A somber outlook for the Russian economy
Amid war and sanctions, Russia’s economy surprises with growth, but Soviet-style defense spending without the necessary exports threatens long-term prospects.
In a nutshell
- Wartime growth provides the temporary illusion of economic health
- Russia’s reliance on weapon and resource exports is unsustainable
- Critical shortages in labor and investment darken its economic future
Amid its all-consuming war against Ukraine, Russia is enjoying surprisingly positive media coverage for its economic performance. Commentators note that in addition to having weathered both war and economic sanctions much better than expected, it is climbing in international rankings and is clearly outperforming other European economies. Although common sense calls for a critical attitude to such reports, the numbers are there, and they originate from reputable sources.
According to the Russian Central Bank, the Russian economy chalked up gross domestic product (GDP) growth of 3.6 percent in 2023, making it the fastest-growing major economy in the world. This year’s first quarter came in at 5.4 percent growth, measured in annual terms. The country enjoyed a surplus of $50.2 billion in 2023, and $40.6 billion in the first half of 2024. Fixed capital investment for 2023 was up 9.8 percent, and the first quarter of 2024 showed an annual increase of 14.5 percent. Unemployment dropped from 5.8 percent in 2020 to 2.6 percent in 2024.
In early June, the World Bank reported that having already overtaken Germany, Russia has now also overtaken Japan to become the fourth-largest economy in the world, after China, the U.S. and India (measured according to purchasing power parity). On July 1, it upgraded Russia from being an “upper-middle-income” to a “high-income” country, placing it in the company of the G7 group of leading industrialized economies.
While there is no reason to question the veracity of these numbers, there is every reason to ask what conclusions should be drawn. Judgments based on a few select macroeconomic indicators are fraught with danger, and in an extreme case like the Russian war economy, additional caution is needed.
The gloom behind the numbers
The simplest explanation is the right one: Russia’s GDP growth stems from a massive boost in spending on defense. Large amounts of money are being funneled to contracting Russian soldiers, many of whom will be killed in Ukraine, and to the production of military hardware, much of which will be destroyed on the battlefield. Neither of these outputs can be justified in the long term.
Facts & figures
Russia triples defense spending compared to 2021 levels
On July 3, two days after the World Bank presented its upbeat vision of Russia’s ascent in international economic rankings, the head of the Russian Central Bank, Elvira Nabiullina, noted that the economy faces serious constraints in labor resources, long-term investment and access to foreign technology. In economic growth theory, it is well understood that the main drivers of growth are labor, capital, technology and land. The Russian economy is now severely limited in three of those four categories (the amount of land at its disposal remains bountiful).
While at first glance the balance sheet may seem rosy, war and sanctions combine to depress the outlook. The massive wager on military production is crowding out civilian production. Companies outside the military sphere face mounting labor shortages and rising costs of inputs, woes that may soon be compounded by a spike in borrowing costs.
At the end of July, the Central Bank raised its key rate by 200 basis points, to 18 percent. That is more than double the rate of 8.5 percent in July 2023, and it will translate into market rates that are prohibitive for civilian investment and household mortgages. It is not surprising that business profits are tumbling. By the end of August, the Russian stock market had dropped by 25 percent, from an optimistic peak in mid-May. The Central Bank also noted that the depleting National Welfare Fund may be fully exhausted in 2025.
Declines in all non-military production
The boost in military production also means a drop in the production of agricultural machinery, translating into rising food prices. Between January and July this year, the output of combine harvesters fell by 9 percent and that of tractors and seeders by more than 22 percent. In mid-August, suppliers of key food items informed retailers of pending price hikes of up to 40 percent, citing high inflation and debt service, together with rising costs of shipping, personnel, packaging and raw materials.
The sanctions regime against Russian exports of oil and imports of electronics for missile production has been leaking like a sieve. Nonetheless, the threat of secondary sanctions for doing business with Russian banks has caused Chinese banks to almost completely halt transactions, refusing to accept payment even in Chinese renminbi. Banks in Turkey, the South Caucasus and Central Asia are following suit.
The Russian economy has reverted almost fully to its traditional pattern of forced mobilization of resources for military production. Gone are the days when economists talked about diversification and a booming service sector. Instead, Russia again relies heavily on the export of natural resources to pay for imports of machinery and manufactured goods to boost Russian military production. Meanwhile, China has almost completely taken over the civilian car market.
All these traditional sources of export revenue – oil, gas and weapons – are now under severe pressure. The outlook for Russian oil was negative even before the war: Production has reached a plateau and will soon start declining. Although sanctions have failed to block the Russian export of oil, the main customers – India and China – may now demand very high discounts, eroding Russia’s revenue.
