Summary

The economy of Russia is highly responsive to oil price fluctuations with a 10 percent increase in oil price increase leading to a 2.2 percent growth in GDP. At the start of 2014, the country was already suffering from the weak economic growth, partly due to the ongoing crisis in Ukraine and Western sanctions and the recent plunge in global oil prices put even further strain on the Russian economy. In heavily oil dependent countries, oil revenue shocks affect output asymmetrically, that is, output growth is adversely affected by the negative oil shocks whereas positive oil shocks play a limited role in economic growth.

Sanctions have hit the Russian economy is three ways; massive capital outflows, access to international financial markets and business & consumer confidence. The economic outlook is not very optimistic with quarter-to-quarter real GDP (at 2010 prices) expected to fall at an annual rate of 21.74 percent in 2015, 16.32 in 2016, and 19.21 in 2017.

Russia would not have been so adversely affected by the falling oil prices if it had developed a successful diversification plan. But, this requires political commitment, consistent policies, financial resources, and investment in human capital. As the World Bank suggested, in order to secure future growth, Russia will have to find the way to expand other tradable industries otherwise, the long-run perspective of the Russian economy is far from strong.

Background

For much of the past decade, oil prices have been high – bouncing around $100 per barrel since 2010 – due to soaring oil consumption in countries like China and conflicts in key oil nations like Iraq. Oil production in conventional fields could not keep up with demand, so prices spiked. High prices benefited oil ex-porters like Russia at the expense of oil importers. Soaring oil prices spurred companies in the US and Canada to start drilling for new, hard-to-extract crude in North Dakota’s shale formations and Alberta’s oil sands.

Then, over the last year, demand for oil in places like Europe, Asia, and the US began tapering off, thanks to weakening economies and new efficiency measures. Added to this is the fact that the oil cartel OPEC decided not to cut production as away to prop up prices. By late 2014, world oil supply was on track to rise much higher than actual demand and since summer of 2014, the price of crude oil has declined by more than half.

World oil supply and demand. Source: International Energy Agency
World oil supply and demand. Source: International Energy Agency

Russian economy and oil

At the start of 2014, Russia was already suffering from weak economic growth due to the ongoing crisis in Ukraine. In November 2013 Ukraine’s President Viktor Yanukovych refused to sign a European Union Association Agreement (EUAS). This rejection sparked mass protests on the streets of Kiev. Russia backed ousted Yanukovych, annexed Crimea in March of 2014 and invaded eastern Ukraine. In response, the US and Europe levied sanctions on Russian government officials through assets freezes, visa bans, and controls on exports of energy technology that would have helped Russia develop its Arctic.

The Ukraine crisis with several waves of Western economic sanctions imposed on Russia combined with a 50-percent drop in the global oil prices, Russia’s key commodity, put even further strain on the Russian economy. After the country’s 1998 financial crisis, most of the oil produced has come from drilling and re-drilling old Soviet oil fields and almost no efforts were made to develop new fields. In response to falling oil prices, the Russian economy started to fall into recession. Official data shows that in 2014 the real GDP grew by only 0.4 percent. Over the last year, the official annual inflation rate increased from 6 percent to 9 percent and food prices climbed by 25 percent. Between June and December 2014, the Russian ruble declined in value by 59 percent relative to the U.S. dollar.

USD v Ruble (XE.com)
USD v Ruble (XE.com)

Impact of oil price fluctuations on the Russian economy

There exists a plethora of economic studies investigating the impact of oil price fluctuations on macroeconomic performance in industrialised countries and emerging economies. Most of these studies concentrate on the effect of oil prices on the economic growth, inflation dynamics, investment, current account balance, and the exchange rate. Since the oil crisis of the 1970s, economists have been trying to estimate the effects of oil price volatility in oil importing as well as oil exporting economies, both small and large.

As it is well understood, the findings differ depending on whether the economy is an oil-exporter or oil-importer. In addition, since oil prices had a tendency to rise for much of the last decade, most of the existing literature analysed the high oil price phenomenon.

Historic Brent Crude oil price (Global Financial Data)
Historic Brent Crude oil price (Global Financial Data)

Small oil importing countries are price takers in the international market due to their size. Their demand is not of a significant magnitude, which does not empower them to exert influence on the international market. Thus, they take oil prices as given. For such countries, high oil prices are undoubtedly associated with low economic growth. High energy prices adversely affect consumer spending through disposable income, fuel the higher costs of production, lower profits, and, as a result, cause the growth rate to fall.

As an example, Aydin and Acar (2011) analysed the economic effects of oil price shocks in Turkey and confirmed that high oil prices cause reduction in output and consumption. Most of the small open oil importing economies do not succeed in generating enough savings, which is necessary to ensure high investment levels and sustainable growth. The increased dependency on energy imports destabilises these economies and results into high ratios of current account deficits. Furthermore, with the increase in oil prices, money demand also increases, which causes inflation to rise and investments to fall.

Unlike small economies, large oil importing economies – the economies that have the market power to affect world oil markets – are less sensitive to oil price shocks. Research shows that in countries like the U.S., Europe and China, while the impact of oil price fluctuations is still present, the negative effects of rising oil prices pale in comparison to small oil importing economies. It is true that any shift in oil price results in substantial revisions in these countries’ national budgets, but the negative effect is not as severe due to strong investment and foreign capital inflows that can offset the adverse effects of high oil prices.

On the other hand, oil exporting countries, like OPEC, Russia, Norway, and Canada, benefit from high oil price. High oil prices help net oil exporters generate high profits. Rautava (2004) reported a positive effect of oil price increase on the Russian economy. He found that a 10 percent increase in oil prices leads to a 2.2 percent growth in Russia’s GDP.

