Editors' note: This column is part of the Vox debate on the economic consequences of war.
Following the Russian invasion of Ukraine in late February 2022, many countries imposed sanctions on Russian banks, entities, and individuals. The current sanctions are well described in Berner et al. (2022). Huang and Lu (2022) and Deng et al. (2022) deliver the first estimates of the sanctions impact on world financial markets. Ferrara et al. (2022), in turn, apply a high-frequency approach to connect the financial stress index and macroeconomic risks of the sanctions for the euro area. Brunnermeier et al. (2022) discuss the implications of the sanctions against the Central Bank of Russia for the architecture of the international monetary system. However, the current debate is missing a comprehensive set of model-based estimates of the macroeconomic effects of the sanctions.
We fill in this gap using a vector auto-regression (VAR) model of the Russian economy developed in Mamonov and Pestova (2021) specifically to capture the macroeconomic effects of sanctions.
The effects of the current sanctions could be roughly divided into (i) financial and demand-side effects and (ii) supply-side effects. Our model is able to capture the demand-side effects. The supply-side disruptions arising from technological bans and the breaking of supply chains are yet to be fully realised in the future and that requires a different modelling framework.
The demand-side effects: Back-of-the-envelope calculations
To estimate the demand-side effects of the sanctions, we build on our structural VAR (SVAR) model. In our analysis, we approximate the severity of sanctions by the sovereign international bond spread (over the US short rate). According to Mendoza and Yue (2012), this indicator summarises investors’ expectations about the future path of the economy; in our case—under sanctions.1
We add the central bank’s key interest rate as one of the endogenous variables in the structural VAR model. This flexibly accounts for monetary policy responses to rising currency risks during crisis times. In the structural identification (Cholesky ordering), we order monetary policy rate last among the eight endogenous variables in the model. By doing so, we assume that the international bond spread reacts faster to the sanction news than the central bank. The estimation period covers January 2000-December 2020.
The estimated impulse response functions (IRFs) of the endogenous variables to a one percentage point international bond spread shock appear in Figure 1. All the responses, except for the trade balance (TB), are statistically significant and are in line with macro theory predictions: industrial production, consumption, investment, and foreign borrowings decline, whereas the real effective exchange rate and monetary policy rate rise. We will use the peaked levels of the estimated IRFs below.
Figure 1 Impulse responses of key macroeconomic variables to the country real interest rate (RIR) shock
Note: IP is industrial production, Consum is real consumption expenditures of the households, Invest is gross fixed capital formation, TB is trade balance, ExtDebt is corporate external debt, RIR is the real interest rate, MonetPolRate is the CBR’s key interest rate.
Source: The authors’ estimates
Our model successfully identifies periods of the large positive country spread shocks over and above macroeconomic conditions. Among the identified periods, we observe spikes in the spread (or real interest rate, holding short-term US interest rate constant) during the Crimean ‘first wave’ and US/Syrian ‘second wave’ sanctions (Figure 2).
Figure 2 Time evolution of the identified real interest rate (RIR) shock
Source: Authors’ estimates
We do not have a model-identified country spread shock now. However, information on spreads suggests that an exogenous—or clearly prior to the current macroeconomic worsening—rise of the spread has amounted to 35-45 percentage points, depending on whether the one-year yield is taken into account or not (Figure 3) and assuming constant international short-term rate (as average in March–February 2022). This increase in spreads could be partly explained by the heightened default risks of the Russian government. A full default, however, has not occurred. Still, even when the first payment on dollar-denominated Russian bonds was made following the invasion and panics were relieved, sovereign international bonds are traded with about 40% yield to maturity.2
Figure 3 Yield to maturity of the Russian US dollar-denominated government bonds
With the estimated IRFs (Figure 1) and the size of the country spread shock that occurred during the first month of the war (+35-45 percentage points, Figure 3), we produce a set of out-of-sample forecasts. We predict that industrial production (IP) will decline by 21-27% per annum by the end of 2022. Given the 0.67 elasticity of GDP to IP, we further obtain that the GDP will fall by –12.5 to –16.5%, per annum. Regarding private consumption, we have a range of estimates: between –11 and –15%; a similarly obtained range of estimates for investment is bounded by –30% and –40%.
Given the expected decline in imports, our model produces a sharp rise in the trade balance—by +40 to +60% in 2022. However, it does not—and cannot—account for problems with cargo deliveries and export embargo which jointly reduce exports. Overall, we expect the 2022 trade balance to stay at the levels of 2021.