Russia’s natural gas market, previously chief in Europe, is almost dead. The Nord Stream pipelines are gone, and by the end of the year Ukraine will shut remaining transit routes to Hungary and Slovakia. When that happens, all that will remain are two lines to Turkey (the Blue Stream and the Turk Stream) and one line to China (the Power of Siberia). Moscow has been pleading with Beijing for a second line (the Power of Siberia II) but it is clearly not going to happen. Having failed to develop serious capacity for liquefied natural gas, Russia will be stuck with massive but near worthless reserves of gas in the ground.
Nations shun Russian weapons
As for the Kremlin’s continued export of weapons, its war against Ukraine has doused such hopes for a long time to come. Potential customers have registered how Russia’s so-called “wonder weapons” have been defeated in Ukraine; how hypersonic missiles like the Kinzhal and the Zircon proved to be no match for American Patriots; and how the “most advanced” surface-to-air missile system in the world, the S-400 Triumf, proved incapable even of defending itself against old American ATACMS. It would not be surprising if India and Turkey are having second thoughts about the billions they spent on acquiring the obsolete S-400s.
Orders for Russian military jet fighters had been canceled even before the full-scale invasion of Ukraine, not only by India but also by other important customers like Algeria, Egypt and Indonesia. Long-standing defense partner China is said to have begun developing its own engines for its new line of fighters, decreasing its reliance on Russia.
With all its traditional sources of export earnings thus in jeopardy, the question becomes: What may the Kremlin look forward to exporting instead? The answer is – not much. Even if Moscow does manage to maintain some exports, continued sanctions will bar Russian producers from access to vital intermediate goods, preventing them from interacting within global value chains. Protracted isolation from the developed parts of the global economy will be tantamount to a move toward North Korean autarchy.
The Russian military-industrial complex has performed better than expected during the war. It has managed to keep up the assembly of missiles (through the import of sanctions-busting components), and to continue some advanced research and development, especially in electronic warfare and countermeasures against Western weapons. However, potential customers are surely considering not only quality concerns, but also that for many years to come, Russia will be so focused on production for its own needs that assuring supply to foreign buyers will be extremely difficult.
Scenarios
Russia has reverted to what was known during the Cold War as “structural militarization”: All resources are devoted first and foremost to the military-industrial complex. Although the opportunity cost for the Soviet Union in trying to keep pace with the United States in the arms race was substantial, it is still likely to be dwarfed by what is now to come. It is worth noting that Hitler delayed proclaiming total war until 1943, because he was aware of the effects it would have on the overall economy. Russian President Vladimir Putin opted to proclaim total war in May 2024, calling on all officials to consider themselves mobilized for the war effort and to act as if they are on the frontline. Although the Russian economy has not yet transitioned to full war mobilization, it is very clearly moving in that direction.
Highly likely: Economic “primitivization” leads to despair
As an expanding share of GDP is allocated to external and internal security, the economy will come under immense stress. Even if the notion of economic collapse should be used with care, there can be little doubt that Russia is facing a grim future – with or without a victory over Ukraine (and whatever that “victory” might entail).
Underfunded health care and education will have severe negative impacts on public health, demography and the quality of human capital, exacerbating the damage already done by large numbers of young urban professionals either opting to leave the country or having been killed in Ukraine.
Already dilapidated infrastructure will reach breaking points, amplifying problems of flooding, collapsing bridges and sinkholes in urban roadways. Increasing technological obsolescence will finally cause previous predictions of a “primitivization” of the Russian economy to come to pass, as the relative share of the primary sector in the country’s GDP will expand. An economy that increasingly relies on digging, drilling and pumping will not have a bright future in a world undergoing a green transition.
Unlikely, but increasingly possible: State collapse
The short-term outlook hinges on how these deteriorating indicators will influence the political system. It is possible that a perfect storm emerges: The financial system goes into tailspin; continued Ukrainian attacks on the energy system cause blackouts even in Moscow; food shortages ripple through the provinces; and traumatized soldiers returning from the war create havoc in the streets. These risks combined produce mounting fears of a Russian state collapse. Although the likelihood is still below 50 percent, the odds are improving rapidly.
Possible: The Kremlin hangs on
In contrast, it also remains possible that money printing and residual commodity exports will tide Moscow over for another few months. In this scenario, a continued erosion of sanctions will allow for imports via third countries, harsh repression will maintain order and intense infighting among the elites will stave off any plans of a coup.
Yet, even if Russia extricates itself from its war against Ukraine without being defeated, even if it is allowed to refuse to pay war reparations, and even if the sanctions regime is lifted, the structural damage already done to the Russian economy is so severe that it will take a very long time to remedy. The specter of state collapse will not fade away.
For industry-specific scenarios and bespoke geopolitical intelligence, contact us and we will provide you with more information about our advisory services.
Sign up for our newsletter
Receive insights from our experts every week in your inbox.
