In a recent episode of the “Economics Out Loud” podcast, NES Professor Konstantin Egorov and Professor of Economics at the University of California, Los Angeles Oleg Itskhoki discussed the future of the Russian economy, exchange rates, and the government’s capacity to stabilize the economy. The main takeaways follow below.
Oleg: When half of Russia's foreign exchange and gold reserves were frozen, the national Central Bank lost a fine-tuning tool that allowed it to deal with the exchange rate volatility through currency interventions. The regulator resorted to another tool which was severe restrictions on capital flows, financial repression: it was impossible to withdraw foreign cash from bank accounts, physically buy it with rubles, move it abroad, etc. At the same time, the ruble is now supported by a strong trade balance: while imports collapsed, exports went up, thanks to the appreciation of oil and natural gas, among other things. As a result, Russia faced a significant inflow of foreign currency.
The combination of this fundamental factor and exchange restrictions worked out: the fall of the ruble exchange rate was reversed. The supply of foreign exchange exceeds the demand for it, and the authorities can actually set any exchange rate they want. But this is a temporary equilibrium, it is quite difficult to predict what can happen even through the end of 2022.
Konstantin: The demand for the US dollar has fallen more than its supply. Common people do not really need dollars right now: you cannot buy cash, and you really need to trust the bank if you want to buy and leave it in a bank account. For corporations, the role of the exchange rate has also strongly declined. When the exchange rate is managed manually, companies need to think less about fundamental factors and more about what restrictions the Central Bank and the government can impose.
Konstantin: Many companies are leaving Russia but it does not happen overnight. It takes time since firms have large stocks and production facilities here. Therefore, people may get an impression that nothing terrible has happened. However, the worst is yet to come. The main blow on the economy is not a reduction in the range of consumer goods, but the loss of access to technologies, components, and spare parts for manufacturing. We will not feel this effect of sanctions immediately.
So far, companies underestimate their dependence on imports. In part this is due to the underestimated import dependence of their Russian suppliers or poor understanding of the scale of the problems (for example, in logistics) that will come to the fore when a company will try to find a substitute for Western suppliers in China.
Further to that, leading Chinese firms that are actively involved in international trade are curtailing their cooperation with Russia due to the pressure from their Western partners. Therefore, there is a risk that we will get contracts with only those Chinese firms that are not afraid of Western pressure because they operate on the domestic market only and are less efficient .
A less obvious problem that Russia will face is an even greater monopolization of the economy: many Western companies are leaving the Russianmarket; their business is transferred over to firms that have already been in this industry. This means that the number of market participants will decrease.
Oleg: We probably underestimated the inertia in the behavior of most economic agents. Western firms are not rushing to withdraw from Russia, as it is easy to leave but difficult to enter the market. They continue to pay salaries hoping to save employees just in case they resume operations in the country. A huge number of contracts continue to be executed. And this strikes me as an economist, because the common assumption is that there is no point in sticking to contracts if it becomes clear that they cannot be fulfilled in the medium term.
Apparently, in a situation of great uncertainty, firms avoid abrupt decisions, they prefer to hold the course “business as usual”. But this cannot last forever. Due to accumulating imbalances – firstly, in the supply chains and secondly, in the labor market – firms will have to lay off employees.
The peculiarity of this crisis is that it is not a temporary shock, but a phase shift: Russia is moving into a new, absolutely different environment for many years to come. Therefore, bank savings or warehouse stocks cannot help survive it. This is a transition to a lower level of well-being and consumption, poorer availability and quality of goods. It will involve both a decrease in the range of available goods and an increase in their prices.
Shocks of this magnitude have barely ever happened in countries with above-average income. This is a unique experiment that the Russian economy was put in.
Uncertainty is very high, partly because the whole world is also facing a huge uncertainty. However, it is already obvious that a lot of things in Russia will freeze in their development, and a lot will be primitivized. Before, Russia has tried to develop its manufacturing relying on Western technologies. And now it is losing access to them and will have to replace these technologies with more outdated ones. For example, the quality of cars, planes, and train cars will most likely decrease over time. I remember my trip to Cuba. This is a country that has frozen in its development, which is very clearly demonstrated by its automobile fleet: Cadillacs from the 1950s, Soviet Zhigulis, and very cheap Chinese cars.
Russia is going to face not just import substitution, but technological regress. I highly recommend reading an article on this topic by Branko Milanovic (professor at the City University of New York).
Konstantin: It is very difficult to find who will be the winners from what is happening. And people will be losing in different ways, and their well-being will fall differently. For example, my well-being depends very much on the Internet, and it will be a big blow for me if Russia is cut off from modern music and cinema, and, God forbid, if YouTube stops working in Russia. However, it will only impact my consumption while many people actually earned money from their online activity, from Instagram and Facebook ads (owned by Meta, a company recognized as extremist and banned in Russia – editor). And this made it possible to reduce inequality within the country.
