The global economy is at a turning point, and many aspects of the current global transformation are more crucial for the Russian economy than they are for other countries.
  |   Ksenia Yudaeva

The global economy is at a turning point, and many aspects of the current global transformation are more crucial for the Russian economy than they are for other countries.

The term ‘structural transformation’ is typically used to refer to what has been happening to the Russian economy since February 2022, when it was hit by tough sanctions. However, we must understand that there is a substantial structural transformation taking place in the global economy as a whole. This process is not commonly described as a structural transformation. Terminology such as ‘fragmentation’ is used more often, but this makes no difference. The current drastic shift began to take shape as early as the middle of the previous decade, but it has now intensified.

Its main aspects are:

  1. The actual cessation of the processes of globalisation and, conversely, the beginning of the processes of deglobalisation, and attempts by governments to stimulate the relocation of production chains to their own or at least to friendly countries (what is called ‘friendshoring’ (link in Russian)). This may result in the disaggregation of the global economy into blocs. It will not necessarily be difficult. Most likely there will be two cores, an eastern core and a western core, roughly speaking, and a set of countries which are eager to cooperate with both blocs.
  2. The growing influence of national security issues (link in Russian) on economic policy. The selection of partners for friendshoring is primarily based on national security considerations. In general, we can say that the influence of geopolitics on geoeconomic factors is growing.
  3. It is yet to be seen whether these processes will affect the entire spectrum of markets or only the industries most critical (or strategic) for economic development in the 21st century or for national security. In particular, computer technologies, primarily chip manufacturing and artificial intelligence technologies, are among the industries most often subjected to restrictions, though it is obvious that the restrictions will go further.
  4. Fragmentation is also gaining momentum in the financial sphere due to, among other things, the active use of financial sanctions. The main issue in the current environment is the transition from a single dominant world currency in which the vast majority of foreign trade transactions are settled and capital flows take place (the US dollar) to a multi-currency system (link in Russian), as existed in the interwar period, when the US dollar and the British pound sterling were rivals, or earlier, when the gold and silver standards coexisted. In today’s world, the possibility of the Chinese yuan’s strengthening its role not only as a reserve currency, but also as a transaction currency (link in Russian), is undeniably attracting great attention.
  5. The active use of industrial policy to accelerate structural transformation in these areas. It should be noted that the United States has become the current leader in industrial policy ( Inflation Reduction Act), which has produced disagreements even with its EU partners.
  6. The influence of other trends that are not connected directly with geopolitics continues. These trends may be strengthened or weakened by geopolitical issues. The policy of countering climate change is very vital in this regard. Recently, there have been numerous discussions that the climate agenda has been slowed down due to the embargo imposed on Russian oil and petroleum products and the new configuration of the energy markets. However, this very embargo has created incentives for the development of green technologies. In addition, the introduction of green technologies in European countries has become an argument not only from the climatic, but also from the geopolitical point of view (link in Russian), as it will make them less energy dependent. The climate agenda thus remains a driver of change, and its influence will only increase in the future.
  7. From a social point of view, society in many countries remains polarised, and this leads to radicalism and populism in politics, a lack of space for compromise, and a narrowing of opportunities for the implementation of unpopular social reforms.
  8. For many years demographic trends have indicated the ageing of the world population and even a population decline in certain countries. In recent years, these processes have been pronounced in China as well. This, along with other factors, has led to slow-down in economic growth together with low unemployment.
  9. Demography, social polarisation, growing reliance on industrial policy, climate policy, and finally, geopolitics proper and national security issues can be regarded as factors behind the growth of government spending or, at a minimum, its maintenance at a high level. Given the high levels of public debt, this can create a threat of fiscal dominance (link in Russian) in monetary policy and financial systems in certain countries. We did see symptoms of this in 2020 during the first attack of COVID-19, when a number of emerging market economies, such as Indonesia, for the first time in many years, switched to budget financing by the central bank via the acquisition of bonds in the primary market. However, the risks of fiscal dominance are more likely to be realised not through ‘issuance’, which is usually sterilised within the operational framework of monetary policy, but through the establishment of lower interest rates than those needed to fight inflation.
  10. Of course, everything mentioned above can affect economic growth, well-being, and inflation. We know from economic theory that fragmentation and deglobalisation lead to higher prices for a broad range of products and falling living standards. Growth rates may either decrease to reflect the disruption in production chains and the lack of traditional imports, or temporarily increase due to the formation of new production facilities and new production chains. However, it must be understood that this will be a kind of compensatory (or recovery) growth from a lower level of well-being. The disinflationary trend seen in the beginning of the 21st century and which is associated with globalisation is developing into a proinflationary trend (link in Russian). This is likely to lead to higher real equilibrium interest rates, at least in the short and medium term.
  11. Over the past 10–15 years, the financial market has repeatedly experienced periods of high volatility, but central banks have always responded with monetary policy easing and the use of special tools to maintain financial stability. In the new environment, there is still space to use these special tools, but the space to use lower interest rates has shrunk. And we see that, despite the reforms carried out, the financial market has turned out not to be ready for such a policy change. The recent banking mini-crisis, which primarily hit medium-sized banks in the United States, is largely associated with these trends. Silicon Valley Bank’s problems were connected precisely with the fact that its policy was quite normal for low interest rates, but it made the bank vulnerable to higher interest rates. In general, the adjustment to the new reality will require yet another wave of changes to business models in the financial sector. This will contribute to any further fragmentation of markets, which may be fraught with spikes in volatility and overall risks to financial stability.
  12. This situation requires that central banks create another set of tools to maintain financial stability. However, the symptoms of ‘financial dominance’ (link in Russian) have become more pronounced. This is a relatively new term to describe a situation in which maintaining financial stability requires lower interest rates than those needed to fight inflation. Therefore, there is a risk that central banks will have to sacrifice and accept higher inflation in the name of financial stability.

