CHAPTER 8
Putinomics under Pressure

In September 2013, notables from across Europe and the world gathered in the Livadia Palace, a vacation retreat built by the last emperor of Tsarist Russia just outside of Yalta, a resort town in the Crimean Peninsula. The Livadia Palace was where Stalin, Churchill, and Roosevelt met in February 1945 to carve up Europe at the end of World War II. The Yalta Conference, and the deal that the “Big Three” signed there, is remembered primarily for separating Europe into two halves, one capitalist and the other communist, laying the ground for a decades-long Cold War.

Most attendees of the 2013 conference in Yalta—including a former German chancellor, CIA director, and World Bank president—did not fully understand the historical irony at play. One person who did understand was Sergey Glazyev, President Putin’s leading adviser on Eurasian integration, who represented Russia at the conference. In late 2013, the European Union appeared ready to sign a free-trade deal with Ukraine, a move the Kremlin saw as Western intrusion on its sphere of influence. Speaking at the conference, Glazyev warned the audience that for Ukraine, the long-discussed trade agreement with the European Union would be “suicidal.” He urged Kyiv to sign a Russian trade pact instead. Petro Poroshenko, then Ukraine’s trade minister and now its president, struck back, telling Glazyev that thanks to punitive Russian trade sanctions on Ukraine, “for the first time in our history more than 50 percent of people support European integration. Thank you very much for that, Mr. Glazyev.”¹ The audience, mostly of Western officials and business leaders, applauded.²

At the sidelines of the conference, Glazyev spoke with journalists to make sure that his point got through. “Ukrainian authorities make a huge mistake if they think that the Russian reaction will become neutral. . . . This will not happen.” To the contrary, he promised that the trade deal with the European Union would lead to Ukraine’s default and an economic crisis. He predicted that Ukraine would suffer social division if it signed the trade agreement, hinting that separatist movements in the Russian-speaking eastern and southern provinces of Ukraine might be one result. “We don’t want to use any kind of blackmail,” Glazyev claimed. “This is a question for the Ukrainian people. But legally, signing this agreement about association with [the] EU, the Ukrainian government violates the treaty on strategic partnership and friendship with Russia.” The risk—or threat—was clear. “Signing this treaty will lead to political and social unrest,” Glazyev insisted. “There will be chaos.”³

On that score, Glazyev was right. Less than six months later, Russia seized Crimea and fomented a rebellion in eastern Ukraine, prompting international financial sanctions and sending investors fleeing. At around the same time, the price of oil crashed, from over $100 per barrel in early 2014 to half that price by the middle of the year. Russia’s economy was already teetering on the brink of recession before it was hit by the combination of war and an oil shock. The years following 2014 were the most difficult Putinomics had faced. The Kremlin responded by betting that 2014 and 2015 were a repeat of 2008 and 2009, years that also saw recession, low oil prices, and foreign wars. As in 2008 and 2009, Putin’s mix of cautious fiscal and monetary policies proved sufficient to steer Russia through the crisis, but failed to restart rapid economic growth.

No Time for a Crisis

Even before the shocks of 2014, Russia’s economy was veering toward recession. Investment and GDP growth were sliding downward. Annual growth of around 4 percent in 2010 and 2011 fell to barely 1 percent by 2013. The causes of the slowdown were varied. Putin’s return to the presidency in 2012 had done little to improve things. An atmosphere of stagnation set in, and private investment slumped. During the 2008 crash, money fled the country, as foreigners and wealthy Russians alike moved capital to more secure markets. But though the country had seen strong levels of capital inflows in the years before the crisis, the end of the recession did not see capital return to Russia. Instead, money continued to flow out, not at the devastating rate of 2008, but leaving nonetheless. That meant less capital to fund investments in Russia.

One reason for the investment slowdown was that Putin’s cronies were playing an ever-larger role in the economy. In 2012, for example, Rosneft, the state-owned firm run by long-time Putin associate Igor Sechin, announced it was buying TNK-BP, an oil company jointly owned by a group of Russian businessmen and BP, the British energy giant. It was not only in the energy sector that big, state-owned, crony-controlled firms expanded. By 2013, the three biggest state-owned banks controlled 60 percent of all banking sector assets. Meanwhile, the government failed to significantly improve conditions for private sector firms, with Russia ranking in the bottom half of World Bank metrics on the ease of getting a construction permit or trading across borders.⁴

FIGURE 18 Private capital inflows, 2005–2013 (billion U.S. dollars). Bank of Russia.

The government responded to falling private investment by boosting public investment, especially through big prestige projects. The 2014 Sochi Olympics, for example, were not only a sporting event. Nor were they simply a PR project to boost the government’s popularity—though, like every Olympics, that was surely part of the government’s goal. Sochi was also a massive construction project, designed to revitalize the entire region. In 2012, Vladivostok hosted the Asia-Pacific Economic Cooperation (APEC) summit—and received a $21 billion infrastructure investment in advance to spruce up the city.⁵ Kazan got similar funds before a 2013 sporting event.

