His war on Ukraine may not be unfolding according to plan, but President Vladimir Putin can still claim that the Russian economy is performing, as he says, “better than previously expected”. This kind of understatement is unusual for the Kremlin leader: with a tight labour market and inflation showing no signs of abating, the Russian economy is in fact overheating.
Look beyond the surface, however, and it is clear not only that the current boom is temporary, but also that it is the prelude to a painful economic future. Putin has moved the economy into full war-financing mode. This implies that he is planning for a long conflict in Ukraine, which Russia invaded in February 2022.
Russia’s GDP will expand by 2.2% this year, according to the International Monetary Fund’s most recent prediction. That’s three times as fast as the euro zone’s expected growth this year. Back in February, the IMF’s forecast that Russia would grow by 0.7% in 2023 was widely judged to be optimistic. The main reason for the surprise boom is the spending bonanza unleashed by the government, which has broken with a long tradition of fiscal restraint to finance its war in Ukraine.
The defence budget has risen to an equivalent of 3.9% of GDP this year from 2.7% in 2021, the year before the invasion of Ukraine. It will jump by more than 70% in 2024, reaching about 6% of GDP, according to official plans. And these are conservative numbers, because other types of war spending – such as new construction in the occupied territories – are hidden in other sections of the budget.
The war effort is concentrating public resources on a military-industrial sector rife with corruption, inefficiency and alien to the concept of profit.
Military priorities are also weighing on the rest of the industry by mobilising human resources, contributing to a tight labour market. The unemployment rate fell to an all-time low of 3% in August – it had never been below 4.4% before the war. More than 300,000 Russian men have been mobilised for the war. Employers are complaining about staff shortages, which are becoming acute even in industries, such as textiles, with few connections to the war machine.
The Russian economy’s good performance is also helped by its gradual adaptation to Western sanctions. Moscow has found loopholes and new trade routes to import banned components that are first exported by Europe to other countries – from aviation parts through Lithuania to microchips through Kazakhstan. Meanwhile the rise in oil prices, up nearly 60% since their March lows, is providing some welcome economic relief, and much-needed revenue for the government. Putin now says that the budget deficit will be just 1% of GDP this year, half previous government estimates, thanks to oil and gas taxes.
The good news, however, is limited to the short term. In the medium term, the economy is threatened by a series of “time bombs”, to use the words of Russian economist Alexandra Prokopenko.
The first is the exodus of talent. The tight labour market is also due to the emigration of qualified workers after the Ukraine invasion. According to an estimate by Re: Russia, an independent publication, between 800,000 and 900,000 Russians have left the country since February 2022. They include many highly skilled workers, notably in the tech industry, and employees of foreign-based firms or organisations. That will, over time, affect the economy’s growth potential.
The second threat is the ailing rouble . The Russian currency is down 30% since its January high. Its fall has accelerated since the June mutiny of Putin’s former ally Yevgeny Prigozhin and his Wagner mercenaries. The Bank of Russia has been unable to stem the slide even after raising its key rate from 7.5% to 13% this year.
The central bank is using monetary policy to counter the government’s expansionary fiscal policy, but inflation is now running at an annual 6% and could reach 7% in the coming months. The Bank of Russia has resisted widespread capital controls. That didn’t prevent the government from deciding on Oct 13 that 43 big exporters will be forced to deposit 80% of their foreign currency earnings with Russian banks and convert 90% of that amount into roubles – two desperate measures designed to boost the currency amid waning demand for the rouble.
As sanctions and other barriers shut off the country from the rest of the world, Moscow is tightening its grip on the economy. First by seizing the assets of foreign companies leaving Russia, such as French food group Danone or Danish drinks giant Carlsberg, and ensuring they fall into friendly hands. Then by drawing a list of a series of once-privatised Russian companies that Putin wants to reclaim for the state. In a country where corruption is already rife, this raises the spectre of massive inefficiencies in the industrial and banking sectors.
Russia’s prospects when military spending starts shrinking are dire. The partial circumventing of sanctions does not make up for the loss of technology transfers from Europe or the United States. Shrinking public investment in schools and education, due to the priority given to the military, will add to the loss of productivity over the medium and long term. And in a country where life expectancy at birth is already below 70 years – compared to more than 80 years in Europe, 78 years in China and 76 years in the US – reduced investment in the health system will aggravate the country’s terrible demographics.
Worse still, Russia will emerge from the current moment as a financial vassal to its big neighbour. The economic boom comes at the price of growing financial dependence on China. Trade between the two countries has soared as Beijing has bought much of the oil Russia can no longer sell to Europe. And the yuan has replaced the dollar as Moscow’s currency of choice.
Russia is displaying all the problems of an “emerging” economy with the growth rate of a mature industrial one. And it is forced to rely on a currency that is not fully convertible, managed by another government to suit its own interests. Those may prove, over time, the most potent economic and strategic time bomb.
The economy is already showing strains and the IMF expects GDP growth to halve to 1.1% next year. Putin may be tempted to double down and keep spending, especially because he will seek re-election in 2024. Even though there is little doubt about the outcome, more spending on pensions and social services would still help buttress his standing. Forcing the economy to run at the current pace will, however, exacerbate its current problems and only delay the major bust that they will trigger. — Reuters
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