Putin’s Unsustainable Spending Spree

How the War in Ukraine Will Overheat the Russian Economy

After Russia invaded Ukraine in 2022, its economy seemed certain to suffer as a coalition of Ukraine’s allies, led by the United States, imposed an unprecedented program of sanctions. Many figures, including U.S. Treasury Secretary Janet Yellen and EU Sanctions Envoy David O’Sullivan, predicted that these would force Russian President Vladimir Putin to choose between the war and a struggling economy. But Russia’s economy has defied these predictions. Thanks to record state spending, the Russian economy will grow faster than the global economy in 2023. Whereas the latter is forecast by the IMF to grow by three percent, the former is predicted by the Russian government to grow by 3.5 percent. When the exact figures come in, Russia’s economic growth in 2023 will likely turn out to have exceeded three percent, and Putin will no doubt boast about this in speeches ahead of this spring’s presidential election.

Rather than signaling economic health, however, these figures are symptomatic of overheating. The Russian economy’s problems, in fact, are such that Putin is facing an impossible trilemma. His challenges are threefold: he must fund his ongoing war against Ukraine, maintain his populace’s living standards, and safeguard macroeconomic stability. Achieving the first and second goals will require higher spending, which will fuel inflation and thus prevent the achievement of the third goal. High oil and gas revenues, adept financial management by the Russian authorities, and lax enforcement of Western restrictions have all played their part in Russia’s economic growth, but they mask growing imbalances in the economy.

Ahead of the Russian election, Putin is unlikely to mention that over a third of Russia’s growth is due to the war, with defense-related industries flourishing at double-digit growth rates. Civilian industries, which are also involved in producing products for the front—such as footwear, clothing, and medicine—lag slightly behind. Russia’s bright 2023 economic landscape concealed dangerous tradeoffs made in pursuit of short-term gains. Even if Moscow’s financial leadership succeeds in cooling down the economy by the end of 2024, major problems caused by the war are inevitable. These include discontent over underfinanced public health, mounting shortages of tools and equipment due to the tightening sanctions regime, and major dislocations caused by mammoth investment in the defense industry. Future generations will pay a heavy price for the current state of affairs, although for now this is the last thing on the Kremlin’s mind.

The war has markedly changed the Russian economy. Moscow has had to adjust its policy to fund its armed conflict against Kyiv, maintaining its military apparatus and police force, and integrating the territories it has annexed from Ukraine. These priorities have necessitated significant spending commitments that collectively threaten Russia’s economic stability. The Kremlin will spend six percent of GDP (more than eight percent when combined with spending on national security) on the war in 2024. This is more than the 3.8 percent of GDP that the United States spent during the Iraq war, although it falls short of the prodigious sums the Soviet Union allocated during the years of stagnation and its invasion of Afghanistan (18 percent of GDP).

Military spending has even eclipsed social spending—currently less than five percent of GDP—for the first time in Russia’s post-Soviet history. This pivot toward a militarized economy threatens social and developmental needs. The four annexed regions of Ukraine have already received the equivalent of $18 billion, and in 2024 almost $5 billion is expected to be transferred from the federal budget to regional budgets. No other regions in Russia receive this level of investment, which only increases interregional inequality. Rather than restore dilapidated housing in Russia, the Kremlin prefers to spend money on building houses and roads in annexed territories, to replace the houses and roads that Russian troops destroyed during their brutal invasion.

Rather than signaling economic health, Russia’s growth is symptomatic of overheating.
Russian industry has been transformed, with defense sectors now overshadowing civilian industries. The defense sector’s enterprises are now operating at a fever pitch and, as a consequence, any surge in demand is likely to force prices to rise because of the sector’s inability to increase supply. The military sector is receiving a disproportionately high amount of government spending, and it is also siphoning off labor from the civilian workforce, leading to an abnormally low unemployment rate of 2.9 percent. Before the war, Russia’s unemployment rate typically stood at around four to five percent. The military and public sectors now employ 850,000 more people than in late 2022–23. The invasion of Ukraine also prompted about 500,000 Russians to emigrate in 2022, driving shortages of qualified specialists and blue-collar workers.

Meanwhile, living standards have risen across Russia, and the percentage of Russians living below the poverty line has dropped to 9.8 percent, the lowest since 1992. Naturally, there are regional variations, and areas that have sent a significant number of their men to fight in Ukraine—including Altai Krai, the Altai Republic, Buryatia, Chechnya, and Dagestan—have witnessed the fastest income growth in low-income groups. This relative increase in prosperity can be expected to continue as Moscow disburses funds to the families of the deceased and wounded.

