Over two years on from the invasion of Ukraine, Russia is the most sanctioned nation in the world. And yet the country’s economy is set to grow faster than any G7 democracy this year. How is this possible?
Back in 2022, Boris Johnson vowed to ‘squeeze Russia from the global economy piece by piece, day by day and week by week’. President Joe Biden promised that sanctions would ‘impose a severe cost on the Russian economy, both immediately and over time’.
Russians are spending more on restaurants, white goods, and even property – they have never had it so good
Yet these dire warnings never materialised: Russia’s economy has proved resilient in the face of sanctions. Moscow’s flexibility in restructuring its trading relationships and domestic demand has allowed it to weather the storm. Since 2022, China has steadily replaced the European Union as Russia’s primary trading partner and tech supplier. At home, meanwhile, the increase in military spending has given a significant stimulus to the broader economy.
Last month, the International Monetary Fund (IMF) raised its forecast for Russia’s economic growth to 3.2 per cent in 2024. This brings the country in line with the global average and exceeds the forecast growth rates for the US (2.7 per cent), the UK (0.5 per cent), Germany (0.2 per cent) and France (0.7 per cent).
Key business sentiment indicators, such as the central bank’s business climate indicator – a barometer of companies’ views, based upon opinion surveys, and optimism in industry more generally, are running high. The manufacturing purchasers’ managers index (PMI), a fundamental reading of business confidence, has reached its highest level in almost 18 years. Salaries, adjusted for inflation – still high at 7.4 per cent but stable – are rising, especially for low- and middle-income workers. Russians are spending more on restaurants, white goods, and even property – they have never had it so good. Yet the bad news for Russians – and for their president Vladimir Putin – is that this economic success is built on sand.
Russia’s state spending drives growth, and currently the war is dictating this spending. Government spending is set to rise by half by the end of the year compared to 2021.
In 2022, the first year of the war, fiscal spending jumped by a quarter, more than double the inflation rate, to just over 32,000 billion roubles. The government increased its spending by 4 per cent in 2023 and will top it up with another 4,000 billion or so roubles (approximately 12 per cent) this year. Adjusted for inflation, this is a 14 per cent rise between 2021 and 2024.
It is this colossal spending boost which is fuelling Russia’s evolving war industry. Russia’s direct military spending almost tripled as a share of GDP to 6 per cent from 2.7 per cent in 2021, the last year when it was kept roughly in line with the two decades’ average of 3 per cent. Taking into account classified expenditure, payouts to war widows and war-related spending in the occupied territories of Ukraine, the true share of GDP is undoubtedly higher.
As in Soviet times, the war has been a financial boon for Russia’s military-industrial complex and related industries, the armed forces and their families, and all parts of the public sector connected with defence and security. Military plants, sitting almost idle a decade ago, are now working around the clock.
The increased demand for labour brought about by this pivot to a war-time economy has clashed with a dwindling supply of workers, drained by mobilisation, emigration, and a reduction in the inflow of migrants from Central Asia. Faced with a workforce shortage, the military industry has been forced to increase average salaries by at least 50 per cent compared to before the war. Salaries are rising faster in traditionally depressed industrial regions such as in the Urals, the Far East, and central Russia, and among blue collar workers. No wonder unemployment is down to an all-time low of 2.7 per cent – as Putin loves to regularly boast.
Another consequence of increased government spending is that it is fuelling a boom in consumer spending. This, in turn, is bringing in higher tax revenues, allowing the government to spend even more. This, of course, is also what is keeping inflation above 7 per cent, but that doesn’t seem to bother the Kremlin, which remarkably is enjoying record-high approval ratings.
But where is all this money coming from? The answer is simple: from the export of oil and other commodities. At the start of the war, the West was trying to square an awkward circle: how to deprive Russia of its export revenue while keeping its oil flowing into Western markets.
This strategy was never going to work. Sanctions on oil came too late and were too soft. This hesitation gave Russia time to redirect its sales from Europe to Asia, primarily to India and China. True, the cost of sales is higher, equipment has become more expensive and difficult to obtain, but, for now, the revenue Russia is earning from the sale of its oil and other commodities is fuelling their budgetary spending. And this spending, in turn, is fuelling economic growth.
So, is the war good for the Russian economy? An analogy by the 19th-century French economist, Frederic Bastiat, helps to explain why it’s not. Bastiat described a boy who has broken a window. The boy’s father pays a glazer to replace it, spending the money on goods and services, and thus provides a boost to the economy. But the assumption that breaking windows is good for economic growth is a fallacy, Bastiat explains. By spending the money on reglazing the window, the boy’s father can’t spend it on other goods and services for himself. Neither, more importantly, can he spend it on investing in productivity. The overall effect is negative, albeit possibly a delayed one.
In Russia, the broken windows are the army’s tanks and missiles. Producing them round the clock isn’t increasing productivity. The high demand for workers and difficulties accessing Western technology mean Russia actually saw a record 3.6 per cent fall in labour productivity in 2022 (second only this century to the 4.1 per cent fall recorded in 2009 amid the global economic crisis). A slight rebound in 2023 failed to bring productivity levels back to pre-war levels.
Against this backdrop, companies cut capital investments in anticipation of declining profits and rising taxes. Sensing an unclear future, consumers also tend to spend, not save. This has also happened in Russia.
In the future, a drop in oil prices or a further rise in sales costs driven by sanctions would dent the state’s revenue. Cutting military-related spending would risk endangering social stability, as it would result in a loss of jobs in the war industry and an overall slowing of the economy. The non-military sectors of the economy would also suffer from underinvestment and low productivity. Meanwhile, Western capital and technological markets would remain closed to Russia.
Suddenly then, Putin or his successor would find themselves in the thankless role of Mikhail Gorbachev, who became the Soviet leader 40 years ago. Like in the late Soviet Union, a need to balance the budget amid lower revenue, declining productivity, and a lack of foreign financing would sooner or later make unpopular decisions necessary, be that a reduction in fiscal spending or allowing persistently high inflation.
Like the Soviet Union before it, Russia is mortgaging its future to pay for today’s war and economic growth. For now, it is able to sustain this – but it wouldn’t take much more pressure to see the fragile economy Putin has constructed come crashing down. When that might be rests in the hands of the West.
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