The Western sanctions imposed against Russia in response to its full-blown invasion of Ukraine were not just designed to put a cost on Moscow’s actions, but also to stem the flow of materials and money enabling it to wage war. Why did this hope fall short, and how is Putin’s wartime economy faring as we approach 2024 and the second anniversary of the invasion? What do we know of the current state of the Russian economy, and what indicators can we use to plot its trajectory?
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Alexander Gabuev. Welcome to Carnegie Politika podcast. My name is Alexander Gabuev. I'm director of Carnegie Russia Eurasia Center in Berlin and the host.
The war is approaching its sad second anniversary, and we've all been surprised about many things. First, that this war is even possible. But there are many surprises that continue to unfold.
One of the major miracles and unexplained realities is the remarkable resilience of the Russian economy. When the West has introduced sanctions against Russia immediately after the full-blown onslaught on Ukrainian territory, the hope was that the sanctions will attach costs to Russia's behavior, but at the same time will be also able to stop the flow of materials and money to Putin's war chest and impact the Kremlin's decisions and probably it would stop the war, but it never materialized.
Today we're going to talk about why that happened and how Putin's war economy doing going into 2024? What should we expect?
We have a terrific guest to help us unpack this reality. My colleague Alexandra Prokopenko, who is a non-resident scholar at Carnegie Russia Eurasia Center, and she's also working for ZOiS and German Council for relations (DGAP). Before the war she has been senior advisor at Bank of Russia, Russian Central Bank and had a journalistic career working as the Kremlin reporter for multiple Russian publications, including Vedomosti, back then a very reputed business newspaper.
A very warm welcome, Alexandra!
Alexandra Prokopenko. Hello, Sasha. Very nice to hear you. Very nice to meet you here.
Gabuev. Before you left Russia, you've been employed by the Central Bank, which seems to be the ivory tower, or the castle of competence inside the Russian bureaucracy. All the time that I’m discussing Russian politics with Western interlocutors, my main point is that if you are looking for Team A within the Russian bureaucracy, don't look at the Russian military or Russian intelligence, look at the Central Bank. That's where the most competent people are employed.
You were among the few officials who resigned and left the country. Not many of your peers, be it in the Central Bank or other ministries, have followed the same trajectory. They've stayed and probably the fact that these competent people are still working for the Russian government is one of the secret souses behind the remarkable resilience of the Russian economy.
How do you explain the fact that many Russian bureaucrats chose to stay, even though, as we know from our conversations, many of them do not approve of Putin's war?
Prokopenko. As you said, the central bankers are the most competent part of Russian bureaucracy, or as we might refer to it, the Russian public services. You are correct that unfortunately not so many people who serves in the public sector resigned and left Russia. But there are multiple reasons behind that.
First, I need to say that it's a personal choice. I've made my own decision based on my career, destiny, and life. I don't judge those who stayed, those who left, or even those who changed their views, going from neutral towards the authorities and Putin's regime to fully supporting what's happening now. And honestly, I was very sad to know that.
When speaking about the system as a whole, it's important to admit that besides personal career, people in public service, be it in the US, Europe, or elsewhere, are also making a moral choice. If we speak about a moral career in Russia, I would say excessive reflection and morality within the system is often a disadvantage, as it distracts from focusing on results.
Why Russian bureaucrats are so effective? They are very focused on results. The secret sauce of being effective here is efficacy and loyalty. When people enter public service in Russia, they know they must make various moral compromises. Each compromise is seen as a necessity in order to continue their career, maintain their position, improve their status, and be useful, or in simple words, to remain effective. That's a very important ingredient of the recipe explaining why they've stayed.
The second important reason is that no one from top bureaucrats resigned and left. There are multiple reasons behind that. One of them is simply fear. People are afraid of being prosecuted or detained or having their team members followed by the Secret Service. They all are intimidated by the FSB (Russian acronym for Federal Security Service): [head of the Central Bank of Russia Elvira] Nabiulina, [the Minister of Finance Anton] Siluanov, [the Minister of Economic Maxim] Reshetnikov, [the Prime Minister of Russia Mikhail] Mishustin. All of them remain. People on the lower floors, seeing their chiefs still in position, also copy this kind of behavior.
