The Budget is Falling Apart: Rising war costs, declining exports and a slowing economy are pushing Russian authorities towards easing monetary policy
A combination of sustained increases in spending on the war in Ukraine, an economic slowdown and falling export revenues is pushing Russian economic authorities to reconsider their approach to economic policy. To patch up the widening budget gap, they will most likely need to ease monetary policy and accept higher inflation as a consequence.
Meanwhile, the recently revised federal budget for 2025 is already beginning to unravel. The deficit over the first half of the year has nearly exhausted the full-year limit. Expenditure is up 20% compared to last year, while revenues – both oil and gas and non-oil and gas – are under pressure from lower oil prices on one side and a continued economic slowdown on the other.
The oil and gas revenue target might still be met, provided oil prices do not fall much further and the rouble weakens slightly. However, the shortfall in non-oil and gas revenue appears to be an even more serious issue. The Ministry of Economic Development’s forecast, which underpins the budget, assumes GDP growth of 2.5% for the year, but even 1.5% now seems rather optimistic. The latest data indicates a continued decline in economic activity. In this context, higher taxes on corporate profits and personal income are unlikely to compensate for the shortfall in turnover-based tax receipts.
As a result, expectations of a key interest rate cut by the Central Bank have become widespread. The Bank’s leadership is also sending encouraging signals, even though progress on disinflation looks reasonably good, it remains fragile. For the rate cut to have a tangible effect on economic activity, it would need to be reduced by more than 100 basis points. Even then, this alone would not be enough to fix the budget. What could help is accelerated devaluation, which would increase rouble-denominated budget revenues even if oil prices decline.
In turn, devaluation would reverse the disinflationary trend. However, Russia’s leadership appears to have come to terms with the idea of loosening monetary policy and tolerating higher inflation targets. In practice, this will mean a redistribution of costs: higher inflation will favour businesses over ordinary citizens, whose incomes will be adjusted downwards after the growth seen in 2023–2024. The budget figures may just about add up, but the costs of rising war expenditure will ultimately have to be borne by the public.
Tighter sanctions against Russian oil could significantly worsen the situation. However, Donald Trump has once again postponed this threat by 50 days, and the Kremlin may hope that his habitual leniency towards Putin will reappear in the autumn. That said, the threat of tariffs alone could lead Indian buyers to partially shift towards Middle Eastern oil, ultimately reducing Russian export volumes, which would be an additional problem for the budget.
The Russian authorities will be forced to adjust their economic policy, driven by the simultaneous slowdown in the economy and the decline in export revenues combined with the need to finance the ongoing war in Ukraine. As a result, the decision will likely favour higher inflation, which will both stimulate economic activity and reduce the size of the budget deficit. However, this manoeuvre will only work if oil and gas revenues do not suffer a major blow, that is, if no new secondary sanctions are imposed on buyers of Russian oil, as threatened by President Trump.
The revised budget parameters, approved by Vladimir Putin just over two weeks ago (with increased spending and reduced revenue targets), will almost certainly not be met. This follows from the Ministry of Finance's data on budget execution for June: the budget deficit for January–June 2025 has already nearly reached the annual target of 3.7 trillion roubles (1.7% of GDP), compared to just around 600 billion roubles for the same period last year.
For the whole year, the updated budget envisages 42.3 trillion roubles in spending and 38.5 trillion in revenue. In the first half of the year, spending amounted to nearly 21.3 trillion and revenue to 17.6 trillion. A year earlier, spending over the same period was 17.7 trillion and revenue 17.1 trillion. This means spending rose by 20% year-on-year, while revenue increased by just 3.5%. Moreover, in recent wartime years, actual spending has consistently exceeded plans by the end of the year. There is little doubt that the same will happen this year. In the electronic budget, the allocation has already been increased to 42.9 trillion roubles. According to forecasts from the Telegram channel MMI, final spending may reach at least 46 trillion. This is entirely plausible: as previously reported, planned military expenditures appear insufficient if intense military operations continue throughout the year (→ Re:Russia: Budget for Military Build-up).
At the same time, revenues are also likely to deviate from plan, but in the opposite direction. Both oil and gas and non-oil and gas revenues may come in below government expectations. If current trends continue, the budget deficit could reach 4–5% of GDP by year-end.