Risks for Russia

For the Russian economy and the national financial system, a significant number of the trends listed above are relevant. Additionally, they are much more relevant than they are for other countries considering the impact of sanctions.

Primarily, this is related to the actual structural reconstruction of the Russian economy following the closure of Western markets. Our economy has already demonstrated a high degree of adaptability, but the need for further adaptation remains, due both to the fact that the sanctions on oil and petroleum products were introduced only recently and that the threat of new sanctions or new waves of tighter secondary sanctions exists.

Under these conditions, it is necessary to counteract the intensification of the processes of economic isolation, not to mention the potential of a slide into autarky, which will definitely result in a decrease in welfare and will slow economic development, even if the economy demonstrates relatively high rates of compensatory or recovery growth for a certain period of time. Thus, from the point of view of economic development and financial stability, including in terms of technological risks, a policy of maintaining economic ties and building production chains with countries that are, at a minimum, friendly, is a must.

From the perspective of financial stability, structural transformation is an unconditional challenge, as it leads to a decrease in the creditworthiness of traditional borrowers and to the need to lend to the projects of borrowers whose solvency is vague. All of this requires larger capital cushions for banks.

We are introducing special regulation to stimulate the processes of structural transformation, and this implies a certain amount of regulatory easing for transformation projects. However, for the purposes of financial stability, we are limiting the total amount of such easing to avoid a significant reduction in the capital of the banking sector and a decrease in confidence in it. The experience gained from the recent banking crisis in the United States mentioned above is an example of such a balanced approach.

The issue of weighting the risks associated with security with the risks of economic development in the making of decisions is becoming increasingly important. This can be well seen from the issue of information transparency, which is, on its face, rather simple. Last year, exemptions from information disclosure somewhat reduced sanction risks. However, it is evident that the downside of this process is primarily a reduction in the ability of Russian economic agents to make decisions based on real data. Those who make investments in financial markets are particularly affected. That is why the Bank of Russia has begun to disclose information and consistently supports the continuation of the process in all areas, except for those rather narrow spheres in which sanction risks have truly and directly increased.

Recently, we have repeatedly talked about the inflation risks associated with the budget. However, the budget may also entail risks to financial stability as well, including due to higher volatility of interest rates and a possible decrease in the level of confidence in the market. That is why budget consolidation, the adaptation of the budget to new conditions, and a long-term sustainable fiscal rule are necessary not only for price stability, but for financial stability as well.

The risks associated with the narrower space for settlements in US dollars and euros are worth focusing on separately. On the one hand, there is no other option in the context of the sanctions: we need to formulate alternative calculations which strengthen financial stability, among other things. On the other hand, uneven adjustment, in which export payments switch to alternative settlements faster than import payments, asset repurchases, and other transactions do, is fraught with, at a minimum, spikes in volatility and an occasional inability to proceed payments. Currently, the risks of secondary sanctions and the closure of the remaining channels for settlement in US dollars and euros have increased, which may lead not only to risks to financial stability, but also to challenges for the economy. Contrary to common belief, the reduction of this risk lies less in the financial plane and more in finding ways to transfer not only export, but also import and other payments into alternative currencies, levelling the imbalances among the foreign exchange flows in foreign trade.

One method of adjusting the economy to the new payment realities has become, to say, the outsourcing of financial services to the financial systems of other countries. This applies to companies, which are no longer required to return foreign currency earnings, and to households who are now actively using the banking systems of other countries to pay for trips and imported goods and to store savings. These households and companies need to monitor both the risks of secondary sanctions and the stability of the financial institutions of other countries. It is also necessary to understand the particularities of currency control, which is widespread in the countries whose currencies are not freely convertible. For the Bank of Russia, this is a matter of the financial stability risks associated with the corresponding financial flows, which is why we will strengthen monitoring in this area.

Currently, there are specific risks that arise in connection with Russian companies’ buybacks of production assets from foreign companies. The payments for such transactions are usually made in US dollars or euros, and the opportunities for the payment or receipt of these currencies in the Russian market have been reduced. Additionally, most of these transactions are made through obtaining loans for mergers and acquisitions, which can lead to an increase in the debt burden for buyers. If a business fails in the absence of foreign owners, such as, for example, due to problems with materials, components, spare parts, etc., this higher debt burden will create additional risks for the banking system. This is a special area of our focus, and we are intensifying our monitoring of it.

Of course, the current situation has other risks associated with, for example, mortgage or retail lending, interest rate risks, and so on. The spectrum of potential vulnerabilities from the point of view of risks to financial stability has increased overall, and it is necessary to remember about these vulnerabilities and to keep them under control in the shaping of not only Bank of Russia policy, but of governmental policy in general.