It's also important to note that personal sanctions are playing a role. Many people are now on the sanctions list simply because they work in the Russian public sector, or because their position requires them to attend Putin's meetings, leaving them no way to avoid sanctions. People are frustrated, and I think that anti-Western sentiment is growing, which is also good for Putin and bad for the West. It doesn't play on the Ukrainian side, and for the sake of victory.
Gabuev. I also know a couple of stories where working for the Russian bureaucracy on topics that are “vegetarian,” very far removed from the war, like climate change or digital governance, is really a kiss of death. This track record of being employed by the Russian state makes people unemployable, even if they choose to leave Russia. It serves as a warning to everybody else in the Russian bureaucracy about whether they should abandon their posts and seek employment somewhere else, as people will be deemed unemployable anywhere in the global economy because of this track record.
I can understand the fear, given how many mysterious incidents where people are falling out of windows in protected hospitals are happening, and these cases remain uninvestigated. Perhaps some of them are real suicides, and maybe some are actual accidents.
Prokopenko. Who knows?
Gabuev. Who knows! It's true.
I think the competence of the Russian bureaucracy, including central bankers, is one ingredient. However, the resilience of the Russian economy could not be explained solely by the quality of human capital. Without a robust and resilient economy or other contributing factors, I don't believe that genius alone can turn it around and make the economy work the way the Russian economy has.
How do you explain the fact that, now in the second year of the war, after all possible sanctions over the last 18 months, the Russian economy is in growth territory? Putin predicts 3.5 percent growth, and the IMF predicts 2.2 percent, but it's still growth despite all the possible sanctions. How do you explain that?
Prokopenko. First, let's go back to February 2022 and see in what shape the Russian economy was just before the war. It's important to keep in mind that it was in very good shape. The country was experiencing a recovery after the pandemic, with GDP in the first quarter growing at 3.5 percent. Citizens' wages, credit mortgages, and spending were on the rise. The population, tired of the coronavirus, was spending aggressively, leading to robust figures in domestic demand. Additionally, tourism and transport were recovering. Unemployment was at historically low levels, a figure we’ll revisit later.
The main external risks for Russia were considered to be the tightening of monetary policy by developed countries due to inflation, which could have spillover effects on the Russian economy and the economies of emerging countries. Additionally, there were concerns about possible new strains of the coronavirus.
The unprovoked full-scale invasion of Ukraine rapidly turned this bright picture into a bleak one. However, here, we need to stand and examine precisely what Russian financial authorities have done.
First, they were prepared for sanctions. The Russian government, presidential staff, and state businesses conducted stress tests. However, of course, no one expected that the West would play its best cards with the first sanctions package. What was done by the Ministry of Finance and Central Bank in response? They essentially put the Russian economy into an artificial coma by raising the key rate to 20 percent. Additionally, they imposed temporary capital controls, compelled exporters to sell export revenues, and prohibited non-residents from leaving Russian markets. This was in response to the freezing of Russian Central Bank Reserves.
We need to admit that from the Western point of view, freezing Russian reserves was a very effective symbolic gesture and measure. However, if you're implementing inflation targeting, excessive reserves of the Central Bank may not be necessary because of a floating exchange rate that adjusts itself to fluctuations. Reserves can be used to mitigate volatility, but basically, they might not be needed.
All these actions by Russian financial management were timely and bold. They allowed the Russian economy to sustain itself, combined with the excessive revenues from oil and gas. As we remember, the West stopped buying Russian oil and gas very late due to global concerns over rising prices and possible distortions in the energy market.
This combination of factors allowed the Russian economy to sustain itself in 2023 and gave time to Putin, the government, and Russian businesses to adjust their strategies, turning to new markets, mostly China and India. It's worth noting that Turkey is a significant buyer of Russian energy resources, and Eastern European countries are importing a substantial amount as well.
The year 2022 was a period of adjustment to sanctions, and in 2023, we saw the results of these adjustment policies combined with increased military spending. As we come to the end of 2023, the Russian economy is showing bright figures. However, behind them, there's an overheating of the economy, essentially meaning a deduction from the future.
Gabuev. Let's take a step back. I totally agree with you that 2022 was still an abnormal year. For most of the year, Russia enjoyed windfall profits from still being able to sell hydrocarbons to Western markets. Russia turned off the tap on natural gas in late summer, and the oil embargo was introduced only in December. So, Russia really pocketed a lot of petro euros and gas euros in 2022, and then the adjustment was unfolding.