Russia needs infrastructure investment, especially outside of Moscow and St. Petersburg. Yet projects such as the Sochi Olympics cost far more than they will provide in future growth. Estimates of the total cost of the Olympics vary depending on what types of investments are included in the calculation. What is clear, however, is that a significant share of the funds invested were wasted or stolen. Alexei Navalny’s Anti-Corruption Foundation has alleged numerous well-documented instances of corruption related to Sochi construction projects.⁶

The way that Sochi was financed allowed its costs to be hidden from public view, at least at first. Most of the major construction projects in Sochi—from hotels to transport to the Olympic village—were managed either by oligarchs or by state-owned firms. This model was chosen because it gave powerful groups access to large revenue streams, and because it gave the government specific individuals to hold responsible if problems emerged. As a management model, the system was far from optimal, though it was well suited to the oligarchic class that Putin had raised.

The individuals and state-owned firms who received contracts to build Sochi got most of their funding from the state. This came not in terms of cash grants but through “loans” from a “bank”—Vneshekonombank, or VEB, the state development bank. VEB is called a bank, but it does not accept deposits and in practice functions like an investment fund. Its mandate is to lend to projects that boost long-term growth. VEB played a crucial role in funding Sochi, extending credit for hotels, a new airport, a new power plant, and even the Olympic village itself.⁷ Most of these transactions, however, were not really loans. When real banks make real loans, they expect them to be repaid. At VEB, by contrast, it is unlikely that managers expected most of their Sochi “loans” to be repaid. From the beginning, it was clear that costs were inflated, that expectations of post-Olympics income were overestimated, and that the oligarchs who received VEB credit had the political clout they needed to wiggle out of whatever repayment commitments they made.

VEB disbursed around 250 billion rubles (over $7 billion) for Olympics-related projects.⁸ By labeling handouts as “debt”—as if it would be repaid in the future—Russia’s leaders disguised reckless and corrupt spending schemes as “investment,” postponing the bill for several years by hiding the true cost on VEB’s balance sheet. The final price tag for VEB’s bailout will be billions of dollars.⁹ Stuffing VEB with corruption-fueled debt was a clever political move. But schemes like this were hardly the type of investment that Russia needed to restart economic growth.

The Eurasian Economic Union and the Protectionist Turn

The state spending boom of the post-2012 period only had a chance of working if new funds were directed toward projects that would boost long-term growth. Russian leaders realized that trade could play a key role in supporting growth, especially in manufacturing industries. Several policy initiatives sought to encourage trade between Russia and its neighbors. After nearly two decades of debate, for example, Russia finally joined the World Trade Organization in 2012, reducing tariffs and eliminating other trade barriers. Many Russian economists, however, believed the country needed grander integration plans if it was to retain its economic and political weight. When Russian leaders looked at the world, they saw several rising trade blocs. The European Union had integrated the economies of its twenty-eight member states and imposed binding rules on other major trading partners such as Turkey, Switzerland, and Norway. The United States, which already had the North American Free Trade Agreement, had begun negotiating the Trans-Pacific Partnership with some of Asia’s largest economies. China’s economy was growing by double-digit rates each year and had become the largest trading partner even of faraway nations such as Brazil.

Russia had no such trading blocs—and no interest in being a junior member in Europe’s trade zone. If Russian manufacturing were to boom, some economists argued, the country needed supply chains that crossed national boundaries, as did those in China and Southeast Asia. Russia’s existing trade infrastructure made this kind of tight integration difficult. The countries on Russia’s borders, especially Belarus, Kazakhstan, and Ukraine, the Kremlin concluded, could play a role not unlike the one Mexico plays for the United States, or Poland today plays for Germany—suppliers of quality but lower-priced labor, as well as large markets for consumer goods.

When framed this way, the idea of an economic union with neighbors in the post-Soviet space made sense. Ukraine, Belarus, and Kazakhstan combined had a population 50 percent the size of Russia’s. If united, they would drastically expand the potential market for Russian firms. Belarus and Ukraine had industrial bases that despite post-Soviet difficulties were still closely integrated with Russia’s. Kazakhstan was in an oil-fueled boom. And all these countries had Russian-speaking elites with personal connections to Russia dating from Soviet and even pre-Soviet days. From this perspective, an economic union between Russia and Ukraine might have made even more sense than one between the United States and Mexico.¹⁰

Yet Russia was ambivalent about trade deals. During Putin’s first term as president, the government appeared to be moving quickly toward joining the WTO, spurred on by China’s successful membership application in 2001. Domestic opposition, however, soon gathered strength. The basic impediment to WTO membership was Russia’s trade profile. Countries generally choose to sign trade deals to gain access to export markets. Russia, however, did not have an export industry that was pushing for trade deals. The country’s biggest export products were oil and gas, followed by industrial and precious metals. Commodities face far fewer trade barriers than do manufactured goods, because countries that don’t have their own supplies of oil or diamonds have no choice to buy them on the world market.¹¹ Import substitution is impossible.