Concerning corporate external debt, our out-of-sample forecasts imply a complete shutdown of firms’ borrowing abroad, given the size of the country’s spread shock.
Finally, we predict that the real effective exchange rate (REER) will rise by 40%, on average in 2022, given the country’s spread shock. Assuming a 20% consumer price index (CPI) in Russia and 4% CPI abroad, we obtain that the growth of the nominal exchange rate (US dollar to ruble) may reach 63%, meaning that, absent capital controls, we may observe 122 rubles per one dollar, as an average in 2022.
Discussion of the forecasts
Sanctions will no doubt generate a deep recession in the Russian economy. First, according to the Bloomberg forecast, the Russian GDP will fall by 9.6% in 2022 with a peak quarterly GDP decline reaching –15.7% of annual growth rates.3 This survey-based forecast fairly accommodates our model’s forecast. Russia’s government bodies provide a less pessimistic forecast of a 6-8% decline.4
The history of the last three decades shows that the Russian GDP was falling by up to 16% at the peak of the transformation crisis at the beginning of the 1990s, by 5% during the sovereign default crisis of 1998, by up to 9% during the global crisis in 2008, and by just 3% in the local crisis phase in 2014. Therefore, the currently predicted decline exceeds in magnitude all of those previously observed during normal crises and is comparable to the one during the most painful transformation crises.5
Debates on the effects of potential oil (and gas) embargo on Russia’s balance of payments
Clearly, a potential embargo on oil and gas has not been ‘priced’ yet by the country’s sovereign spread (Figure 3) and is thus not accounted for in our macroeconomic forecasts. In turn, Bachmann et al. (2022)’s estimates show that the German economy could lose only up to 3% of GDP in case of a full embargo on the import of Russian oil and gas. In turn, Chepeliev et al. (2022) argue that banning Russia’s exports of fossil fuels will have overwhelming adverse impacts on the Russian economy. As Guriev and Itskhoki (2022) further suggest, this embargo could be “the fastest way to stop Putin’s war in Ukraine.” Although desirable, our draft calculations show that such an embargo would not necessarily undermine Russia’s balance of payment because of the record-high prices on exported raw materials (even under discounts) and the imposed capital controls.
Let us clarify this important issue. In the pre-war year 2021, Russia enjoyed the current account surplus and record-high exports of $490 billion of which oil and gas products constitute only half, according to the official balance-of-payments data. In 2022, a potential oil embargo by the EU and US (50% of Russian oil export) and cutting of natural gas imports by the EU (70% of Russian exports) by two-thirds would decrease the exports by only one-fourth. The EU ban on imports of metals costs as little as €3 billion.6 Restrictions on food, agricultural, and wood and paper exports implemented by Russia are of lower importance for the overall stability of external balance because they constitute less than 10% of total exports.7 Under reasonable assumptions on import dynamics,8 which is expected to decline by almost two times, this yields around $200 billion of trade balance surplus in 2022,9 roughly the same number as in 2021, i.e. before the war.10,11
Overall assessment of the effects of sanctions
The war and the sanctions, even absent of a potential oil and gas embargo, are likely to produce one of the deepest economic crises in Russia over the last three decades, most comparable to the transformation crisis (1992) that followed the Soviet Union’s collapse and possessing some features of the sovereign default crisis (1998). The Russian economy will nonetheless continue to rely on the existing export model which is hard to undermine. The population will struggle with the ‘new poor’ who will be appealing to the mechanisms of household adaptation to deep crises that had been widely employed in the 1990s (switching from to informal sector of the economy and turning to home production of food due to very high inflation, see Mamonov et al. 2021). As a negative unintended spillover effect, this will touch on not only the Russian population but, more broadly, a wide range of households in many developing countries across the globe (Artuc et al. 2022).
Artuc, E, G Falcone, G Porto and B Rijkers (2022), “War-Induced Food Price Inflation Imperils the Poor”, VoxEU.org, 1 April.
Aguiar, M and G Gopinath (2006), “Defaultable Debt, Interest Rates, and the Current Account”, Journal of International Economics 69(1): 64-83.
Bachmann, R, D Baqaee, C Bayer, M Kuhn, A Löschel, B Moll, A Peichl, K Pittel and M Schularick (2022), “What if? The Economic Effects for Germany of a Stop of Energy Imports from Russia”, ECONtribute Policy Brief No. 028.
