From adaptation to mobilisation: The logic of changes in state-business relations in the context of war and sanctions

In early 2023, analysis was conducted in an article for Re:Russia (→ Andrei Yakovlev: Worse Than A Crisis) on the factors that predetermined the resilience of Russian business to the shock of the war and international sanctions in 2022. Based on a new series of interviews (including a number of follow-up interviews with respondents from 2022), this paper examined the factors that influenced economic dynamics in 2023. It also analysed the changes in the relationship between the state and business that began in the second half of 2023 and developed in the first half of 2024 through a series of signals given to business, the resulting expectations of entrepreneurs, and – based on this – the likelihood of a change in the economic model that has existed in Russia for the past two decades.

The empirical basis for this work consisted of 44 interviews conducted in 2022–2023 with 31 respondents, including directors of industrial enterprises, heads of IT companies and firms in the service sector, representatives of business associations, banks, and industry experts. It should be emphasised that this sample does not claim to be representative. This is due to its small size, as well as to an objective bias in favour of more successful firms (in a crisis, firms facing serious difficulties tend to be less available for contact). Nevertheless, the information obtained from the respondents included in the sample meets the objectives of the work, as we primarily aimed to understand which micro-level factors ensured the relative resilience of the Russian economy and to what extent their effects might continue in the future.

Old and new factors of high adaptability to the 'new reality' in 2023-2024

The key events of 2022 were perceived by businesses as an acute external shock requiring an immediate response. Initially, business owners and managers maintained expectations of a ‘return to normality’. However, by autumn 2022, amidst the transition of military operations into a phase of protracted confrontation, intensification of international sanctions, mobilisation of 300,000 workers into the army (in addition to the emigration of several hundred thousand more), and the shift of the economy to a 'war footing', respondents began to sense the onset of a 'new reality'. The main features of this 'new reality' included the long-term isolation of the Russian economy and its growing dependence on China. Despite these conditions, four primary factors continued to influence the adaptability of Russian business in the early stages: (1) the market nature of the Russian economy (with its flexibility and adaptability to external shocks), (2) the habitual stress resilience of Russian entrepreneurs and their ability to find survival solutions, (3) the competence of officials in the economic sector of the government, and (4) the established mechanisms of their communication with businesses.

In 2023, three new factors contributing to firms' adaptation to the ‘new reality’ were added to these. First, the so-called fiscal impetus – the active injection of state funds into the economy from the end of 2022, primarily directed at financing the military-industrial complex and infrastructure construction, as well as payments to mobilised individuals and contractors. These were substantial amounts, with more resources allocated to regions that had long been considered depressed. Overall, the ‘budgetary impulse’ became a significant factor in maintaining demand in the economy.

Second, a new factor in 2023 was the general growth of wages. The initial impetus came from wage increases in the defence sector, driven by a significant rise in state defence orders. Since the mid-2000s, enterprise leaders had regularly mentioned a labour shortage, but complaints did not translate into noticeable wage increases. Workers' bargaining power in the Russian labour market has traditionally been weak due to the actual absence of trade unions and an informal agreement among entrepreneurs to avoid wage competition (as such competition would lead to wage increases and reduce average profits for all enterprises).

The uniqueness of the 2023 situation lay in the fact that against the backdrop of a labour shortage, caused by long-term demographic factors and exacerbated by the force majeure outflow of labour (emigration, mobilisation, contract hiring), a significant sector of the economy faced a multiple increase in order volume from the state and resorted to a sharp wage increase (2-2.5 times, according to enterprise managers). However, these wage increases in the defence industry forced enterprises in other civilian sectors to raise wages as well to retain workers. For example, the owner of a logistics complex in a region in the European part of the country reported having to raise warehouse engineers' wages to 70-80,000 rubles, while in 2021, a good wage in that region was considered to be 30-40,000. The only reason for this increase was the presence of many military factories in his city, where wages for workers of this qualification had risen to about that level, and active hiring was ongoing. If he hadn't matched this, his workers would have moved to those factories, and his business would have halted due to the lack of such specialists on the local market. Thus, for the first time in many decades, the balance of power between workers and employers changed in the Russian labour market.

