Note: KSG will release an assessment in August 2024 of Russia's economic activity in Africa and South America to supplement this report.
Key Takeaways:
Russia’s transition to a war economy has been successful in the short term, with economic growth driven by government investment in defence (and related) industries. However, high levels of government spending are highly likely unsustainable in the long term and leave the Russian economy exceptionally vulnerable to shocks to the global oil and gas markets.
However, the Russian economy faces two significant challenges as it risks overheating: labour shortages and high inflation.
KSG assesses that the Russian Central Bank is highly likely to raise interest rates in July 2024 to curb inflation; however, underlying economic challenges are likely to persist. Labour shortages are highly likely to continue into the long term; this is likely to be one of the primary (and most difficult to resolve) threats to Russian economic security.
Russia has become highly reliant on China for trade; Russia has also been actively seeking to strengthen its economic and political partnership with India. KSG assesses that Russian engagement in these regions is unlikely to signal growing Russian influence, instead representing a reorientation to focus on Russia’s available import-export markets and alliances.
The primary risk for business leaders and Western policymakers is China’s concomitant ascent in economic and international political power, with Russia increasingly becoming the junior partner in the Sino-Russian relationship.
Post-February 2022 Economy
Russia’s apparent economic resilience has broadly taken economists and policymakers by surprise. Russia has defied expectations of economic collapse in the face of broad and far-reaching economic sanctions; however, KSG assesses that positive growth figures are highly likely unsustainable, and are a misleading reflection of economic performance.
Prima facie, the data suggests a relatively favourable economic situation since the 2022 invasion of Ukraine. Despite ditching the economic orthodoxy followed after the 1998 financial crisis (characterised by prudent macroeconomic policy and integration with global markets), many traditional economic indicators suggest a positive economic outlook:
Russian GDP grew from $1.84 trillion in 2021 to $2.27 trillion in 2022 before falling slightly to $2.02 trillion in 2023.
Growth in Russian GDP led the International Monetary Fund (IMF) to upgrade its 2024 growth forecast for Russia from 1.1% to 3.2% in April 2024.
Unemployment has fallen to record lows, from 4.7% in 2021 to 3.1% in 2023.
The Russian State Statistics Service records a 5.8% growth in real incomes in 2023.
Russian Federal Tax Service data reveals that income tax revenue was 40% higher in 2023 than in 2021.
These indicators suggest that sanctions have failed to hamper Russian economic growth and apply pressure on Russian consumers.
Labour Supply and Inflation
However, this positive outlook obfuscates the unsustainable impetus behind the state’s economic growth – military-related spending. Russian military expenditure grew from 3.6% of GDP in 2021 to 5.9% in 2023 and is projected to account for 7% of GDP (around $140 billion) in 2024; defence spending will exceed social expenditure for the first time in modern Russian history.
Economist Alexander Kolyandr summarises the Kremlin’s economic dilemma:
“The government can’t cut spending as long as the war continues. The war, however, saps the labour force, fuelling inflation and diminishing both welfare and public sentiment. And high interest rates, necessitated by all that inflation, stifle investment in productivity and further distort the economy.”
Military expenditure is directed primarily at the factories (now working at full capacity) manufacturing goods necessary for the war effort, construction in the occupied territories, salaries (and substantial bonuses) for contract servicemen and defence-sector workers, and compensation for bereaved family members. According to Russian Federal Tax Service data, incomes rose substantially between 2021 and 2024 in traditionally middle-low income regions where military production and construction are the primary employers. High salaries indicate increased demand and competition for workers; however, demand is not only driven by competition with the defence manufacturers – the Russian labour market has suffered a considerable decline in supply since February 2022.
Military recruitment and emigration drive the increased pressure on the Russian labour market. According to official statements, 490,000 contract soldiers were recruited, and 244,000 were mobilised in 2023 alone; the personnel ceiling of the Russian armed forces now stands at 1,320,000. In January 2024, Vladimir Putin stated that Russia had over 600,000 active personnel in Ukraine, although observers estimate the number to be closer to 470,000. Paired with the drain of having a large number of fighting-age men serving in the military and not working in civilian sectors, British Defence Intelligence estimates that the Russian armed forces have sustained 465,000 casualties since February 2022 – a considerable and irreversible drain on labour supply. Moreover, 820,000-920,000 Russian citizens are estimated to have left the country since February 2022 (although some may have returned). As a result, the Russian economy is now short an estimated 4.8 million workers.