Dual shortfall in revenues
According to the revised budget, oil and gas revenues should reach 8.3 trillion roubles for the year. In the first half, 4.7 trillion was received, which is nearly 17% less than during the same period last year. Yet oil was more expensive at the start of the year than it is now, or is expected to be in the coming months. The budget assumes an average annual oil price of $56 per barrel for tax purposes. In April, a barrel of Urals crude cost $54.76; in May, $52.08. Prices rose to $59.84 in June amid escalation in the Middle East, but are likely to fall below target again in July. The second half of the year will also see additional supply hitting the market as OPEC+ production limits are further eased (→ Re:Russia: Victim of Surplus). However, Russian gas export revenues are also declining. LNG exports remain at previous levels, but pipeline gas supplies to the EU have almost halved due to the suspension of transit through Ukraine, according to Reuters.
The government, however, has a real chance of meeting its revised oil and gas revenue target, according to economist Sergei Aleksashenko. Even at current oil prices and exchange rates, July revenues will roughly double those of June, thanks to the collection of the additional income tax. Based on his calculations, if from August to December the rouble price of Russian export oil for tax purposes remains at the June level (4,100 roubles per barrel), the Finance Ministry could receive 8.6 trillion roubles, which is 300 billion more than planned.
Finally, oil and gas revenues are being suppressed by an overly strong rouble. The government’s plan assumes an average exchange rate of 94.3 roubles to the dollar. To achieve this, the second half of the year would need to see the dollar worth more than 100 roubles. A weaker rouble would help stabilise the budget.
However, weak oil prices are not the only problem facing the revenue side of the budget. The government began preparing for a likely decline in oil and gas revenues last year by raising tax rates on corporate profits and personal income. The budget plan anticipates a rise in non-oil and gas revenues of 18% compared to the previous year. Yet, by the end of the first half of the year, the increase amounted to only 12.7%. Over the six-month period, the budget received 12.85 trillion roubles in non-oil and gas revenues out of the 30.18 trillion roubles planned for the year. At the same time, corporate profit tax revenues rose 1.7 times between January and May, VAT receipts grew 1.5 times, and excise duty income increased by 25%. However, these categories account for only around 15% of total budget revenues. Meanwhile, receipts from key turnover taxes (primarily VAT) grew by just 7.1% in the first half of the year compared to the same period last year, which is below inflation and therefore represents a decline in real terms.
The main factors behind the shortfall in non-oil and gas revenues in nominal terms are the slowdown in economic activity and disinflation (the weakness of imports combined with a strong rouble further exacerbates the situation, notes Olga Belenkaya, Head of Macroeconomic Analysis at Finam). In the first quarter, GDP growth year-on-year was just 1.4%, according to Rosstat, compared with the 2.5% annual figure used in the budget forecast. From January to May, the index of output in the main types of economic activity (a metric closely aligned with GDP) also stood at 1.4%, compared with 6.4% in January–May 2024. The Central Bank is currently projecting growth of 1–2% for the year, while the latest macroeconomic survey gives a median estimate of 1.5%. The May survey by the HSE Development Centre forecasts a figure of 1.4%. A more pessimistic projection comes from the government-aligned Centre for Macroeconomic Analysis and Short-Term Forecasting (CMASF), which predicts 1–1.4%.
Meanwhile, economic momentum continues to weaken, dragged down by contraction in the extractive sector and the 'narrowing' of growth areas in manufacturing (→ Re: Russia: Broad front and narrow). In June, the S&P Global PMI in manufacturing industries plummeted into negative territory. The index fell to 47.5 points from 50.2 in May, its lowest level since March 2022. Surveyed businesses reported a decline in production amid falling new orders. The threat of a recession had receded following relatively strong figures in April, but prospects for the third and fourth quarters remain bleak.
Shifting priorities
The simultaneous sharp slowdown in the economy and fall in export revenues (likely to be further worsened by a poor harvest, in addition to oil and gas losses) is pushing economic policymakers towards a shift in priorities. Sustaining economic activity, even at the cost of higher inflation, could help address the growing budgetary problem. However, such a pivot would require a notable reduction in the key interest rate.
Price growth is clearly slowing: in March, it was +0.65% month-on-month, in April +0.4%, in May +0.43%, and in June just +0.2%. Annual inflation in June declined to 9.4%, better than the Central Bank’s April forecast of 10.1%. That said, this does not signal reliable disinflation. In July, price increases will be driven by rising utility tariffs and petrol prices. Moreover, disinflation remains uneven, as noted by analysts at Raiffeisenbank. Food and service sector inflation remains in double digits at 11.9% and 12% year-on-year respectively, while the slowdown in goods inflation to 4.5% year-on-year is largely attributable to the strong rouble; a trend that would reverse if the rouble weakens. Inflation expectations (another key indicator for the Central Bank) fell only marginally, from 13.4% in May to 13% in June, and may rise again in July due to tariff hikes.