To assess the macroeconomic implications of this shift, it is important to take into account the unidirectional elasticity of wages. Wages can remain stagnant for a long time, but once they are increased, it is very difficult to reduce them back down. The Russian defence industry employs around 1.5 million people, while the total number of employed in the Russian economy is about 73 million. This means that if the effect of competitive wage increases spills over into the civilian sector, this factor will not cease even if budget cuts lead to reduced funding for the defence industry and lower payments to defence personnel. In 2023, respondents across various regions reported a 20-25% wage increase in the civilian sector (in 2023, nominal wages on average grew by 14% across the country; according to Rosstat, in January-April 2024, the increase was 19% compared to the same period last year, or 10.5% in real terms). Of course, future inflation may erode wage increases, but in 2023, wage growth was a standalone factor driving economic dynamics and increasing consumer demand in the market.

Third, another factor was investment activity, which, according to respondents' estimates, remained high in 2023. There are specific explanations for this. On one hand, several sectors saw opportunities arising from the exit of foreign companies. For example, in the electrical engineering industry, before the war, around 40% of the market was held by European firms such as ABB, Siemens, and Schneider Electric. Of this volume, about 25% was direct imports, and 15% was produced at Russian subsidiaries of foreign companies.

When these companies left, demand persisted. If in the early 2000s there was a fundamental quality gap between imported and Russian products in this sector, over the past 20 years, many Russian firms have emerged that, while still falling short of their European competitors, are not radically inferior. These firms began to acquire assets sold by the departing European companies and to establish new production facilities, investing money into these ventures.

The structure of investment purchases in the electrical engineering industry also changed. Historically, 80-85% of the equipment in this market was sourced from Europe. New production facilities typically worked with engineering companies – integrators who provided turnkey solutions: they formed orders, sourced equipment from various manufacturers, conducted installation and setup, offered warranties, and ensured maintenance. This was quite expensive but high-quality. Now, however, not only have equipment manufacturers but also engineering companies ceased to work with Russia.

As a result, Russian second-tier firms have been forced to take on new functions in order not to lose their positions amid persistent demand. Now they are independently procuring equipment from various suppliers, integrating it into technological processes, and handling installation and setup. It turns out that their engineering staff generally possesses the competencies required for these new functions. Additionally, the composition of newly procured equipment has changed. About half of the equipment is still imported (though now with a significantly larger share from China and Turkey), while the other half consists of Russian-made equipment. It has been found that there are machine-building enterprises in Russia capable of producing equipment that is acceptable in terms of quality and performance. In other words, the exit of European companies from Russia has pushed domestic companies to explore new functions and niches, and they have largely managed to adapt.

On the other hand, amidst financial sanctions, Russian entrepreneurs have largely lost their traditional means of hedging political risks by transferring excess funds out of the country into foreign bank accounts. It has now become significantly more difficult to do this, not only due to Russian restrictions but also due to policies from the EU and the US. Moreover, keeping money in domestic accounts is also risky because of ongoing practices of coercive measures against businesses. For raiders, taking over a business without money in its accounts is a headache, while a business with large account balances becomes very attractive. Consequently, to dispose of excess funds, entrepreneurs are investing in available assets, which results in additional investments.

Sectoral differences and drivers of change in the second phase of adaptation

The above analysis does not highlight differences specific to different sectors, regions and types of enterprises. Our sample is insufficient for this purpose. Our sample is insufficient for this purpose. Relying on data from broader formal surveys and Rosstat, it is possible to note that two major industries – automotive manufacturing and woodworking – are still in a deep depression. In the case of the automotive industry, this is due to a high dependence on imported components and parts. For woodworking, it is due to its historical orientation towards European markets (closed to Russian companies since 2022) and excessively high logistical costs for supplying to Asian markets. In contrast, there are clear gains for the defence industry in machine-building. Additionally, respondents observed a continued high level of activity in the construction industry due to mortgage programs for housing construction and funding for infrastructure projects, as well as federal budget allocations for building defensive structures and housing in occupied territories. The increase in wages has led to a rise in consumer demand, including higher demand for products from the agro-industrial complex and expanded demand for services such as domestic tourism and catering.

As already noted, relative gains were generally experienced by depressed regions. These regions saw a larger scale of mobilisation and military recruitment, accompanied by monetary payments that were 4-5 times, or even more, higher than the local average wages. Often, depressed regions were those with a high concentration of defence industry enterprises. The expansion of military orders led to increased consumer demand and economic activity in these regions.

