09 07 2023

Is the Russian economy really a mystery?

Moscow cityscape Moscow cityscape Valerii Tkachenko. https://commons.wikimedia.org/wiki/File:Red_square_Moscow_cityscape_(8309148721).jpg

The Russian economy has apparently resisted the ‘sanctions from hell’ which were supposed to lead to an economic collapse. This has left a lot of economists and politicians perplexed. But it is no mystery. Sanctions hurt, but they also create opportunities, particularly in big and relatively advanced countries as Russia. The reason it is so difficult for many economists to understand is that they have enclosed themselves in a narrow neoliberal universe. What is happening in Russia has an important message for developing countries.

The ‘sanctions from hell’ did not produce the expected collapse of the Russian economy. Most major international financial institutions now expect the Russian economy to grow in 2023, after a negative growth of 2.1% in 2022 - the Russian prime-minister expects at least 2% in 2023 (unless something unexpected calamitous happens). This has left many observers of Russia scratching their heads: how can this be possible with all the sanctions put in place by NATO+ countries? Are the Russians defying gravity?

Of course they are not. And of course the impact of the sanctions has been severe. In 2021, before the start of the Ukraine war, I wrote here, about what would happen in case of war and ‘sanctions from hell’: ‘If trade were made completely impossible, Russian oil would still go to the world market, but the flow of natural gas from Russia to Europe would stop.’ ‘There would be a chaotic situation for some time, during which these (the Russian companies) would scramble to find new suppliers, locally or in other countries. However, (…..) it is not doomsday’.

And that is more or less what has happened. Russia’s main export products continue to reach the world markets, even if, in the case of oil, now by sea rather than through pipelines to the EU. Transport costs have become higher, and discounts are necessary to attract new clients (mainly India and China). And Russia has reduced natural gas production because of problems with markets.

Local industries have had to find new sources for inputs. Some inputs are now produced in Russia, others are sourced mainly from China, India and Turkey, and others are coming as parallel imports (via third countries). As foreseen, some industries have been seriously disrupted for a period (for example car production, which is still expected to reach only 50% of the pre-war level in 2023, or production of domestic commercial aircraft where modifications of existing models have been necessary to substitute parts from ‘unfriendly’ countries with local production, leading to delays of several years).

Car production in Russia collapsed in 2022 due to lack of parts and low demand. The photo shows Lada Vesta, introduced in 2015, when Renault owned Autovaz. Production of it stopped completely in 2022, but restarted in 2023 with a new version with no Western parts (Vesta NG). ABS brakes and EPS have been sourced somewhere else, probably China. It went on sale in June 2023 (at a price of around USD 18,000 for the basic version).

As the Russian economy has returned to growth, the main hurdle is presently labour shortages, as unemployment is at a historic low (3%), and companies are hiring more workers, particularly skilled workers, not least in the engineering and IT sectors. This should not come as a surprise, as some imports are being displaced by local production, which of course requires more workers. As a result, real wages are growing, particularly in the sectors with the biggest demand. Due to the labour shortages, some companies are now investing in improved technology, for example industry robots (where Russia is an absolute laggard internationally) or robots in agriculture (where it is particularly difficult to attract workers).

The swift adaptation of the Russian economy to sanctions is not only a surprise for foreign observers, but also for the Russians themselves. When the Soviet Union collapsed, the new generation of leaders of the private and the public sector wholeheartedly adopted the internationally dominating neoliberal narrative, and, as it is often the case, the newly converted turned out to be ‘more catholic than the Pope’, with profound disbelief in the State being able to play any meaningful role in the economy. Privatisations, deregulation, low taxes, free trade and free financial flows were considered the only efficient road to economic prosperity – they adopted the crudest version of the ‘Washington Consensus’. Neoliberal thinking is still dominant among many economists and politicians in Russia, not least in the Central Bank. A good example is Alexei Kudrin, who started working for Boris Yeltsin in 1996, and was Minister of Finance from 2000 to 2011, until recently one of the most trusted advisers to President Putin. He declared doom for Russia after the annexation of Crimea in 2014, and again after the invasion of Ukraine saying thatRussia's economy is set for biggest contraction since 1994’. He was obviously wrong and has apparently now been sidelined.

