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The costs of Russia’s shift towards isolation

  • It is highly likely that the war in Ukraine will accelerate Russia’s shift towards isolation and into autarky. (See here.) This will prevent Russia from catching up with more advanced economies, while the West will face some difficult choices as higher defence spending and greater energy security move up the agenda.
  • The implications of the war for Russia’s long-term outlook is a huge topic and one we will cover in more detail in the coming weeks. There is also much uncertainty about how Russia’s place in the global economy will evolve. At the extreme, Russia could become like North Korea, almost entirely cut off. For now, we assume a further retreat into isolation would mainly involve a rupturing of economies ties with the West.
  • In theory, Russia has the scope to achieve strong rates of economic growth as it catches up with richer countries. As Chart 1 shows, its productivity is only about 35% to 40% that of US levels. And it has managed to grow strongly during some periods of relative isolation before, including the earlier part of the Cold War. However, growth back then was driven by heavy investment and rapid industrialisation. Russia is in a different place now. Even in the decade or so before the current war, Russia was failing to close any of the productivity gap with the US due to its ageing infrastructure and need for wholesale reforms across its institutional framework. (See here.) A further retreat into isolation will only make its job even harder, restricting Russia’s ability to adopt technology and know-how from overseas.
  • There are various ways in which poorer economies can benefit from more advanced ones. One is by adopting technology from abroad via imported goods and services. Yet many countries have now banned exports to Russia of advanced technology. And the bans are not just about end products; the US has prohibited exports to Russia from any country of any product created using US software or equipment. Another way in which technology is transferred across borders is through foreign direct investment, for example if a foreign company expands its operations into Russia or invests in a Russian firm. FDI in Russia, which has already fallen significantly in recent years, will now dry up and it could take years or even decades for Russia to regain credibility with investors.
  • Russia does not have the capabilities to replicate domestically the technology that it would otherwise have gained from overseas. In that regard, it is different from China which has significant scope for “catch-up” growth, yet at the same time is driving technological innovations in a number of fields, including next generation telecommunications technologies and AI. (See here.) In the Global Innovation Index, Russia is at number 45, compared to China at 12. Indeed, the heavy state involvement that would likely come with isolationism would further reduce the chances of internally-driven productivity gains in Russia.
  • Meanwhile, a shift towards isolation might also make it harder for Russia to deal with its demographic challenges. Russia is one of the countries set to be most affected by an ageing population. According to the UN’s 2019 population projections, Russia’s working-age population (aged 15 to 64) is due to fall by 8% by 2030 and some 20% by 2040. (See Chart 2.)

Chart 1: Russian Productivity (% of US level, Constant Prices, 2015 PPPs)

Chart 2: Russia Working Age Population (15-64, mns)

Source: OECD

Source: UN

  • In recent years, net inward migration, mostly from the post-Soviet states, has offset some of the natural fall in the population. (See Chart 3.) But Russia may find it harder to attract migrants now, while emigration out of Russia may rise. Russia therefore faces a nasty combination of continued weak productivity growth and slow growth of the workforce. Even before the war, we expected potential growth as low as just 1.25% to 1.5% a year. In the coming years, productivity growth may struggle to offset the drop in the working age population, possibly even leaving the Russian economy failing to expand at all.
  • As for the implications of Russian isolationism for the West, the West’s trade and financial exposures to Russia are, energy aside, fairly limited. (See here.) So the implications of Russia’s economic withdrawal won’t be anywhere near as big as if, say, China fully decoupled from the West.
  • The main implication will be to drive the West towards greater energy security. In the very near-term, this might mean having to delay renewable targets, as counties increase their domestic oil and gas production. But in the medium-term, all of this should accelerate the transition towards renewable energy. German Chancellor Olaf Scholz announced this week that Germany will now aim to get all of its energy from renewable sources by 2035, rather than 2050.
  • Speeding up the green transition could make it more costly. In particular, it could force firms to replace equipment prematurely, and allow less time for new technologies to reduce the cost of the transition. (See here.) And given that Russia produces some of the metals used in green technologies, countries will now have to source potentially more expensive alternatives from elsewhere. Europe has the greatest incentive to speed up its transition and so in theory might see the most disruption, but at least it is already further ahead with its policies to reduce emissions than most other parts of the world.
  • There will also be implications for the West of Russia’s continuing geo-political threat. One is a permanent increase in military spending. The NATO target is that members should spend at least 2% of GDP on defence, but many do not manage this. (See Chart 4.) Germany has already said that it will now seek to meet this target. Even countries which already meet this target might raise their spending. For example, military spending in the US is relatively high at 3.7%, but during the Cold War, it averaged 7.8%.
  • Moreover, both the public and private sector will have to spend more on cybersecurity. Like defence spending, money spent on preventing cyberattacks does not directly make an economy any more productive or leave people better off now. Instead, the benefit is avoiding an adverse event sometime in the future. (See here.) While the economy is therefore better off in the long run that it would otherwise be, it is still worse off than in a world without the threat from Russia, in which the money spent on defence and cybersecurity could be spent in more productivity-enhancing ways.
  • All of this will add to the fiscal challenges that countries were already facing in the wake of the pandemic-related rise in public sector debt and the growing costs of an ageing populations. Those countries that are unable or unwilling to borrow more to fund higher defence spending will have to choose between raising taxes or cutting other types of spending. One potential silver lining, though, is that the EU is considering more joint bond issuance in order to fund the extra war-related spending. (See here.) Another round of joint EU borrowing so shortly after the supposedly one-off Recovery Fund would mark another significant step towards a European fiscal union and an improvement in the long-term resilience of the currency union.

Chart 3: Russia Population (Annual Change, Mns)

Chart 4: Defence Spending in 2020 (% of GDP)

Source: UN

Source: SIPRI


Vicky Redwood, Senior Economic Adviser, victoria.redwood@capitaleconomics.com