In 2022 and 2023, the situations faced by enterprises of different sizes diverged. In 2022, amid the shock of sanctions, large and medium-sized firms fared better than small businesses. Like small businesses, they encountered severe problems, but they traditionally had broader avenues for communication with the state apparatus – both directly and through business associations. In contrast, small businesses in 2022 faced a contraction in demand for their goods and services, as this category of enterprises is much more dependent on consumer demand.

From 2023 onward, the prospects for large and small businesses began to shift. Large enterprises, in general, started to experience more problems due to restrictions on access to modern technologies (including maintaining the functionality of existing equipment). Moreover, large firms tend to have a longer planning horizon, making it increasingly apparent to many of their owners and top managers that there are no real prospects for the development of the Russian economy and their businesses in the conditions of international isolation.

Two events have also played a significant role in changing the expectations of large businesses. First, a series of lawsuits brought by the Prosecutor General's Office, which began in the summer of 2023 and are still ongoing, aimed at seizing assets into federal ownership not only from foreign owners, but also from Russian owners. And, second, the government's introduction and the State Duma's adoption of a budget for 2024 with record levels of military spending, signalling that the Kremlin had no intention of ending the war. These plans were later confirmed in statements by Putin and other officials.

Conversely, small and medium-sized enterprises’ assessments have started to improve since the end of 2022. One obvious reason for this improvement was the increase in consumer demand due to the general rise in wages across the economy. Another reason was the active involvement of small businesses in evading sanctions, specifically by sourcing components, spare parts, or assemblies from other countries that were banned from exporting to Russia by the US and the EU. This type of business involves certain risks and often requires complex supply chain arrangements but is highly profitable. Additionally, regulators in the US or the EU find it challenging to track the operations of such small firms.

Another less obvious reason for the improved outlook for small and medium-sized businesses is the growing interest of large Russian companies in cooperation with domestic suppliers. It is worth noting that most large private sector manufacturing enterprises in the Russian economy underwent restructuring and modernization in the 2000s or 2010s – improving internal business processes, updating equipment, and adopting modern technologies. However, during this period, they primarily sourced spare parts, components, or individual assemblies from foreign (mainly European) suppliers. 

The challenge for Russian small and medium-sized enterprises was that, despite offering good value for money, they often struggled to consistently meet the standards required by large manufacturing consumers. Large companies found it more cost-effective to maintain established relationships with a network of European suppliers rather than investing in training local suppliers to meet these standards (as IKEA did with its local suppliers).

In 2022, sanctions changed this dynamic. Even in cases where European suppliers continued to serve their Russian manufacturing customers through third countries, these customers began to consider the risks of supply disruptions if sanctions were expanded or enforcement was intensified. In this context, the costs of training local suppliers and additional quality control measures became justifiable – especially given that large Russian enterprises, having gone through modernization, already possessed the necessary engineering and technical expertise. In this sense, it can be argued that sanctions led to an increased demand for products and services from small and medium-sized manufacturing businesses.

Signs of a shift in the model of state-business relations

It should be underscored once again that the main factors behind the successful navigation of the 2022 shock by the Russian economy were its market character, which allowed firms to adapt to radical changes in external conditions, the competence of the government's economic bloc, and the high revenues of the budget and large companies, which ensured the maintenance of demand. A significant role was also played by the experience gained by Russian businesses in overcoming numerous crises over the past 15 years. Entrepreneurs who remained in the market were both psychologically and operationally prepared for ‘black swan’ events and had built up reserves and financial cushions for ‘rainy days’. From the perspective of a normal market economy, these reserves are additional costs that slow down development, but in moments of sudden shocks, their presence makes it easier to navigate through crises. Government officials managing the economy also constantly faced crises and learned to respond to them through communication with businesses.

Historically speaking, it can be said that in the 2010s the Russian economy began to develop institutions and mechanisms that resembled elements of the 'developmental state' characteristic of South-East Asian countries. One vivid example is the Industrial Development Fund, which was established in its current format in 2014 and had been actively mentioned in a positive light in interviews with company leaders since 2016-2017. The problem, however, is that these institutions and mechanisms emerged in the absence of fundamental factors that underpinned the catch-up development seen in Southeast Asia. These were economies oriented towards broad importation of technologies (as a tool for increasing productivity) and export as an indicator of firm success (which, despite corruption, allowed for the exclusion of ineffective firms from state support and the support of effective ones). Russia attempted to follow this path in the 2000s and 2010s (with limited success), but with the onset of the war against Ukraine, the Kremlin deprived the Russian economy of access to both modern technologies and major export markets in developed countries. It is already evident that while Asia is prepared to purchase Russian raw materials at a discount, there is no demand for Russian manufactured goods there, and Africa lacks the funds for such products.

