The Russian economy is experiencing its hardest times since the 1998 Russian financial crisis. The Russian ruble (RUB) has fallen dramatically against the USD and EUR, inflation has increased, and its economic growth has slowed down. What are the factors behind the current Russian economic crisis? (For related reading, see article: How Russia Makes Its Money And Why It Doesn’t Make More .)

Everything started with the illegal annexation of Crimea by Russia, which prompted many countries to protest the Russian invasion by applying economic and administrative sanctions against this country. The USA, Canada, the European Union, Norway, Japan, Australia, and Switzerland are major countries that imposed sanctions, including a travel ban on key politicians and individuals, the freezing of assets, the imposition of a ban for lending to major state-owned Russian banks etc.

Falling oil prices coincided with these sanctions and became an additional driver of Russia’s economic crisis. (See article: What Determines Oil Prices? )

Rise in inflation rate

The Russian government responded to the sanctions imposed by these countries by levying counter-sanctions: restricted import of agricultural products and other consumer goods. This decision had at least two negative consequences for the country:

1) It increased the cost of goods in local currency, thus resulting in higher inflation. (See video: What Is Inflation? )

2) It decreased the quality of goods available locally in Russia.

The current capacity of Russian agriculture does not allow the country to meet its food needs solely through domestic production. Therefore, the country is dependent on imports. (See article: Interesting Facts About Imports and Exports .) As its number of potential suppliers of key goods shrank as a result of the sanctions, Russia had to turn to neighboring CIS (Commonwealth Of Independent States) countries from which to import the required goods. Now that the number of their competitors has diminished, these new suppliers will tend to increase the price of their goods, and Russia has no choice but to accept the increased prices. Decreased competition will also lower the quality of goods, because producers are less concerned about quality standards, due to their confidence that Russia must buy their goods, because of the lack of availability of alternative suppliers. Another factor that affects the quality of goods is that now Russia will import more of its goods from developing countries, which do not possess manufacturing and storage technologies that are as advanced as those of their developed competitors, such as EU states.

As a result of the combined effects of all the factors stated above, in November 2014 Russia’s annual inflation rate was 9.1% — the highest rate since 2011.

Currency depreciation

Since September 2014, the Russian ruble has tremendously depreciated against major world currencies such as the USD and EUR. (For a more in-depth understanding of the processes that drive the rise and fall of currency values, see: Global Economic Analysis — Currency Appreciation and Depreciation .)

A decrease in exports resulted in a reduction of the foreign currency flow in the country, and falling oil prices accelerated this process. As of the writing of this article, the price of a barrel of oil hovered below $50 — almost half of what it was a year ago.

The panic of holders of Russian currency who wanted to convert their wealth to USD or EUR before the currency declined too much further compounded this process. The graph below demonstrates the dramatic decrease of the value of the Ruble against the Dollar (The line in the chart is sloping upward because the USD is quoted in terms of the Ruble, e.g. 1 USD = 70 RUB).

The Russian Central Bank raised interest rates by 6.5% to 17%, hoping that it would, if not reverse the current trend, slow down the free fall of the RUB against the USD. (See article: What Are Central Banks? )

Russian President Vladimir Putin’s request that Russian billionaires sell dollars and Euros was another action to support the Ruble.

Russian international reserves (the external assets that are readily available to, and controlled by, monetary authorities for meeting balance of payments financing needs, for intervention in exchange markets to affect the currency exchange rate, and for other related purposes) decreased from $510.5 billion to $386.2 billion during 2014.

GDP growth rate decline

As shown below, the combined effect of declining exports of goods and services and low oil prices has resulted in downside pressure to Russia’s GDP . On the other hand, increasing consumption activities have dampened this downside effect. Year-over-year-basis quarterly GDP growth slowed down in the first three quarters of 2014. In the third quarter of 2014, GDP growth was only 0.7%, which is 10 basis points less than it was in the second quarter and 20 basis points less than the first quarter.

The World Bank updated its GDP growth projection for Russia for 2015 and 2016 to reflect the increased volatility in oil prices. According to the organization’s upper-case, baseline and lower–case scenario, real GDP growth projection is estimated as 0%, -0.7% and -1.5% respectively in 2015. Thus, based on the most likely (baseline) scenario, which assumes an average oil price of $78/barrel, in 2015 the World Bank forecasts real GDP contraction by 1.7% for Russia.

Negative impact on neighboring economies

Shifts in the Russian economy, whether upward or downward, affect the economies of neighboring countries, particularly Caucasus and the Central Asia (CCA) region, as a result of the consequent impact on remittances, trade and investments. The recent contraction in the Russian economy will therefore have a negative impact on the economies of these countries.

Remittance s — money transfers from immigrants in Russia to their home countries— decreased in dollar terms as a result of the currency devaluation. These immigrants primarily come from Central Asia, Caucasus and some of Russia’s western neighbors such as Belarus.

According to an IMF survey, the slowdown in Russia’s economy is expected to cause about a 1 percentage point decline in the GDP of Caucasus and Central Asia.

The economic crisis of Russia will also put upward inflationary pressure on agricultural products in countries in the region from which Russia imports. Farmers, attracted by the prospect of higher prices for their goods in the Russian market, will choose to export their products to this country, and this will lead to a price increase in region countries as well, due to a resulting shortage in domestic supply.

Additionally, now that the Russian ruble has declined dramatically, Russian goods and services have become comparatively cheap in dollar terms for foreign countries, and many people from CIS countries want to exploit this opportunity by investing in the Russian market, e.g. purchasing real estate, the prices of which decreased by almost 50% since 2007 in dollar terms, despite an increase in RUB prices. Increased selling of local property to finance Russian real estate investments will lead to downside pressure on local real estate prices that in turn can fuel the local mortgage crisis in these countries.

The Bottom Line

The current Russian crisis is a clear example of how geopolitical risk is real and, in fact, can dramatically change a country’s economy as well as the economies of neighboring regions. Russian politicians’ decisions might not only result in circumstances that sink the country’s economy, but could also make the lives of residents of other countries who have economic and socio-cultural ties with Russia worse off.