13.12.24 Analytics

Who Will Break The Camel's Back? The successes of the Russian economy over the past two years are creating conditions for a future crisis


The discussion about the resilience of the Russian economy has come almost full circle: the alarmist assessments of early 2022, which predicted a significant decline, have been replaced by confidence in its flexibility and stability. This view became nearly universal precisely when the economy began to show clear signs of distress.

The market-driven nature of the Russian economy has been one of the key factors behind its resilience, while its resource-based orientation and the expansion of the military sector allowed for a swift shift from recession to growth. At the same time, despite rising military expenditures, the budgetary structure appears even more robust than before, according to Russian economists, who, for these reasons, have referred to the Russian economy as ‘the reliable rear guard of the dictator’.

However, the market-driven nature is not the only factor contributing to the Russian economy’s resilience. Amid the imposition of sanctions, 2022 turned out to be a year of a positive external shock, as additional revenues from energy resource exports amounted to 8.5% of GDP. This impulse played a crucial role in helping the economy adapt and transition to growth. Yet, we still do not know how its trajectory will look once the effects of this shock are fully exhausted.

The structure of economic growth in 2023-2024 also does not indicate a healthy economy: the lion’s share of growth was driven by public administration, the forced replacement of the previous transport and logistics infrastructure, and military-industrial sectors. Meanwhile, the 'civilian' economy remained largely stagnant. This has created a 'growth gap': the rapid economic activity in certain sectors led to a significant increase in citizens’ purchasing power, but the consumer economy could not respond to this impulse due to a lack of resources, which were instead diverted to the state sector.

The growth observed in 2023-2024 has led to an expansion of the non-market segment of the economy, financed largely by budgetary funds. At the same time, protectionist policies tend to deliver significant results in the initial stages of their implementation but become a serious burden over time. This very burden of the non-market sector, along with the reliance on 'manual' economic management, represents the main challenges for the Russian economy: in the medium term, they could create the preconditions for an economic crisis.

From alarmism to euphoria and back again

The question of the resilience of the Russian economy has once again become central to discussions, having completed almost a full circle of debate. In the spring of 2022, the vast majority of experts predicted a decline of around 8% for the Russian economy under the influence of Western sanctions (see the Central Bank's forecast and the consensus forecast from the Higher School of Economics' Development Centre). This alarmism was replaced by a period of triumphant reports of a new economic upswing, in which the Russian economy appeared as a phoenix, emerging from the fire of sanctions revitalised and strengthened. Indeed, four quarters of moderate contraction in 2022 and early 2023 (averaging a 2.4% annual decline) were followed by four quarters of growth (averaging 5.2% compared to the same quarter of the previous year) and a gradual slowdown in the second and third quarters of 2024 (+4.1% and +3.1% annually).

However, precisely at the moment when the resilience of the Russian economy became common knowledge, it began to show clear signs of distress. By the end of summer 2023, experts started discussing overheating, manifested in mounting inflationary pressures. Since then, in an effort to cool the economy, the Central Bank raised the refinancing rate seven times, eventually bringing it to a level exceeding the crisis peak of 2022. Yet this did not lead to a sharp economic slowdown or a reduction in inflation, which continued to rise throughout the year (from August 2023 to July 2024) and resumed its upward trend after a brief decline in early autumn. According to official data, in November, prices increased by 1.4% compared to October. On an annualised basis, this monthly inflation translates into price growth exceeding 16% (taking seasonal factors into account). In the first ten days of December, prices grew by 0.6%, which could result in approximately 2% growth for the month (prices are unlikely to decline ahead of the New Year), and this figure, when annualised, translates into price growth of around 20%, according to calculations by the MMI Telegram channel.

This corresponds to the definition of galloping inflation and means that economic agents, adapting to the pace of currency depreciation, are inclined to spend money quickly or invest in reliable assets, while investments with relatively long payback cycles appear unreliable and unprofitable. Such a level of inflation is not, in itself, an indicator of crisis and can coexist with economic growth, but it points to accumulated imbalances that will inevitably lead to certain consequences.