Since mid-2023, two additional factors have emerged. First, the Kremlin’s announced 70% increase in military expenditures for 2024 poses risks of macroeconomic destabilisation and lowers economic agents' expectations. Second, there are signs of a shift towards a mobilisation-based economic model. In 2023, there were indications of a nascent redistribution of property. Legal actions by the Prosecutor General’s Office to seize large stakes in federal ownership, supported by arguments that owners' actions were 'violating Russia’s economic sovereignty,' created significant tension in the business sector, which also spilled into the public domain. The Kremlin’s decisions to nationalise prominent companies like Rolf and Makfa had significant resonance, significantly heightening negative expectations.

The arguments in the lawsuits filed by the Prosecutor General's Office since the summer of 2023 regarding ‘threats to Russia’s security and sovereignty’, as well as the similar grounds for seizure of property explicitly stated by Putin at the RSPP Congress in April 2024 ('when the actions or inaction of the owners of enterprises and property complexes cause direct damage to the country's security and national interests') suggest that this new wave of coercive pressure on businesses not only reflects the private interests of certain elite players but also signifies the beginning of a shift towards a different economic model.

It should be noted that discussions about this type of transition have been ongoing in Russian bureaucratic circles for several years. For example, in the book 'Crystal of Growth: Towards the Russian Economic Miracle', published in 2021, one of the key authors, Alexander Galushka – former president of the Business Russia Association and former Minister for the Development of the Far East – presents this concept in a rather systematic manner. Between 1929 and 1955, the USSR set a global economic record for growth rates that has yet to be surpassed by any country in the world, and according to the book’s authors, the key to achieving exceptional economic development is to apply this 'priceless' historical experience. Criticism of the arguments presented in the book about the effectiveness of the Soviet 'mobilisation economy' is given in a detailed review by Professor Grigorii Khanin, co-author of the notorious article 'False Figures', which was published during the Perestroika period, and Dmitry Fomin ('What Stalin’s Economy Can Teach Us'). 

However, these criticisms did nothing to hinder the campaign promoting the book in the public sphere as a 'fundamental scientific monograph' that shows the way to a 'Russian economic miracle.' The activity surrounding this campaign created the impression that influential figures were backing the book’s ideas to justify a transition to a 'mobilisation' model of the economy. For example, in May 2023, during a speech at the St. Petersburg International Legal Forum, Alexander Bastrykin, the head of the Investigative Committee, directly advocated for the nationalisation of key economic sectors to ensure 'economic security in wartime.' Notably, in 2024, this line of thinking began to be expressed not only by security officials but also by representatives of the economic block of the government. For example, former investment banker and current Minister for the Development of the Far East Alexey Chekunkov, in a comment for RBC, mused about the 'replacement of businessmen' with certain 'creators' and 'servants,' as well as a transition to a model of 'patriotic socialism' – with a direct appeal to the construction of communism in the Soviet era.

The problem is that in the mobilisation model proposed by the authors of Crystal of Growth, there is no place for the current large private businesses. In such an economy, all 'strategic heights' are controlled by the state. Those who disagree with this approach will 'fall out of windows' (as has already happened to several top managers of major Russian companies in 2022–2023), while the remaining entrepreneurs will at best be relegated to the role of new 'red directors,' appointed and dismissed by decisions from the Kremlin (which is precisely what Minister Chekunkov discusses).

Is movement towards a mobilisation model inevitable?

On the whole, the events of the second half of 2023 and the beginning of 2024 suggest that the political-economic system established under Putin has objectively reached a crucial juncture. For a long time (essentially since the Yukos case), this system was based on the premise that businesses had ample opportunities to make profits in exchange for a principled refusal to engage in political activities not sanctioned by the Kremlin. The key player in this model was the state apparatus. This predetermined the significant role of the high bureaucratic elite, which had relative autonomy, managed considerable resources, and generally pursued liberal economic policies. These policies formed the foundation for a market economy that proved resilient to strong external shocks.