Moreover, the decline in labour supply, increased labour costs, and high levels of defence-related government spending (also taking the form of preferential loans) have all contributed to high inflation, which stands at 8.6% in July 2024, up from 4.3% in July 2023 and over double the Russian Central Bank’s target of 4%. Mounting inflation suggests domestic producers and service providers struggle to match rising consumer demand, buoyed by record employment levels and military factories operating at full capacity. This indicates that some sectors of the Russian economy are running the risk of overheating.
The Russian Central Bank is aware of this. It is working to mitigate the risk of overheating by keeping interest rates elevated at 16% (even higher than the Ukrainian rate of 14.5%) to curb consumer demand and borrowing to reduce inflation. However, with inflation showing no signs of abating, KSG assesses that at its next Board meeting on July 26th, the Russian Central Bank is highly likely to raise interest rates to 17-18%. This assessment is based on the discussion at the previous board meeting in June 2024, which decided against raising interest rates immediately, opting to wait for further economic data to emerge before elevating the key rate. However, given that inflation is driven mainly by state-military spending and a diminished (and ever-declining) labour supply, a further elevation of the key interest rate is unlikely to reduce inflation significantly (if at all).
KSG assesses that while high interest rates will shrink real incomes and deter investment (without having a significant impact on inflation), Russia is likely to avoid a severe recession (or economic collapse) by continuing to draw capital from its National Wealth Fund ($34 billion was withdrawn to cover the budget deficit in 2023), raising taxes, and collecting revenue from oil and gas exports to sustain economic activity.
This approach is highly unlikely to be sustainable; growth relies on government spending, leaving the Russian economy over-exposed to global oil prices. If Urals (Russian oil) falls below its 2023 average of $62.99 per barrel, the liquid reserves of the Russian National Wealth Fund could be exhausted by the end of the 2025 budgetary year.
Labour shortages are highly likely to persist and grow larger as the war continues. This issue represents a serious challenge to Russia’s future economic development, as it is unlikely that shortfalls in labour can be substituted by migrant workers, mainly migrating from Central Asia. Firstly, this is due to the scale of the shortfall. Secondly, the sharp rise in anti-migrant views among the Russian public since 2022 (and the Crocus City Hall terrorist attack in March 2024) makes it an unpalatable solution that would likely generate domestic political instability.
Russia's Global Influence
Naturally, Western political and economic sanctions have required Russia to reorientate its focus on to ‘neutral’ states; therefore, since February 2022, Russia has strengthened economic and political ties with states such as China, India, Iran, (Taliban-led) Afghanistan, and North Korea, in addition to several Sub-Saharan African nations.
KSG assesses that Russia’s strengthening of economic and political ties with these states is unlikely to represent a growth in Russian global influence; instead, such manoeuvres are more likely to constitute a pragmatic shift towards the potential international partnerships that remain available to Russia.
Despite prevailing rhetoric surrounding the creation of a global multipolar bloc (to rival Western hegemony) through BRICS, India and China likely view trade with Russia as an economic opportunity to obtain cheap resources and expand export markets; India and China are unlikely to desire a more substantive security-based relationship with Russia.
Moreover, due to Western technological and financial sanctions, Russia’s transition to a war economy and the associated likely economic difficulties, KSG assesses that Russia’s leverage in its international engagements has significantly deteriorated since pre-February 2022.
China
Since February 2022, Russia and China have continued to build a close political relationship, underscored by deepening economic ties. Bilateral trade between Russia and China has increased substantially as Russia has sought new markets for its fossil fuel and raw material exports while substituting US-European imports. Chinese customs data recorded that Sino-Russian bilateral trade reached $240 billion in 2023, up from $145 billion in 2021; 31% of Russia’s exports now go to China, while Chinese goods account for 37% of Russia’s imports. However, KSG assesses this relationship as asymmetric, representing growing Russian reliance on China.
Firstly, Russia is now heavily reliant on China (and India) as an export market for its fossil fuels and raw materials – China is now the largest importer of Russian fossil fuels.
Between 2021 and 2023, Russian oil exports to China have risen from 1.6 million barrels per day to 2.3 million per day.
Pipeline gas deliveries exceeded the contracted volume by 47% in 2023 and are expected to reach 30 billion cubic meters in 2024.
