Russia's war economy starts to cool | DW Business

Summary of Russian Economy Analysis

Key Concepts: Recession, State Spending, Market Adjustment, China's Role, Military Spending, Sanctions, Inflation, Unemployment, Technological Deprivation, Investment Climate, War Economy.

1. Recession and Economic Outlook

• Official Acknowledgment: Russian authorities are officially admitting that Russia is on the edge of a recession.
• Recession Definition: Recession in Russia differs from developed economies; it won't necessarily lead to massive unemployment due to the current historical low of 2.3%.
• Inflation: A surge in inflation is not anticipated, but the economy was previously overheated, growing by 4.3% in 2024.
• Technical Recession: The economy contracted in the first quarter (1.4% growth) and forward-looking indicators suggest low economic activity in the second quarter, indicating a technical recession (two consecutive quarters of contraction).
• Potential Growth Trajectory: The economy is returning to its potential growth trajectory of around 1-1.5%.
• Government Tradeoff: The government faces a tradeoff between presenting rosy figures and acknowledging a healthier, but slower, economic growth of 1-1.5%. Putin has signaled acceptance of lower figures.
• Spending Cuts: Recession will likely lead to spending cuts in 2026.

2. Factors Keeping the Russian Economy Afloat

• Three Pillars:
  • Massive State Spending: Fiscal and credit impulse injected into the economy exceeded 10% of GDP over the last three years, with a significant portion going to the military-industrial complex.
  • Market Structure: The market economy allows for quick adjustments to changing realities, enabling Russia to adapt to sanctions. Example: Adjustments to oil sanctions in January involved rerouting flows and finding new intermediaries, diminishing the sanctions' effect within three weeks.
  • China's Lifeline: China has successfully substituted European countries and firms in terms of Russian imports and provides a market for Russian hydrocarbons.
• Limitations:
  • Low Unemployment: Lack of available workers limits economic expansion.
  • Maximum Capacity: Russian industry is operating at maximum capacity, preventing further output increases.

3. Military and Defense Spending

• Budget Allocation: National defense accounts for about 30% of the annual national budget.
• Beneficiaries: Primarily the Ministry of Defense, followed by other enforcement agencies like the Federal Security Service and the penitentiary system.
• GDP Allocation: Combined military spending and spending on national security are near 7.7% of GDP this year.
• Consensus: There is a consensus among the Russian economic bloc that this level of military and security expenditure will persist at least through 2026 and 2027.
• Spending Breakdown (Projected 2026): Approximately 6-7% of GDP on military, a similar amount on social spending, and the rest on the civil economy.
• Impact on Population: People will experience a slower increase in their quality of life, and inflation will continue to bite, despite efforts by the central bank.
• Post-War Spending: Military spending is expected to remain high even after the war ends, as Putin aims to reconstitute Russia's military potential.

4. Sanctions and Their Effectiveness

• Miscalculations: Some sanctions were miscalculated due to the rush to implement them.
• Adaptation: Russian businesses and authorities have been actively adjusting to sanctions.
• Lack of Global Support: Sanctions are not supported by the entire globe, allowing eastern countries to profit by selling to Russia.
• China's Role: China's role is crucial in mitigating the impact of sanctions.

5. Inflation and Interest Rates

• Inflation Rate: Inflation is around 9.5%.
• Key Interest Rate: The Russian Central Bank has kept its key interest rate steady at 21%.
• Economic Health Indicator: High interest rates indicate that the economy is not in a healthy state, even during periods of growth.
• Central Bank Tactics: The Central Bank's tactics are working, with inflation trending downward from nearly 10% at the beginning of the year to around 6% monthly.
• Future Rate Cuts: The Central Bank will inevitably be forced to soften monetary policy, but the timing depends on state spending for the next year.

6. Economic Costs of the War

• Loss of Competitiveness: Sanctions have led to technological deprivation, hindering Russia's potential to be at the technological forefront.
• Technological Dependence: Russia is becoming more dependent on countries willing to sell technology, and domestic products are becoming less competitive.
• Economy of Yesterday: Russia risks becoming an "economy of yesterday," with limited chances of advancing in AI, quantum computing, biotech, or other advanced technologies.

7. Low Unemployment Risks

• Manufacturing Expansion: Low unemployment hinders manufacturing expansion due to a lack of available workers.
• Wage Inflation: Competition for workers leads to increased wages, which in turn increases inflation and reduces market competitiveness.
• Demographic Forecast: This limitation will persist due to dire demographic forecasts.
• Factors Contributing to Low Workforce Availability:
  • Bad demographic forecast.
  • War distracting people from the economy.
  • Military-industrial complex attracting workers with high salaries and cheap state funding.
  • Emigration of 650,000 people, including high-quality human capital.
  • Decreased migrant inflow due to the war and anti-migrant rhetoric.

8. Energy Sector and Geopolitical Risks

• Straight of Hormuz: Concerns about Iran shutting down the Straight of Hormuz.
• Impact on Russia: While a surge in oil prices would benefit the Russian budget in the short term, Russia lacks the infrastructure to fully capitalize on the situation.
• Limited Gains: Russia can pump more oil to fill the niche liberated by Iran, but it's not enough infrastructure yet.

9. Potential Changes in US Sanctions Policy

• Trump Administration: The current lack of coordination between the US, Europe, and the UK on sanctions is already a gift to Putin.
• Sanctions Likely to Remain: Sanctions are likely to remain in place for a while, as lifting them is complicated.
• Putin's Influence: The extent to which Putin can keep Trump's attention remains an open question.

10. International Investment

• Lack of Real Investment: There is no real international investment in Russia.
• Russian Origin Money: Foreign money coming into Russia is primarily of Russian origin, routed through other jurisdictions.
• Unstable Investment Climate: Investors view Russia as unstable and non-investable due to an unpredictable investment environment.
• Shift from Liberal Market Economy: The illusions of Putin building a liberal market economy are gone.
• Risks of Nationalization: High margins cannot attract foreign investors due to the risk of business seizure or nationalization.
• Protectionism: Russia's drift towards protectionism also deters foreign investment.

11. Post-War Economy

• Military Spending to Remain High: Military expenditures will remain elevated even after a potential peace deal, as Putin needs military reconstitution.
• Uncertainty Relief: Eliminating the uncertainty related to the war would be a great relief for businesses and policymakers.

12. European Preparedness

• European Union Readiness: Question of whether the European Union is ready for a potentially better armed and dug-in Russia.
• Russia's Continued Presence: Russia will remain on the map, and Putin is committed to arming the country.
• West at War: Putin is at war with the West, a reality to which Europe must be prepared.

Conclusion

The Russian economy, while not collapsing, faces significant challenges including a technical recession, high inflation, and a shrinking workforce. Massive state spending, particularly on the military, and support from China are keeping the economy afloat, but at the cost of long-term competitiveness and technological advancement. Sanctions have had a limited impact due to adaptation and lack of global support. Even after a potential peace deal, high military spending is expected to continue, posing a long-term challenge to both the Russian economy and European security.