The Lotus Eaters

With their backs to the wall and crippled by dysfunction and a lack of imagination, Russian officials are starting to spin fairy tales about what the economy will look like in the years ahead. Not all of these fairytales are entirely false, per se, but they're clearly inspired by pressure from the Presidential Administration, Putin himself, and the 'party of war' within the regime jockeying for status and power. The head of VTB Andrei Kostin is confident that Russia will return to 2021 GDP levels in 4-5 years during his appearance at the Eastern Economic Forum with a 4% decline this year and a 1.5% decline in 2023. Putin himself asserted at the Forum that GDP for the year would only decline by about 2%, which is closest to Economy Minister Maxim Reshetnikov's prognosis of 2.9% decline for 2022. Sber head German Gref seems more realistic at 4.5% for 2022 and so on:

One of the best indicators from the EEF that the leadership has lost the plot was Putin's reflexive need to assert that inflation in the US is rising, whereas it's coming under control in Russia. Turns out that natural gas prices are a Europe story, not a US one, and that larger factors than Russia has anything to do with are driving crude oil – and US inflation – down, dashing the likelihood that inflation can weaken the ongoing consensus of escalating support for Ukraine:

Not only are these assertions stupid, but they speak to the emotional need to frame whatever the state is doing on the economy in terms of conflict and competition with the US/West. In much the same way there is a conscious effort on the part of political technologists to foster a social turn towards 'immaterial' values, technocrats, middling managers, and the Boss himself are now tasked with dressing up poor data and anecdata in their Sunday's best. That is anathema to effective decision-making, and only going to increase the dissonance within the government over what they are briefing, debating, and actually implementing.

Bloomberg's reporting on the internal deliberations in Moscow over the economic outlook pierced the veil a bit with the worst-case scenario a particularly illuminating peek into the inadequacy of current economic measures:

If we want to take a step back further, it's important to remember that in 2020, real incomes plummeted to levels not seen since 2008 with the 2021 recovery in incomes disputed by the underlying surge in inflation that began in Q3 2020 and never stopped through the invasion and convenient methodological changes. There is therefore the possibility here that incomes remain at or below their 2008 levels in real terms by 2030 under the assumption that any economic recovery will have to be driven by domestic demand to a greater degree than exports so long as US and EU sanctions constrain the power of exporting sectors to drive consumption, production in other sectors, and investment.

In order to lift domestic demand, however, the Ministry of Finance and Central Bank need to reshape their own assumptions about inflation risks and the role of combined current account and fiscal surpluses in maintaining the integrity of the ruble and financial/price stability. As of now, the ongoing fight between the two institutions is at an impasse: deficit spending necessitates an increase in taxation per their assumptions, which would further weaken consumption and investment. Everyone knows there's no conceivable way that the state is going to crowd in a bunch of private capital right now to finance an industrial boom. The state needs to guarantee there'll be future demand in the first place. Regional governments are already granting concessions without any private capital invested, effectively eliminating any role for private capital and resurrecting a 5-year old debate about whether such concessions should legally be considered procurement contracts instead. Not even the obvious underinvestment into infrastructure can convince capital to take a chance these days. Worst of all, the available reserves from the National Welfare Fund could be exhausted by 2024 assuming the government draws it down to cover a deficit without borrowing.

I've long been of the view that Russia, in pre-invasion conditions of course, has had the capacity to borrow significantly more than it has for most of the last 20 years. COVID only strengthened this view for me. Look at how paltry the country's deficits have been in response to prior economic shocks:

It is truly absurd just how much was wasted from 2003-2008 and also that the 2020 consolidated deficit was just 4% of GDP while external borrowing as a share of GDP spiked nearly 20% over the course of the worst of the pandemic. Most of that external borrowing was from Russian banks and investors using their foreign branches to buy OFZs. Lest we forget that in the spring of 2021, the Ministry of Finance was having a hard time finding buyers for OFZs because they had reimposed austerity and returned the budget to surplus, killing the market for more sovereign debt (and therefore an expansion of broader lending and investment activity) in the first place. Pension funds provide a useful window into the problem of pursuing further structural adjustment via fiscal policy (e.g. tax increases) when you've already done so for 14 years. The following is data on the national pension fund – LHS is millions of rubles and RHS is %:

It may seem small, but in a country with an aging population and shrinking workforce, it's no small fiscal maneuver to try to reduce the federal budget's share of payments into pensions from 50% down to 40%. The pension reform was partially aimed at doing this as well, creating more breathing room by making tax payments and contributions from employers and employees responsible for a greater share of ensuring the fund's solvency. And that's also acknowledging that pension benefits have been hit multiple times since 2014 and not kept pace with inflation.

