What's going on with the Russian economy?

The sanctions are working, but Russia has adapted to them. How is the Russian economy doing after 20 months of the Russian full-scale invasion of Ukraine?

Ukraine's Western allies have imposed severe restrictions on Russia's economy since the beginning of the full-scale invasion. Eleven sanctions packages covered the Russian banking system, industry, and even the energy sector.

The restrictions concerned exporting dual-use goods to Russia that could be used for weapons production. International corporations began to leave the Russian market en masse.

Twenty months into the full-scale invasion, the partners' enthusiasm for introducing new sanctions packages has somewhat waned, and the restrictions that have already been imposed are gradually losing their effectiveness. Moreover, the Russian economy is showing signs of moderate recovery, which has enabled the Russian Ministry of Finance to allocate record war spending in the 2024 budget.

The Kyiv School of Economics (KSE) has recently released a report on the state of the aggressor country's economy as of October 2023. The report indicates that the Russians have adapted to life under sanctions and are managing to circumvent restrictions and even generate income amid high oil prices.

What is happening in Russia's economy, and what new sanctions might hinder the Kremlin's ability to finance the war?

Sanctions against Russian oil

Restrictions on Russian oil took effect on 5 December 2022. The G7 countries, in fact, capped the maximum price at which the "black gold" can be purchased from the Russians at US$60 per barrel. This move was expected to reduce the Kremlin's ability to finance the war rather than lead to an oil shortage in the global market.

This mechanism was implemented through the mediation of Western insurers. The fact is that tankers carry most of the oil that the Russians do not transport through pipelines. Furthermore, each tanker must have appropriate insurance, otherwise the vessel cannot enter ports. This is precisely why Ukraine's allies have banned companies from taking out insurance policies if the selling price of the oil they transport exceeds the established limit.

This restriction initially seemed quite effective as average Russian oil prices fell to US$50-52 per barrel. However, its price has been steadily above US$60 per barrel since July and exceeded US$80 in September.

Russia has managed to circumvent the measures by forming what is called a "shadow" fleet. The Russian Federation has, in fact, purchased or leased old tankers around the globe and used them to deliver its oil. The crucial thing is that these tankers also have insurance policies, but not with Western companies. Therefore, the export price of such oil is not regulated by Western sanctions.

As of August, tankers that were not insured by EU or G7 companies delivered a total of 65% of Russian oil transported by sea. This compares to only 20% in April 2022.

The Kremlin also managed to find an alternative to Western markets besides replacing Western tankers. The EU, the US, and the UK accounted for 55% of Russian oil consumption in early 2022. Raw materials have been transported mainly to China, India and Türkiye since the beginning of 2023.

Of course, this diversification of export destinations has its drawbacks. Russia is not selling oil for US dollars but for less convertible currencies. India, for example, pays in rupees [US$1 = roughly INR 83]. Consequently, this leaves Russian oil exporters stuck with billions of rupees, which they can actually use only to acquire goods from India.

Nevertheless, Russian oil revenues have been steadily increasing over recent months. It's all thanks to the rise in global oil prices and Russia's expanding ability to circumvent price restrictions with the help of the "shadow fleet".

As export revenues grow, so do tax revenues to the Russian coffers. They reached RUB 1 trillion [US$ 10.6 billion] in September.

The state of the Russian budget

The year 2023 kicked off with good news for Ukrainians: the Russian federal budget deficit was growing faster than expected, reaching 80% of the annual forecast in three months.

However, the actual financial problems in Russia had started a little earlier. The Russian budget deficit exceeded RUB 4 trillion [US$42.5 billion] in December 2022. This happened in the first month of the oil export restrictions.

The record deficit forced the Russian government to seek additional sources of funding. Regrettably, Russia still has significant financial reserves that can support its public finances.

"We must admit that Russia was preparing for war not only militarily but also financially. For example, it has reduced its dependence on the dollar and euro in the structure of its gold and foreign exchange reserves. Besides, it has accumulated about US$180 billion in the National Wealth Fund (NWF)," explains Yuliia Pavytska, co-author of the KSE report on the state of the Russian economy.

The Russian government financed its expenditures directly from the NWF in December 2022, the most critical month for the Russian budget, by RUB 2.4 trillion [US$25.4 billion]. The remaining deficit was covered by domestic borrowing, mainly provided by local state-owned banks.

The Russian government also used funds from the NWF in 2023, but to a much lesser extent, covering expenditures worth RUB 560 billion [roughly US$5.6 billion] in January-September.

Wasting the National Wealth Fund has had its effect. Although its size has remained virtually intact in RUB terms since the beginning of this year, it has fallen from US$182.6 billion to US$140 billion in foreign currency.

As impressive as US$140 billion is, the vast majority of the IWF's assets have low liquidity. The fund holds almost US$43 billion in relatively liquid assets, such as euros and Chinese Yuan [US$1 = roughly CNY 7.3]. A further US$30.6 billion is gold. The rest are shares in the domestic majority state-owned Sberbank and other assets that take time to sell. Put another way, the Russian government is running out of options to quickly support the budget with this fund.

The necessity to support the Russian federal budget with funds from the NWF fell in 2023 as the situation for the Kremlin began to improve. The budget deficit was shrinking, and there was even a surplus in some months. Consequently, the annual deficit plan reached 58% in January-September, compared to 80% in the first quarter.

The recovery in oil exports and the devaluation of the rouble facilitated this. The latter was not a decisive factor behind the growth of Russian budget revenues. The higher level of global oil prices meant that Russia's oil and gas income also increased in dollar terms.