The continuing conflict between the West and Russia over Ukraine is beginning to cause a larger toll on Russia. Putin is placing its global reputation ahead of its economy. The Russian market plunged at the threat of new sanctions from the EU and the US while its currency hit a record low. US politicians have recommended further sanctions aimed at Russia’s petrochemical and banking sectors due to increased violence among the Ukraine-Russian border. Russia’s recent actions have been viewed as antagonistic and imperialistic these past few months. Unfortunately, while it may appear that Russia looks strong, its economy is beginning to hurt. Russia has already earmarked $7 billion for economic aid to give to Crimea.
As I’ve mentioned in previous posts, one of the key determinants of foreign direct investment and capital flows is political risk. Russia’s actions and potential sanctions makes it an increasingly risky investment. The Central Bank of Russia recently released a report stating that Russia had a capital outflow of at least $51 billion in the first quarter of 2014. If the trend continues, Russia could stand to lose around $200 billion, or 1% of its total GDP. The World Bank believes that Russia’s economy could shrink around 2% in 2014. The confidence of Russia’s economy in Russia is deteriorating rapidly as well. There has been an increase in emigration and the cost to import in response to Russian people’s lack of confidence in the market. The fear of stagnation is extremely real with Russia’s low growth and high inflation. Russia’s central bank at the beginning of April said that growth would most likely fall below 1% with the lending rate staying at 7% and the inflation rate at around 6.64%. Unfortunately, Russia most chose between strengthening the ruble through high interest rates or lower interest rates in hopes of spurring growth. Russia foreign policy has drastically hampered its monetary policy. The large capital flight is due to the political risks and the central bank of Russia had to reply with higher interest rates in order to maintain some of the investment that it needs for growth. The high inflation rate and high interest rate makes it difficult for the Central Bank to control inflation unless it wants to increase the interest rate further, slowing growth even more. Russia’s low, decreasing growth increases the chance that Russia could face another recession.
Russia’s main hope in protecting their economy has been the gas they supply to the EU and Ukraine but as Russia raises prices, these countries begin to search for alternative options. Ukraine recently stopped purchases of Russian gas and is actively searching for alternatives. With the US becoming one of the largest producers of oil and gas, Ukraine could look to the West for help with its energy problem.
Russia’s actions right now provide a great case study about politics versus economics. Russia is playing a political game right now and it’s drastically hurting its economy. Interestingly enough, Putin’s approval rating is at 72% after the annexation of Crimea. It will be interesting to see how high it stays as the economy continues to deteriorate and as the West increases sanctions.