The dictator's market and commodity backyard

The Russian economy remains resilient despite unprecedented Western sanctions and high military expenditures, primarily due to its market-oriented nature – this is the main conclusion of the report ‘The Dictator's Reliable Rear Guard’ prepared by Russian economists Sergey Aleksashenko, Vladislav Inozemtsev, and Dmitry Nekrasov. Russia has 6.5 million private companies and 10.2 million individual entrepreneurs and self-employed individuals, who together provide jobs for nearly half of the country’s workforce. It is the private sector and state companies operating in a market environment and adhering to market principles that have played a key role in the structural transformation of the Russian economy. Entrepreneurs fought fiercely for survival because they were defending their own property, the economists point out.

The report polemically challenges analysts who exaggerate the degree of ‘Sovietisation’ of the Russian economy, believing the economic effects of authoritarianism to be similar to those of a planned economy. It also rebuts those who see Russia’s resource dependence solely as a weakness. The Russian economy is poorly suited for dynamic development due to numerous constraints, but for resisting external pressure and preserving the status quo, authoritarian institutions and the resource-based nature of exports prove to be significant advantages, the authors reasonably argue. The world cannot function without Russian raw materials, and this has become a key factor in maintaining the primary flow of Russian exports and the failure of the Western coalition’s sanctions policies. Additionally, the restructuring of the economy toward military production has initiated resource redistribution processes, which have driven both production growth and an increase in citizens’ incomes.

Russia will continue to adapt to financial and sectoral sanctions by leveraging the ‘built-in stabilisers’ of its market-based, resource-driven economy, the report’s authors predict. One of these stabilisers is inflation. Its elevated level should be seen as the norm (at least, the norm during wartime) and as a means of redistributing resources between sectors. Inflation and the ruble exchange rate also serve as important stabilisers of the budget system. The budgetary framework remains relatively stable, even despite the significant increase in military expenditures.

Although sanctions-limited access to modern technology and capital will constrain economic development, Russia is capable of waging a war of attrition on its current scale for as long as Vladimir Putin wishes, the report’s authors believe. And if public finances face more serious challenges, their burden, in an advanced autocracy, will be shifted onto businesses and citizens through inflation and higher fiscal pressure (which is already happening to some extent).

Positive shock vs. negative shock

It is hard to disagree with most of the conclusions in this thorough and professional report, which highlights the factors behind the resilience of the Russian economy. However, several factors and circumstances remain on the periphery of its logic and argumentation.

First and foremost, 2022 was not only a year of sanctions and the associated negative shock for the Russian economy but also a year of abnormal export revenues, which reached $595 billion as a result of skyrocketing demand for energy resources and rising prices. This is $170 billion more than Russia’s average annual export revenue over the 10 pre-war years ($425 billion), which was already at record-high levels. Sanctions largely cut the Russian economy off from the West, but at the same time, they effectively granted it a windfall equivalent to 8.5% of GDP. These revenues, combined with the design of the sanctions, which helped Russian authorities combat capital outflows, resulted in trade and current account surpluses of 14% and 10.5% of GDP, respectively, in 2022 (compared to average values of 9.1% and 3.6% from 2011-2019).

This situation played a major role in helping the Russian economy withstand the shock of sanctions, and it is quite likely that despite their market adaptability, Russian entrepreneurs' efforts would have gone unrewarded had this stabilising factor and the barriers to capital outflow not existed. From a macroeconomic perspective, 2022 was a year of a positive shock for the Russian economy, which created the momentum for the surge in economic activity in 2023-2024. (Similar external surpluses were previously observed in Russia from 2001-2006, supporting an average economic growth rate of 6.5%.) In addition, as the report’s authors note, around 17% of the 2023 budget expenditures were financed using ‘NWF reserves’, i.e., monetary issuance amounting to approximately 5.5 trillion rubles (equivalent to $60 billion).