Cukrowski (2004) argued that for Russia low oil prices have the potential to destabilise the overall economy through a setback to output and fiscal revenue. In addition, Mehrara (2008) found that in heavily oil dependent countries, oil revenue shocks affect output asymmetrically, that is, output growth is adversely affected by the negative oil shocks whereas positive oil shocks play a limited role in economic growth.

Some research suggests that oil prices tend to influence the exchange rates. As an example, studies of Norway and Russia have  found that for oil exporting economies, an increase in oil price results in an ex-change rate appreciation. On the other hand, Ito (2010) found that a rise in oil price causes the Russian currency to depreciate both in the short run and long run.

Impact of sanctions on the Russia

Many scholars argue that sanctions are largely ineffective; the success rate of sanctions ranges from less than 5 percent historically to approximately 34–38 percent at best. Politicians and policy makers largely consider them as a substitute for war but always debate about their effectiveness. Drezner used game theory to predict whether to impose sanctions or not, and if implemented, how effective those sanctions are. He argues that the imposition of sanctions causes a deadweight loss of utility for both the sender country and target country, and thus both countries try to find a compromise and make an agreement before imposition. He suggests that if the sender country incurs small economic costs in relation to GDP in imposing sanctions, while the target country incurs tremendous losses, the large gap in opportunity costs makes both the sender more likely to impose sanctions and the target country more likely to concede.

Now, what are the incurring costs of economic sanctions for Russia? The multilateral economic sanctions due to the Russia–Ukraine geopolitical tensions have hit the Russian economy through three main channels.

First, these tensions led to massive capital outflows, deteriorating Russia’s capital and financial account balance. Further, falling oil prices caused the ruble to lose half of its value against the US dollar. The depreciation of the ruble increased inflationary pressures, resulting in a significant tightening of monetary conditions. This increased costs to borrowing, further restricting access to domestic credit for both investors and consumers.

Second, the sanctions restricted Russia’s access to international financial markets, as most Western financial markets were closed to Russian banks and companies.

Third, business and consumer confidence deteriorated as a result of increased uncertainty. further contracting consumption and investment activities. Lastly, foreign direct investment into Russia fell significantly in the first three quarters of 2014. Compared to the same quarters in 2011–2013, foreign direct investment decreased by 47 percent (World Bank Group, 2015). The sanctions have also had substantial impact on trade flows. Russia’s ban on food imports from Western countries and the weakening exchange rate resulted in a plunge in imports.

Crashing GDP

The Russian economy is currently experiencing a slowdown due to the fall in the price of oil and Western sanctions. From Q4:2014to Q1:2015, the real GDP (seasonally adjusted) fell by 37.92 percent at an annual rate. If sanctions continue to be implemented throughout 2017, various academic reports predicts that on average the quarter-to-quarter real GDP (at 2010 prices) will fall at an annual rate of 21.74 percent in 2015, 16.32 in 2016, and 19.21 in 2017. If sanctions are to be removed at the end of 2016, the year of 2017 will look much better. The quarter-to-quarter real GDP may grow on average at a 5.45 percent annual rate in 2017. Finally, if the US and EU agree to remove the sanctions early in 2016 (which is highly unlikely), it has been predicted that on average in 2016 we may see a quarter-to-quarter real GDP growth at a 4.33 percent annual rate and a 5.15 percent annual rate in 2017.

In retaliation to financial and trade sanctions brought by the EU, US and other countries, Russia banned imports of a wide range of U.S. and European foods (beef, pork, poultry, fish, fruit, vegetables, cheese, milk and other dairy products). The weaker ruble and Western sanctions on food imports pushed up inflation. According to IFS, inflation rate in Russia jumped from 7.68 percent to 9.58 percent in the last quarter of 2014 and to 16.2 percent in the first quarter of 2015,

A bear mauling

Russia is a resource dependent economy and has little incentives to expand alternative industries especially while oil prices are high. The relatively high oil prices make prices of other goods relatively more expensive, which weaken consumer demand and make alternative sectors uncompetitive. Further, high wages in the resource extraction industry, and the difficult living conditions in the remote regions make those regions unattractive for alternative industry workers.

Before the global financial crisis of 2008–2009, Russia was among the fastest growing emerging countries due to high oil prices. However, the shale oil boom in the US and Canada, low demand in China, and petroleum efficiency in the advanced countries caused the global crude oil prices to fall by more than 50 percent last year. The decline in oil prices severely hurt Russia’s economy

Russia would not have been so adversely affected by the falling oil prices if it had developed a successful diversification plan. But, this requires political commitment, consistent policies, financial resources, and investment in human capital. Misaligned economic policies, inadequate diversification strategies, and weak institutions always hold back private investment and discourage economic growth. As the World Bank suggested, in order to secure future growth, Russia will have to find the way to expand other tradable industries. Otherwise, the long-run perspective of the Russian economy will not be very optimistic and as strong as the Russian bear might be, it will forever be beholden the global bear markets.

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References
  • Aydin, Levent, Acar, Mustafa, 2011. Economic impact of oil price shocks on the Turkish economy in the coming decades: a dynamic CGE analysis. Energy Policy 39, 1722–1731.
  • Ito, Katsuya, 2010. The impact of oil price volatility on macroeconomic activity in Russia. Doc. Trab. Anal. Econ. 9 (5), 1–10.
  • Mehrara, Mohsen, 2008. The asymmetric relationship between oil revenues and economic activities: the case of oil exporting countries. Energy Policy 36 (3), 1164–1168.
  • Rautava, Jouko, 2004. The role of oil prices and the real exchange rate in Russia’s Economy—a cointegration approach. J. Comp. Econ. 32 (2), 315–327.

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