The two ongoing wars, Russia’s invasion of Ukraine and Israel’s invasion of Gaza have wrought havoc in terms of human lives and also to the economies of the countries and regions attacked. But what about the impact on the economies of the invading powers. What has been the impact of the wars on the economy of Russia and that of Israel?
As is quite well known by now, in spite of 13 rounds of sanctions, amounting to more than 16500 individual sanctions, as well as being cut off from major global markets and financial flows, the Russian economy in 2023 outpaced both the United States and Europe, increasing in size by 3.6%. It is also slated to grow faster than all the G7 economies in 2024. Such a turnaround was possible only because of a confluence of a whole set of factors — the most obvious reason, of course, being the war boost to the domestic military-industrial complex, a sector which has a sizable weight in the domestic economy. But there are a host of other reasons, some not so obvious, and which shed light on the future prospects of the Russian economy.
A vital reason why Russia has not been affected adversely by sanctions is thanks to the critical, early in the value chain nature of crucial natural resources and inputs that it produces. These products are beneficiaries of wide-ranging global demand and have very low substitutability. Manufacturers can vouch that there are few substitutes for nickel, oil, natural gas etc. Substantial suppliers are scarce and downstream users are left exposed. The further down you go in this ever widening stream of economic activity, through ever expanding list of intermediate inputs, and finally to the end of the manufacturing chain with customer-facing products, e.g. mobile phones, appliances, furniture etc., there are many alternative suppliers and considerable substitutability. All of this grants early-in-the-chain suppliers significant hold-up power.
A distinguishing characteristic of the country’s economy prior to the Ukraine war was the over-globalised, elite-oriented import consumption-based trade driven by rent seeking networks. This snobbish, pretentious hyping up of foreign goods was partly also a psychological residual from the consumerist complexes of the Soviet era, a belief that anything and everything from abroad was better. It was easy to market to the “green” set of consumers in the immediate post-Soviet space. This resulted in suppression of local industry, goods and services, even those where domestic industry was competitive. The sanctions regime and the ongoing decoupling have willy-nilly set those imbalances and distortions right. It’s the reason why we suddenly see a spurt in local light manufacturing activity, such as furniture manufacturing and food processing industry, as well as construction materials, agriculture, some segments of machine tools etc. in many of which Russia had a comparative advantage, and which were being imported from abroad due to the conscious de-industrialisation of the post-Soviet era.
Large idle capacity and resources were left over from the Soviet Union in the manufacturing and many other sectors, and this huge capacity underutilisation in industry and agriculture — built and developed during the Soviet era, and which had been lying dormant, came to the rescue of the economic authorities.
It should also be noted that many of the things previously imported from the West were not particularly critical or high-tech, with some notable exceptions. Many had easy substitutes, both domestically, which spurred the local economy, as well as substitute imports from countries like China (Taicang, a small city which boasts the presence of almost 500 German companies and a total of more than 6 billion U.S. dollars in German investments, has received a boost in the last few years through its exports to Russia, and earned the nickname “little Germany.”). Critical, not easily substitutable imports in the pre-Ukraine war period included things like packaged medicaments, the key German, French and Italian export to Russia, as well as some high-end machine tools and chips. US exports to Russia included, among other things, planes, helicopters and spacecraft, and those restrictions and sanctions have boosted the domestic sector, long a mainstay, and an advanced, competitive sector in the former Soviet economy, which further underscores the points above.
In short, the extensive experience of autarchic independent development during the entire Soviet era has come in handy and the economic authorities in Russia have little reason yet to boast of their policy prowess. However, the reenergizing of the natural resource export markets, restructuring of elements of the supply chain, which relied on the west, together with policies implemented to boost domestic sectors, do redound to the credit of the policy makers.
Some of the fortuitous economic responses have been a one-time adjustment, and for a sustained momentum a range of policies and reforms would be required to boost productivity through innovation, modernization of key sectors and rebuilding of critical infrastructure. In case the current momentum is maintained, and it’s a big if, the Russian economy would probably overtake Japan, given the trends in both economies, to become the fourth largest in the world in Purchasing Power Parity terms, within the next three years or so, having already overtaken Germany last year. To some extent this would also be due to the lack of focused policy consensus in Japan and the failings and limitations of that country’s economic space rather than just effective policies and diligent governance in Russia.
On the other hand, the Israeli economy has started taking a hit. In the fourth quarter of 2023, Israel’s economy contracted almost 20% at an annualised rate, compared to the third quarter.
The Israeli economy, of course, is a totally different creature — heavily dependent on the external sector for resources, both natural and financial, for trade and investment linkages, and indeed, even for labor resources. The economy still managed to eke out 2% growth for 2023, but this year looks problematic, partly due to the call-up of reserves and the shutting out of Palestinian workers. Also, estimates are sketchy, but apparently close to 300,000 dual citizens and temporary residents, many employed in the high-tech sectors have left the country. For an already highly militarised economy, adverse shocks of this nature to the civilian labour force can be debilitating. Foreign trade is also going to be severely impacted because of incipient boycotts in many parts of the world. These factors together with the lack of natural resources and a crushing dependence on the West, especially the United States, both of which are some distance away, will likely result in supply chain impediments and significant uptick in inflation in the near future, in addition to a shock to the GDP. As someone noted — the problem with the Israeli economy is that it wants to be European while being located in the Middle East.
In addition to the high tech sector, the diamond industry, one of the mainstays of the economy, has taken a double hit; partly because of a global downturn in the last couple of years and the uncertainties and disruptions caused by Russia’s war on Ukraine, the former of being among the largest global producers of diamonds. Other key sectors negatively impacted include construction and tourism.
The one stable and consistent piece of good news for Israel seems to be the continued financial and other kinds of support from the United States. In addition to the federal government, there are reports that even the state governments are now lending a helping hand by buying “Israel bonds”, although the shaky level of confidence in Israel’s economy is underscored by the significantly higher interest rate (spreads) it will have to pay.
The two wars and other prospective hotspots have further strengthened the trends towards global fragmentation and decoupling that were already in place. All this is happening against the backdrop of a steady shift of the economic center of gravity to the global south. Until now, the global economic order has been based on four guiding principles: market-oriented economics, globalisation/free trade, national sovereignty, and democracy. It is difficult to see how the tenuous co-habitation of these four mantras can survive in the present circumstances. Even the US, the primary architect of this order, and which has faced offshoring, growing inequality and de-industrialisation in trying to balance all four, is setting up tariffs and promoting state-driven industrial policies, proving that national sovereignty is paramount and comes at the expense of globalisation and free markets. The inherent contradictions of reconciling all the four are coming to the fore and the cracks in the international order are widening.
Ashok Bardhan is an independent economist.