However, in the wake of the political protests of 2011–2012, the balance of power within the elite shifted. The Kremlin opted for a protective policy, and the high bureaucracy began to lose its influence. It became clear that, in the absence of political competition, its autonomy was illusory. Senior officials are appointed by Kremlin decisions and can be dismissed in the same manner; if desired, it is not difficult to imprison them on corruption charges, as happened with Nikita Belykh, Alexei Ulyukaev, and Mikhail Abyzov

After the Yukos affair, big business lost its status as a full-fledged member of the ruling coalition. However, over the years, they played an important role in the existing model, ensuring its economic stability. This is why, in relations with businesses, the Kremlin tried to maintain the previous 'social contract' all these years, striving to support conditions for entrepreneurial activity. One manifestation of this contract in the 2010s was regular pressure on the bureaucratic apparatus within the framework of the National Entrepreneurial Initiative to improve the technical conditions for doing business (evidenced by Russia's noticeable advancement in the World Bank's Doing Business ranking). Another manifestation of the same liberal policy was the deliberate suppression of collective worker actions by the authorities (against the backdrop of exceptionally weak official trade unions), resulting in low labour costs for businesses.

Compared to the bureaucracy, relatively large businesses are, by definition, more autonomous actors. Officials only have the authority granted by the state, and with the loss of this authority, they lose access to resources. Entrepreneurs, on the other hand, have significant financial resources and enterprises with thousands of employees at their disposal. Additionally, unlike officials, entrepreneurs retain the ability to travel abroad and, in most cases, have foreign assets. The heterogeneity of Russian business is also important: alongside several large companies whose businesses arose from political connections and access to rent sources, there are tens of thousands of firms that built their businesses in market conditions. This was made possible by liberal economic policies, and the activity of these firms enabled the Russian economy to withstand extensive international sanctions. However, due to their market nature, such businesses may demand liberal policies, especially in conditions of market contraction and reduced profits.

In this sense, business poses a more serious threat to the Kremlin than the bureaucracy. Until now, the Kremlin has bought business loyalty thanks to the super-profits of 2022 and partly 2023, which arose due to the contradictory design of international sanctions. Additionally, 'personal sanctions' worked in favour of the Kremlin, effectively pushing major entrepreneurs into Putin's embrace. Finally, the opportunity to purchase the assets of foreign companies leaving Russia served as an additional 'loyalty bonus'.

However, the growing tension in state finances, indicated by the continued expansion of military spending and steps toward increasing the tax burden, will inevitably worsen the overall economic situation and already negatively affect business expectations. In this scenario, it will be harder for the Kremlin to maintain business loyalty. It is highly likely that businesses (primarily large enterprises) will face the greatest losses in the future, not only due to rising labour costs and increased tax burdens but also due to probable expropriations and redistribution of assets. In the logic of populist politics, the most 'obvious' candidates for this are the 'oligarchs' of the Yeltsin era.

Until 2024, the Kremlin had enough money to simultaneously finance the war, cover social obligations, and support the economy, thanks to continued oil exports amid rising global prices. Tightening budget constraints will accelerate the transition to a new, tougher political-economic model (this direction will also be influenced by the worsening situation on the front lines). From the perspective of regime survival, there seem to be no alternatives to moving toward such a model.

By engaging in a full-scale war, the regime broke the socio-political balance that had ensured its stability for the past 20 years. As a result, despite actively demonstrated signs of stabilisation, its position is actually unstable. The problem for the Kremlin is that most of the current business and bureaucratic elite do not want to live within such a model, which in itself may be an argument for accelerating the transition to it, which in turn will become a tool for changing the composition of the current elite. The speed of the transition to the new model will depend on several factors, and one key factor is the amount of financial resources available to the regime.

Such a threat theoretically might incentivize large businesses to take collective action, as happened in 1996 amid fears of a communist victory in the presidential elections. However, the more likely scenario still seems to be the one from 2003 – when, during the crisis sparked by the Yukos case, large businesses were unable to collectively defend their interests. The difference now is that instead of receiving high incomes as compensation for 'political loyalty' (as in the 2000s or 2010s), Russian businesses will at best find themselves in conditions similar to modern Belarus with its state-controlled economy. Simultaneously, this would mean the destruction of the economic base that the Putin regime has relied on for two decades in its foreign and domestic policies.