This does not mean that the stability factors noted in the report are insignificant, but it is difficult to assess their net effect without considering the resource windfall. One way or another, we still do not know how the Russian economy will perform under sanctions and high budget expenditures, the bulk of which are concentrated in the military sector, once the positive shock of 2022 has been fully exhausted.

‘Growth scissors’ and its sources

The Russian economy is growing, but the quality and quantitative parameters of this growth require close scrutiny. When comparing the sectoral and industrial contributions to GDP in 2023 with their shares in 2021, the structural changes become quite noticeable. These changes indicate that the main drivers of economic growth were public administration (its share of GDP increased from 6.85% to 7.78%, +0.93 percentage points), transportation and storage (+0.67 pp), three 'military' manufacturing industries (fabricated metal products, computers and optical instruments, and other machinery and equipment, collectively +0.51 pp), one civilian sector – food production (+0.22 pp) – as well as software development (+0.33 pp) and construction (+0.2 pp). Meanwhile, the shares of agriculture (-0.7 pp), mining (-0.83 pp), manufacturing as a whole (-0.36 pp, due to declines in metallurgy, oil refining, woodworking, and automobile production), and healthcare (-0.42 pp) decreased.

In other words, there has been a redistribution of resources from the private sector to the state and from civilian sectors to military ones. The greatest contribution to import substitution came from the transition from foreign software to domestic alternatives, while in infrastructure, spending was directed toward reorienting it eastward.

Industrial production growth appears impressive compared to the end of 2021: according to the Centre for Macroeconomic Analysis and Short-Term Forecasting, the production index rose from 103.5 points to 109 (with 100 being the 2021 monthly average). However, excluding the aforementioned rapidly growing sectors linked to the military, monthly production growth is effectively zero (→ Re:Russia: Cooling with Overheating). Similar calculations by the Central Bank show that intermediate manufacturing industries remained stagnant, consumer-oriented industries showed moderate growth, while investment-oriented sectors, especially those linked to military production, have been booming since the autumn of 2022.

Output of manufacturing industry groups, 2019-2024, %, 100% = 2019

Thus, the lion's share of economic growth has resulted from forced investments in replacing lost infrastructure (including software import substitution) and in military production. In the first case, the infrastructure was not expanded but duplicated with new structures, while in the second case (military production), the output was not consumed by domestic Russian consumers. At the same time, the increase in real disposable incomes of the population in the third quarter of 2024 amounted to 13.9% compared to the third quarter of 2021.

As a result, the war and sanctions have created a sort of ‘scissors’ in the Russian economy: between the rapid growth of incomes and consumer capabilities of the population on the one hand, and the weak growth of consumer-oriented industries on the other. The growth of solvent demand since mid-2023 did not trigger a corresponding response in industries focused on domestic consumer demand, which is explained by the aforementioned trend of resource redistribution from the private sector to the state.

The quality of economic growth is determined by the incentives driving it, i.e., the sources of investments that ensure this growth. Therefore, it is useful to examine how investment sources changed in 2023–2024 compared to the pre-COVID period of 2014–2019. The most significant change is the 6 percentage point decline in the share of 'other' investments, which include 'funds from external organisations' and 'foreign investments.' Two-thirds of this gap was filled by investments financed through budgetary funds, while one-third was replaced by enterprises' own funds.

Structure of investment financing sources in 2014-2019 and 2023-2024, %

In other words, while businesses fought for survival, their efforts accounted for only one-third of the overall success, while two-thirds were driven by state investments.

Who will break the camel's back?

Market economies are prone to economic crises. In this sense, the key argument of the report – that the market nature of the Russian economy has been an important factor in its resilience – is absolutely valid retrospectively as one explanation for the economy’s resistance in 2022 and 2023. However, it does not hold prospectively; in other words, it tells us nothing about whether the Russian economy is threatened by a crisis in the future.

As additional elements of Russia's economic stability (besides its market character), the report highlights the steady flow of resource revenues and the reliability of the budgetary framework, which the government manages to maintain by shifting the burden of expenditures to domestic sources. Economic growth (even if concentrated primarily in the military sector) ensures that budget revenues grow faster than inflation.

