadily fall behind the rest of the world.
The EU has not gotten off scot-free either. The disappearance of Russian gas has been especially painful. As bne IntelliNews reported, Europe’s heavy industry has been shutting down as things like the fertiliser, chemical and other industrial subsectors that rely on gas as an input or a fuel have been force to close because they can’t afford to buy gas, can’t get enough, or have simply become economically unviable with gas prices more than ten times their usual level.
Both Russia and the EU have to some extent de-industrialised as a result of the sanctions war.
In this context to ask “who’s winning” is to oversimplify the problem. Europe can replace Russia’s gas with LNG and import the chemicals it can no longer make. Russia also can offset the pain of sanctions with the higher prices of the commodities it produces, as economists say that higher prices are here to stay as a result of the unprecedented attempt to inflict sanctions on one of the world’s biggest producers of nearly every commodity under the sun. Nevertheless, much of the damage done to both sides is directly comparable, even if the sectors worst affected are different.
One of the issues underpinning the EU’s relative good performance is that it has pulled its punches at nearly every stage of implementing the nine packages of sanctions so far.
The first “massive package” of sanctions imposed in the first week of the war have probably done the most damage and will continue for the foreseeable future. Even if Russian President Vladimir Putin were to die tomorrow and the war ends, it is unlike that any of the biggest sanctions would be withdrawn for decades, as was the case with the Soviet-era Jackson-Vanik sanctions.
The first sanctions to target energy were the fifth package of sanctions in April that included coal and limits on providing shipping services to Russia. But as this disproportionately hurt the Greek economy, its shipping lobby successfully won exemptions, so a month after the shipping bans went into effect on August 10 Russia was exporting more coal than ever before and at prices that are 165% higher than last year.
As bne IntelliNews detailed in a recent blog, as the sanctions regime progresses they are becoming increasingly more symbolic as Europe is being as careful to not hurt itself as it is enthusiastic to punish Russia. Moreover, as the boomerang effects of sanctions become more pronounced the remarkable unity shown by the EU in March is already visibly cracking. In this context it is no surprise that Europe’s economy has been “largely spared” a lot of damage from the sanctions as they were specifically designed with that goal in mind. And they had to be, as the support for sanctions runs the whole gamut from Poland, which see Russia as an implacable foe, to Hungary, which is energy dependent, and its leader Prime Minister Viktor Orban admires Putin’s strength.
Given the EU’s prerequisite for a unanimous approval amongst all 28 member states, each package is subject to a laborious process of negotiation and compromise that inevitably waters down their impact at each stage.
Even with the oil price cap scheme imposed on December 5 – potentially the most damaging sanction to date – set the cap at a level that makes no difference to the Russian budget at all: the cap was set at $60 per barrel of oil, whereas Russia currently sells its Urals blend at $55 or less. The stated aim of the sanction is to cut the Kremlin off from its oil revenues but $60 allows the Kremlin earn just as much as before.
Effect on Europe
The main channel transmitting the effect of sanctions on Russia to Europe and the rest of the world has been through the polycrisis that has induced soaring inflation, fuelled by rising food, commodity and energy prices that have done significant damage that can’t be avoided.
As bne IntelliNews has written elsewhere, inflation, and food price inflation particularly, is infectious. The US has suffered far less damage than Europe, as it is largely self-sufficient in most of the commodities Russia sells. Yet because of the way the food commodities market works, sky-high prices for grain in Cairo will immediately push the cost of wheat in Kentucky up to the same level, even if the US imports no grain at all. (It’s because the farmer in Kentucky could export at the higher prices if he wanted to that prices rise.)
The energy crisis and cost-of-living crisis has also been especially damaging in the West, with the UK suffering the most. Thousands of small and medium-sized enterprises (SMEs) are being put out of business by unaffordable power bills and it is here that the EU member states have been spending their money to alleviate the pain.
More specifically, the EU report on the sanctions impact found the restrictive measures have caused supply issues in sectors like wood and precious metals, but wider disruptions have mostly been because of the macroeconomic problems already described and Moscow’s own retaliatory steps like cutting off gas supplies to Europe over the summer.
For example, steel producers from Spain to Germany are beginning to slow down or entirely stop their output as the high energy costs make production unsustainable, even with steel prices up to near record levels. Construction steel is typically made in power-intensive electric furnaces that have been hit hard by the record power prices in Europe. So far, more than 3mn tonnes of annual capacity are already being affected by sharply rising costs, reports Steel News. At the start of September India’s ArcelorMittal, one of the largest steelmakers in the world, said it was planning to close two of its plants in Germany amid soaring electricity costs.
