After years of painstakingly rebuilding Russia’s economy in the aftermath of the disastrous reign of Boris Yeltsin, which culminated in the GKO default in 1998, Vladimir Putin, Yeltsin’s successor as president of the Russian Federation, undid all his hard work with one stroke of the pen when on February 24th he decided it was time to invade neighbouring Ukraine (not counting Crimea, which he seized in 2014). Although pressure was building in the months preceding the invasion and U.S. intelligence repeatedly warned for a large-scale war, markets reacted in shock because the idea didn’t make any sense and was considered to be a very unlikely scenario (for example, Eurasia Group, a reputable political risk research and consulting firm, assigned a 5% probability to this event in mid-January).
Hey, I’m back in the USSR, you don’t know how lucky you are …
The U.S. and EU (plus allies, but excluding China) responded by imposing an elaborate set of sanctions. Two days before the invasion (after Putin recognized independence of two separatists regions in Donbas), a ban on purchasing Russian (local currency) sovereign bonds issued after March 1st, 2002, (March 9th for EU investors) was announced. This was followed by the blocking of VTB and implementation of U.S. dollar correspondent and payable-through account sanctions on Sberbank (it still can operate in euros, though). The EU cut 7 banks, including VTB (but not Gazprombank and Sberbank), from SWIFT, the cross-border payments messaging system. But the real gamechanger was the decision to freeze Russia’s FX reserves. This forced Russia’s central bank to hike its policy rate from 9.5% to 20% in order to stymie a bank run. Russia implemented capital controls, including a ban on purchasing bonds from foreigners and a forced exchange into rouble of 80% of foreign revenue proceeds earned by corporates.
Clearly, the impact of Putin’s Ukrainian “special military operations“ on the Russian economy will be disastrous. The rouble weakened from 75/USD at the start of the year to 102/USD (or -26%), after having plunged to a low of 139/USD on March 7th. Sovereign bonds denominated in rouble trade (if that is the right word when no one is bidding) at 5.5% of principal. The economy surely will enter into a deep recession. We would guestimate that the economy this year will shrink by at least 10% (we expect a contraction of 15% over 2022-2024 as it is highly unlikely that the West’s sanctions will be reversed anytime soon). This number is, not scientifically, based on big economic contractions we have seen in the past*. This time around, Russia will also suffer from foreign companies that flee the country whilst there will be a draught of FDI for years to come. Inflation is expected to spike to at least 30% as food and fuel prices rise and imports have become dearer. Pensioners will, once again, live in poverty and the middle class will be wiped out. Even though Russia went into this self-made crisis with a low debt burden (gross public debt was 18% of GDP), we expect a severe deterioration in the government’s finances even though it, somewhat surprisingly, continues to service its debt obligations (coupon payments on two dollar Eurobonds were made earlier this week). Higher oil & gas prices may soften the blow but many traders will be wary to buy Russian crude (also because it is difficult to insure tankers bound for Russian ports) and the country’s largest client, China, will take advantage and demand steep discounts to offtake the hydrocarbons. In any case, the EU will speed up its plans to transition to renewable energy (or coal if need be). Government expenditures will sharply increase: fighting a war is not cheap, especially when Ukrainians are reluctant to accept Putin’s authority. Barring a negotiated solution, Russia eventually will crush Ukraine’s brave opposition (using its proven strategy by indiscriminately bombing hospitals and schools and killing innocent civilians) but it is highly likely that Ukrainian resistance to Putin’s puppet regime, that he is likely to install in such scenario, will not ebb and that substantial army forces would be required to keep control over the country. According to the Cost of War project at Brown University, the occupation of Afghanistan by the U.S., a similar mission impossible, costed US$ 400 billion per annum, or about 25% of Russia’s GDP (measured in dollars at the exchange rate of the start of this year).
The Ukraine girls really knock me out…
Meanwhile, Putin may (or, rather, will) face increasing dissatisfaction at home, especially when the economic consequences start to sink in (think of empty shelves in shops) and military body bags arrive. In order to quell dissent, Putin already ordered to detain protesters, close independent media outlets and block critical websites. This comes on top of outlawing opposition political parties and assassinating or jailing their leaders. Repression will be central to Putin’s governing style; he even said that he will purge fellow Russians that oppose his chosen war. Eventually, Putin will go under but at a terrible cost to both Ukrainians and right-minded Russians. Welcome back in the USSR…
*For example, Mexico (1995), Indonesia and Thailand (1998), Argentina (2002, 2020), Turkey (2001), Venezuela (2002, after 2015) and following the pandemic (2020).