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Putin's Fortress Russia Takes Its Toll

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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It's difficult to quantify the damage Western economic sanctions have done to Russia. The country's slump is almost exclusively due to a drop in oil prices, which has led to a sharp currency devaluation and a jump in interest rates. Yet the sanctions have fueled the Kremlin's paranoia, lending Russia's economy an aura of autarchic defensiveness.

Russian exports are down 31.9 percent in January through September, and imports have dropped 38.8 percent. One could argue that this downturn in foreign trade is due to the ruble's devaluation. Self-isolation, however, has played a major role too. One form of this self-isolation is unilateral trade restrictions like President Vladimir Putin's vindictive and ineffective food embargo against countries that have sanctioned Russia. Another is the country's increasing financial lockdown.

The embargo has failed on multiple counts. An August government report showed that though food imports made a disproportionately large contribution to the general decline in trade, Russian producers were unable to fill the gap in the market immediately, resulting in rapid price growth and an increase in embargo-busting schemes. For example, European Union exports of milk and cream to Belarus increased in 2014 by a factor of 573; obviously, all the extra European milk went to Russia. Landlocked Belarus also became a major fish exporter. At the same time, EU agricultural exports just kept growing as if the Russian market never existed; Poland's, for example, increased by 7.1 percent last year and by 6.4 percent in the first half of 2015.

Undeterred by the debacle, the Russian government wants to re-enact the experiment in other markets. From January 1, 2016, government agencies have to prove they need foreign software before they can buy it. A separate government decree only allows such purchases if there is no equivalent Russian software. The reasoning for this is a noxious mixture of fear that Western countries could be spying on Russia through office applications and enterprise resource planning systems and a misguided desire to spur local development by shutting off competition. The European Business Association, the biggest foreign business lobby in Russia, recently sent a letter to the government expressing concern that Western tech companies may be unable to keep operating in Russia under these conditions. 

The clumsy trade restrictions, however, are only part of the story. According to the Central Bank, the Russian private sector, long a huge net external debtor, has recently turned into a creditor: The world now owes it $73 million.

The Central Bank's definition of the private sector includes large state-controlled companies such as Sberbank, VTB, Rosneft and Gazprom, all hit by Western financial sanctions, but also real private companies for which access to Western funding is merely uncertain or more expensive. Because of these constraints, and also because of exchange rate uncertainty, these businesses have done their best to pay off foreign debts and load up on foreign assets.

As they did that, two trends became obvious: a rapid deterioration of the Central Bank's international reserves and significant capital flight. The reserves reached a nadir of $350.5 billion in March, having fallen by more than $160 billion since the beginning of 2014. In the same 15 months, Russia lost $185 billion in fleeing capital. After a debt balance was reached, both drains stopped abruptly. International reserves are now up to $374.6 billion, and capital flight in April through September reached just $7 billion. 

This is great for Russia's currency reserves, which financial authorities are careful not to draw down as oil revenues shrink, instead allowing the ruble to devalue. Yet the implication is of a country in a defensive crouch. Business has stopped attracting cheaper foreign resources for domestic investment, and there's a 5.8 percent investment drop in January through September. It has also stopped expanding outside Russia.

At the same time, the government is making a special effort to curb illegal capital outflow. This week, police in Moscow detained banker Alexander Grigoryev -- a SWAT team laid him out on the floor of a restaurant where he was having dinner with his girlfriend -- and charged him with illegally moving $50 billion out of the country over the last three years. Most of the money was allegedly moved out through Moldova and the Baltic states. Russian firms, set up especially for the purpose, guaranteed the debts of companies in those countries. The companies defaulted, their fictitious creditors went to court in Moldova, Lithuania and Estonia, and the court decisions served as legal grounds for money transfers out of Russia. 

The scheme was in existence for years, at last since 2011, but the crackdown has only come now that the government has gotten serious about keeping money inside Fortress Russia.

Russia's isolationist economic policy is a combination of misguided protectionism, vindictiveness, espionage fears, financial management aimed at minimizing external risks and harsh police action. It has a certain consistency and harmony to it, and it is synchronized with relentless propaganda aimed at making Russians feel besieged by a hostile world. More than anything else, it is a reflection of President Vladimir Putin's views on everything from economics to geopolitics. Fortress Russia is in Putin's head, and Russians, who are forced to pay for it with a drop in living standards -- disposable incomes are down 3.3 percent in January through September -- are OK for now with living within this mental construct.

(Corrects capital flight figure in the seventh paragraph.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net