The existence of relatively open markets in commodity trade was good news for Russia’s powerful commodity producers, but it meant that these firms had no reason to advocate for trade deals. Russia had many firms, however, that sold manufactured goods to the domestic market and feared competition from cheaper Asian firms or higher-quality European ones. Oligarchs such as Oleg Deripaska, whose companies produced cars and airplanes, mobilized their political machines against WTO accession. Agricultural interests pointed out that WTO rules would restrict farm subsidies. Retail and service businesses feared competition from efficient foreign chains. What sounded to the government in the early 2000s like a good idea quickly became a political quagmire.¹²

As market reforms stalled in the mid-2000s, so too did WTO accession. The president lost interest, apparently deciding the economic benefit from greater trade was outweighed by the political cost. Only when Dmitry Medvedev became president in 2009 did the WTO process restart, driven by liberally inclined advisers who believed more trade would help Russian firms modernize through cross-border integration.¹³

The long delay over WTO membership contrasts with the rapid push for Eurasian integration that began after Putin returned to the presidency. One reason that the Eurasian Economic Union developed more rapidly than Russia’s WTO membership is that Russian firms sensed real benefits coupled with limited costs. Yet there was also a strong political rationale to Eurasian integration. Even as some Russian economists pointed to the benefits of greater trade, other Russian leaders saw a contest for political influence—and even for control. Discussions about trade blocs are never politically neutral, of course. Some countries are in, meaning that others are out. Someone writes the rules that others must follow. The European Union, for example, dictates rules to new member states. Belgium, which has been an EU member since the beginning, has had far more influence than Croatia, which joined in 2013. U.S. rhetoric regarding the failed Trans-Pacific Partnership bloc was more openly political, with Barack Obama insisting that “we can’t let countries like China write the rules of the global economy,” arguing that the United States should establish trade rules itself.¹⁴

In some sense, then, the Kremlin’s view of economic integration in geopolitical terms is not surprising. But compared to other countries, Russia’s view of economic integration seemed to preference geopolitics more than the European Union, or other trade blocs it was ostensibly emulating. The European Union, for example, has never had a dominant member. While France has always played a key political role in European integration, the German economy was always the powerhouse. Today Germany is widely viewed as the most financially powerful EU country—but it makes up only a fifth of the union’s economy. It is regularly outvoted by coalitions of other member states.¹⁵ Even in instances such as the Greek financial crisis, where Germany was seen as the leader of a push for austerity, it was able to implement such a policy only because a group of other countries agreed with it.

The Kremlin’s plans for Eurasian integration, by contrast, always had a clear leader in mind. That does not mean other members were uninterested. Kazakhstan, in particular, has supported economic integration with Russia both for economic reasons and as a means of guaranteeing it is not too dependent on China, its largest trading partner.¹⁶ But it was impossible to deny that a union that included Russia and its neighbors would center on its most populous member in a way the European Union never has. That, to the Kremlin, was the point. As one Russian analyst put it, “Russia will still gain real advantages from creating a trade bloc around itself.”¹⁷

Russia’s neighbors Kazakhstan and Belarus reacted positively to the idea of greater economic cooperation, as did Tajikistan, Kyrgyzstan, and Armenia. Ukraine—which has a larger population than these countries combined—did not. Unlike the countries of Central Asia and authoritarian Belarus, Ukraine had far less interest in Russia’s integration plans. A significant portion of the country’s population was strongly anti-Russian in its political views and wanted to integrate with Europe instead.¹⁸ No less important, most of Ukraine’s oligarchs feared that a union with Russia would reduce their political and economic influence. They were more skeptical of a move toward Europe—which would impose new rules on their behavior—but had even less interest in closer ties with Russia.¹⁹

Russia’s attempts to cajole Ukraine into further economic integration came just as Kyiv was preparing to sign what in EU jargon is called a “deep and comprehensive free trade agreement,” or DCFTA. Unlike a straightforward deal to reduce tariffs, the European Union’s DCFTA offered extensive access to European markets in exchange for Ukraine’s adoption of EU regulatory standards. These stipulations conflicted with what Russia was seeking from Ukraine to join its own economic union.²⁰ Ukraine would have to choose between the two. The Kremlin believed that if Ukraine were to join the EU trade zone, Russian influence in the country would decline sharply. Both the European Union and the Kremlin angled to convince Ukraine to join their respective trade blocs. The European Union softened its stance on whether Ukraine had to release imprisoned former prime minister Yulia Tymoshenko before signing the DCFTA.²¹ Russia offered preferential trade provisions.²²

Yet in addition to offering carrots to Ukraine, Russia also brandished sticks. The Kremlin threatened huge tariff increases on Ukrainian-Russian trade if Kyiv signed the DCFTA.²³ Yet Ukraine still leaned toward the EU. Europe’s economy was far larger than Russia’s, and more developed. Ukraine itself was divided, though most of the country’s oligarchs, and the middle classes of its capital city, Kyiv, believed the EU option was better for economic and political reasons. Russia responded by restricting Ukrainian exports beginning in the summer of 2013, imposing painful losses on Ukraine.²⁴