Berner, R, S Cecchetti and K Schoenholtz (2022), “Russian Sanctions: Some Questions and Answers”, VoxEU.org, 21 March.
Born, B, G Müller, J Pfeifer and S Wellmann (2020), “Different No More: Country Spreads in Advanced and Emerging Economies”, CESifo Working Paper No. 8083.
Brunnermeier, M, H James and J-P Landau (2022), “Sanctions and the International Monetary System”, VoxEU.org, 5 April.
Chepeliev, M, T Hertel and D van der Mensbrugghe (2022), “Cutting Russia’s fossil exports: Short-term pain for long-term gain”, VoxEU.org, 9 March.
Deng, M, M Leippold, A Wagner and Q Wang (2022), “Stock Prices and the Russia-Ukraine War: Sanctions, Energy and ESG”, Swiss Finance Institute Research Paper No. 22-29.
Ferrara, L, M Mogliani and J-G Sahuc (2022), “High-frequency Macroeconomic Risk Measures in the Wake of the War in Ukraine”, VoxEU.org, 7 April.
Guriev, S and O Itskhoki (2022) “The Economic Rationale for Oil and Gas Embargo on Putin’s Regime”.
Huang, L and F Lu (2022), “The Cost of Russian Sanctions on the Global Equity Markets”, SSRN Working Paper, 18 March.
Mamonov, M and A Pestova (2021), ''‘Sorry, You're Blocked.' Economic Effects of Financial Sanctions on the Russian Economy”, CERGE-EI Working Paper Series 704.
Mamonov, M, A Pestova and E Sargsyan (2021), “Food Supply, Poverty and Public Health during the Transformation Crisis of the 1990s in Russia”.
Mendoza, E and V Yue (2012), “A General Equilibrium Model of Sovereign Default and Business Cycles”, The Quarterly Journal of Economics 127(2): 889–946.
Monacelli, T, L Sala and D Siena (2018), “Real Interest Rates and Productivity in Small Open Economies”, CEPR Discussion Papers 12808.
Uribe, M and V Z Yue (2006), “Country Spreads and Emerging Countries: Who Drives Whom?”, Journal of International Economics 69: 6-36.
1 Of course, this indicator has limited ability to capture other aspects of sanctions including technological disruptions and particular asset freezes. However, it follows a long literature stressing the role of the country spread shocks in emerging economies’ business cycles (Uribe and Yue 2006, Aguair and Gopinath 2006, Born et al. 2020, Monacelli et al. 2018).
2 This means that even under no ‘illiquidity-type’ default (because of asset freeze), the country’s medium- and long-run economic perspectives are perceived by investors as gloomy enough (low or negative future technological and economic growth).
3 See here.
4 See here.
5 Of course, we need to treat the out-of-sample forecasting results obtained with our (S)VAR model with some caution because the size of the country spread shock is unprecedented and the model is simply not ‘experienced’ in this direction. A clear drawback in our forecasts is that corporate external debt is predicted to be completely shuttered by the beginning of the next year, which seems over-estimated. However, we stress that in the rest, the model delivers GDP forecasts that are fairly within the broader range of estimates born by economists around the world nowadays.
6 See here.
7 See here.
8 See here.
9 We do not know yet many parameters, for example how serious are the transportation problems of export deliveries, and by how much export prices will go up.
10 Recently, under the pre-war structure of export deliveries and world prices, for the two months of January and February 2022, Russia earned $39.2 billion in revenue on its current account.
11 As of the current writing, we do not know yet the size of capital outflow in February and March 2022—probably, it was huge. Without the CBR’s international reserves to sustain the balance of payments, the inflow of currency through the current account should exceed capital outflow through the financial account. Under no new debt issuances, capital outflow through the channel of Russia’s net external debt payments in 2022 can be estimated as $70-80 billion. Of this, nonfinancial corporations amount to $25.6 billion per one-two quarters of 2022; roughly $50 billion per year plus $10 billion by banks and $10 billion by the government. Similar numbers are provided by CMASF (a pro-government think-tank in Moscow). Given the restrictions on ruble convertibility and cross-border money transfers and asset freezes, it is hard to expect further capital outflow through asset and foreign currency purchases. Therefore, capital outflow may be less than it would be without sanctions, and therefore under current regulation, the oil and gas embargo alone may be inefficient in stopping currency inflows and producing a balance of payment crisis in Russia.