Borrowing constraints are more serious now that Russia has significant capital controls and, perhaps more importantly, fiscal expansions are more inflationary in conditions where real resources are more scarce (such as the effect of sanctions on imports). That's what made it all the funnier when it emerged that the Chinese government has refused to allow the Ministry of Finance to place sovereign bonds on auction denominated in CNY, cutting off what otherwise could have been a release valve within the Russian financial system for the accumulation of CNY from commodity exports alongside the expansion of CNY-denominated lending that is now being worked out through banks such as VTB. People love to talk about multipolarity and the end of dollar hegemony, yet also forget that there are reputational costs for any country with a strong currency trying to "break" the financial blockade on Russia.

Maybe China isn't recycling as much of its current account surplus into USD, but I do wonder how many of the assets it is acquiring are denominated by currencies issued by central banks with swap lines to the Federal Reserve. Russia is almost definitely not providing a safe haven, virtually every other developed market economy has a swap line or direct link to the USD, and any assets in major commodity exporters will entail USD-pegged currencies or otherwise a direct relationship with the USD via liquidity preferences of commodity-exporting firms and governments. Saying no to Russia also reinforces the reality that capital controls limit China's room to internationalize its currency as does its current account surplus. Regardless, Russia's now paying the price for past fiscal caution as it cannot convert inflows of CNY into domestic debt issuances as it may have hoped. I'm looking to see where they propose any tax increases given they've done their best to wring more revenues out of consumption and incomes for years as it is. But the more you see someone claiming that "Fortress Russia" policies are working to insulate the country and its beleaugered technocrats from a deeper economic shock, the more skeptical you should be about the priors of such a statement. "Fortress Russia" robbed the country of the productive capacities it needed to weather sanctions effectively. Hope those lotuses taste alright in Moscow.

1. The consolidated budget ran a whopping 2.1 trillion ruble surplus for January-July, which is pretty crazy when you consider how much they're trying to cut spending where they can. The Centarl Bank is reportedly looking at creating a fund to compensate investors who've lost out due to sanctions, which one imagines would end up consuming a ton of the surplus done right. And deputy finance minister Alexei Lavrov is now pushing an effort to further restrict information about state procurements . . . which would make it even harder for anyone on the outside to assess the efficacy of spending whatever revenues they do haul in.
2. Production of the Sukhoi-75 Checkmate fighter is expected to launch in 2026, with the first flight tests expected in 2024. It's making use of the components from the Su-57 and we'll have to see just how much the high-end tech has been affected, but by announcing it a few years out, they're buying time to sort out the details before further public releases.
3. The Central Bank is looking out as the quality of goods is likely to decline more significantly as parallel import schemes and new products replace ones previously bought from Western vendors and some in Japan, South Korea, even China, and elsewhere who've turned away from the Russian market to varying degrees. Cars are the obvious case, but it's a broader problem all the way down to having adequate bearings for industrial uses.
4. Yuri Trutnev is touting contracts from the Eastern Economic Forum are worth an estimated 3.2 trillion rubles, though we have no idea what the timeframe for them looks like and to what degree these agreements are materially significant. Budget money is still the prime mover for major investment. Look no further than Rosatom, which is now asking for 200 billion rubles to build a new wharf for ship construction by the end of the year.  

Like what you read? Pass it around to your friends! If anyone you know is a student or professor and is interested, hit me up at @ntrickett16 on Twitter or email me at nbtrickett@gmail.com. Always happy to look at any freelance opportunities pertaining to Russia, Eurasia, energy and commodities, or my old love foreign policy.

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