Ukraine’s president, Viktor Yanukovych, faced a dilemma. He had alienated the country’s oligarchs and Kyiv’s middle class with his family’s rapacious corruption.²⁵ The country’s economy was in a tailspin, caused in part by Russian trade sanctions. The European Union was pressuring him to release his main political opponent from jail, where she sat on trumped-up charges.²⁶ The government was also running out of money, and Yanukovych knew the IMF would demand politically unpopular fiscal changes if he were to seek a bailout. When Russia swooped in to offer $15 billion plus discounted gas sales in exchange for his rejecting the EU trade deal and promising to join Russia’s own trade bloc, it was an appealing proposition.²⁷

War in Ukraine

Appealing, that is, to Ukraine’s president. Kyiv’s middle classes were rather less impressed with a deal that tied their corrupt dictator to a more powerful neighboring one and closed off the prospect of using closer ties with the European Union as a lever for democratizing their own country. Urged on by Mustafa Nayyem, a crusading journalist, Kyiv took to the streets and demanded that Yanukovych sign the deal with Europe. Ukraine’s class of oligarchs was no less fed up with Yanukovych, though for far less noble reasons than Ukraine’s citizen protesters. The middle class and the oligarchs turned up the pressure on Yanukovych. After violence broke out on the Maidan—Kyiv’s central square—the president fled to Russia, and a new government, which backed the trade deal with Europe, took power.

Russia interpreted the new government in Kyiv as a threat. The Kremlin resented the loss of influence in Ukraine. It feared for the security of its naval base in Crimea and its gas deals. It resented what many Russians saw as a U.S.-led strategy of regime change in Kyiv. It was terrified of the spread of “chaos” and “disorder”—the terms Russian leaders most frequently used to describe the Maidan protests.²⁸

In response to what it saw as an “illegal coup,” Russia annexed Crimea and fomented a rebellion in eastern Ukraine. It is hard to imagine a worse time for a war for Russia. Whatever positive impressions the Sochi Olympics had created in world public opinion were immediately erased. The West united against Russia, ejecting it from the G8. A patriotic fervor swept over Russia. It quickly became clear that the Kremlin lacked a plan for how to integrate Crimea into Russia given Ukraine’s hostility. Crimea lacked direct transport links to Russia, necessitating the construction of a multibillion-dollar bridge to the peninsula. Similarly, Russia began drawing up hasty plans to create new electricity links and to hike Crimean pensions as a means of solidifying support. The adventure in Ukraine was turning out to be an expensive proposition.²⁹ “The Ministry of Finance was not asked in advance about the possible price of the decision on the accession of Crimea,” Deputy Finance Minister Tatyana Nesterenko explained after the fact.³⁰ It would struggle to deal with the consequences.

Sanctions and Countersanctions

The most immediate cost to Russia came from the economic sanctions that Western countries slapped on Russia’s economy. After Russia’s annexation of Crimea, the West levied relatively light economic sanctions on Russia, prohibiting investment in Crimea and punishing individuals involved with the annexation decision. The more economically significant sanctions were imposed beginning in July 2014, after the United States prohibited energy firms such as Novatek and Rosneft and state-owned banks Gazprombank and VTB from accessing U.S. capital markets.³¹ The European Union soon followed with its own financial sanctions. As Russia’s intervention into Ukraine expanded, so too did U.S. and EU sanctions, hitting a larger number of firms in different sectors.³²

By the end of 2015, Western powers had prevented most of Russia’s largest banks and energy firms from raising capital or refinancing debt in Western markets. They also prevented the export of high-tech oil extraction equipment to Russia and imposed sanctions on Russia’s defense industry.³³ U.S. and EU sanctions were implicitly or explicitly followed by Norway, Switzerland, Japan, Australia, Canada, and several countries in the Balkans.³⁴ No less significantly, firms in many Asian and Middle Eastern countries have declined to expand lending to Russian entities, fearing retribution from American regulators.

The Ukraine war was not the first time economic sanctions have played a significant role in Russian foreign policy. In the Soviet period, for example, Western countries imposed extensive restrictions on trade with the USSR, though over time many were removed. Still, countries such as the United States sought to link trade with Soviet behavior. For example, the Jackson-Vanik Amendment, passed by the U.S. Congress in 1974, limited trade with the USSR unless Moscow let Jews emigrate and unless it respected other human rights standards. The Jackson-Vanik Amendment was only formally repealed in 2012, though its provisions had long been waived. However, it was replaced by the Magnitsky Act, a bill that freezes the assets of Russians implicated in the death of Sergei Magnitsky, a lawyer who died after being beaten in a Russian jail, where he was imprisoned for uncovering government corruption. The Magnitsky sanctions had a negligible economic effect, but they enraged the Kremlin.