Sanctions have forced the Russians to rethink the neoliberal dogma. As an example, the Russian President admitted in 2021 his surprise ‘that Russia’s import substitution effort has produced "serious" result, although he had "certain concerns" when it began’. (There is an good overview over the challenges Russia faces in this Chinese research paper).

The Russian ‘industrial policy’ with its effort to substitute imports and create what they call ‘technological sovereignty’, particularly since 2014, has often been derided, inside and outside the country, as an erroneous policy incurring enormous costs and producing practically no effect. It is incorrect to say that there has been no effects, as there are many cases of newly developed domestic products, and some results are highly visible, particularly in the agricultural and food processing sector, but also within for example aviation and machine building. However, I think it is correct to say that this process has been very slow up to the invasion of Ukraine in 2022. The ‘sanctions from hell’ have obviously created a new sense of urgency and kicked many Russians into action, and things have finally started moving faster. As the saying goes: “Necessity is the mother of invention”,

The Russian aircraft MC-21, analogue to Boeing 737 and Airbus 320, was originally developed with many Western parts (engine, landing gear, avionics etc.). As sanctions have been gradually sharpened since 2014, the aircraft has had to be modified several times. The MC-21-310, which has no parts from ‘unfriendly countries’, has thus been delayed several years. The domestic PD-14 engine, which will substitute the American Pratt & Whitney PW1000G, was certified in Russia in December 2022. A smaller version (PD-8) for the regional ‘Superjet 100’ is under testing, and a larger one for upcoming wide-bodies (PD-35) is under development.

The reason this type of processes is so slow, is mainly inertia, or even laziness. Imagine for example a Russian oil, gas or mining company having to choose between using a trusted (Western) supplier of equipment and technology and buying or developing a domestic product. For these companies money is not a problem, but it is so much easier and less risky to just buy well-known imported goods ‘off the shelf’. The risk of supply interruptions was not considered a serious issue – until now. A good example is the private company Novatek, the biggest LNG producer in Russia. They had developed and patented their own LNG technology, but as the first pilot production line ran into complications, they decided to continue with imported technology for the rest of the production lines (from Austrian company Linde). Now, under sanctions, they have developed it further and are now suddenly convinced it can work. There are many similar examples. As German company Siemens pulled out of Russia, the country had no longer access to large Combined Cycle Gas Turbines, which power stations use to produce electricity from natural gas – a catastrophe waiting to happen when the existing turbines have to be replaced in the coming years. A similar domestic turbine has been under development for years – now a prototype (called GTE-170) has successfully gone through tests and the company promises to produce eight annually, which should cover the needs of the country (and permit the company to recoup the development costs in four years, it says). Before the sanctions, they would have had a hard time selling these domestic turbines as they lack a track record, but not now, as Siemens or GE turbines are out of reach. Something similar has happened for large diesel or gas ship-engines. In the software sector, both government and private companies have been accustomed to Western software, and shifting to domestic software would imply disruptions and upfront costs as systems and processes would have to be changed and people trained (even if later there would be large savings from license fees). They are now suddenly interested in the local software, which in many areas is quite developed despite the limited market opportunities, so the sector is now booming and desperately trying to hire more people. And so on.

Since the conflict with Ukraine started in 2014, Russia has had a problem with supply of large ship engines. United Engine Corporation (UEC), part of Rostec, has developed the 27,500 hp M55R diesel gas-turbine power unit. Severnaya Verf Shipyard picture.

What happens is that sanctions are a double-edged sword. They do damage to the sanctioned country, but they also force it to develop its own production, and if it has a basis of know-how and skilled people, engineers and researchers, they may be able to do so. These markets can then be lost for the sanctioning country for ever. That is what probably will happen for many Western companies because of the sanctions against Russia and China.

The history of particularly Asian countries shows that Industrial policy can lead to swift development, but the results are not guaranteed. Industrial policy can also degenerate into corruption and subsidies for inefficient producers, or in unnecessary promotion of local production where there are no security risks and imports can provide the products at lower cost. Heavy investment in education, research and development is necessary for industrial policy to succeed, and solid links between academic institutions and industry are essential. And, as I have noted earlier, there are considerable requirements in the area of the quality of the public administration, political legitimacy and governability.