European fertiliser producers are also shutting down across Europe, unable to get the gas that is one of their main feedstocks for production.
The German chemicals powerhouse BASF, Germany’s biggest user of gas, has already temporarily shuttered 80 plans worldwide and is slowing production at another 100 as it plans further output cuts depending on what happens to gas prices. Rival ammonia makers Yara and CF Industries said last month they were also slashing ammonia production in Europe due to soaring gas prices.
And Warsaw-listed Polish chemicals powerhouse Azoty and its listed unit Pulawy have suspended or reduced production of some products, including nitrogen fertilisers and ammonia, due to skyrocketing prices of gas, the companies said on August 23.
In Romania, the operations of fertiliser producer Azomures have been disrupted since December 2021 by high gas prices. Azomures produces 50% of the fertilisers used by Romanian farmers and is the largest natural gas consumer in the country, accounting for 10% of total consumption.
The list goes on.
As of the end of November the EU has approved more than 150 national measures to mitigate the shock of Russia’s invasion against Ukraine as part of a temporary crisis framework that allows flexibility within state aid rules, which will add up to €525.5bn, according to the assessment.
At this stage it is impossible to say if German petrochemical, plastic and fertiliser plants that have been forced to shut down due to the sanctions war will ever be able to restart, but according to the EU assessment Europe can live without them if it has to.
Effect on Russia
Russia’s macroeconomic position is good, with most of the headline numbers registering surprisingly mild contractions given the severity of the sanctions. However, the effect of high commodity prices masks the pain most of the country is feeling; oil, gas, metal and grain revenues are all earned at the federal level, whereas the regional economies are dependent on income and local company corporate taxes, and so local economies are much more exposed to economic problems than things like Russia’s current account surplus suggest.
A drilldown into Russia’s industrial production by region by political analysts Andras Toth-Czifra highlights the impact on various Russian regions.
November was the seventh consecutive month of industrial production contractions as output went down for mining (-2.7% vs -1.8% in September); electricity, steam, and air conditioning (-2.4% vs -1.5%); manufacturing (-2.4% vs -4%) and water supply, wastewater disposal, and the collection and organisation of waste (-7.4% vs -7.5%).
Most of Russia’s internal regions are specialist producers based on their natural resources and have been differently affected depending on the product. For example, Toth-Czifra says there are continued problems in the timber producing regions of the Northwest, as well as regions which are heavily exposed to carmaking, such as Kaluga, Tartarstan and Tolyatti, after the automotive industry collapsed. Entire cities are dependent on carmaking, so the collapse of the sector is causing local crises that can't be easily solved.
Machine building, coal mining, metallurgy and more recently gas producing regions, all of which are either facing export bans or logistic bottlenecks thanks to the railways clogging up, are all feeling pain.
These problems are manifest in the region tax revenue collection, which was holding up well in the first half of this year but began to tumble in the third quarter, says Toth-Czifra. While the regional budgets are currently on track to end the year on plan, it is already clear that the centre will have to start paying subsidies or offering credits to a lot more regions in 2023 as their financial situation worsens. At the end of July only nine of Russia’s 82 regions had collected less than half their due taxes. But November 17 regions had fallen behind the budget plan for tax collection.
“Siberia and the Far East are still doing relatively OK, with some notable exceptions. But due to a lack of infrastructure and very concentrated investments into a handful of big projects, there's a limit to how much these regions can heat up as others cool down,” says Toth-Czifra.
The picture Toth-Czifra's deep dive paints is that Russia is not in trouble yet, but is clearly already feeling some pain and the situation is deteriorating, but not crashing.
“Even if the situation still worsens before the end of the year, the federal budget will likely simply increase transfers for now. But these problems will continue and receipts – including personal income tax, which has been fairly stable so far – will drop further in 1H2023,” Toth-Czifra said in a post on social media.
In the long term Europe has already won. Russia has been through five big crises in the last three decades and it has bounced back from each stronger and richer. However, it cannot recover from this crisis like it has done from the others.
Since 1991 Russia has been a market economy and outward looking, trading actively with the whole of the rest of the world. The difference with this crisis is that is no longer true. It has turned inward and the sanctions seek to restrict its trade.
Russia oil exports are a perfect example. Until February, Russia was selling oil at market rates and had finally joined the OPEC+ cartel to be better able to manipulate international prices. Since February Russia has been happy to offer discounts as deep as 35% on the market price, simply to keep the revenues coming in. The Kremlin is now more focused on earning enough cash to pay for the war and economic support at home than it is on profitability. And this mentality will have to remain in place until sanctions are lifted and it is returned to the international community. That could take generations to happen.