Yet it is Russia, not the West, that has most enthusiastically embraced the use of economic sanctions in Eastern Europe.³⁵ Over the past decade and a half, the Kremlin has repeatedly imposed politically motivated trade sanctions on nearly all its neighbors. Georgia, for example, suffered heavily from Russian trade sanctions during the 2000s. In 2003 the Rose Revolution brought to power a government that criticized Russia, tried to reestablish control over separatist regions backed by Moscow, and sought to integrate rapidly with the West. In response the Kremlin imposed a series of economic sanctions on Tbilisi. The conflict began with a steep hike in gas prices, followed by a complete cutoff, which forced Georgia to turn to its neighbor Azerbaijan for supplies. Then Russian health inspectors declared Georgian wine—a major export product—unsafe for consumption. A health ban on mineral water, another important export, quickly followed. Trade volumes plummeted. In 2005, before the sanctions, Georgia exported over $150 million to Russia each year, but that fell to only $20 million by 2009.

Moldova’s experience has been similar. In 2013, as Moldova prepared to sign an Association Agreement with the European Union, Russian health inspectors claimed that they found traces of plastic in Moldovan wine and announced a ban on imports. This was not the first time Russia had prohibited Moldovan wine—in 2006, it was also banned for a year. Russia hoped that the economic pressure would “persuade” Moldova that joining the Russian-led Customs Union was a better idea than moving closer to the European Union.³⁶ Central Asian countries have also suffered from Russian economic pressure, for example, when Russian leaders threaten to deport migrant workers.³⁷

It was ironic, then, that Russian leaders so loudly criticized Western sanctions amid the war in Ukraine. The West’s sanctions hurt, especially the decision to prohibit many large Russian firms from accessing Western capital markets. They forced a significant deleveraging of the Russian financial system, as the country’s biggest banks paid back dollar- and euro-denominated loans and were unable to find new ones.³⁸ Sanctions pushed down the value of the ruble, and probably knocked at least 0.5 percent off Russian GDP growth in 2015.³⁹

The most significant cost of Western sanctions, however, was political. So long as the sanctions persist, Russia faces the stigma of Western condemnation. It makes sense, then, that the Kremlin’s main response to Western sanctions was also fundamentally political. The “countersanctions” that the Kremlin implemented beginning in August 2014 banned the import of food products from countries that levied sanctions on Russia.

One rationale behind the “countersanctions” was simple retribution. The West punished Russia, so Russia had to strike back. Most estimates of the financial losses caused by sanctions, however, indicate that their cost to Europe was limited and declined over time. (Only 1 percent of U.S. agricultural exports were sent to Russia, so sanctions had an even less significant effect on America.)⁴⁰ European producers found new markets for most produce that previously went to Russia. Some sectors, notably dairy, fruits, and vegetables, saw export declines that were linked to Russian sanctions.⁴¹ But economists who have researched the issue have found that a year or two after Russia imposed its ban on European food imports, most European producers had found new export clients willing to pay similar prices.⁴²

The ability of European farmers and food producers to adjust undermined the Kremlin’s second goal of countersanctions: convincing Europe to abandon sanctions against Russia. One rationale for punishing Europe’s farmers is that they are politically powerful and well-organized. If they turned against sanctions on Russia, one might surmise, support for sanctions in Europe would decline. This has happened to a certain extent, but the utility of agricultural lobbies as an antisanctions force was not as significant as Russia apparently hoped.⁴³

The inability of Russian countersanctions either to impose a large cost on Europe or to change EU policy led some Russians to conclude that the Kremlin had a third aim in mind: benefiting domestic producers by cutting off foreign competition. Indeed, after the countersanctions were imposed, the Kremlin itself began talking about the benefits of “import substitution,” the process of replacing less expensive imports with more expensive but domestically produced goods.⁴⁴

Some import substitution would have happened anyway in 2014 thanks to the ruble’s devaluation, which drastically increased the price of imported goods. Prohibitions on imports sped this process along. Certain business groups and some Russian officials promised that import substitution would boost domestic production and encourage long-term growth.⁴⁵ Russian journalists, however, noted that less high-minded motives also played a role in the continuation of the food import ban. Some top officials, including Agriculture Minister Aleksandr Tkachev, owned large agribusinesses themselves and thus benefited from Russian prohibitions on agricultural imports.⁴⁶

The Oil Crash

Even as Russia struggled to jump-start its economy and work around Western sanctions, a new threat emerged over which the government had far less control. America’s energy industry was causing Russia far more pain than any sanctions Washington could impose. Thanks to the technology-driven tight-oil boom, U.S. oil production nearly doubled between 2007 and 2015.⁴⁷ In mid-2014, oil traders, who had not expected such a rapid increase from the United States, suddenly realized that the world faced a glut of oil. As new American supply rushed onto world markets, the price of oil crashed. Oil traded above $100 per barrel in early 2014, but by the end of the year it hovered around $50. The price bounced slightly higher toward the middle of 2015, only to dive even deeper in early 2016.