Prokopenko. And also, dollars and yuans...
Gabuev. That's true, and pounds. Early this year in 2023, you remember that the Russian budget went into deficit with a lot of military expenditures. Most likely, the figures on Russian budget expenditures were really alarming. Towards the end of this year, we see that the budget deficit is around one percent of GDP. These figures are not that alarming at all. Why is that? What has happened?
Prokopenko. It's quite easy to answer. At the beginning of 2023, we witnessed advanced payments that the Russian government made to enterprises, mostly in the industry serving the military and the frontline, but also in the construction industry. So, they used advanced payments in their business models.
It was very unusual the way Russia distributed the budget money within the economy. In previous years, the majority of spending occurred in the fourth quarter, not the first one. This was quite new, and it put Russia-watchers in a position where they started predicting huge deficit numbers and other challenges for the Russian economy. However, we then saw that the pace of state expenditures within the year flattened. In the middle of the year, Russia became able to circumvent the oil price cap and oil sanctions. Russian exporters adjusted their strategies and created a huge shadow fleet, allowing them to transport oil to customers without worrying about the price cap. This also improved Russian incomes from oil and gas.
Now we witness how the Russian deficit will exceed a little bit, I think one percent. We don't know the whole expenditures Russia will try to make in this December. I need to remind that in 2022 there was a huge payment to the social fund. That’s a fund that combined the pension fund and social fund. Probably they can consider doing something this year. Maybe some payments to the population can be expected in December because Putin is running for elections in 2024. This combination of factors brings the economy to the point where we are. And in terms of figures, it's quite good.
Gabuev. Russia has just passed a new budget where nearly 40 percent of expenditures are military expenditures and expenditures related to internal security. For the first time since the collapse of the Soviet Union, Russia is spending about six percent of GDP on defense. This is a huge number.
How do you explain the priorities for the budget? What is the budget telling us about what Putin wants to spend money on? How sustainable is this new budget construction? Can Russia afford this military defense spending?
Prokopenko. We need to admit that, for the first time in Russian modern history, military expenditures have exceeded social spending. Social spending next year is planned to be less than five percent of GDP. Military expenditures, and that's only the Defense Ministry’s budget alone, will amount to 10.8 trillion rubles, which is, as you correctly said, six percent of GDP. However, I would recommend combining this spending with expenditures on national security, which exceed 3.5 trillion, making it all together about eight percent of GDP that Russia is going to spend on the so-called siloviki.
This is the combined budget of the Ministry of Defense, Rosgvardia (The National Guard of the Russian Federation), FSB, and the penitentiary system, and it is substantial. We have never witnessed that before, and we don’t see same figures in the projections for 2025, which I also don't believe yet, I think the Russian Ministry of Finance will revise them significantly.
It is important to understand what is within military expenditures. We see about two to three times growth in purchases of weapons and military equipment, inflation on arms and military equipment (which was about 20 percent, quite correlated with the prices of industrial manufactures), payments to personnel, which are growing, and payments to the wounded and families of the dead. All this amounts to 10.8 trillion rubles, which is a lot.
The priorities of the 2024 budget include continuing the war with Ukraine and national security. There are also the four so-called “new regions,” the annexed territories, that Russia plans to “develop.” In 2023, the head of Rosfinmonitoring (The Federal Financial Monitoring Service of the Russian Federation), Yuri Chikhanchin, revealed that they spent 1.7 trillion rubles, which is approximately 18 billion dollars, on these annexed territories. I think they will continue this level of spending. These are the priorities.
Are they sustainable? This is a very good question because the budget has a very bold assumption of high oil prices. They predict that Brent oil price would be approximately 85 dollars per barrel, the average oil price. This means that Urals price would be approximately 70 dollars per barrel. They also predict economic growth, the economy itself will produce taxes, and they will collect them to finance the war and social spending. It's important to keep in mind that the Russian Financial Ministry is financing military and social spending from what they get from non-oil and non-gas revenues.
They predict very low inflation, which I don't believe is possible with the 22 percent expenditures growth. It cannot be combined with a 4.5percent inflation rate by the end of 2024. There is also a bubble in the mortgage and construction sectors, which Russian financial authorities will need to address somehow in 2024.