Indeed, while the share of oil and gas revenues in the budget averaged 38% from 2016 to 2021, in 2023–2024 it dropped to just 31%, with non-oil and gas revenues increasing from 62% to 69%, respectively. However, growth linked to domestic production accounted for only about two-thirds of the increase in non-oil and gas revenues (3.9 percentage points), while the remaining portion (2.4 percentage points) came from the category of ‘Other revenues’, which are far less stable. Moreover, if output growth is primarily concentrated in the sphere of state consumption, it does not ensure revenue growth outpacing expenditures (since in this case the state essentially pays taxes from its own pocket). This imbalance cannot be offset if output and fiscal revenues in civilian sectors decline.

As for export revenues, they remain not only a critical source of budget income – whose importance would increase further if the economy slows – but also a key channel for currency inflows and import capabilities. In this sense, the export sector remains a source of both multi-faceted stability and multi-faceted vulnerability for the Russian economy, depending on price conditions in global markets.

While Russian businesses have indeed played a significant role in adapting the economy to new conditions, and 6.5 million private companies and 10.2 million individual entrepreneurs and self-employed individuals operate in a market environment and largely follow market rules, the same cannot be said for many large Russian economic entities that receive various forms of state support, as well as the military sector, whose size has expanded dramatically. A significant portion of Russian industry is integrated into the state corporation Rostec, which functions as a kind of state within a state, formally neither a market company nor a fully public one.

At the end of 2022, the US Department of Commerce ceased recognising Russia as a market economy. According to American officials, the key criteria for determining a market economy include currency convertibility, wage formation mechanisms, conditions for foreign investments, and the degree of state control over production assets and company decisions. The department noted that as a result of extensive state intervention in the economy, Russia has experienced a rollback in all these areas. While this decision may be partly circumstantial and function as an additional sanction (classifying an economy as non-market allows the US to impose anti-dumping measures on Russian exporters, which they cannot appeal), there is no doubt that Russia's isolation from global capital markets and major reserve currencies weakens the effectiveness of market indicators.

Arguably, the clearest example of the economy’s de-marketisation is the fact that an increase in the Central Bank’s refinancing rate has no impact on either inflation or economic growth. This is because a significant number of economic actors receive either advances from the state budget or funds at subsidised budget rates. In other words, the space for market-based credit in the economy has been substantially reduced in favour of non-market lending. This is also reflected in the changes to the structure of investments described earlier: while in 2014-2019 budgetary funds accounted for 30% of external investment financing, in 2022-2023 their share exceeded 40%.

Economic history clearly demonstrates that various forms of protectionist measures, including import substitution programs, can yield positive effects in the early stages, as firms launch production financed by the state. However, once support diminishes, these effects quickly wane. Furthermore, the costs of such projects often tend to escalate sharply during implementation. For instance, 1.5 trillion rubles have already been spent on the program to develop a domestic fleet of passenger aircraft, but a recent audit revealed that even its partial completion will require an additional 4 trillion rubles (→ Re: Russia: The Strategy is Not Taking Off).

In other words, the prosperity of the Russian economy over the past two years has largely been tied to non-market factors and has led to the expansion of the non-market sector. This is one of the key challenges the economy currently faces and will continue to confront in the future. The burden of this sector could ultimately be the factor that breaks the back of Russia’s market economy.

Although the majority of economic actors in Russia still operate according to market laws, in terms of management and regulation, an excessively large role is played by manual (state-driven) control. So far, Putin has managed to balance four main objectives: financing his political projects, ensuring rents flow to his clientele, maintaining adequate levels of social spending, and preserving macroeconomic and fiscal stability. However, now that confrontation with the West (including military confrontation) has become the regime’s outright ideology, the importance and scale of political projects have grown significantly. Additionally, Russia’s detachment from international capital markets has increased the state’s burden of financing economic growth and maintaining infrastructure.

All of this does not mean that an economic crisis in Russia is inevitable. However, the prerequisites for a crisis scenario in the medium term have been sufficiently established.