The shockwaves of the geopolitical crisis surrounding Ukraine have reached Russia’s economic system, but after the spring period, the economic costs related to economic growth, the ruble and financial markets appear to be contained.

       The shockwaves of the geopolitical crisis surrounding Ukraine have reached Russia’s economic system, but after the spring period, the economic costs related to economic growth, the ruble and financial markets appear to be contained. Is there indeed not much that can be expected from this crisis for Russia’s macro-economy, or will the negative implications accumulate later on? There could be several metrics used to gauge the impact of the geopolitical conflict and sanctions on Russia’s economy. First and foremost, there is the scale of net capital outflows from Russia, which is complicated by further deceleration in investment growth and a broader economic slowdown. In this respect, net outflows in Q1 2014, which reached more than USD 50 bn (one of the highest quarterly figures in the past several decades) likely did result in a blow to Russia’s growth performance, but nearly half of these outflows took place before the geopolitical escalation in March. Furthermore, the pace of net outflows sharply decelerated in April, when they declined to less than USD 5 bn, which was in large part due to the stabilization in the dynamics of the ruble.

       Another way to gauge the effects of the geopolitical crisis is to look at the dynamics of Russia’s financial markets, including those of the ruble. The ruble's dynamics represent one of the greatest paradoxes of the spring’s geopolitical crisis, as in the course of the events in Ukraine, the ruble, after a brief period of weakness, significantly gained strength; in the beginning of March the ruble/dollar rate stood at RUB/USD 36, but in recent weeks, after a major escalation in geopolitical risk, it strengthened to RUB/USD 34-35. This paradox is partly explained by the decisive measures taken by the CBR, directed at neutralizing ruble volatility through forex interventions. But another factor was that the ruble was already too weak in the run-up to the outbreak of the Ukrainian crisis, with the key factor accounting for the ruble's weakness in January-February being capital flight from emerging markets.

       The stock market is now broadly in line with the levels of the beginning of March, which effectively suggests that the most sensitive of all market segments in Russia has shrugged off the escalation of geopolitical risk in Ukraine thus far. Again, rather counter-intuitively, the fixed-income market appeared to react more to the geopolitical risks, which may be partly due to the fears of sanctions against Russia’s macro-economy, as well as the relatively higher valuation emanating from significant inflows into Russia’s bonds throughout the past year to year and a half (partly on the back of Euroclearability in Russia’s OFZs).

       Another possible metric is the dynamics of the real economy. Here again things appear to be completely counter-intuitive. After the peaking of capital outflows in Q1 2014, threats of sanctions and a general sense of the inevitability of a full-blown recession, Russia’s industrial sector and the broader economy exhibited signs of acceleration in April-May. In particular, industrial production accelerated to 2.4% YoY in April, while GDP growth has moderately recovered to more than 1% YoY, thus reducing the probability of a technical recession in H1 2014. Among the factors that may have contributed to the acceleration in economic growth was the effect of the ruble's weakness, as well as import-substitution arising from a reduction in the supplies of manufactured goods from Ukraine and some of the economies of the “far abroad.”

       The theme of import-substitution and industrial policy featured prominently in the discussions at the St. Petersburg International Economic Forum. The hope was that statements from the Russian authorities at the St. Petersburg Forum would delineate a clear set of priorities for raising Russia’s growth rates, hopefully within a framework of a comprehensive new reform program. The highlight at the Forum was Putin's formulation of a new vector of Russia’s economic policy, the main elements of which included the following goals:

       ？ Simplify selection of investment project and provision of state guarantees

       ？ Develop large-scale projects: provide domestic industries with cheap and long term funding

       ？ Recapitalize systemically important banks.

       ？ Provide funding at rates no higher than inflation + 1%. The CBR should make proposals on this issue and adopt them later this year.

       ？ Stimulate non-energy exports, which should grow no less that 6% pa; support non-energy companies to render them competitive at the international level; pursue import-substitution in telecoms, energy, machine engineering and agriculture.

       ？ Support the introduction of new technologies by local firms and localization of production processes.

       ？ Impose higher taxes on weak fixed assets, abandon "dirty" technologies by 2015. An inventory and re-evaluation of all fixed assets should be performed by 2015, especially in industrial production, transportation and communication industries in order to replace decrepit capital equipment.

       ？ Deliver public funding for the modernization of Russia’s technological base starting from 2015.

       ？ Prioritize infrastructure projects, most notably at the regional level and with more active use of PPPs.

       The above measures suggest that the Kremlin may be opting for greater reliance on industrial policy, which includes elements that have been observed in previous episodes involving modernization in Asian economies, such as Korea for example. One of the novelties within this version of industrial policy is the emphasis on exports, most notably non-oil exports, as the key economic goal. Such an Asian economic model may accordingly be predicated not only on the re-orientation of trade and financial flows to Asia, but also on the use of some of the elements of Asia's own modernization experience in attempting to boost growth.

       Whether such a strategic turn to industrial policy and Asian-style export-led growth brings success is very hard to tell. This may indeed be the first time that Russia is embarking on a large-scale industrial policy effort in its post-Soviet economic history. While in the 1990s industrial policy was hampered by a lack of funds, in subsequent decades the emphasis was made on attaining macroeconomic stability. Some initial steps towards launching industrial policy measures in 2006-2007 were later undermined by the 2008-2009 financial crisis. Whatever the outcome, it may turn out that rather than the effect of sanctions per se, the more significant implication of the current geopolitical crisis is that it may have pushed Russia into eventually making the choice between stability and growth, between rules and discretion, as well as the direction and the mode of economic modernization, which may have significant and lasting effects for Russia’s development.

       Views expressed are of individual Members and Contributors, rather than the Club's, unless explicitly stated otherwise.