The "military operation" has been going on for a month now. How it will change the economy of Russia, Ukraine, and the world

A month has passed since Russia began its "special military operation" in Ukraine. Its main price is human lives, which have already been counted in the thousands. But the economy of Russia, Ukraine, and the world will also pay a high price. We have tried to assess the short-term and long-term consequences of the "special operation" for the economy and business. Russia. Events are moving very quickly, and assessments are becoming outdated faster than they are made. But so far the macroeconomic situation looks like this. Macroeconomics. The Russian economy is likely to experience its most powerful collapse since the global financial crisis of 2008-2009: Barclays predicted a 12.4% decline in Russian GDP this year, Goldman Sachs lowered its forecast of a decline from 7% to 10%, Bloomberg notes. The economic decline will be gradual and will accelerate by mid-2022, when the country will fully feel the effects of sanctions in the form of falling consumption, investment and imports, according to Barclays. Exports from Russia will suffer more than expected - it follows from the data on loading of ports in recent weeks, explain in Goldman lowering its forecast. As expected in the investment bank, exports in the second quarter will fall by 20% year on year, in all 2022 - 10%. Assuming exports are not de jure banned, they will begin to recover in the second half of the year. The abolition of most-favored-nation trade with Russia by the EU and the U.S. (which allows for higher customs duties) will lead to the diversification of export destinations rather than its destruction, expect Goldman. Analysts predict that the export of gas this year will not fall, and oil - will decrease by 20%. However, they note a high level of uncertainty associated with the duration of supply disruptions. Imports will fall by 20% in 2022. This will only increase the fall in GDP by 5 percentage points due to Russia's relatively weak integration into the world economy: most of the Russian economy is "quite insignificantly" dependent on imports. For example, in the mining industry only 7% of intermediate goods and technologies are imported. In the automotive and pharmaceutical industries the share of imports is much higher, but their contribution to GDP is not as high. "On average on the pharmaceutical market, according to our estimates, less than half of the drugs are produced in Russia, and those are based on foreign substances. And of the innovative drugs that are protected by patents, about 80-90% are supplied to Russia from abroad," co-founder of the biotech investment fund ATEM Capital Anton Gopka told The Bell. At the same time, according to Rosstat, at the end of 2021 40% of the resources of retail trade were imported goods. The uncertainty in assessing the impact of import restrictions is related to what share of imported goods and services will be replaced. For example, the departure of Western oil service companies should have a "moderately negative" impact on Russian oil companies in the medium term, Aton analysts wrote. They expect digital products for oil and gas prospecting, exploration and production to be replaced by solutions from domestic companies and internal products from major oil companies. The current account surplus of $205 billion in 2022 (the forecast is almost unchanged) will allow Russia to service its debt and allow companies to pay dividends to non-residents, and the Central Bank will be able to gradually remove capital restrictions, Goldman said. Inflation and the rate of the Central Bank The annual inflation rate in Russia as of March 18 has already accelerated to 14.53% in annual terms from 12.54% a week earlier. Analysts at Renaissance Capital in a March 15 review suggested that by mid-2022 the acceleration of annual inflation in Russia could reach 16%. Ruble devaluation, according to their estimates, adds 5 p.p. to the growth of consumer prices, and the deficit of imported goods - another 3-4 p.p. A poll of analysts conducted by the Central Bank, published on March 10, gave a median forecast of 20% by the end of 2022 (the previous poll, held before the start of the "special operation", gave 5.5%). If the forecast comes true, it will be a record since 2000. Despite these figures, as well as record inflation expectations in the history of observations, at the March meeting of the Central Bank did not go to another increase of the key rate, raised on February 28 to 20%. The emergency key rate hike, along with direct restrictions on currency operations, helped reduce the risks of the banking sector, according to the Renaissance Capital and suggest that the next step of the Central Bank may be the beginning of rate cuts. By June, the results of the "military operation" and the final adjustment of the sanctions and counter-sanctions regime may become clearer, and the focus will be on recession risks, analysts write. By the end of 2022 the key rate may decrease to 13-15%, by the end of 2023 - to 7-9%, the company predicts. The reduction in real disposable income of Russians (due to inflation and a potential upsurge in unemployment) will likely lead to a squeeze in domestic consumer demand, and the recession in the Russian economy will reach 6-10% per annum in 2022, economists said "Renaissance Capital". Structural changes The Bell talked to Oleg Itzhoki, a professor at the