In the good old days, industrial policy was mainly tariff protection, for example in the US in the nineteenth and part of the twentieth century, but since then many countries have used more sophisticated and effective policies, for example France, Japan, China and South Korea (I recommend readingKicking Away the Ladder: Development Strategy in Historical Perspective’ by South Korean institutional economist Ha-Joon Chang for an excellent, non-technical overview).

The Washington Consensus was deemed to have buried ‘development economics’ for ever. For an ageing development economist as myself, who has never believed that neoliberalism was the road to prosperity for developing countries, it is a satisfaction to see that a more nuanced view of economic development, solidly based in history rather than in simplistic neoclassic theories, is back in fashion, at least in part of the world.

It is fascinating to see how the chattering classes in the Western countries are scoffing at the idea that sanctioned countries may have a future. In this condescending view, solidly rooted in colonial supremacy thinking, it is impossible for other peoples such as the Chinese and the Russians to do without the brilliant Western culture and civilisation. Being ‘isolated’ from this civilised world, 'Borrell’s garden’, means becoming a pariah, and will inevitably lead to poverty and decline. They really believe it. Poor fellows.



A note on the economic growth in Russia

As I have noted before, there are some people who deny there is anything to explain concerning the Russian economy: the appearance of resilience is false, it is a result of the Russians hiding and distorting data and international organisations as IMF and the World Bank letting the Russians fool them. In reality, the Russian economy has already collapsed.

The origin of this fanciful story is Prof. Jeffrey Sonnenfeld. He earned his MBA and PhD degrees from Harvard University and started teaching at Harvard Business School, moving later on to Emory University. After an obscure conflict at Emory, where he apparently was framed and fired after a public scandal, he succeeded in coming back and was accepted into Yale School of Management, where he set up his own Institute, which he calls ‘The Chief Executive Leadership Institute’. His speciality is courses for CEOs of big companies and research in corporate leadership, and he has written a book – drawing on his own experience – on how disgraced CEOs can have a come-back.

In 1929, investigative reporter Tintin sets out for the Soviet Union to reveal the truth about communism, and by the way find the famous ‘Moscow Gold’. He successfully reveals that the Soviet industrialisation is a lie – the factories are empty and a worker is shovelling wet straw into a furnace to generate smoke for the chimney. It looks as if Prof. Sonnefeld has been inspired by this story. https://www.tintin.com/fr/albums/tintin-au-pays-des-soviets

He has no relation to Russia at all, apart from the fact that his grandparents migrated from the Soviet Union to the US in the 1920ties, and he has never published anything on the Russian economy (as far as I can find). His publications are all on corporate leadership and in particular the role of CEOs. After the start of the Ukraine war, he set up a project keeping track of international companies that have left Russia, publicly shaming the ones that have chosen to stay. However, this is a political activist project, not a research project. Even so, he has engaged in a very public, heated clash with a group of researchers from University of Gallen, Switzerland, who reported that most Western Companies in Russia are still active there. I have no opinion on this quarrel, and it is of no relevance here.

Sonnenfeld has a very high public profile, and his declarations on the Russian economy are widely reported in Western media – the name 'Yale University' seems to impress journalists and editors, particularly when the message is one they would love to hear. His lack of expertise in macroeconomics or Russia doesn’t matter. He scolded IMF for ‘recklessly reporting’ a minor negative growth for Russia in 2022 and – horror – projecting positive growth for 2023. “Why Is the IMF Pushing Putin's Economic Propaganda?”, he asks. ‘With ‘Zero Visibility’ into the Russian Economy, the IMF is Parroting Putin’s Line’, he and his colleagues write.

Well, most do recognize that the sanctions didn’t work as expected and that the Russian economy is now growing. Just to put Sonnenfeld’s fanciful story to rest, this quote from Reuters: ‘Russia's factory activity expands for 14th month running in June (2023)’. This is according to US consultant company Standard & Poor’s Global Purchasing Managers' Index (PMI) for manufacturing, and is based on interviews with leaders of main manufacturing companies around the world, including Russia. Just for comparison, in June 2023 the PMI for Russia was 52.6, while the global (world) PMI was at a six-month low of 48.8 (below 50 means contraction). So, unfortunately for Sonnenfeld, Standard & Poor has apparently also let itself being fooled by ‘Putin’s lies’.




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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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