China has also purchased 20% of Russia’s LNG and 47% of Russia’s total coal exports since December 2022.
Secondly, Russia has become reliant on imports of advanced and dual-use technologies from China in the face of far-reaching Western sanctions.
China went from supplying 32% of Russia’s dual-use technologies in 2021 to 89% in 2023.
China more than doubled its exports of semiconductors to Russia in 2022, directly exporting $179 million worth, with more shipped indirectly via third-party countries.
China has become Russia’s leading machinery supplier, with monthly exports averaging $3.377 billion in 2023.
Plastic and rubber exports to Russia averaged $560.6 million per month, while chemicals averaged $527.81 million per month in 2023.
The high variance in Sino-Russian trade complexity and comparative advantage that China has in most manufacturing sectors suggests that the trading relationship is heavily skewed in China’s favour; Beijing can purchase relatively cheap Russian fossil fuels (enabling China to diversify its energy portfolio) whilst exporting dual-use and civilian goods to what has essentially become a captive market in the face of Western sanctions.
This economic asymmetry has manifested in Russia making extraordinary geopolitical concessions to China. During his plenary speech at the 2023 Eurasian Economic Forum, Putin suggested that he was supportive of integration between the Chinese Belt and Road Initiative and the Eurasian Economic Union (EAEU) – a highly significant statement as the EAEU is a customs union that was initially designed to limit Chinese influence in Russia’s ‘sphere of influence’. KSG assesses that this highly likely signals a growing understanding in Moscow that Russia has few remaining options but to strengthen ties with Beijing – on Chinese terms. Therefore, Russian reliance on Chinese trade and capital negatively impacts Russian geopolitical (and economic) leverage in Central Asia and other global theatres.
India
Similarly to China, India has sought to pursue a ‘non-aligned’ foreign (and trade) policy vis-à-vis Russia and the Western response to its full-scale invasion of Ukraine. As was previously set out by KSG, India-Russia relations have remained amicable since February 2022. At the recent joint summit, leaders of both countries reaffirmed a mutual desire to strengthen economic and political cooperation. However, unlike the Sino-Russian trading relationship, currently, India is primarily an export market for Russia – Indian exports to Russia amounted to $4.26 billion in 2023-24, while Russian exports to India totalled $61.44 billion. Despite the rhetoric of strengthening ties, KSG assesses that Indian-Russian economic relations remain vulnerable to pressure from Western nations and are more likely to represent economic pragmatism than a genuine swing by India towards deepening ties with Russia.
A significant proportion of Russia’s $61.44 billion in exports to India in 2023-24 was represented by increased crude oil exports driven by Western sanctions on Russian fossil fuels. In May 2023, Russian crude oil constituted 40% of India’s total crude imports; following the full-scale invasion of Ukraine, Russia has displaced Iraq as India’s top supplier of crude, while India is now Russia’s second largest market (behind China) for crude oil exports and fossil fuels as a whole – in 2021 Russia exported only 0.1 million barrels per day to India. Therefore, India has taken a key role in importing and (crucially) refining Russian crude.
Since 2022, India has purchased Russian crude at a significant discount, refined it domestically, and sold it on the global market (often to Europe), at which point it is impossible to determine the product’s original source; thereby, some Indian businesses have effectively enabled Russian oil companies to circumvent sanctions. Moreover, to evade enforcement of the oil price cap (which limits the price of Russian crude to $60 per barrel), some traders have purchased ageing vessels registered to shell companies to transport Russian oil (under regularly changing flags) and trade above the $60 per barrel price cap – known as the ‘shadow fleet’, there are an estimated 591 of these vessels globally, and many operate in India.
However, despite India’s crucial role in enabling Russia to continue its global oil exports, there are indications that New Delhi is cautious in avoiding overly committing to Moscow; this trend is especially pronounced in the sphere of defence cooperation. India is traditionally the world’s largest arms importer. However, Russian arms exports to India have been declining consistently since 2009-2013, from 76% (of Indian arms imports) to 36% between 2019-2023. Although the most recent drop is partly attributable to a sharp decline in Russian arms exports as a whole, driven by domestic demand since February 2022, Indian defence officials have expressed an unwillingness to commit to purchases beyond what is necessary to maintain the existing kit. Concerns over Russian arms' quality, performance, unpredictable cost and delivery time drive this hesitance.
