Presentation at Konkuk University on current challenges to the Russian economy. The focus is on Ukraine-related sanctions and diversification issues.

1. Russian Economy Today: Major
Risks and Challenges
Alexandre Repkine
November 12, 2014

2. Kievan Rus
• Kiev originally the center
of Rus, a federation of
East Slavic tribes, ca 882-
1240
• 1223: invasion of the
Mongols
• 1240: Total destruction of
Kiev, end of Kievan Rus
• 1480: end of the
Mongolian domination

3. Grand Moscow Duchy
• Late medieval state centered on
Moscow, 1283-1547
• Moscow first mentioned in a 1147
chronicle
• In 1547 Ivan the Terrible
proclaimed the Tsardom of Russia
• Ukrainian lands dominated by
Polish and Lithuanians from the
end of Mongol rule in 1480
• Crimean Khanate established in
1449, existed until 1783: neither
Russian nor Ukrainian

4. Tsardom of Russia
• 1547-1721
• Grew 35000 sq.km. a year
• 1654: Bogdan Hmelnitsky,
a Ukrainian leader,
offered the Tsar to make
Ukraine part of Russia to
avoid Polish domination

5. New Russia
• 1764: Russia
conquers the lands to
the North of Black
Sea from the
Ottoman Empire
• The new region is
called New Russia,
active migration by
Slavs: Russians and
Ukrainians
• 1783: Russia annexes
Crimea after
defeating Crimean
Khanate

6. The Soviet Time
• 1917: Communist revolution in Russia
• 1918: Ukraine proclaims an independent Ukrainian Socialist Republic
• 1922: the USSR formed that included Russian Federation, Ukrainian Socialist
Republic (formed in 1918), Belarussian Socialist republic, and Transcaucasian
Socialist republic
• Ukraine becomes an autonomous republic within the Soviet Union
• 1954: Crimea transferred from the Russian Federation to Ukraine
• 1991: Collapse of the Soviet Union, Ukraine’s independence

7. Ukrainian Crisis
• 21 November 2013: President Yanukovitch backs out of signing the
Association Agreement with the EU, accepts $15bn loan from Russia
• 22 November 2013: Protests break out in Kiev, the capital
• 20 February 2014: large-scale clashes between police an protesters
• 21 February 2014: Peace agreement signed between opposition leaders
and Yanukovitch, also signed by Foreign Affairs ministers of Germany and
Poland
• 22 February 2014: Radical opposition leaders refuse to recognize the
peace agreement, make Yanukovitch leave Kiev
• 23 February 2014: Turchinov proclaimed enacted President of Ukraine
• 23 February 2014: Law granting Russian the regional status language
abolished
• 27 February 2014: Crimean parliament decides to declare independence
• 16 March 2014: referendum in Crimea on independence
• 18 March 2014: President Putin signs a decree on Crimea re-joining Russia

8. Sanctions: History
• First Round:
– Immediately after March 16, 2014 following on Crimea’s joining
Russia
– Target: individuals banned from visiting EU, Canada, the US;
doing business is also prohibited with them
• Second Round:
– April 28, 2014
– Further visa bans, 17 Russian companies
• Third Round:
– July 17, 2014: Malaysian MH17 crash
– Government-owned Russian banks, trade restrictions on
defense industry, additional visa bans
– Inability to borrow for more than 30 days

9. Ruble Depreciation
RUB/EUR
RUB/USD
• Depreciation by 23% (RUB/USD),
14% (RUB/EUR)
• Most depreciation occurred after
the third (sector) round of
sanctions
• Capital flight due to increased
geopolitical uncertainty
• Exports did not grow
proportionately to ruble’s
depreciation due to global
economic slowdown
• Ability to borrow abroad restricted
by sanctions, limiting supply of
foreign currency

10. Inflation Acceleration
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
2014 0,59 0,70 1,02 0,90 0,90 0,62 0,49 0,24 0,65
2013 0,97 0,56 0,34 0,51 0,66 0,42 0,82 0,14 0,21 0,57 0,56 0,51
2012 0,50 0,37 0,58 0,31 0,52 0,89 1,23 0,10 0,55 0,46 0,34 0,54
2008 2,31 1,20 1,20 1,42 1,35 0,97 0,51 0,36 0,80 0,91 0,83 0,69
• Inflation picked up significantly shortly after the first round of sanctions
• Inflation rate kept roughly at or below the similar inflation level of 2008, the year of
the global crisis
• January--September 2014: 6.27%
• January—September 2008: 10.57%; January-September 2013: 4.72%

11. Capital Flight
• Sharp increase in capital outflow in January 2014 was attributed to looming Western sanctions
• Capital outflow is not much different relative to the average of previous years
• Capital outflow does not increase dramatically as sanctions mount
• Capital outflow is probably more the result of Russia’s structural problems rather than sanctions

12. Russian Stock Market Response
March 2014
Sanctions
September
1995
March
2004
March 2014
Sanctions
August
2008
3 November
2014
• RTSI grew
after the first
round of
sanctions
• Market as a
whole
appears to be
ranging
• 2008 crisis
had much
larger
negative
effect
Source: RBK quote.rbc.ru

13. Russia’s Food Imports Ban
• Import ban on food imports from the EU, US, Canada, and
Australia seems most important response so far (7 August,
2014)
• In August alone
– Moscow food prices up by 7%
– St. Petersburg, 10%
– Pork and chicken prices up by about 25%
• Poland, Finland and Lithuania most affected by the Russian
food ban

