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Russia as a strategic challenge as well as an opportunity

Russia as a strategic challenge as well as an opportunity

In the past, Russia has described the EU as ‘our natural and most important partner’. However, the current state of affairs makes Russia a challenging market to be in; but the way in which industrial sector is adjusting to the EU sanctions on Russia shows the potential and opportunity of Russian market place.

Russia is the largest country in the world, with a surface of over 17 million sq. kilometers, almost twice as much as the second largest, Canada. Although it has one of the lowest population densities, with only 8.5 inhabitants per sq. kilometer, it is still one of the most populous countries, with almost 145 million inhabitants. Russia’s population is mostly urban with more than 70 % living in cities. The capital city Moscow is the largest, with almost 12 million residents and St. Petersburg, an important economical and cultural hub is home to over 5 million people.

Economic overview of Russia

Following the collapse of the Soviet Union, the transition from a centrally-planned economy to market economy was unsuccessful for Russia. Its GDP fell from $ 500 billion in 1990 to less than $ 200 billion in 1999. In an attempt to address the economic turmoil, the government began to privatize many Russian industries with exceptions in the energy and defence sectors. The devaluation of the Russian ruble in 1998 after the financial crisis known as the ‘ruble’ crisis, together with the continuous rise in oil prices from 1999 to 2008 propelled the Russian economy to grow at an annual average rate of 7 %. Heavily reliant on its energy sector exports, Russia was among the hardest-hit economies by the 2008-09 global economic crisis: the economy plunged by more than 7.5 % in 2009 as oil prices plummeted. The economic contraction was the sharpest since the 1990s, but no long-term damage was caused due to the government’s proactive and timely response to protect the key sectors of the economy, in particular the banking sector from the after effects of the crisis. As a result, Russia’s economy began to grow again and increased between 3.5 % and 4.5 %, from 2010 to 2012, before slowing down to less than 1.5 % in 2013 and 0.6 % in 2014.

2014 was a year shocks for the Russian economy as it experienced two major shocks. The first shock was the sharp decline in oil prices during the third and fourth quarter of 2014, exposing Russia’s extreme dependence on global commodity cycles. After fluctuating at around $ 100 per barrel from 2011-2013, crude oil prices ended 2014 at less than $ 60 per barrel. The second shock was the economic sanctions resulting from geopolitical tensions, which negatively affected investments in Russia. Rising inflation further compounded Russia’s economic woes as the economy contracted more than 3.5 % in the 2015.

In 2017, the economy has begun to turn around, thanks to improved oil prices and agreements on cutting down oil production to control the supply. Consumer price inflation and interest rates continue to decline, fostering both investment and consumption. Business sentiment is improving and investment is rising. Unemployment has declined further and is now about 5.5 %. Rising wages and falling unemployment has further increased the internal consumption and demand. Inflation has been falling rapidly since August 2015, when it peaked to more than 15 %. Along with the fall in inflation, Russian bonds and equities are performing well against those of other emerging markets. Considering $ 40 per barrel as average price for Urals oil, the Central Bank expects the economy to expand at a rate of 1.4 % in 2017. However, the upturn is fragile as it rests mainly on the rebound of commodity prices. Most structural and policy obstacles to higher sustainable growth remain in place.

Major sectors for Russian economy

Crude oil, petroleum products and natural gas comprise more than 50 % of total exports, iron and steel represent around 5 % and other mining sector related exports including gems and precious metals account for about 2.5 %. Trade with Europe represent around 50 % of total exports while Asia has an export share of roughly 30 %. Russian exports to the U.S., Africa and Latin America combined represent less than 5% of total shipments. Russia’s main imports are food, meat and dairy products, which represent more than 15 % of total imports. Other significant imports include automobiles, pharmaceuticals, plastics as well as optical and medical instruments. Exports peaked in 2012 reaching $ 500 billion; imports peaked in 2013 reaching $ 340 billion. Its main export partners are the Netherlands, China and Germany. Russia is also a member of the BRIC, a group that unites Brazil, Russia, India and China, due to their similar stage of economic development.

Current state of affairs: EU-Russia trade relations

As its largest trading partner, it is important to analyze Russia’s relations with Europe. In analyzing the trade relationship between the EU and Russia, both economic and political aspects have to be taken under consideration. The relations between the EU and Russia have never been easy, but in 2014 they entered a new and particularly difficult phase after a showdown between the two sides over Ukraine’s association agreement with the EU, followed by the conflict in Crimea and Eastern Ukraine. The EU and other Western countries have imposed sanctions against Russia, and Russia has retaliated with counter-sanctions. With a deadlock in Ukraine and Russia’s intervention in Syria, no end to the current tensions is in sight. Despite the political tensions, economic ties between the two sides remain close. From an economic viewpoint, it is clear that Russia has been an important trade partner for the EU, as it is a neighboring country with a large market that has been a traditional destination for exports from many EU member states. The EU is by far Russia’s largest trading partner, whereas for the EU, Russia ranks amongst the top five. Russia is also an important source of imports to the EU, above all as a supplier of minerals, raw materials, oil and gas.