If the situation remains relatively the same—with the same level of sanctions pressure, and oil prices staying stable—Putin will be able to get through 2024 with the resources he has. The sanctions have isolated the Russian economy from most external shocks.
However, if there are changes in oil prices, or if the Russian authorities experience some economic success, they might decide to make unexpected expenditures on various projects. This could also bring some distortions to the current design of the budget and the overall performance of the economy.
Gabuev. What about the labor market? I assume, that given the outflow of the workforce due to people's exodus—nearly 500,000 have relocated from Russia, including competent, well-educated workforce—and the large number heading to the front lines due to the cashouts, government financial incentives and demand in the military industry, Russia should be facing a labor shortage, given its demographic situation. How is the government addressing that?
Prokopenko. I don't think the government has a lot of options to address that. They know about the problem and regret it, but they can't attract migrants in the necessary amounts to fulfill vacancies for multiple reasons. Migrants are usually low-qualified workers, and there's a fear they might be moved to the frontline, something they don't want. Plus, in their countries, they could be prosecuted for serving in this war. Secondly, they cannot hire migrants in the expanded military-industrial complex because non-Russian citizens are not allowed to work in this kind of industry.
The only way Russian businesses are addressing this problem is by raising wages. These growing salaries need to attract people, for instance, to stay in the industry. In terms of the individual, the situation is quite favorable for workers because they feel quite confident. I wouldn't say they feel confident about tomorrow, as they're spending money. We're seeing a boom in consumer spending. People are not saving much; they're buying new cars, apartments, and doing renovations, just because they have no confidence in tomorrow. That's their strategy to improve their well-being.
In terms of the economy, labor shortages are a limitation to future growth. This is the same limitation as export revenues, which are not growing. There's not much the Russian government can do; they don't have many options. And of course, the war takes away young and capable men, young and capable workers. I wouldn't exaggerate the importance of brain drain because it's only about 500,000 people, and partly they are still employed by Russian companies. But combined with everything else, and with the expanded military-industrial complex attracting people from civil sectors, I would say the situation is quite bad and unbalanced.
Gabuev. To finish this up, you've drawn a picture that is sustainable and that most likely gives Vladimir Putin resources to continue this war definitely in the next year without major disruptions, but probably for two or three years as the resources will be there.
Help me understand what kind of long-term problems this current policy will create for the economy. What dilemmas are your former colleagues and other capable managers in the Russian economic bloc facing going forward in the next three to five years?
Prokopenko. First, there is no planning for three to five years in Russia. Their timeline horizon is quite short, and if someone claims to predict what will happen at the end of 2024, I would say that probably this person is a liar. No one knows. A lot depends on what's happening at the frontline and how the situation will go there. That also makes all predictions very shaky and weak.
I see that Putin is now trying to solve a trilemma. He needs to continue war spending, because around the military expenditures, I would say, the economy is on a “war needle.” The current pace of GDP growth is mostly because of these war expenditures, which basically means that once the Russian state stops spending on the war, the growth will stop or slow significantly. You need to maintain these kinds of nonproductive expenditures, which bring inflation to the economy, and the Central Bank needs to keep interest rates high for longer. Next year, the key rate will be in double digits. It's also a sign that the economy is not healthy. If you have a healthy economy and moderate, sustainable growth, you don't need a double-digit key rate. You don't need such costly money within the economy.
Secondly, it's very important to maintain the appearance that everything is going according to plan, that there is a contract with the population, and that he is still delivering. War is not a global war, but it's still a “special military operation,” and people can continue their lives as usual, business as usual.
And third, of course, is macroeconomic stability. Some decisions, like imposing capital controls or breaking the budgetary rule, which was not only about saving extra revenues from oil and gas but also limited government spending. Abandoning these institutions means that in the future it will be more complicated for the financial leadership, for the Kremlin, and for Putin to deal with future shocks. And the economy constantly faces different shocks.
At the moment, the economy looks resilient. But it's like Putin navigates it the way he navigates his yacht, as if it's an icebreaker. But it's not.
Gabuev. You said that whoever making a prediction about what will happen in Russia towards the next year is most likely doesn't really know what he/she’s talking about. There are many moving pieces, and the situation is dynamic. We should reconnect toward the end of next year to compare notes and see what has happened. I'm very grateful for your time, Alexandra.
Prokopenko. Thank you, Sasha. Thank you for having me here. My pleasure.
This transcript was generated automatically.