14. Abolishing Bilateral Corridor on
November 10, 2014
• The Ruble was allowed to
move within bounds for a
bilateral currency basket
prior to the sanctions
• Corridor bounds were
adjusted tens of times since
the start of 2014
• Discount rates increased
three times since January
2014
• Interventions until 2015
only at the bounds
• Floating exchange rate
introduced in 2015
Source: Roskomstat

15. What Measures Would Really Hurt
the Russian Economy?
• Restrictions on gas and oil exports
• Exclusion from financial networks: VISA,
Mastercard, SWIFT etc
• Persuade OPEC to increase oil production

16. Oil and Gas in the Russian Economy
Budget crucially depends on
the oil-gas revenues
30% of all Russian gas
production is meant for exports
Rising energy prices increased oil-gas
revenue component of the Russian
budget without any growth in the
physical volumes
Non-oil deficits persisting

17. Oil Price Evolution
If the trend
continues:
• Further
deterioration of
the government
budget
• Depreciation of
the ruble
• Further pressure
on the National
Welfare Fund to
finance budget
deficits  risk of
social unrest
(2018?)

18. EU’s Dependence on
Russian Energy Supplies
EU depends on about
1/3 of its energy
consumption on
imports from Russia:
• 34% crude oil
• 26% solid fuels
(mainly coal)
• 32% natural gas
Germany, Italy, and
Eastern European
countries are the most
vulnerable importers

19. EU and Russia’s Dependence on
Ukrainian Transit
BR
RU
POL UKR
TRK
GE
SW FI
North Stream
South Stream
• 42% of Russian gas exports
depends on Ukrainian
transit
• Ukraine’s inability to pay
the contracted prices led
to gas supply shortages in
2006 and 2009
• Ukraine’s current debt
reached $5bn
• To avoid dependence on
Ukraine, Russia started
constructing the North
and South Stream pipe
routes

20. Gas Dependence and Sanctions
• One way to really hurt the Russian economy is to
limit her gas and oil exports
• Cutting Russian gas and oil imports is:
– Difficult since alternative suppliers are difficult to find
– Politically impossible since the voters will not
welcome electricity and heating shortages
• Therefore, the most potent measure to ‘punish’
the Russian economy will not be taken in the
foreseeable future

21. Other Potent Sanctions
• Ban VISA, Mastercard etc from doing business
with Russia
– Private companies are unwilling to lose their business
– Byron Pollitt, VISA’s CFO, in April 2014:
• "We are caught between the politics of the United States and the politics of Russia. We're clearly seeing a drop-off in
cross-border volume, and sanctions are expected to have some impact on volume."
• "We have 100 million cards there and it is not in anyone's best interest, inclusive of the Russians, to make those cards not
available to their own citizens.”
• Exclude Russia from financial networks e.g. SWIFT
– Applied to Iran in 2012
– May be difficult to apply to Russia since that would
hurt EU’s trade with Russia, including energy import
deals

22. SWIFT Statement
SWIFT Statement:
http://www.swift.com/about_swift/shownews?param_dcr=news.data/en/swift_com/2014/PR_swift
_sanctions_statement.xml
Brussels, 6 October 2014 - SWIFT and its stakeholders have received calls to disconnect institutions and
entire countries from its network – most recently Israel and Russia.
SWIFT is a neutral global cooperative company set up under Belgian law. It was established by and for
its members to create a shared worldwide messaging service and a common language for international
transactions. SWIFT provides services to over 10,500 financial institutions and corporations in over 200
jurisdictions around the world. SWIFT is a critical service provider to the financial industry and plays a
pivotal role in supporting international commerce and trade.
SWIFT services are designed to facilitate its customers’ compliance with sanctions and other
regulations, however SWIFT will not make unilateral decisions to disconnect institutions from its
network as a result of political pressure.
SWIFT regrets the pressure, as well as the surrounding media speculation, both of which risk
undermining the systemic character of the services that SWIFT provides its customers around the world.
As a utility with a systemic global character, it has no authority to make sanctions decisions.

23. Economy Near Potential Output
• Growth rate of 7% prior to the crisis of 2008
– High carbohydrates prices
– Spare capacity
• Growth rate of ~1% during 2009-2013
– ~5% for similarly large emerging economies
– ~3% for resource-rich countries
• Currently
– Weak credit growth
– Slow rate of new business creation
• Structural problems, not cyclical ones, mostly constrain the
expansion of potential output

24. Resource Rents and Red Tape
• Resource-rich countries are prone to high resource rents
– Short-termism
– High extent of reliance on subsidies and transfers
• Red tape restrictions
– Far Eastern tuna / sanctions
– Incumbent bureaucracy has few incentives to promote
competition
• Importance of performance-oriented public sector
– Weaning bureaucracy off the resource exports revenues
– Linking size of compensation to performance indicators

25. Oil/Gas and Hard Budget Constraints
• Carbohydrates-based growth ensures persistence of soft budget
constraints
– Janos Kornai (Econometrica, 1979)
– Bailing out loss-making state enterprises during the Soviet time
– Source of government transfers and subsidies to pay for social
obligations e.g. pensions currently
• Hard budget constraints
– Shown to increase aggregate production efficiency
– Are spurred by
• US/EU sanctions
• Dwindling oil prices
– Are Russia’s chance to diversify its economy away from being a
carbohydrate-oriented one

26. Diversification
• Tangible assets: not a major problem
– a wide range of industries
– decent GFCF rates
– Improving infrastructure
• Intangible assets: institutional framework
– MAJOR problem
– Contract law
– Independent courts
– Police corruption
– Accountable public sector
• Geographical
– Decreasing extent of dependence on EU for hard currency flows
– Reorientation to emerging Asian markets, specifically China
• “Power of Siberia”
• Transsiberian link to Korean railway networks
– Payments in rubles/yuan