Until 2008, trade between the EU and Russia grew rapidly. Due the global economic crisis of 2008 and protectionist policy measures imposed by Russia the mutual trade between the two dropped substantially. In August of 2012, Russia joined the World Trade Organization (WTO). The EU supported this accession process significantly, paving the way for further improving its trade relations with Russia. As a result of joining the WTO, Russia also changed its protectionist stance to some extent by reducing the import duty, both on industrial and agricultural goods, and export duty on raw materials, including in the sector that EU countries are primarily interested in, petroleum products, timber and metals, including precious metals, etc. As a result, EU exporters had improved opportunities for access to the Russian market. Russia also reduced its state subsidies in agriculture, opened up its services market, and made many more changes in its policies with an aim to improve its international trade. However, after 2013, due to some restrictive measures including higher import duties on certain products above the WTO norms that Russia committed to when it joined the WTO and the Eurasian Customs Union, that Russia entered into with Kazakhstan, Belarus Armenia and Kyrgyzstan complicated the situation and affected the trade negatively.

Impact of sanctions

When analyzing the impact of EU sanctions, it must be understood that the purpose of sanctions is always political and that they are imposed only when all other political and diplomatic measures have failed. The EU resolution adopted in July 2014 to impose sanctions, against Russia was directly linked to Russia’s actions in Ukraine and Crimea. Countries that adopt trade sanctions are fully aware that they may backfire on their own economies, but do so in order to achieve important political goals. In the current situation, EU sanctions are planned to have a minimal negative impact on EU member states. The measures have been enforced in a balanced manner in four key sectors: energy, finance, defense industry and sensitive technologies. Over the last 2 years, the sanctions have had an impact, although they need to be considered along with other factors that influence the Russian economy. The most important of these have perhaps been the decrease in oil prices on the world market and the drastic fall in the value of the Russian ruble. The currency devaluation has been further exacerbated by sanctions in the finance sector, which have drastically restricted Russia’s access to financial markets.

Russia’s extensive ban on the import of agricultural products was its reaction to the sanctions imposed by the EU and its allies. However, according to some estimates, this has had a more negative impact on Russian consumers. Russia’s import ban extends to a large variety of agricultural products, including meat and dairy industry. The impact of the ban on EU commerce as a whole is quite small, affecting less than 5 % of the EU’s agricultural exports. The impact is uneven between member states. The countries for whom Russia has been a traditional destination for agricultural products like Poland, Finland and the Baltic States, have felt this negative impact the most. The EU’s response to Russia’s block on imports was providing subsidies to perishable fruits, vegetables, as well as the dairy industry and helping those who exported to Russia in finding new markets by supporting the export-promotion programs for agricultural products. The support includes taking part in trade fairs and the costs of business delegations. Thus, Belgian pears and Polish apples have entered the Canadian market, Irish beef has found a market in the US and Japan has become a target for the Estonian dairy producers.

How European businesses are adjusting to western sanctions

It is obvious that the European businesses in general suffer due to the sanctions. But the small and medium companies suffer significantly more than big ones. The big companies have already localized their production lines, created more than half a million direct and indirect jobs and are now comfortably manufacturing their goods in Russia. With a cumulative European investment in Russia totaling to the tune of € 170 billion, therefore, in general, the sanctions have not deterred large corporations from continuing their business in the Russian market. Infact we could witness even more and more companies trying to localize their productions in Russia for 2 main reasons. The first and one of the most important reason is the devaluation of the Russian ruble. Before sanctions and the economic crisis, Russia was quite an expensive country to start manufacturing operations. With the ruble depreciation, it has become almost twice cheaper for European corporations to produce in Russia. Secondly, there is the Russian government policy that aims at attracting investments and localization of foreign production. For example, Alstom, Siemens, Schneider Electric, and others have localized their production in Russia long ago. It happened because Russian state-owned companies are major clients for these corporations and only the companies that have already localized their equipment and production in Russia could successfully bid for a state tender. But one very important thing to understand is that sanctions against Russia are U.S and EU sanctions, not UN sanctions that were adopted by the UN Security Council; hence, companies are finding legal ways on how to play around the sanctions and keep the interests of industrial sector untouched.

Trade flows have decreased dramatically in the sectors affected directly by the sanctions, there has also been a crisis of confidence, as concerned investors did not hurry with the launch of new projects, while simultaneously freezing ongoing ones. The significant decline in the relationship has had a painful impact on the economies and businesses of both sides and probably will be felt for some time.

Author: Sushen Doshi, International correspondent for World of Industries


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