University of California at Los Angeles, about the long-term effects of the "military operation" on the Russian economy. He calls what is happening "an experiment on the Russian economy and the Russian population, which has never been conducted on such a scale anywhere else. He identifies three main shocks in the situation: Goods will begin to disappear from the economy. "Some goods will simply disappear because of the closure of imports of key components needed to complete their assembly process. And such shortages can provoke a cascading effect, because if one item goes missing from the economy, it often leads to problems with the production of others," Itzhoki explains. Many things can be produced in Russia - and eventually will be - but the adjustment process will be long, it could stretch on for years. An inevitable drop in personal income due to unemployment or declining wages and, as a consequence, a severe drop in demand. "People will greatly change the structure of their consumption, giving up many things that are not vital. This will produce a cumulative effect: one person loses his job, reduces his spending, and this causes someone else to lose his job - usually in the service sector," explains the economist. There is no way to prevent a decline in income - it is already in place, and the state has no tools to stop it. The risk of European rejection of Russian oil or reduction of its imports. As long as the Russian economy has not gone into complete autarky, export revenues will allow to establish new imports from third countries and avoid the budget deficit. "But if foreign currency revenues are lost, the budget will become deficit, the state will not be able to fulfill its social obligations. And then the government can force the Central Bank to start actually printing rubles to pay salaries and pensions," Itzhoki explains the twist. The result of these shocks in any case will be a decline in the economy's ability to produce goods and services. And adjustment to these shocks can occur in three ways - either through unemployment, or reduction of social benefits, or inflation and a fall in the real purchasing power of wages and pensions, says Itzhoki. After entering the acute phase of the crisis, the state may choose the path of inflationary accommodation - that is, printing money, the economist does not rule out. And to curb inflation, it may start to introduce price controls. Such a combination would lead to a commodity shortage and reduction of jobs due to the closure of businesses, and eventually to the nationalization of business. But the alternative - the government's refusal to fulfill its obligations to pay wages and pensions - could be even worse. What business thinks "Everything we've been building for thirty years is in ruins," a quote from Alfa Group co-founder Petr Aven to the Financial Times describes the mood of the overwhelming majority of the business community. Big business crisis. The unprecedented scale of sanctions imposed on Russia in a month of "special operations" has worsened the situation of almost all big business in the country. More than two hundred companies and three dozen co-owners of large enterprises have fallen under restrictions, while the EU and the U.S. have also imposed a number of painful trade restrictions. Here are just the first few examples of the new harsh realities: Severstal lost access to the European market due to sanctions against its main shareholder Alexei Mordashov, which accounted for a third of its revenues; Uralkali faced problems in repaying its loan due to sanctions against Dmitry Mazepin; and Sibur, according to Reuters, risks losing $500 million in investments in a joint venture from Sinopec - the risk of consequences for cooperation with Russian counterparts scares even its powerful Chinese partner. The exodus of foreigners and the problems of import substitution. The only beneficiaries of the sanctions crisis in the foreseeable future will be competitors of foreign retailers and fast food chains that voluntarily left the Russian market: among the nearly three hundred companies that partially or completely froze operations in the country this month were all major foreign retailers, from IKEA and Inditex to H&M and McDonald's. However, despite the bravura statements of politicians about the readiness to "import-substitute" the international giants, Russian entrepreneurs will hardly be able to do this in any time, Mikhail Goncharov, the founder of Teremok pancake houses, told The Bell: "To work like McDonald's, you need to create a very effective discounter from scratch. This is important to understand: McDonald's is a discounter, the most complex business model in existence. To recreate this story in Russia in a few years is unrealistic: we don't have that kind of experience, that kind of technology, and that strong brand. Import substitution also has another deterrent: dependence on imported components. For example, the co-founder of the Russian clothing brand 12Storeez, Ivan Khokhlov, is not happy about the departure of Zara and H&M: "Our production is based in Russia, but 80% of the cost is imported components. We buy fabrics and accessories in dollars, but our revenues are received in rubles, and we have already lost a lot in efficiency. Anti-crisis measures. Russian authorities, in spite of skepticism of businessmen, regularly announce new packages of "anti-sanction" measures to support business. Many initiatives resemble