With Russia currently experiencing economic turbulence due to the Ukraine crisis, falling oil prices and the sanctions wars, influential economist Yakov Mirkin predicts further difficulties and warns against the Kremlin undertaking ill-advised strategies.

Will the economic crisis be the price to pay for Crimea? Pictured: An unfinished 16-storey building being demolished in Sevastopol. Photo: TASS / Alexei Pavlishak

Industrial production in Russia is a function of the price and volume of oil, gas and metal exports. Ahead lies a long season of low global commodity prices and a stronger dollar, which will suppress prices even more. In the past six months oil prices have fallen by almost 50 percent. Metal prices have been on the slide for three years.

With the Brent crude oil price at $60-70 a barrel, Russia’s real GDP can be expected to contract by 3-5 percent in 2015 (crisis-hit 2008-2009 saw a 7.9 percent dip).

The EU is currently a key customer for Russia, making up 49 percent of its exports and imports, while trade with China amounts to little more than 10 percent. Switching exports to Asia requires many billions of dollars of investment and time, therefore the spat with Europe will hurt the Russian economy

Meanwhile, the financial and technological boycott will put a lid on any potential increase in fuel production. Not straight away, since that could destabilize the eurozone, but year after year Russia’s share (currently one third) of the European energy market will wane. Since this is the official policy of the EU and the U.S., 2015 could see fuel exports to Europe decline in physical terms. It is already happening with gas: In August-October 2014 gas supplies to Russia’s “far abroad” (outside the CIS) fell by 20 percent and liquefied gas by almost 30 percent.

All this will aggravate Russia’s economic woes and cause a further weakening of the ruble, taking into a range of 60-75 to the dollar. Double-digit inflation (up to 15-20 percent) is inevitable, and the lending rate will hover at around 20-27 percent. Russia will again become the world's largest holder of cash dollars and euros (50-80 billion). 

There will be ongoing capital flight and a 20-30 percent reduction in direct and portfolio investments in the economy. The financial situation could deteriorate further as a result of the monetary authorities' dubious decision to float the ruble during the currency crisis and attempt to keep it in check through ultra-high interest rates and a contraction of the ruble money supply. For a weak economy on the brink of crisis, these measures are repressive.

But there are good news for Russia. Before 2014, the ruble was roughly 1.5 times overvalued. Devaluation was already on the cards. When in early 2014 the ruble has began to weaken against the U.S. dollar and the euro, it has sharply improved Russia’s trade balance. In the first three quarters of 2014, the country accumulated an unusually large surplus on its trade balance of more than $150 billion. 

Although some key sectors of the domestic economy are 50-90 percent dependent on imports, it seems that local businesses are trying to take an opportunity to replace them. The cheese may be rubber, but at least it’s homemade. There are no imports of marbled beef or jamon, but Russia has its own alternatives.

Russia’s international reserves in gold and foreign currency presently stand at more than $400 billion, the fifth largest in the world. The foundation of the economy — the flow of currency against the flow of raw materials — is still holding out. This means that for the time being there is no prospect of a default. External debt owed by the government and corporations is 3.7 percent and 32 percent of GDP, respectively (as of the beginning of 2014). The amounts are negligible, all the more since 70-90 percent of the debt is long-term and most is made up of loans by shareholders to their own companies and ordinary foreign currency deposits in banks.

In 2013, GDP per capita in Russia was more than $14,000 — higher than in Poland and Hungary. In 2015, after the devaluation of the ruble, the figure will drop to $8,000-10,000. Maybe even less. Possibly, it will decrease even more to the level of South-Eastern Europe. But a certain degree of stability will set in.

Russian citizens will become poorer. The official unemployment rate will rise to around 7 percent (compared to 8.4 percent in 2009 and 5.6 percent in 2014). Abroad, wallets will be half their former width, and as far as Russians are concerned, there will be more emigrants and fewer tourists. The latter, who contribute significantly to feeding the resort owners of Europe and Asia, will drop by 20-40 percent.

But there is one feature of emerging markets that serves to dampen any crisis: the informal economy, which kicks in when hard-hit families start to grow their own food and exchange goods and services among themselves. The shadow economy, which even in good times is estimated to account for 20-40 percent of Russian GDP, will grow rapidly. It is likely to rise to 30-50 percent, and this will help people to survive the difficult period.

Looking further ahead, beyond 2015, there are risks and uncertainty. If solutions are not found to the country’s current economic problems, then the next year will be spent sliding towards a much deeper crisis 1.5-2 years down the road (although Moscow coffee shops and theaters will, as before, be packed to the rafters).

How will the Kremlin respond to the challenges in 2015?

Russia can respond to the challenges facing it in two ways.

The first one is to mobilize, turn inwards and become an ivory tower, with state capitalism in the economy and increased military spending. That is not a solution, but a fallacy fraught with systemic risks.

The second answer is a new bout of economic liberalization targeted explicitly at growth and releasing the energy of small and medium businesses and the middle class. These measures include shock tax incentives for business growth and modernization, a 50 percent slash in the regulatory burden, softer monetary policy, greater availability of credit and low interest rates, suppression of non-monetary inflation, freezing of prices and tariffs in the public sector, ownership deconcentration, de-monopolization, promotion of a competitive environment, stabilization of the ruble, and a low exchange rate.

In other words, there should be a transition to what is known as a “government of development” and a “central bank of development.” One might even fancy the idea of a “Russian economic miracle” the same one that was achieved by “Asian tigers” or post-war Germany and Italy. It is this option that would create a new economic platform to restart relations with the West and the post-Soviet countries.

What happens if this recovery fails to materialize? The impending deep crisis in Russia — the world's largest supplier of raw materials in possession of strategic nuclear weapons — will set off a “chain reaction of systemic risk,” especially in the EU and emerging markets (Russia and the U.S. have few economic ties).

If even Greece, whose GDP is barely one ninth of Russia’s, was able to bring the world to the verge of a new financial crisis in 2010-2012, imagine the storm that a full-blown financial and economic crisis in Russia would whip up (not today’s local currency affair), and that is even if one assumes that the majority of Western financial institutions and money have already left the country’s markets by then.

Russia’s integration in the world economy and global finances today is several orders of magnitude higher than it was at the turn of the 1990s. In this sense, sanctions have their limits. They cannot drive Russia into a corner. Both sides have to engage in dialogue, otherwise Europe (especially Eastern Europe and Germany), the BRICS and the emerging markets of Latin America (always linked to Russia’s dynamics) can expect severe economic turbulence, in comparison with which the eurozone debt crisis will seem like child’s play.

The opinion of the author may not necessarily reflect the position of Russia Direct or its staff.