Nevertheless, a rate cut at the Central Bank board meeting on 25 July now seems almost inevitable. Deputy Governor Andrei Zabotkin has already admitted that it could be cut by more than 1 percentage point, even before the publication of July data on inflation and inflation expectations. Analysts' opinions are split: just over half anticipate a 2-point cut to 18%, slightly fewer predict a 1-point reduction. No one expects the rate to remain unchanged. This shift in sentiment is not due to confidence in disinflation, but to the rapid economic slowdown amid a steep drop in external revenues. Under such conditions, the objective of 'cooling' the economy seems irrelevant, even if the Central Bank’s inflation target has not been 'substantively' achieved. However, for the rate cut to impact the economy, a mere 100-basis-point reduction (1 percentage point) will clearly not be sufficient.
However, even in the case of a more decisive rate cut, its economic effects will not be immediate and thus won’t solve budgetary problems quickly. At the same time, a significant softening of monetary policy will lead to a weakening rouble. Raiffeisenbank analysts expect the key rate to fall to 16% by autumn. This would make rouble-denominated assets less attractive (also due to fading hopes of a swift end to the war, and rising risks of tighter sanctions). Russian authorities may further stimulate rouble devaluation by allowing foreign investors to sell part of their frozen Russian assets, blocked in retaliation for the freezing of Russian assets in the West, according to Sergei Aleksashenko (as of end-2023, the Deposit Insurance Agency reported over 1 trillion roubles in such 'Type C' accounts, no more recent data is available). This would accelerate rouble depreciation and improve budget figures by boosting rouble-denominated revenues even from cheaper oil.
Losers, non-losers and the ‘Trump factor’
It is clear, however, that a combination of rate cuts and devaluation will reverse the disinflation trend. But under current circumstances – with active military operations ongoing – there are no painless choices. Within Russian business circles and the government, the Central Bank’s 4% inflation target has long been considered irrelevant (→ Re:Russia: A Phantom Target). Higher inflation will favour businesses over citizens, who sit at the end of the 'pricing chain' and whose incomes will be adjusted downward following the increases of 2023–2024. It will affect to a lesser extent those sectors prioritised in the budget. Vladimir Putin has already instructed the government and the Central Bank to ensure that, in 2025, the 'output of industrial products in priority sectors of the manufacturing industry should not fall below 2024 levels.' Clearly, this refers to the military sector, which must be shielded from the effects of both interest rates and inflation.
Thus, the government may be able to improve the budget figures by effectively redistributing costs, which, in fact, continue to rise. For example, expenditure on 'manpower' involved in supporting this year’s offensive operations has increased by at least a third compared to last year and may reach up to 2% of GDP in monetary terms (→ Re: Russia: From Living Force To Dead).
However, these plans could be derailed by a tightening of sanctions against Russian oil and gas exports. According to Reuters sources, EU countries have nearly agreed on a new format of sanctions targeting Russian oil. Whereas previous discussions focused on reducing the price cap to $45 per barrel, a new mechanism involving a 'floating' cap is now under consideration. The maximum price would be automatically reviewed every three months and set at 15% below the average market price over the preceding ten weeks. At current prices, this would mean a cap below $50 per barrel. However, the United States is unlikely to support the plan, in which case its effectiveness would be limited.
The US, for its part, may still adopt a bill proposed by Senator Lindsey Graham, judging by Donald Trump's latest statements. The bill would allow the American president to impose tariffs on countries purchasing Russian resources. During a meeting with NATO Secretary General Mark Rutte, Trump declared that Washington would impose tariffs of 'around 100%' on Russia and its trading partners if a ceasefire agreement in Ukraine is not reached within 50 days. This could potentially force Russian oil out of the Indian market, which currently accounts for around 37% of Russia’s total crude oil exports, replacing it with Middle Eastern oil (→ Re:Russia: Victim of Surplus). That said, Trump has postponed similar threats against Russia numerous times in the past, so the Kremlin may once again count on his leniency. Nevertheless, Trump’s threat alone could lead Indian refiners to partially shift towards Middle Eastern oil. In that scenario, volumes of Russian exports would gradually decline, creating additional pressure on the budget.