To Russia, 2014 felt like 2008 in repeat. The country was as dependent as ever on oil export revenue, having only recently dragged its economy out of the previous recession. To the Russian government, however, the analogy with 2008 was reassuring. They had survived that crisis, many reasoned, so they could survive this one, too. The 2008 crash provided lessons, the government believed, that could shape its policy response. The Kremlin was determined not to make the same mistakes twice. In the 2008 crisis, Russia’s central bank held the value of the ruble roughly constant against the dollar, even as oil plunged. Doing so required spending billions of dollars from the central bank’s currency reserves. Yet facing the risk of running out of dollars, the bank had to let the ruble fall against the dollar. Between July 2008 and July 2009 the ruble fell from twenty-three per dollar to thirty-five per dollar, where it stayed for the next several years.

After the 2008 crisis, however, Russia’s leaders concluded that their monetary policy response made little sense. The Bank of Russia had spent over one-third of the country’s currency reserves defending the ruble—over $200 billion—only to let the ruble fall in the end.⁴⁸ The next time, they concluded, it would be far better to let the ruble adjust more rapidly, preserving the reserves. A speedier devaluation might also bring positive economic effects, since a cheaper ruble would benefit exporters, making their products more competitive abroad.

Devaluation was also key to preserving a stable government budget. In 2009, because of the delayed devaluation, the budget swung into a huge deficit, reaching over 7 percent of GDP.⁴⁹ Russia’s budget depended heavily on the ruble/dollar exchange rate. The reason is oil. A significant share of Russia’s government revenue is collected through taxes on oil production and export. (The share of oil in total government revenue varies, of course, based on oil’s price.) Oil is priced in dollars. Almost all of Russia’s government spending, however, is priced in rubles, from pensions to road building to officials’ salaries. If the ruble falls against the dollar, each dollar of oil taxation brings in more rubles. Devaluation, therefore, is a tool to balance the budget.

Russia’s central bank chief, Elvira Nabiullina, prefers to describe its policy since the 2014 oil price crash as “inflation targeting,” referring to a strategy of monetary policy making in which a central bank tries to hit a certain level of inflation—4 percent in Russia’s case—rather than keeping the currency at a specific level. Even before the 2014 crisis, the Bank of Russia had announced plans to move toward an inflation-targeting regime, though it only did so in late 2014, when the sliding oil price forced its hand.⁵⁰

Yet it would be naive to think that inflation is the only concern of monetary policy makers. In theory, the Bank of Russia is independent from political meddling. Russia’s weak legal institutions mean the country’s central bank is far more susceptible to political influence than peers in advanced countries. Off the record, policy makers speak relatively openly about ramifications of the exchange rate for the federal budget, something that “independent” central banks in theory should not do.⁵¹ Most foreign exchange investors realize that the person who ultimately decides monetary policy is the president. It is no surprise that Putin’s public statements often cause the ruble’s value to fluctuate.⁵²

With the president’s support, the Bank of Russia let the ruble’s value collapse in 2014.⁵³ Dragged down by the sinking price of oil, the ruble fell from thirty-five per dollar in mid-2014 to nearly sixty by the end of the year. Newspaper headlines often screamed that the ruble was falling out of control, but devaluation was a deliberate strategy. Letting the ruble sink saved the government budget by increasing the number of rubles the government collected from taxing oil exports. The downside of devaluation, however, was inflation. Many Russian consumer goods—from food to clothes to cars—are imported and priced in dollars. Devaluation increased the number of rubles needed to buy these goods. This caused inflation to hit 11.4 percent in 2014 and 12.9 percent in 2015. For only the second time since Putin took power, the inflation-adjusted value of wages fell in 2015, by a whopping 9.5 percent. For the first time, inflation-adjusted pension payouts fell, too. The central bank’s decision to let the ruble slump functioned like a tax on household incomes. Devaluation saved the budget, but it did so by shifting the costs of the crisis onto the population. This also fit the preferences of Putinomics: wage growth was a goal, but preserving budgetary stability—and thus the Kremlin’s room for maneuver—was more important.

FIGURE 19 Foreign exchange reserves and exchange rates, January 2014–January 2016. Bank of Russia.

Credit Where Credit Is Due

The family budgets of the Russian population thus were not the first worry of economic policy makers as the ruble fell. Many Russians, especially the poor, suffered a painful decline in living standards as inflation increased. But after fifteen years of rapid wage increases, everyone knew how to survive an economic crisis—especially given that even after real wages fell in 2015, they decreased only to 2012 levels, still double the level of the early 2000s.⁵⁴ The memory of recent economic hardship, combined with a widespread belief that the crisis was caused primarily by oil price swings and aggressive foreign sanctions, meant that there was little popular pressure on the government.⁵⁵

The immediate threat of devaluation was to the country’s banks. If there was one lesson from the 2008 global financial crisis, it was the risk of letting big banks fail. The collapse of Lehman Brothers in September 2008 froze U.S. financial markets and pushed the country into a devastating recession. In that same crisis, Russia acted aggressively to bail out its own banks, hoping to avoid similar contagion. In 2014, the risk to Russia’s banking sector was not nonperforming loans but Russian banks’ funding model. Russian banks made most of their profits—from banking services to car loans—in rubles. In the decade up to 2014, however, they had borrowed huge sums in dollars and euros. This made business sense: Russia’s biggest banks could borrow dollars and euros from Western financial markets at low interest rates, lend in rubles to Russians at higher interest rates, and pocket the difference.

