With last weekend’s vote in the Crimea and troop movements on Ukraine’s border, Russia has significantly raised the ante in its standoff with the West. Europe and the United States have already imposed sanctions, so far mostly visa restrictions and asset freezes. These will motivate the oligarchs to pressure Putin. They are exposed, for as a matter of course they ship their wealth into Western real estate, commercial interests, and financial assets. Still, Putin has threatened with the significant oil and gas supplies Russia provides Europe, suggesting that sanctions will “boomerang” back against the West. No doubt, if he makes good on that threat, it will cause harm, especially to the already beleaguered European economies. But Russia is highly vulnerable, too. It needs the oil and gas sales even more than Europe needs the Russian oil and gas.
Putin’s problem is that Russia has become a petro economy. It depends on the sale of oil and gas for the bulk of its revenue and so for just about everything else it needs. It is a weak position to say the least. Putin bears much responsibility for bringing his country to this point. The Soviet Union left Russia a broad and industrialized, if remarkably inefficient, economy. To be sure, Putin’s predecessor, Boris Yeltsin, sold off much of this inheritance. But since, Putin has actively neglected broad development, forcing Russia to depend increasingly on sales of this natural inheritance. Incongruous as it might seem, given Russia’s communist past, the country today has much in common with those trust-fund babies who never develop themselves but instead subset, albeit sometimes glamorously, on their inheritance. Summary statistics paint a vivid picture.
Despite Russia’s huge size and once imposing productive machine, today oil and natural gas amount to fully 30 percent of the country’s gross domestic product (GDP) and 80 percent of its exports. Oil and gas revenues account for half the government’s budget. Overall, Russia registers a low per-capita income figure of $9,000 a year. But since most of the oil income goes to the Kremlin, the average Russian has to get by on the equivalent of only $6,100 a year. Even the sovereign wealth fund Russia established to invest a portion of its oil revenues sees little in the domestic economy and sends 70-80 percent of its assets abroad. Russia’s oligarchs have pronounced the same negative verdict on Russia’s economy and have followed suit, rendering themselves susceptible to the recent sanctions.
The Russian economy’s vulnerability was painfully evident during the 2008-09 recession. Because that global economic decline dried up demand for oil, the price of hydrocarbons fell 75 percent. Russia’s oil-dependent economy collapsed. The country’s index of industrial activity fell at a 60 percent annual rate, far worse than the 17 percent experienced in the United States. Russia’s stock market, well aware of the economic damage, fell 68 percent, a much bigger drop than the 45 percent decline suffered by global stock markets on average. The world’s capital markets, aware of Russia’s precarious position, shied away from its debt, making it difficult and expensive for the Kremlin to raise funds. With hardly any revenue coming in, Russia spent 40 percent of its foreign-currency reserves in less than two years. More damning still, the government’s heavy dependence on oil and gas revenues rendered it impotent to relieve the economic pain. The best it could do was hope that other, truly developed nations would revive their respective economies, resume oil purchases, and pull Russia along. Russia had become a purely passive economic player.
Against such a background, Putin’s warnings ring hollow. To be sure, the United States and especially Europe would suffer. Germany, in particular, has much to lose. A big part of its exports provide Russia with the heavy equipment, metallurgy, and fine machinery that that Putin’s economy can no longer produce for itself. Meanwhile, the European Union depends on Russia for a touch over a third of its natural gas flows. Obviously an escalation of the economic standoff would force Europe to scramble to substitute for Russian purchases and energy supplies. A temporary easing of European budget austerity could help a lot with the former, while with the latter, the United States could help by pushing out more gas exports. But even if the West would suffer in such an economic confrontation, and Ukraine still worse, there can be no doubt that Russia would lose still more, especially if at the same time the West broadened the scope of its financial sanctions.
Some have suggested that Russia can cut off Europe and still prosper by selling to the Chinese. Chinese sales might mitigate the strain, but they can hardly lift it. For one, inadequate infrastructure exists for volume sales to China, certainly at levels sufficient to replace what Russia would lose from Europe. Because of the infrastructure problems, sales to China would come at greater cost, yielding Russia and the Kremlin that much less. And finally, the Chinese, well aware of Putin’s problems, would surely drive a hard bargain on price, further reducing the take from such sales.
Putin doubtless knows well that if he had to make good for very long on his threat to cut off the oil and gas flows to Europe, Russia would quickly face ruin. Even Russia’s state oil company, Gazprom, has tacitly admitted the fact: though the Kremlin refuses to talk to the new government in Kiev, referring to it as fascist and illegitimate, Gazprom still sells it oil and natural gas. The worst it has done is erase the former price discounts. Surely the diplomats can use this knowledge to negotiate a solution that avoids further economic pain to either side.
Milton Ezrati is Senior Economist and Market Strategist for Lord, Abbett & Co. as well as an associate of the Center for the Study of Human Capital at the State University of New York at Buffalo. He writes frequently on economies and finance and is just completing a book on demographics and globalization.