or repeat steps that the government has already taken in the covid crisis: a new stage of capital amnesty, relaxation of licensing requirements, a moratorium on inspections of individual entrepreneurs and small businesses until the end of the year, payroll credits, the extension of tax payment deadlines, etc. Of the new proposals we can highlight the government's system of grants to young (up to 25 years) entrepreneurs for up to 500 thousand rubles (and up to 1 million if a young entrepreneur will launch a business in the Arctic) and announced in Moscow the collection of applications for grants for the opening of public catering networks - the idea of "Russian McDonald's" does not give up the team Sergei Sobyanin (in Rospatent already registered and suitable trademark "Uncle Vanya"). Pessimism of small and medium business. The authorities have not yet succeeded in reaching out to small and medium-sized businesses with the idea of a window of opportunity, according to the results of the first surveys of entrepreneurs. According to a study conducted by the NAFI analytical center, which included 500 owners and managers of small and medium-sized businesses, in March the percentage of respondents, negatively assessing the situation of their company has doubled compared to February - from 22% to 40%. Moreover, the most pessimistic are representatives of microenterprises - among them only 15% give a positive assessment of the state of their business. More than half of all respondents - 51% - expect an escalation of the crisis in the next three months. According to another survey conducted by the service "Action Accounting", every fifth company from small business has already cut part of its staff or sent them to downtime since the beginning of the "special operation" crisis. Nearly 14% of respondents' revenues collapsed by more than 50%, and 3.5% of companies have not survived the new reality. The rise in the cost of everything and the collapse of logistics. The two main misfortunes that have haunted Russian entrepreneurs since the first days of the hostilities are the currency surge and broken logistics chains due to the closed EU skies and problems at customs. All goods that were not on the sanctions lists and continued to be shipped from abroad increased in price by 40% or even more in line with the exchange rate. This happened, for example, with flowers on the eve of March 8, the hottest day for this business. Part of the goods (mainly the main spring asset of traders - Dutch tulips) got stuck on the border, and what arrived, sellers had to buy back 40-200% more expensive than they planned, told The Bell partners flower marketplace Flowwow. Car Market Collapse. Some segments of the business experienced a real collapse this month. For example, with the outflow of Western automakers from the country, the collapse of the ruble and the disruption of logistics chains, the car market experienced a shock. The interlocutor among car distributors told The Bell that Russians who had savings of several hundred thousand or millions rubles at the end of February decided to exchange their money for cars in droves. The high demand continued despite the spike in prices - according to Autonews, about 20 companies rewrote their price lists in February and raised ex-works prices for dealers by a few tens of thousands to 4 million rubles. Alexei Golubyatnikov, general director of Rolf Group's Yasenevo location, explains that under such conditions those who had kept money in foreign currency and whose ruble savings rose along with the prices were ready to buy cars. By the end of March the market had calmed down, he said, and the increase in prices compared with mid-February is from 20% to 60%. At the same time, because of the withdrawal of Western corporations and the suspension of Lada and Renault production by AvtoVAZ, new cars will completely disappear in a few months and the market will be reoriented towards used cars. Pharma Risks. Medicines and medical equipment are not subject to sanctions and, despite statements by manufacturers condemning Russia's policy, continue to be supplied to the country. "In medicine, the humanitarian component is very important. So [political] pressure in our sphere is quite difficult to exert. Then we will have to admit that no one is interested in the current situation," Arkady Stolpner, co-founder of the Sergei Berezin Medical Institute, explained to The Bell. Nevertheless, according to him, the prices for imported drugs depend on the exchange rate, and the broken logistics complicate the delivery of components for medical equipment and it is impossible to replace them within a short time in the country. Anton Gopka, a pharma expert and cofounder of the biotech investment fund ATEM Capital, holds the same position. In his opinion, the real risk for Russian pharmaceuticals lies in the actions of the government: "Instead of increasing budget allocations into healthcare, it expands the boundaries of compulsory licensing. And this looks dangerous. Indeed, at the beginning of March, Mikhail Mishustin's cabinet issued a decree that allows not only the production of drugs in Russia in circumvention of international patent law, but also deprives the patent holder of monetary compensation. An escalation of the conflict with the international pharmaceutical giants could push the authorities to impose counter-sanctions like the food ones, Gopka fears. He characterizes the potential arbitrary