Moreover, New Delhi is keen to maintain and strengthen emerging defence and trade ties with France, the US, and other Western nations. After becoming the largest recipient of French arms exports 2019-2023 and India signing a landmark agreement in 2023 for Hindustan Aeronautics to manufacture jet engines alongside General Electric, strengthening defence cooperation with Russia would likely be diplomatically problematic. These developments contextualise India’s move away from importing Russian arms; given the geopolitical tensions between Russia and the West, New Delhi understands that maintaining close defence ties with Russia is highly likely to limit the willingness of Western states to cooperate with India. Therefore, KSG assesses that Indo-Russian defence cooperation is highly likely to decrease steadily as India seeks to develop and procure more technologically advanced arms (and technology-sharing) through more predictable defence partnerships with Western countries. Conversely, KSG assesses India’s refocusing on arms technology-sharing and trade with Western nations as highly likely to create significant opportunities for Western arms manufacturers to invest in Indian projects and potentially carry out production in India.
Looking Forward
1 KSG assesses that the Russian economy will highly likely face significant challenges in the coming two years, regardless of the outcome of the war in Ukraine.
Labour shortages will almost certainly persist in the long term, and inflation is unlikely to subside until the government curbs high spending.
Russia’s new wartime economic model is reliant and over-exposed to shocks in the global oil market – a drop in global oil prices or high-scale impediments to Russian extraction are highly likely to create significant economic instability in Russia.
If and when the economy is transitioned back to a civilian economy, growth is highly likely to cease (and will likely regress) as levels of state economic intervention will return to pre-February 2022 levels.
Russia is highly unlikely to attract significant post-war foreign investment due to its potentially limited economic prospects, but largely because most capital will be concentrated on Ukrainian reconstruction and economic development.
2 Russia is highly likely to continue directing its natural resource exports to India and China.
However, new and updated sanctions (especially secondary sanctions targeting Indian and Chinese financial and corporate services) would elevate the risk of such transactions, likely discouraging Indian and Chinese businesses from dealing with Russian imports.
3 Although Russia will inevitably continue importing dual-use technologies and consumer goods from China for the foreseeable future, Russia will likely seek to increase imports from India.
Such a strategy would enable Russia to somewhat de-risk from the Chinese market while strengthening ties with India in cooperation outside defence.
In such a scenario, Indian companies in the manufacturing and agricultural sectors will almost inevitably reap monetary benefits.
4 Russia is highly likely to continue pushing for the expansion of the International North-South Transport Corridor to connect Russia to India via Iran.
As a result of the pressures that Russia is facing from Western sanctions, fully establishing this route is highly likely to be a priority for the Kremlin.
Similarly, Russia is highly likely to urgently seek the construction of the Chennai-Vladivostok maritime corridor to consolidate flows of Russian resources and raw materials to India.
However, given war-related fiscal constraints, it remains to be seen how Russia will finance these products.
It is unlikely that these projects will come to fruition in the foreseeable future, as financing is uncertain, and India may not see the upside in deepening ties with Russia outside of rhetoric.
5 Overall, KSG assesses that Russian partnerships with India and China are unlikely to withstand significant Western pressure, whether through incentivisation or punitive measures such as secondary sanctions.
India has already shown signs of taking a pragmatic approach to arms imports, deciding to substitute Russian exports with equipment from the geopolitically antithetical West.
Despite India’s soaring imports of Russian crude following February 2022, tighter US enforcement of sanctions on Russian oil in May 2024 led to a spike in Indian imports of US crude.
This suggests that more stringent sanctions enforcement will likely make Indian oil buyers rethink their sourcing.
Moreover, despite China’s similarly soaring imports of Russian natural resources following the full-scale invasion of Ukraine, China is likely to prioritise trade with the US and Europe over Russia; the latter constitutes only 5.1% of Chinese imports and 3.3% of Chinese exports.
Following the US’ imposition of secondary sanctions in late 2023, targeting financial institutions servicing Russia’s defence sector, many (medium-large sized) Chinese banks stopped accepting Russian payments entirely to mitigate risk.
Although this issue has been resolved (a circumvention has been identified), the quick response to cut off Russian clients indicates that Chinese financial institutions are more concerned about being cut off from the US (and wider global) market, suggesting that there are limits to the ‘no limits’ partnership.
By KSG's Chief Analyst