Overall, the Kremlin wishes to maintain an illusion of normality and even increasing prosperity for its citizens. The distortions in the labor market have pushed up salaries in military industry, as well as in civilian manufacturing, because of the need to compete to attract workers from well-paying military plants. Moscow is, meanwhile, making high payments to soldiers and people mobilized to fight in Ukraine, which are driving consumption. At the same time, thanks to a supply of cheap credit, the government is handing out subsidized mortgages, that are, for the moment, shielding families from economic reality.

The interplay between military spending, labor shortages, and rising wages has created an illusion of prosperity that is unlikely to last. Moscow’s options to deal with the growing labor shortage are unpleasant. It can institute round-the-clock production, encourage the hiring of women and teenagers in traditionally male-dominated professions, or try to find more migrants to fill the growing number of vacancies. But these proposed changes would only make the situation worse.

Because of the labor shortage, Russian companies are already forced to pay higher salaries to their remaining workers or to poach workers for more money from competitors or other sectors. Wages rose in 2023 more than the national average in the Nizhny Novgorod, Novosibirsk, Samara, Sverdlovsk, and Tula regions, where a large number of defense companies are concentrated. As a consequence, the workforce in other regions and civilian manufacturing have been dislocated by workers seeking high wages, exacerbating labor shortages in nonmilitary production and pushing salaries and costs up.

Russia’s war economy has also brought changes to the composition of the Russian middle class, traditionally composed of educated specialists, businesspeople, and IT professionals. Increasingly, however, middle-class Russians are becoming soldiers and police officers—and thus state dependents. This shift is due to war mobilization and the expansion of law enforcement agencies, particularly the Federal Security Service. This change carries economic risks, as it obliges the government to continue to make expensive payments to these groups even when faced with budgetary challenges. These payments are an economic time bomb: high wages are extremely difficult to reduce, and doing so for the main pillar of Putin’s rule—the army and security forces—is not an option.

Increases in wages and state payments have stimulated Russian consumption. Retail sales, in particular, grew by 10.5 percent in November 2023 despite inflation. Putin’s directive to secure the availability of consumer goods has led to greater imports of these goods, discouraging domestic production. He cannot increase domestic production without triggering price hikes or shortages. This would be dangerous: Russians are already feeling the pinch, and complaints about high prices are at the top of the list of grievances to regional and federal authorities.

Only a stable economy that prioritizes maintaining predictable macroeconomic conditions can reliably finance Russia’s war and maintain payments to the population at current levels. Growing spending on war and subsidized loans to people and businesses undermine that stability. Moscow has been particularly proactive in issuing these loans and, as of November 1, 2023, their total value is more than $130 billion. That is approximately 14 percent of the loan portfolio in the Russian banking system and seven percent of GDP. The mortgage lending sector is a particular liability, as it is now driven by soft-loan programs that account for 70 percent of new mortgages. These loans are most in demand among the middle class in Moscow and St. Petersburg, as well as in the Krasnodar region.

As the Russian economy has become more focused on the war, Russians have also become unsustainably reliant on war-related payments. The government refuses to curtail subsidized mortgages because of a powerful lobby of property developers. Although the terms have been slightly tightened, and the down payment raised by five percent, the program has remained. The arguments from the central bank that these loans create an additional inflation pressure, cementing inequality and distorting property prices, have been ignored by the Kremlin. These subsidized loans are paid for by all income categories, meaning that working-class taxpayers are subsidizing middle-class mortgages. More than 60 percent of loans are issued to people who will spend more than half their income repaying them. Increasingly, the loan programs are being accessed by recipients of war-related payments. If the war ended, it would become extremely difficult for them to service their loans, especially in the face of rising prices.

International sanctions have had the unexpected and beneficial effect of insulating Russia from external shocks by cutting it off from international financial markets. But because of the war and the breakdown of relations with the West, Moscow finds itself more dependent on oil than ever. The Russian government is working on the assumption that it will receive almost $119 billion (6.4 percent of GDP) in oil and gas revenues in 2024, which would amount to more than a third of the treasury’s total revenues. Moscow’s 2024 budget also assumes both an average Russian oil price of about $70 per barrel and that Western countries will fail to limit the Kremlin’s oil and gas revenues. These presumptions make Russia vulnerable to fluctuations in oil prices as well as Western countries’ efforts to restrict Moscow’s exports.

