4. Russia is facing a significant demographic challenge: its population is aging and shrinking, and the pressure of pensions on public finances (Russia’s pension system is state-run) is growing, and should escalate in years to come. If in 2014 the ratio of taxpayers of working age (paying payroll taxes) to those of pension age (receiving pensions) was 2.5:1, according to a Rosstat forecast, it should reach 2:1 by 2030. This escalation of fiscal pressure emerged in 2015–16, as the economy stopped growing, as did wages (the basis for payroll taxes), while the government confiscated savings from the cumulative pension scheme for the third year in a row. There is not much space for a viable solution: the government must either increase taxes or the pension age—both would be extremely unpopular—and the decision is therefore being postponed until after the 2018 presidential election.

In this circumstance, the Kremlin is facing a choice between a high budget deficit and a cut in expenditures. Though by all standards the state debt in Russia is small (15 percent of GDP), the government is not willing to increase the budget deficit above 3 percent of GDP, which is considered a secure level. But even this deficit could not be financed by public borrowing, as Western sanctions de facto prohibit Russia to borrow abroad, and the domestic market, lacking long-term savings, cannot accept long-term government bonds.

As a fallback, the Kremlin has only one option at the moment: to freeze and cut (both in real and in nominal terms) its budget expenditures. Public wages have been frozen for 2015–16, though accumulated inflation was 20 percent in two years. In 2016, pensions were only indexed by 4 percent, though inflation in the previous year was 12.9 percent. In 2015, budgetary expenditures (except social and military) have been cut by 5 percent from the level dictated by the budget, while in 2016 they were cut by 10 percent.

In the short run, this policy is rather effective, as it allows to stabilize the budget and does not cause significant social unrest. But in the long run, this approach cannot be justified, leading to accumulating demand for expenditures and degrading quality in public services.

Did Sanctions Matter?

In assessing the economic impact of Western sanctions, one has to be very careful in one’s judgement: Russia is facing a structural economic crisis that was caused by falling oil prices, domestic institutional weaknesses resulting in declining investment and Western sanctions. Since all those factors act together, it is not a trivial task to separate their effects. Sanctions are divided into two varieties: financial and technological. They also cover three main sectors of the Russian economy: banks, military production and the oil sector.

A Coincidence

Undoubtedly, Western financial sanctions are the most easily measured, and the strongest in their effect. They prohibit Western banks and companies from providing capital and loans to Russian banks and companies under sanctions.

Since the mid-2000s the Russian economy has relied heavily on foreign borrowing. After sanctions were imposed, since autumn 2014 Russian banks and companies have had to repay old loans while being unable to refinance even a small portion through new borrowing. Coincidentally, the pressure of the scheduled repayment of foreign loans in late 2014 and early 2015 was enormously high—$73.3 billion in two quarters (about 10 percent of GDP)—becoming one of the dominant destabilizing factors in the fall of 2014. Banks and companies that wanted to repay their loans were seeking hard currency, while export proceeds were declining because of the fall in oil prices. The ruble devalued fast, some days losing up to 10 percent of its value. The situation was aggravated even more by some mistakes made by the Central Bank.

All combined that created a perfect storm for the Russian financial market, resulting in a collapse of the ruble that at one point fell to the level of 1 euro cent per ruble, compared to 2.2 euro cents per ruble a year before. For many, this episode created an impression of the collapse of the entire economy.

But since February 2015, the situation has been improving rapidly. The Central Bank raised its interest rates and started to provide loans in foreign currency to banks and companies looking to repay their debts, thus reducing the demand for foreign exchange in the market. Oil prices rebounded since February 2015, and by May the ruble regained 40 percent of its value.

Since the second quarter of 2015, the pressure of debt repayment on Russia’s balance of payments declined significantly. In the next four quarters combined, banks and companies were required to repay $41.7 billion. The pressure of Western financial sanctions on the balance of payments (foreign debt repayment) in the last quarter of 2014 was twice the burden of lost oil export proceeds. In the first quarter of 2015, those two factors were roughly equal, while afterwards the fall of oil revenues affected the financial situation much more, being four to five times bigger than the repayment of foreign debt.

