How Russia Stays Afloat

WASHINGTON, DC – The long-term sustainability of Russia’s economy is an open question. Cronyism is rife, and Russia’s heavy dependence on oil revenues means that it will suffer whenever oil prices are low. But if the Soviet Union taught us anything, it is that unsustainable systems can survive for many years.

The Russian system today reminds me of the Soviet system I experienced in 1983, when I lived in Moscow, and KGB disciplinarian Yuri Andropov (the “Butcher of Budapest”) was still in power (albeit in poor health). The common economic features, then and now, include low oil prices, a nonviable economic ideology, state ownership of crucial industries, and authoritarian rule.

But one notable difference is that Russia’s macroeconomic management is much more competent today than it was then. Russia is not at risk of running out of financing, despite continued Western sanctions. But its tight resources do limit the Kremlin’s foreign-policy options and aggravate tensions among Russian elites.

Since oil prices started falling in June 2014, Russia has slipped from sixth place to 14th in the International Monetary Fund’s global economic rankings; its GDP (measured in current United States dollars) has dropped from $2.1 trillion to $1.1 trillion – just 6% of US GDP. (And it spends only 8% of what the US does on defense.)

But, though Russia is not economically competitive with the US, its government has maintained admirable macroeconomic balances, even as growth prospects have faded. It took some time for the Russian government to get things right, and its international reserves did slump dangerously in 2014; but that December, the Central Bank of Russia (CBR) finally floated the ruble’s exchange rate, and macroeconomic conditions have since stabilized.

In his public statements, Russian President Vladimir Putin emphasizes five indicators of stability: international reserves, the foreign-payments balance, the budget balance, inflation, and the unemployment rate. Among these, he places the biggest premium on international reserves. At the annual “Russia Calling!” investment forum in October, Putin reported that “international reserves are growing” and “currently stand at around $400 billion” – which is apparently his target amount.

Russia’s international reserves include the Ministry of Finance’s Reserve Fund, which will run out in 2017. But for Putin, all that matters the total size of Russia’s international reserves. By letting the exchange rate float with the oil price, the CBR has managed to maintain a significant current-account surplus, even though lower commodity prices cut exports and imports by half since 2013.

Similarly, the Ministry of Finance keeps the budget deficit at around 3% of GDP, and the falling exchange rate has kept revenues relatively stable in ruble terms, even as absolute revenues have fallen. The government has made up for budget shortfalls by ruthlessly slashing education, health care, and now pensions.

When the ruble depreciated early last year, inflation surged above 16%; but the CBR’s tight monetary policy has since reduced inflation to 6%, with a further decline, to 4%, likely to be achieved next year. Remarkably, the unemployment rate is currently 5.4%, and Russia has managed to keep it below 6% since the oil-price shock; what’s more, public debt is a minuscule 13% of GDP.

Despite these positive indicators, overall investment, GDP, and living standards are falling. Real disposable incomes fell 10% last year, and will likely shrink by another 5-6% this year; investment fell more than 8% last year, and will likely fall by 4% this year; and GDP declined by 3.7% in 2015, and will probably contract this year as well (though by less than 1%).

A Westerner would consider these numbers unacceptable. But ordinary Russians appreciate that their real (inflation-adjusted) incomes doubled between 1999 and 2008. And, at any rate, it is not as though they can protest under the current regime.

Still, Putin once based his legitimacy on economic growth. Now that he can no longer deliver improved living standards, he follows the recommendation made in 1904 by Russian imperial minister Vyacheslav von Plehve: “We need a small victorious war.” Putin has benefited from three so far: the 2008 war in Georgia, the 2014 annexation of Crimea, and the ongoing intervention in Syria since September 2015.

But a previously risk-averse Putin has had to take ever greater risks, not least in Eastern Ukraine, where the conflict that he precipitated has been neither small nor victorious. Eastern Ukraine represents a foreign-policy failure, and it demonstrates that, while Russia enjoys military superiority over its neighbors, it cannot afford protracted wars. The West has been exploiting this weakness with its financial sanctions, which shave about 1% from Russia’s GDP each year they are in place.

Russia’s domestic elites pose another threat to Putin, which is why, since August 2014, he has sacked one KGB general after another, and has sought to eliminate potential rivals. But his purge has stalled, with Russia’s generals still constituting a majority in the country’s “real” Politburo, the Security Council of Russia.

On November 15, Putin took his purge in a new direction with the arrest of Minister of Economic Development Alexei Ulyukaev, one of the remaining liberal technocrats. The next day, when Putin addressed the Ministry of Defense with a prepared, televised speech, the generals in attendance regarded him with evident disgust, and the powerful defense minister, Sergey Shoigu, seemed to ignore him altogether.

Putin is politically savvy and often hides his real intentions. He has frequently taken the world by surprise with improvised wars and diplomatic initiatives, as in Ukraine and Syria. He is financially constrained, but his situation is not hopeless, and we should always expect the unexpected from him. Now that US President-elect Donald Trump’s victory has created a power vacuum in Washington, Putin has a great opportunity to boost his own domestic standing. We can be certain that he will seek to exploit it fully.