Ukraine military gains could deepen Russia’s economic woes

Ukraine’s counter-offensive, which has seen much of Russian-held territory retaken, could exacerbate Russia’s economic woes as international sanctions continue to pound its assets.

The Ukrainian military has had amazing success in recapturing Russian-held territory in the north-east and south of the country in recent weeks. Now Kyiv hopes to liberate Luhansk in the eastern Donbass region, a key area home to one of two pro-Russian self-proclaimed “republics”.

Holger Schmieding, chief economist at Berenberg, said Ukraine’s recent military achievements could hit Russia’s economy hard.

“Even more than before, the Russian economy appears to be slipping into a gradually deepening recession,” Schmieding said in a statement last week.

“The rising costs of a war that is not going well [Russian President Vladimir] Putin, the cost of suppressing domestic dissent and the slow but damaging effects of sanctions are likely to bring down the Russian economy faster than the Soviet Union collapsed some 30 years ago.”

He pointed out that Russia’s main negotiating tool in the face of international sanctions imposed by the West – its influence on the energy market, particularly in Europe – is also waning.

“Although Putin closed the Nord Stream 1 pipeline on August 31, the EU continues to fill up its gas storage facilities at a slightly slower but still satisfactory pace,” he noted, adding that even Germany – which was particularly dependent on Russian supplies — might even do this before winter gets close to its 95% storage target.

Europe’s rapid shift away from Russian energy is particularly painful for the Kremlin: the energy sector accounts for around a third of Russia’s GDP, half of all tax revenue and 60% of exports, according to the Economist Intelligence Unit.

Energy receipts fell to their lowest level in over a year in August, and that was before Moscow halted gas supplies to Europe in hopes of persuading European leaders to lift sanctions. Since then, the Kremlin has been forced to sell oil to Asia at significant discounts.

The fall in energy exports means the country’s budget surplus has been severely depleted.

“Russia knows that it no longer has leverage in its energy war against Europe. Within two or three years, the EU will be rid of its dependence on Russian gas,” Agathe Demarais, EIU’s global forecasting director, told CNBC.

This is one of the main reasons why Russia has chosen to halt gas supplies to Europe now, she suggested, although the Kremlin is aware that in a few years this threat could be far less significant.

The EIU forecasts a 6.2% drop in Russia’s GDP this year and 4.1% next year, which Demarais says is “huge, both by historical and international standards.”

“Russia was not experiencing a recession when it was first placed under Western sanctions in 2014. Iran, which was completely cut off from Swift in 2012 (which hasn’t happened to Russia yet), only experienced a recession of about 4% a year in it,” she said.

Statistics on the true state of Russia’s economy are scarce, and the Kremlin is keeping its cards relatively close to its chest. However, Bloomberg reported earlier this month, citing an internal document, that Russian officials fear a much deeper and more prolonged economic downturn than their public claims suggest.

Putin has repeatedly asserted that his country’s economy is coping with Western sanctions, while Russia’s First Deputy Prime Minister Andrei Belousov said last month that inflation will hover around 12-13% in 2022, well below the bleakest forecasts published by global economists at the beginning of the year.

Russia’s GDP shrank by 4% in the second quarter of the year, according to state statistics service Rosstat, and Russia upgraded its economic forecasts earlier this month, now forecasting a 2.9% contraction in 2022 and 0.9% in 2023, before returning to 2.6%. growth in 2024.

However, Demarais argued that all visible data “points to a collapse in domestic consumption, double-digit inflation and falling investment”, with the withdrawal of 1,000 Western companies also likely to have an impact on “employment and access to innovation”.

“Nevertheless, the real impact of the sanctions on Russia will be felt primarily in the long term. In particular, the sanctions will limit Russia’s ability to explore and develop new energy fields, particularly in the Arctic,” she said.

“Due to western penalties, financing the development of these fields will become almost impossible. In addition, US sanctions will make it impossible to export the necessary technology to Russia.”

“We have cut off three quarters of the Russian banking sector from international markets. Almost a thousand international companies have left the country,” she said.

“Compared to the previous year, the production of cars has fallen by three quarters. Aeroflot discontinues planes because there are no more spare parts. The Russian military takes shavings from dishwashers and refrigerators to fix their military hardware because they ran out of semiconductors. Russia’s industry is down.”

She added that the Kremlin had “put Russia’s economy on this path to oblivion” and vowed the sanctions “will stay here”.

“Now is the time for us to show determination, not appeasement,” von der Leyen said.

As the Kremlin scrambles to strengthen security ties after being shunned by the West, a senior Russian official on a visit to Beijing last week said Moscow sees deepening strategic ties with China as a key political goal. Putin also met with Chinese President Xi Jinping in Uzbekistan last week as the two countries touted a borderless relationship.

However, several commentators have noted that given Russia’s dwindling bargaining power on the world stage, China will hold most of the cards as the two superpowers seek to solidify further cooperation.

“In the long term, China will be the only economic alternative for Russia, but this process will also be difficult as China will remain cautious about becoming dependent on Russian raw materials,” added EIU’s Demarais.