cutoff of western drugs and medical devices supply to the country as "not even a catastrophe, but mass euthanasia". Ukraine Here it is even more difficult to make predictions - as long as the "special operation" continues, even the Ukrainian government itself finds it difficult to assess the losses already incurred in the economy. It will be possible to accurately assess the damage to the Ukrainian economy only after the cessation of hostilities, Ukrainian Finance Minister Sergei Marchenko told Forbes on March 14. Last week, Ukrainian Prime Minister Denis Shmygal estimated it at $565 billion, without explaining the calculation methodology. (The Ukrainian Finance Ministry declined to comment when asked by The Bell.) The 10 regions where the fighting is taking place, including Kharkiv, Kiev and Mariupol, account for half of Ukraine's GDP, Marchenko said. Many logistics chains have been completely severed, many businesses have been physically destroyed, some cannot operate in war mode, and many workers have simply left. "The Ministry of Economy estimated that the losses would amount to one-third to half of GDP. According to another estimate, we are talking about $500 billion," Marchenko said. There is an active discussion in the West about Russian compensation for Ukraine's losses. Ukrainian Foreign Minister Dmytro Kuleba said that Ukraine would raise the issue in all formats of international negotiations. Bloomberg editor John Oeters noted that Russia may also be required to compensate the costs of those countries that host Ukrainian refugees. European Union officials are discussing the possibility of using frozen assets of sanctioned Russian businessmen to compensate for damages, Bloomberg wrote last week, citing sources. The EU is going to work with the G7 to find such assets, the publication noted, as, for example, Germany paid money to Israel for Jews arriving after the Holocaust. The head of the National Bank of Ukraine, Kyrylo Shevchenko, suggested using the Central Bank assets frozen due to sanctions to make the payments. Some European politicians support the idea, Reuters noted. Russian Finance Minister Anton Siluanov estimated the amount of frozen assets of the Central Bank at $300 billion. The World In the short term, Russia's "military operation" will lead to higher global inflation and slower economic growth, the consensus among analysts and international organizations: The IMF will lower its forecast for global economic growth in 2022 and point to the risks of recession in some countries. But there will also be long-term structural changes. Increase in defense spending European countries in connection with the growing military threat will increase spending on defense to the target level for the NATO member states (2% of GDP), writes The Economist. Citigroup believes that 2% of GDP will be the de facto minimum for the alliance countries, and Jeffries estimates that annual defense spending by NATO countries, excluding the U.S., may grow by 25%, to $400 billion. The first signal came just a few days after the start of the "operation": On February 27, German Chancellor Olaf Scholz announced a €100 billion increase in the country's military spending in 2022. For comparison, in 2021 the military budget of the country was €47 billion. By 2024, Germany aims to increase defense spending from the current 1.5% to 2% of GDP. Shares of European defense companies rose sharply after Scholz's statements, Bloomberg noted. In the long term, increased military spending could create new industries and technologies (drones, robotics, etc.) that would then move from state-sponsored laboratories to the civilian sphere (like the Internet during the Cold War), financial columnist Matthew Lynn wrote in The Telegraph before the operation began. But it would also increase taxes and the state's share of the economy, as well as reduce social support for the population, Bloomberg's John Otters predicted. Reducing energy dependence on Russia "Russia is using oil and gas as a political and economic weapon, so Europe must act quickly to reduce dependence on exports from Russia," said Fatih Berol, executive director of the International Energy Agency (IEA), in a statement. In early March, the IEA developed a plan to reduce the supply of Russian gas to the continent from the current 155 billion cubic meters per year (about 45% of all imports) to 55 billion, notes WSJ. The main measure is to increase imports of liquefied gas (by 50 billion cubic meters) from the United States. But there is a problem here - LNG terminals with free capacities are located in Spain, France and Italy, which means that delivering gas to Germany, which is the largest consumer of Russian gas, will increase its cost. Building new terminals will take years. Other measures include new renewable energy sources (24 billion cubic meters), an increase in energy efficiency (14 billion cubic meters), more LNG supplies from other regions, etc. To reduce the volume of Russian gas purchases by 100 billion cubic meters is a very ambitious goal for the EU, says Marcel Salikhov, director of the Economics Department of the Institute of Energy and Finance at the National Research University Higher School of Economics. The key factor is the possibility to find 50 billion cubic meters of free gas in the world LNG market - but the world LNG market is in deficit, and the existing LNG plants are operating in full load mode. "Therefore, the full implementation of such