Oleg: More or less everyone loses from what is happening. Even if someone gets a higher salary, their well-being will still decline, their ability to spend money will deteriorate. Every person loses, without any exceptions. Although everybody does really lose in different ways. On the one hand, the least well off segments of the population, who have less savings and who are more likely to lose their jobs, usually suffer the most from crises. On the other hand, this crisis will hit harder those who had more foreign goods and services in their consumption basket .
Small businesses will suffer very much because the demand for a large share of their services will fall, and the state, in order to prevent the collapse of demand in the economy, will primarily support employment at large corporations – even if they are inefficient.
Oleg: There will be failures in the economy, and the government will be trying to fix them. This is a very inefficient approach because it does not solve the problem.
No local or specific measures can change the general trend of a declining level of well-being and economic primitivization.
At the same time, the Central Bank and the government are walking on a razor's edge: in such a complex situation, it is easy to take measures that can actually make the situation even worse and deepen the crisis. For example, price controsl in the short term may seem the right policy, but then it will lead to a severe shortage. And nationalization of firms leads to even further decline of their efficiency.
Konstantin: Indeed, one part of the government is closing gaps, and the other is at least saying that it will treat the "disease", and not just its symptoms. For example, in order to prevent technological lag, the government will stimulate the development of national technologies. However, it seems to me that very little good can come out of this, and a lot of bad things may follow. For example, the state can support the IT industry in such a way that nominally there will be 50 million people employed in the sector, everyone will be getting subsidies and benefits, but IT products and services will remain at the same level where they were before.
Oleg: Two important things have happened since the Soviet Union. On the one hand, the world has become much more integrated, and it is very difficult for any economy, even as large as the American or Chinese, to manufacture some complex product on their own.
On the other hand, there are countries that make a lot of quite complex goods, or at least assemble them, and you can try to negotiate supplies from those countries. In this sense, the situation may not be as catastrophic as it might seem. But I am not sure that it will be possible to establish supplies painlessly or without some losses.
Konstantin: There is another difference between Russia and the Soviet Union: the USSR was much larger, had a larger population, so it was easier to have a full-cycle manufacturing of products.
Konstantin: It seems to me that it might falter, but it is unclear what can be the tipping point. The inertia force works well: everyone wants to use the same currency. Even if I am uncomfortable with the dollar, I will still use it because others do. And so, the question is how uncomfortable each of us should get with the dollar in order for all of us to abandon it.
Of course, no one likes the possibility that their savings in dollars can be taken away. And this is another reason to stop using this currency and switch, for example, to renminbi. But this is a very big step.
Oleg: Such a transition assumes that there is a currency, say the Chinese yuan, which will not be used for political purposes. But how realistic is this scenario?
There are some fundamental factors that have determined the role of the US dollar. The World Trade Organization, international financial organizations, globalization are all elements of a financial, economic and political system that lives by certain rules that are guaranteed by the United States. Therefore, the tariff war against China started by Donald Trump became a real shock. It was not obvious what rules China had violated and why this trade war was necessary. The United States ceased to be a guarantor of the system of international trade. And this explains why China wants to build a concurrent system of international institutions.
Oleg: It seems to me that the world is on the verge of the most important decision since the collapse of the Soviet Union. It concerns the new architecture of the global economy. There are different scenarios.
The first scenario is the global economy built on the principles of cooperation. On some issues, there will be cooperation between the Western bloc and the bloc of countries around China (with Russia among them). And there will be a confrontation on certain issues, but not a cold war.
The second scenario is the complete splitting of the global economy into the Western and the Chinese blocks. And this will be a shock to the global economy.
It seems that everyone is interested in reaching an agreement. China benefits from a stable world that lives by certain rules. The entire Chinese growth of the last 30 years has been built on the use of Western institutions. It could possibly be feasible to create a system in which China's role would be proportional to its share in the global economy. But besides economic factors, there are political ones. China is undergoing the biggest political changes since the 1970s. So far, its political system has been stable. The power of the Communist Party was preserved, and the leaders were replaced every 10 years, like clockwork. And now China is shifting towards an individualistic regime: Xi Jinping will run for a third five-year term. What kind of political rhetoric he will use to retain power in the environment of fragmentation and deglobalization of the global economy is an open question.
If China tries to seize Taiwan, it will be the most serious shock that we have seen. In this scenario, there will be a large-scale technological crisis, since Taiwan has a huge share of the world chip market.
However, this is a low probability event. And if it does not happen, if there is no fragmentation of the trade system, then I expect a relatively optimistic scenario for the global economy: there will probably be a cyclical crisis (like many others that the world has experienced) with higher inflation, which will be weathered within 3-4 years, and without a terrible surge in unemployment.