Inflation is also fast becoming a problem. Russia’s inflation rate has already surpassed seven percent, forcing the Bank of Russia to maintain interest rates at 16 percent. Despite these high interest rates, businesses and households continue to borrow, indicating high inflation expectations. This means that the key rate will not return to single digits any time soon. This has prompted industrial giants such as AvtoVAZ and Russian Railways to seek subsidies to service their corporate debt. The Russian energy company Rosneft’s CEO, Igor Sechin, has gone further, urging Putin to influence the independent central bank’s decisions. He has not done so. Despite the attacks from oligarchs, the government, and even Putin’s economic aide Maxim Oreshkin, the central bank governor Elvira Nabiullina has maintained her independence in monetary policy decision-making. For the Kremlin, high interest rates constitute an image problem, undermining Putin’s narrative that the Russian economy is stable. A healthy economy, after all, does not need a double-digit key rate.

Volatility in the value of the ruble is further evidence of macroeconomic instability. Since 2022, it has oscillated between 50 and 100 rubles to the dollar. This has been caused in large part by Moscow’s abandonment of the budget rule under which it bought and sold foreign currency from its National Wealth Fund to make up for shortfalls and surpluses in oil and gas revenues. This rule prevented spending from ramping up but was ended in the aftermath of the invasion of Ukraine. Its abandonment left the value of the ruble at the mercy of trade flows. A three-digit dollar exchange rate not only stokes inflation; it triggers public concern.

The authorities cannot remove the main reason for the ruble’s weakening, which is spending on imports, although they can implement control over capital flows. To fight rising prices, they can also restrict exports of certain products, and threaten heavy fines to force retailers to limit markups. Such steps are likely, lest the destruction of the ruble’s reputation leads to dollarization of savings of both business and households, and further capital outflows. Restricting prices will lead to their acceleration in the future.

Putin is apparently sincere in his belief that the Russian Empire and the Soviet Union both collapsed largely because of poor financial management. The modern Russian economy is run by professional technocrats, and Putin listens to their opinions. So far, the situation looks stable in the short term: the availability of yuan and gold reserves means Moscow need not worry about financing external debt. The cost of domestic borrowing has increased, and fiscal space has narrowed, but Russia’s low prewar debt-to-GDP ratio means that debt is unlikely to prove a significant risk in upcoming years. The government may also turn to domestic capital markets to provide financing for state spending as they privatize state property, especially parts of the military industry.

Still, the war is shaking the foundations of Russia’s economic stability. It has already taken its toll on pillars of economic policy crucial for macroeconomic stability, including the budget rule, freedom of capital flows, and—to some extent—the independence of the central bank.

Most of the self-inflicted wounds to the national economy cannot be healed without ending the war and the sanctions regime. Structural problems—particularly dependence on oil revenues, an inability to live without foreign, predominantly Chinese, imports, and negative demographic trends that have been exacerbated by the war—will not go away any time soon. To solve these problems would require years of structural reforms that attract investment and improve human capital. But the Kremlin is unable and sometimes unwilling to take these steps because of Putin’s obsession with political control.

Russia’s economy is more endangered than the growth statistics indicate, and the upcoming election may provoke further fateful decisions that could exacerbate long-term challenges if Putin decides to buy voters’ loyalty by splashing even more cash before polling day. Overheating—often a precursor to recession—is a growing threat, especially when institutions designed to mitigate shocks are either dysfunctional or being obliterated by the exigencies of war. With the war unlikely to end soon, the financial and economic costs will mount and are likely to bite Russia several years from now. This process could be speeded by a major global recession or a slowdown of the Chinese economy, which would hit Russia hard because of its heavy dependence on revenues from commodities exports. The specter of a bitter economic hangover looms large unless a new and sustainable Russian economic model emerges. But that remains highly unlikely. For Putin, the war is now an organizing principle of his domestic and foreign policy. To abandon the war without something that the Kremlin can define as victory would be impossible. A long conflict over Ukraine not only satisfies Putin’s geopolitical ambitions and vision but is also turning into his regime’s survival strategy. The trouble will be that his political goals are incompatible with the economic ones. Eventually, something will have to give.

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