a plan looks impossible, but we can expect a 20% reduction in Russian gas exports to the EU already this year for both political and economic reasons - high prices," Salikhov told The Bell. On March 8, the European Commission published a roadmap for a complete rejection of Russian energy resources (oil, gas and coal) by 2027. The plan is to be presented by May. On the horizon of the next 5-7 years, there is certainly much more scope for reducing purchases of Russian gas, as LNG capacity focused on the European market could be expanded, Salikhov says. "The main sources could be the United States and Qatar, which have a resource base and can increase production," the expert notes. The search for alternatives will mean that gas prices in Europe must remain high for the foreseeable future. Russian gas is one of the cheapest sources of supply for the European market. Gradually abandoning it will keep prices high. Deglobalization Even before the pandemic, between 2008 and 2019, the size of world trade declined from 61% to 56% of global GDP, while international investment declined. Among the reasons are rising customs duties (especially under Donald Trump), the outpacing growth in consumption of services over goods, the inability to further reduce shipping costs, and lr. Russia's "military operation" could be another blow to globalization, writes The Economist. The world economy could become more fragmented: in democratic regimes, voter pressure on governments and consumer pressure on companies could lead to restrictions on trade with non-democratic countries. The fact that sanctions can be used as an economic weapon will lead to the formation of trade alliances of countries with authoritarian regimes. For example, China with a closed autocratic regime (as classified by the Our World In Data project) signed a trade agreement with 14 Southeast Asian countries (ASEAN) in 2020. In the same year, this bloc became China's largest trading partner, surpassing the EU. Non-democratic regimes are more active in investing in the same countries, The Economist notes. The complication of supply chains will lead to higher inflation and slower economic growth, writes Otters. Reducing the role of the dollar The sanctions imposed against Russia - freezing the foreign exchange reserves of the Central Bank, restrictions on currency transactions, a ban on the supply of dollar bills to Russia - will reduce confidence in the U.S. currency. The dominant position of the dollar in the global financial system, which began to assert itself after World War II, is still undeniable, but in some areas its role may be declining, said Gita Gopinath, first deputy managing director of the IMF. In her opinion, some countries will reconsider the currency composition of their reserves. Now the dollar accounts for 59% of the reserves of the world's central banks, while the euro accounts for only 20.5%. The dollar's position is due to the liquidity of the U.S. government debt market: the volume of issued Treasury bonds in circulation is $23 trillion, and many of them are available to international investors. In energy trade, the dollar's role will diminish "forever," according to Gopinath. After sanctions against Russia, Saudi Arabia began discussing paying for its oil supplies to China in renminbi. And this week, Vladimir Putin instructed to convert payments for Russian gas with "unfriendly countries" into rubles (but Europe has so far refused to do so verbally). Russia will indeed seek to switch to settlements in other currencies to reduce the risks of freezing and blocking settlements, Salikhov explains. Perhaps other producing countries, fearing sanctions, will follow the same path. However, one can hardly expect a serious reduction of the US dollar share in international payments for energy resources, says the expert: "The US dollar has no serious rival. China maintains restrictions on capital flows, which is a risk for energy suppliers as well. Growth of the role of cryptocurrencies The military operation has updated the discussion on the role of cryptocurrencies in the global financial system, notes Bloomberg. The volume of exchange transactions using rubles and hryvnias has risen sharply in recent weeks. This may indicate that cryptocurrency is perceived as a protective asset and means of transactions at a time when the banking system is working with disruptions, the agency writes. In the West, the possibility of leaving with the help of cryptocurrencies from personal sanctions of wealthy citizens is actively discussed: for example, this was stated by influential U.S. Senator Elizabeth Warren, Bloomberg wrote. However, representatives of the crypto industry do not agree with this: for example, the head of the largest cryptocurrency exchange Binance, Changpeng Zhao, believes that the public blockchain underlying cryptocurrencies makes them easier to track. But we should probably expect advances in global regulation of the industry anyway, such as those related to the ability of cryptocurrency exchanges to block accounts, Bloomberg notes. Russia's military operation could also have long-term implications for cryptocurrencies. Larry Fink, head of Blackrock, the world's largest asset manager, said in a letter to investors that digital currencies, including stabelcoins, will be more actively used for international transactions, Reuters wrote. The IMF also expects a more rapid spread of digital currencies by central banks, Gopinath noted.