By Richard Connolly, RUSI, 1/22/25
Russia’s economic resilience is defying expectations, enabling the Kremlin to sustain its war efforts in Ukraine despite mounting challenges, and raising doubts about hopes for a swift resolution.
Russia regained the momentum on the battlefield in Ukraine last year. Although Russian progress remains slow and costly, the outlook for the year ahead is bleak. Ukraine’s energy system has been heavily damaged by Russian air strikes, and its forces continue to lose ground in southern Donetsk, where the heaviest fighting is taking place.
Perhaps most importantly, political shifts in some of Kyiv’s key allies – especially the US – could result in crucial financial and military aid being substantially reduced in the year ahead. Together, these trends raise the prospect of Ukraine being forced to accept a crushing defeat after three years of heroic resistance.
Against this lugubrious backdrop, many analysts have seized on what appears to be a rare bright spot: Russia’s faltering ‘war economy’, which – according to some – is ‘Putin’s greatest weakness’. An acute labour shortage, persistent and rising inflation caused by soaring military expenditure, and ever-tightening sanctions will – it is claimed – finally bring about an economic crisis that will force Moscow to abandon its maximalist aims in Ukraine and bring about an end to the war on terms more acceptable to Kyiv and its allies.
Sadly, these hopes are likely to prove misplaced. Russia’s economy has confounded expectations throughout the war and, despite suffering several complications, remains well-placed to support the Kremlin’s ambitions in Ukraine and beyond.
Dashed Hopes…
This is not the first time that Kyiv’s supporters have placed their hopes in Russia’s economy proving to be its Achilles’ heel. In the early months of the war, analysts forecast that Russia would suffer a severe and long recession that would cause living standards to slump and the state’s fiscal resources to dwindle. Moscow, it was hoped, would be forced to make an embarrassing retreat with potentially fatal consequences for President Vladimir Putin and the ruling elite.
But these hopes were soon dashed. The imposition of capital controls, a surge in federal expenditure, and the successful reorientation of foreign trade at breakneck speed arrested the signs of economic distress observed in the first months of the war.
Although Russia did not avoid a recession in 2022, it was much shallower than expected (GDP fell by only 1.9%) as the economy adapted to its new circumstances. Growth exceeded nearly all expectations in 2023 (3.6%), with this momentum continuing into 2024. Output is likely to have expanded by 3.6–4% last year.
…Raised Again
Nevertheless, the quantitative expansion of the last two years has been accompanied by growing signs of weakness on several important economic indicators, raising questions over the quality and sustainability of Russia’s better-than-expected performance.
Mounting labour shortages, fuelled by the demands of war, are just one factor that threatens to derail growth. The massive expansion of the military and defence-industrial production has drawn large numbers of men away from the civilian labour force.
Although Russia undoubtedly faces significant challenges, there is little to suggest that these will result in any significant political consequences that might prompt the Kremlin to rein in its ambitions in Ukraine
Along with rising demand from other sectors of the briskly growing economy, this has caused the supply of labour to tighten considerably. Unemployment reached 2.3% in October, a post-Soviet record low. Maintaining the current rate of economic growth will only be possible if Russia utilises its existing labour force more efficiently.
Labour shortages are not the Kremlin’s only problem. Western sanctions and a shrinking trade surplus contributed to a sharp depreciation of the ruble last year, causing import prices to rise and amplifying inflationary pressures.
At the end of November, the Central Bank of Russia (CBR) recorded an annual inflation rate of 8.9%, well above the bank’s target rate of 4%. Even this rate likely understates the real extent of price growth, with some staple goods registering price increases in excess of 70%.
In an attempt to quell inflationary pressures, the CBR raised the key rate throughout the year, setting it at a post-Soviet high of 21% in October. Many businesses now find the cost of borrowing prohibitive.
Many analysts have attributed these signs of overheating to elevated spending on the war in Ukraine, pointing to record-high military expenditure which is expected to have reached over 7% of GDP in 2024. With defence spending expected to rise by nearly 25% this year, accounting for around 40% of federal government expenditure, some have raised the prospect of Russia slipping into ‘stagflation’, combining high inflation with low to no growth.
Finally, with new UK and US sanctions targeting Russia’s oil industry, and G7 states seeking to tighten the enforcement of the oil ‘price cap’, some hope that Moscow’s vital hydrocarbon revenues will be crimped even further, exacerbating the losses caused by the collapse of Russian gas exports to Europe and flagging coal sales.
Desperate but not Serious
Unfortunately, hopes of an imminent economic crisis are unlikely to be realised. Although Russia undoubtedly faces significant challenges, there is little to suggest that these will result in any significant political consequences that might prompt the Kremlin to rein in its ambitions in Ukraine.
The tight labour market has benefitted many Russians used to stagnant income growth in the decade before the war. Real wages have soared since 2022, fuelling the fastest sustained growth in consumer spending in over a decade. Soaring military production and record-high wages for soldiers have helped reduce some of Russia’s chronic regional inequalities.