It was a good model so long as the exchange rate was stable. When the ruble slumped, however, foreign currency debt was transformed from the cornerstone of Russian banks’ business model to the greatest threat to their survival. Imagine a bank that had to repay a $1 billion loan at the end of 2014. At the beginning of the year, the ruble traded around thirty-five to the dollar—roughly the same rate as the previous five years. The hypothetical bank would have allotted around 35 billion rubles to repay its dollar debt. Yet when the end of 2014 arrived, thanks to the devaluation it now took nearly sixty rubles to buy one dollar. Yet bank revenues—denominated mostly in rubles—were no larger. In fact, because devaluation stressed household budgets, bank profits declined as consumers were increasingly unable to repay their loans. Banks that looked healthy in mid-2014 teetered on the brink of bankruptcy by the end of the year.

Russia’s private sector—banks plus nonfinancial corporations—had borrowed $659 billion by mid-2014 from external sources.⁵⁶ A third of this was borrowed by Russia’s banks. State-owned corporations, especially those in the energy sector, were a second driver of external borrowing. Most of Gazprom’s debt, for example, is denominated in foreign currencies, and by 2016 the firm had over $20 billion in outstanding foreign currency bonds.⁵⁷Rosneft, the oil giant, was even more indebted, entering the crisis having just spent $55 billion buying the oil company TNK-BP.⁵⁸

Rosneft in particular faced worries over debt repayments. According to Moody’s, the credit rating agency, Rosneft had to repay or refinance $26.2 billion between mid-2014 and the end of 2015. It had traditionally relied on Western investors to finance its expansion, and so long as oil prices were high, investors were happy to lend at low rates. But sanctions shut out Rosneft from Western financial markets, and Rosneft struggled to find other financing options. In the end, it refinanced only with help from Russia’s central bank, which agreed to accept newly issued Rosneft bonds as collateral, allowing domestic Russian banks to buy the bonds and promptly exchange them at the central bank. That maneuver took pressure off Rosneft, though the lack of transparency spooked markets and drove down the ruble.

Energy companies were hard hit by the crisis, but they had one advantage over other firms: commodities are priced in dollars, so their revenue was not reduced by the devaluation. Instead, they benefited from the cheaper ruble, which reduced the relative value of their production costs. Russia’s banks faced the opposite challenge. Many struggled to refinance foreign currency loans. On top of that, some of the biggest banks, including Sberbank, VTB, VEB, and Gazprombank, were placed under Western economic sanctions, freezing them out of dollar and euro capital markets.

Russia’s leaders knew that devaluation posed stark threats to the country’s banks—and that if any of the biggest banks were to fail, Russia’s entire financial system could freeze. The central bank was tasked with saving the banking system. First, it loosened regulations, giving banks the option of using the old exchange rate when calculating their capital.⁵⁹ This let banks avoid raising additional funds to compensate for the ruble’s sharp decline against the dollar. Second, in November 2014, the central bank introduced a new program of extending yearlong dollar loans to Russia’s banks, using the country’s foreign exchange reserves to fill the gap that Western capital markets played before sanctions.

Not all the steps that Russia’s government took to deal with the liquidity crisis were helpful. The 2014 decision to let Russian banks buy bonds from Rosneft and exchange them for cash at the central bank stands out as particularly poorly designed, though the central bank was likely under political pressure. Overall, though, the central bank has taken steps to limit the potential downside of its liquidity provision efforts. The main risk to this type of program is that the central bank is left holding obligations from banks that go bust. Bank of Russia governor Elvira Nabiullina, however, has coupled expanded liquidity with an aggressive campaign to close poorly run banks, limiting the chance that Russian taxpayers will be on the hook for bad debts. Thanks to Nabiullina’s campaign against mismanaged banks, a quarter of the banks that were operating as recently as 2014 had been shut by mid-2016.⁶⁰

FIGURE 20 Financial sector external (foreign) debt, 2013–2015 (billion U.S. dollars). Bank of Russia.

Sensible policies by Russia’s central bank ensured that devaluation did not spark a banking crisis. Russia’s banks decreased external borrowing by 38 percent between 2014 and mid-2016, down to $129 billion. External debt owed by nonfinancial firms fell by over $100 billion, a decrease of nearly 20 percent. In general, of course, declining external debt is not good news. Before the crisis, inflows of foreign capital were evidence that investors expected growth. Today, reduced lending is a sign that both Russians and foreigners lack confidence in Russia’s economic prospects. Nonetheless, the rapid but relatively painless decrease in Russia’s external debt burden is an unsung success story, especially for Russia’s central bank. Rarely do countries deleverage so rapidly with so little financial chaos.

