Sergei Guriev examines Russia's rapidly deteriorating fiscal outlook in the wake of the ruble's latest tumble

Within days of Russian President Vladimir Putin’s full-scale invasion of Ukraine 18 months ago, the West imposed unprecedented sanctions on Russia’s central bank, freezing hundreds of billions of dollars of its assets. The ruble plummeted, reaching a record low of 150 to the US dollar a week after the invasion. But after the central bank imposed currency and capital controls, the ruble bounced back, strengthening to ₽51.5/dollar – a recovery that the Kremlin eagerly touted.

Russia’s leaders have less to celebrate today. The ruble exchange rate offers the most visible indication of Russia’s economic performance, at least for Russian households. So, the currency’s recent dip below the politically important threshold of ₽100/dollar has made the Kremlin nervous. And it has put the central bank – which, over the last year, has loosened or removed many of its capital controls – under fire.

Putin’s economic aide, Maxim Oreshkin, has usually criticised the central bank for being overly hawkish. But after the ruble’s latest tumble, he wrote an op-ed blaming policymakers for being too “soft” and allowing excessive credit growth. The central bank immediately called an extraordinary board meeting, where it decided to hike interest rates by a whopping 3.5 percentage points, and signaled that more hikes are likely to come as early as next month. Additional currency controls also appear to be on the table. Meanwhile, Finance Minister Anton Siluanov reportedly advocates forcing Russian exporters to repatriate their dollar revenues and sell them to the central bank.

To be sure, there is no reason to think that Russia’s economy is on the brink of collapse. There is nothing magical about the ₽100 threshold. And the recent rate hike is a textbook reaction to rising inflation; Western central bankers would do the same. Nonetheless, the depreciation has highlighted just how much pressure the war – and the sanctions imposed in response to it – has placed on Russia’s economy.

In April 2022, I wrote that Putin should not celebrate the ruble’s rally, which reflected two developments that would ultimately prove bad for Russia’s economy. First, imports had declined as a result of Western sanctions, resulting in lost access to imported consumer goods and intermediate inputs, thereby constraining Russia’s manufacturing capacity. Second, oil-export revenues had increased – a development that would motivate Western governments to impose an oil embargo and a price cap on Russian crude.

That is exactly what happened. In May 2022, Europe announced that an embargo on about 90% of Russian oil imports would take effect within the subsequent 6-8 months. Not long after, the G7 countries agreed to a price cap.

The delayed introduction of these policies allowed Putin to rake in huge revenues. Though the West had frozen about $300 billion of the Russian central bank’s reserves, Russia’s record current-account surplus in 2022, at $227 billion, almost made up for it. But this bonanza is well and truly over: in the first half of this year, Russia’s oil and gas revenues fell almost by half, causing the budget deficit to grow to 2% of annual GDP.

The oil embargo and price cap also caused Russia’s total exports to plummet by one-third year on year in January-July 2023. As a result, Russia’s trade surplus shrank from $204 billion to $64 billion, and its current-account surplus declined by a factor of six, from $165 billion to just $25 billion.

Predictably, the sharp decline in revenue from hydrocarbon exports has fueled rapid deterioration in Russia’s fiscal position. For a while, Russia’s leaders appeared unfazed: the country still holds substantial renminbi reserves, so it can afford its budget deficit. And the war in Ukraine remains the Kremlin’s top priority: in the first half of this year alone, Russia’s military spending was 12% higher than the amount budgeted for the entire year.

Beyond funding the war, Russia’s government hoped that continued spending would give the economy a Keynesian boost. But these hopes have not materialised, precisely because trade sanctions have undermined Russia’s productive capacity. Isolated from the West and having lost hundreds of thousands of workers to the war and emigration, Russia’s economy simply cannot produce as much as Putin wants.

With Russia’s economy overheating, higher government spending simply fueled inflation. Add to that continued capital outflows – which accelerated after Wagner Group boss Yevgeny Prigozhin’s aborted mutiny in June – and the ruble’s recent depreciation was to be expected. Nor should anyone be surprised by the central bank’s decision to pump the brakes, despite the likely impact of higher interest rates on output growth. Bloomberg now puts the probability of recession in Russia in the next six months at 21%, compared to 6% before the rate hike.

The sanctions are clearly working. But Putin’s continued ability to fund his war in Ukraine shows that more must be done. In light of the elaborate methods companies have devised to circumvent the oil embargo and price cap, the West now must work to close sanctions loopholes, while lowering the oil-price cap from $60 per barrel today to $50-55 per barrel, or even less.

The other important takeaway from the ruble’s recent fall is that Putin is managing to circumvent trade sanctions. The ruble is cheaper because Russia needs US dollars to pay its import bill, which grew by one-third year on year – from $57 billion to $76 billion – in the second quarter of 2023. This increase partly reflects the rising costs of bypassing sanctions, which are compounding the pressure on Russia’s budget and currency. By tightening the enforcement of export controls, the West can raise these costs further, putting Russia’s budget – and thus its criminal war effort – in a choke hold.

Sergei Guriev, Provost of Sciences Po, is the co-author (with Daniel Treisman) of Spin Dictators: The Changing Face of Tyranny in the 21st Century (Princeton University Press, 2022). Copyright: Project Syndicate, 2023, and published here with permission.