Crucially, the absence of a large pool of latent labour need not constrain growth so long as labour productivity continues to rise. Russia’s low-productivity economy means that there are plenty of easy wins available for firms prepared to undertake simple organisational changes or investment in new machinery.
Inflation also has its advantages. Rising prices send important signals to firms to expand supply by investing in areas where prices are growing fastest. Investment – chronically low for most of the post-Soviet period – has grown faster than GDP since the war began. Rising prices have also helped swell public coffers, with turnover taxes like VAT growing at record levels and boosting the Kremlin’s fiscal position.
The CBR’s record-high key rate is not as damaging as it might be in a Western economy, either. Large swathes of Russian business – including those in strategically important sectors – can access state-subsidised loans at considerably lower interest rates. Even those firms unable to access subsidised loans will be able to use record-high retained earnings to finance investment.
Russian consumers have also benefitted from state support. Most mortgages offered during the recent housing boom were taken on at subsidised rates.
Even the extent to which Russia has a ‘war economy’ is exaggerated. While the broad NATO measure of military expenditure is likely to account for around 40% of federal spending this year, this will amount to closer to 20% of Russia’s consolidated state spending (that is, including both regional and national expenditure).
Although this is high, it is comparable to US military spending during the Vietnam War. The militarisation of the economy has undoubtedly grown. However, it remains well below the crippling levels observed in the ‘hyper-militarised’ Soviet economy.
Importantly, many of the features of true war economies – such as price controls, the centralised allocation of resources, and widespread nationalisation of private sector assets – have yet to appear in Russia.
Sources of Resilience
If Russia’s weaknesses are not as severe as many hope, its sources of strength and durability also remain impressive.
Take the country’s balance sheet. Despite fighting the most intense war in Europe since 1945, Moscow has managed to fund the war with staggeringly modest budget deficits of between 1.5–2.9% of GDP since 2022. As a result, the Kremlin has barely had to borrow to fund the war. At around 15% of GDP, Russia has the smallest state debt-to-GDP ratio of the G20 economies.
Despite being cut off from most external sources of capital, Russia remains more than capable of financing domestic investment and government expenditure with its own resources. Over the past two years, Russia has recorded a surplus on its current account – that is, the gap between aggregate savings and investment – of around 2.5% of GDP. For as long as Russia can continue to export large volumes of oil, this is unlikely to change.
Designed to ensure that the Kremlin can pursue a sovereign foreign policy against the interests of the collective West, Russia’s economic system is doing its job
Crucially, the Kremlin’s fiscal position remains very healthy. Tax revenues generated by domestic activity have soared since the war began. Oil and gas revenues are forecast to account for 28% of federal government tax receipts in 2024, significantly lower than the 53% recorded in 2018.
Even if export revenues slump, perhaps due to a looming trade war or China’s spluttering economy, Russia has plenty of resources it could tap to maintain elevated levels of state spending. The largely state-owned banking system is sitting on piles of cash that could be paid as dividends to their owner: the state. Banks could also be directed to buy government bonds, as they were at the end of 2024. If all else fails, the CBR could buy government bonds.
Importantly, Russia’s resilience is not purely financial in nature. The foundations of the market economy built in the turbulent 1990s remain strong. Much of Russia’s unexpected adaptability has come not only from its well-trained and professional economic managers, but also from its large and growing class of private business.
Accustomed to operating in an often hostile and challenging business environment, privately owned firms have exploited the opportunities created by sanctions to supply soaring demand from the government and consumers. The number of registered private businesses has grown briskly since the war began, reaching a record high in 2024. It is this strong base of commercially oriented firms that will enable Russia to continue adapting to sanctions and the demands of war.
Calibrating Expectations
To be clear, Russia’s economic prospects are far from rosy. Property rights remain weak, and the state’s role in the economy is high and growing. The vagaries of the international oil market always retain the potential to generate a strong external shock. Western sanctions will also continue to raise the cost of doing business and restrict the flow of know-how to Russian businesses. As a result, Russia is unlikely to join the ranks of high-income countries any time soon.
However, the country’s poor long-term prognosis should not lead us to overlook its short-term resilience. Throughout its 500-year history, Russia’s economic system has rarely delivered broad-based growth or economy-wide innovation for long. Instead, the needs of the market have usually been subordinated to the needs of the state, often to enable the Kremlin to pursue security-related objectives.
Today’s system is no different. Designed to ensure that the Kremlin can pursue a sovereign foreign policy against the interests of the collective West, it is doing its job. The market is strong enough to give the system adaptability and dynamism. And the state is strong enough to ensure that sufficient resources are mobilised towards achieving its security objectives.
For as long as this equilibrium remains intact, Russia will be able to generate the necessary economic resources to sustain enough military power to wage war in Ukraine and, over the longer term, to rearm for a prolonged confrontation with the West. Any hopes that its economic vulnerabilities will bring it to the negotiating table are therefore unlikely to be realised.