By Greg Ip 

For most countries, the economic slowdown in China and the accompanying slump in commodity prices represent something between nuisance and pothole. For Russia, they are a catastrophe.

Russia's currency and economy, already squeezed by Western sanctions, have been sent into virtual free fall by slumping oil prices. The International Monetary Fund predicted in July that Russia's economy would shrink 3.4% this year, the most of any major emerging market.

That now looks optimistic. Anders Aslund, a Russia expert at the Atlantic Council in Washington, thinks 6% is more likely. Coincidentally, that's close to what the Russian central bank predicted would happen if oil fell to $40 a barrel, roughly its current level.

Russian growth had averaged 7% from 1999 to 2008, due in great part to high oil and natural-gas prices. The oil collapse has exposed deep cracks in Russia's economic foundations: falling productivity, a shrinking labor force, uncompetitive industries, and private enterprise hemmed in by a kleptocratic state and crony capitalism.

The IMF now puts Russia's long-term potential growth at 1.5%. Mr. Aslund thinks it's just 1%, astonishing for a country whose standard of living is barely 40% that of the U.S.

This matters almost as much for the world as it does for Russia. Oil and gas wealth enabled Russian President Vladimir Putin to cement his hold on power domestically and flex Russia's muscles internationally. The loss of that wealth threatens to scramble the world's geopolitical order, though there are no signs of that yet.

There are parallels to the events that toppled the Soviet Union. Until the 1970s, oil and gas didn't dominate the Soviet economy. It was "an advanced (if inefficient) industrial and technological power," writes Thane Gustafson in his 2012 book, "Wheel of Fortune: the Battle for Oil and Power in Russia."

But its days were numbered. Socialist industrialization, stagnant agriculture unable to feed a growing urban population, a parasitic defense complex and uncompetitive manufacturing "made the fall of the regime inevitable," Yegor Gaidar, an architect of Russia's transition to a market economy under Boris Yeltsin, wrote in his 2006 analysis, "Collapse of an Empire: Lessons for Modern Russia."

The oil-price spikes of the 1970s staved off collapse while turning the Soviet Union into a petrostate. Oil and gas exports enabled Russia to pay for grain imports from the West, prop up its Eastern European satellites, and invade Afghanistan.

Mr. Gaidar, who died in 2009, traced the beginning of the end of the Soviet Union to Saudi Arabia's decision in 1985 to cease supporting the price of oil and ramp up production. The ensuing price collapse eviscerated Soviet export revenues. Forced to borrow from the West to pay for grain imports, Russia largely lost its strategic leverage, first over Eastern Europe and then over its Soviet republics. With hyperinflation and famine looming in 1991, the Soviet Union broke up.

The parallels shouldn't be overdrawn. Unlike the Soviet Union then, Russia today is a market economy, albeit one with a large state presence. Macroeconomic policy is relatively responsible. Last year the central bank abandoned the ruble's peg. The resulting drop has sent up inflation and squeezed living standards, but also cut imports.

Western sanctions over Russia's annexation of Crimea and support for separatists in eastern Ukraine have curtailed new foreign borrowing. This has preserved the surplus on Russia's current account--the balance on all trade and investment income--and its foreign currency reserves, preventing the sort of crisis that hit the Soviet Union in 1991 and Russia in 1998.

The more important parallel is the damaging legacy of oil and gas wealth. Russia has suffered a classic case of the "natural resource curse," the tendency of easy resource wealth to prop up inefficient industry, squeeze out manufacturing, and fuel corruption. Natural resource rents--revenues from oil, gas, coal, minerals and forest products minus their production costs--represent 18% of Russia's GDP, the highest among major emerging markets and far more than rich-country oil exporters like Canada and Norway. Mr. Putin has used those rents to modernize the military, expand the welfare state, and finance high-profile projects such as the Sochi Olympics.

Meanwhile, an expanding state-owned sector has undermined what private enterprise Russia had. Mr. Aslund cites the purchase by state-controlled oil company Rosneft of the well-managed, private competitor TNK-BP for $55 billion in 2013. Today, "value-destroying" Rosneft is worth less than TNK-BP was then. Western sanctions will further undermine productivity by depriving Russian industry, including oil and gas, of essential know how. As Western Europe seeks more stable sources of natural gas, Russian exports will be further squeezed.

Former president and current Prime Minister Dmitry Medvedev had sought to spur innovation to diversify away from oil and gas. But as Russia experts Clifford Gaddy and Barry Ickes write in a forthcoming book, even those diversification efforts depend on subsidies generated by oil and gas.

Many of Russia's top officials are well aware of its challenges. Central bank governor Elvira Nabiullina has called the current economic slump "structural," blaming "unfavorable demographic trends" and the "investment climate."

It isn't obvious, though, that Mr. Putin and his inner circle are listening. After all, economic hardship has yet to undermine his popularity at home or his ambitions abroad. History suggests that shouldn't be taken for granted.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

September 02, 2015 14:01 ET (18:01 GMT)