The projections of the CBR say that in the coming two years this amount will not exceed $20 billion per quarter, while deducting the amount of affiliated loans it may be one-third less. Of course, the permanent repayment of foreign debt equivalent to even 3–4 percent of GDP creates significant pressure on the economy, but in the case of Russia, this pressure is compensated by the decline in capital outflow.

Oil Production Grows Under Sanctions

The sector-targeted sanctions that were imposed on the Russian oil industry did not touch the gas sector at all, as Russian gas is vitally important for the European market. And as became evident soon after the announcement, sanctions on the oil industry applied only to Arctic deep-sea and shale exploration. The majority of the reserves of Russian oil companies are located in far distant regions, and cannot be developed without use of the Western technologies that are under sanctions. But those projects are currently in the earliest stages of geological study, and none of them will enter the development stage within the next five years. Moreover, with the current level of oil prices, all those projects are economically nonviable. As a result, Western sanctions have no impact on the current volume of Russian hydrocarbon production.

The best indicator of sanctions’ lack of effect on the Russian oil industry is the steady growth of production in 2014–16, during which Russian oil companies have produced and exported more and more oil from quarter to quarter. During that period, Russian oil companies have also finalized a comprehensive investment in the refinery sector that allows a significant increase in processing depth.

Defense Industry Needs the West

Russia is one of the largest producers, consumers and exporters of weapons in the world. The technology gap with Western countries forced Russian industry to actively use imported components, especially for export contracts, while the technological cooperation inherited from the Soviet Union has created a greater dependence on Russian arms deliveries from Ukrainian supplies.

The scale of the Russian defense industry’s dependency on Western imports is not very large, being estimated at 8–10 percent. But this dependence is concentrated in the most important and technologically advanced areas. Deputy Prime Minister Dmitry Rogozin said that components from NATO and EU countries are used in 640 different models of Russian military equipment, mainly in electronics and optics. Of these, “We will have to replace 571 models [with Russian production] by 2018.” Deputy Defense Minister Yuri Borisov, who is in charge of military-technical support of the Armed Forces, gave slightly different numbers in a report to Putin on July 16, 2015, saying that by 2025, “We plan to substitute imports of 826 models of weapons and military equipment.”

The Russian defense industry’s dependence on Ukraine is concentrated in rocket and space, aircraft, and shipbuilding products, and is much greater. This dependence and the sanctions have led to disruptions in the supply of military products in 2015, particularly in production for the Russian Navy. During the summer of 2015, Putin held a series of meetings analyzing the situation in the defense industry, after which it was decided to change the structure of arms procurement, resulting foremost in a reduction of deliveries for the navy. Obviously, in the near future, other areas of arms purchasing may also be adjusted. For example, the production of the most modern Russian fighter, the Su-35S, involves a large number of imported components, which are not currently produced in Russia. The most serious dependency is in electronics, where Russia has traditionally lagged behind. In 2016, production of these aircraft will be completed using existing stockpiles, but this will be impossible starting in 2017, as supplies will be exhausted.

Today we cannot measure the seriousness of sanctions’ consequences for the Russian defense industry, as they are not so evident today. But in the coming years, those effects will evidently continue to grow.

How Effective Is Import Substitution?

Russian politicians, starting with Vladimir Putin himself, declare that they see Western sanctions not as a punishment but as an opportunity—for Russian businesses to build new enterprises and to take up new market niches. The idea of import substitution has become a popular topic for discussions, and a chance for many ministers and state corporations to receive funding from the budget. The government has established a special commission for this purpose, which analyzes requests for funding, prioritizes them and makes a decision about the form in which funding will be provided (subsidies, loans, direct financing, and so on).