The Bill Comes Due

Prime Minister Medvedev’s visit to Crimea in May 2016 should have been an opportunity to celebrate one of the government’s few recent success stories. The annexation of Crimea was still popular in Russia, and though the decision to seize the peninsula from Ukraine was primarily associated with Putin rather than Medvedev, surely the prime minister expected at least to bask in the annexation’s afterglow. Yet while shaking hands with citizens, the reaction he received was rather different. Rather than accolades, an old woman demanded that Medvedev raise pensions to offset high inflation. “It’s not possible to live in Crimea—prices are crazy high! They didn’t raise [pensions] enough!”⁶¹

Though Russia’s response to the oil slump was orderly, it was not painless. How could it have been? In 2013, Russia exported $350 billion in oil and gas products. In 2015, it exported only $216 billion.⁶² That money could not be easily replaced. The population paid the price of the crisis through inflation, and like the Crimean pensioner nearly all Russians felt it acutely. The government’s response was to blame outside forces—the global oil market and Western sanctions—while promising a return to growth soon. To some, this sounded like an attempt to evade responsibility. Medvedev’s response to the Crimean pensioner, for example, inspired derision. The government hadn’t decided to index pensions for inflation, Medvedev told the pensioner, annoyed that she was badgering him. “There simply isn’t any money now. If we find money, we’ll index them. Hang in there. All the best!” Then the prime minister promptly left.⁶³

Medvedev’s answer was daft politics, but it also recognized budgetary realities. If oil prices stayed at their 2015 level indefinitely, Russia would have to transform its public finances. Like any government whose spending plans exceeded tax revenue, the Kremlin faced three basic options: slash spending, hike taxes, or take on debt. Running up government debt was perceived as dangerous at a time when the West had levied sanctions on Russia, demonstrating it could cut the country off from international capital markets. The Kremlin began spending down its reserves, but with oil prices at $50 per barrel or lower, the reserves would not last long. At the same time, tax hikes and spending cuts were politically controversial especially given the 2016 parliamentary elections and the government’s preparation for Putin’s presumed reelection in 2018. Given the Kremlin’s wariness about expanding its debt burden, some amount of spending cuts or tax increases were unavoidable. But the biggest spending items—on pensions, for example—were also politically crucial, limiting the government’s room for maneuver.

Whose Bill Was It?

What Russia’s government failed to recognize during 2015–16, however, was the extent to which the crisis was self-inflicted. Take the example of VEB, the state-owned bank that lent money to firms that built infrastructure for the Sochi Olympics. Amid the oil-induced austerity drive, VEB—ostensibly a “development bank”—requested a $20 billion government bailout.⁶⁴ In addition to having to write down most of its Olympics-related lending within the first three years after the Sochi games, VEB admitted that it also lent $8 billion to metals firms in Eastern Ukraine, in deals that may be linked to Moscow’s foreign policy aims in that country.⁶⁵ If any of those loans had initial value, they have been devastated by the war in the Donbas. VEB’s new management admits it lost at least 1.5 trillion rubles on its loan book, though full losses may well be higher.⁶⁶ According to Russian media, at least 40 percent of VEB debts are not being paid on time.⁶⁷

Nearly all VEB’s problems were caused by mismanagement or corruption. The Sochi Olympics could have been funded in a transparent and noncorrupt way. VEB management could have implemented sensible risk management procedures. Russia’s government could have kept a closer eye on the bank, rather than using it to fund pet projects. The government could have chosen not to invade Ukraine, provoking Western financial sanctions, which targeted VEB and prevented the firm from rolling over its dollar-denominated bonds.

Even without the need to bail out failed development banks such as VEB, the government was still in no fiscal position to deal with a sustained period of low oil prices. The combination of low federal tax receipts—around 15 percent of GDP in 2013, before the oil crash—and the new spending programs Putin launched upon returning to the presidency had caused Russia’s non–oil and gas budget deficit to zoom higher.⁶⁸ The estimate of the budget deficit if Russia received no oil revenues was always negative, reflecting the reality that Russia could rely on at least some energy taxes. Yet the size of the nonoil deficit ballooned after the 2008–9 crisis and was never reduced. The nonoil deficit, not adjusted for inflation, was around 1 trillion rubles before the 2008 crisis, but never fell below 5 billion rubles after it.⁶⁹ At the same time, Russia had stopped setting aside money in its reserve funds at the same rapid rate.

When oil prices plummeted, therefore, Russia’s budget deficit spiked, hitting nearly 2 trillion rubles ($25 billion) in 2015, or roughly 2.6 percent of GDP.⁷⁰ The deficit would have been much larger were it not for large spending cuts. In inflation-adjusted terms, revenue fell by around 16 percent compared with 2014 figures. Given the political unwillingness to increase indebtedness or hike taxes, this forced a 7 percent reduction in inflation-adjusted spending. Unless oil prices increase, Russia faces a painful choice between hiking taxes, further slashing spending, or increasing its borrowing and thereby placing at risk the macroeconomic stability that has provided the foundation for economic growth since the 1998 crisis. Medvedev’s advice to the Crimean pensioner—”Hang in there!”—was more apt than many realized. Russia’s rulers, not only its pensioners, face tough choices ahead.