Despite predictions that the Russian military budget had reached its peak, the recently announced 2025/26 budget shows otherwise. To keep the war machine oiled and functioning, the Russian government is once again raising military spending substantially to levels not seen since the collapse of the Soviet Union. Some in the Russian elites believe that ongoing high demand in the military industrial complex will expedite economic growth. Several miscalculations by the West and a lack of massive military achievements from Ukraine have allowed the Russian economy to withstand the pressure of sanctions. But how sustainable is the current economic strategy, and how long can Putin fund his atrocious war while damaging crucial yet vulnerable economic sectors like healthcare, education, and science?
This transcript was not edited prior to publication:
Alex Gabuev. Welcome to Carnegie Politika Podcast. My name is Alexander Gabuev. I'm director of Carnegie Russia Eurasia Center in Berlin. We're going to talk about Putin's war economy and the Russian budget that the Kremlin is rolling out this week. The Russian government is announcing the major figures of the budget and to discuss that, the state of the Russian economy and the medium and long-term trajectory I'm joined today by two excellent economists, some of the leading voices on the Russian economic policy, Carnegie's very own Aleksandra Prokopenko, Former Senior Advisor at the Russian Central Bank and fellow at Carnegie Russia Eurasia Center in Berlin. Welcome, Sasha.
Alexandra Prokopenko. Hi
Gabuev. and Alexander Kolyandr, who is a non-resident senior fellow at CEPA and has a very long and illustrious career covering Russian economy in major Western media including Wall Street Journal and investment banking including Credit Suisse. Welcome Alexander.
Alexander Kolyandr. Hello.
Gabuev. Let's start head on. What do we know about the new Russian budget and what are the major figures in it. I remember that a year ago when the budget for 2024 was introduced that had really the record high military expenditures and the planning for year of 2025 and 26 was that military expenditures will go down. A lot of analysts said, well, that's the peak of the Russian military expenditures. They cannot afford to spend so much on national security and defence. And it's only natural that these figures are going down. But what we know by now is that instead of going down, the military expenditures are going up. So, what's caught your eye, Alexander? What's really and important in the new budget?
Kolyandr. I would say you the most important in this budget is that the Russian government continues to spend a lot of funds on tanks and missiles and whatnot on defence and military. That it increases its military spending both in nominal terms and as a share of the GDP, we see a constant rise of the share of the Russian economy spent on the war. And what is probably the most exciting part of all that is that the Russian government is still able to afford it. So just think about that. We are entering the third year of the war. Russian defence or military spending ah is expected to overshoot 6% of the GDP next year, despite all the promises that it would go down. And the budget deficit you know, this problem of every single country at war is only half percent of the GDP. So, Russia can increase its military spending and is also able to support its economy without causing any internal problem, at least on paper.
Gabuev. Alexander, the increase in the military budget, is it coming at the expense of something else? Are other expenditures or healthcare, infrastructure cut, or they are the same and the Russian government is just spending more on defence?
Kolyandr. Well, there is a decline at the share of the GDP in almost everything like social spending and media, sports, medicine, whatnot. So yes, there is a decline, but it is not anywhere as crucial as the decline, say, in the late 80s or the early 90s. So, it's a mild decline in social spending, but there is still social spending. And as far as I can see, the Russian government is able to increase its military spending mostly because it believes that it will earn more money next year. It's kind of a combination. We spend a little bit less on military stuff, but we also expect to get more money next year.
Prokopenko. May I jump in here and clarify that it seems that government is going to increase military expenditures from non-oil and gas revenues. And mostly, non-oil and gas revenues in 2025, which are jumped up to 73%. Its tax increase introduced in 2024. So basically, this addition of military spending will be paid by people and corporates, not because there is some extra money produced by the economy. So, it was a political decision to increase taxes and these increased taxes and inflationary tax because the economy generates additional VAT tax because of inflation. All this increase will go to additional military spending, not into health care or social policy or education or even infrastructure. We already see the decline in state spending on road construction, on bridge construction, and on restoration of utilities and infrastructure which cries being under-financed for years. And that's the problem.
Kolyandr. If I may, just to sum it up. The increased military spending is coming from effectively several sources. One of them is slashing non-military spending as Alexandra has just said. Secondly, it comes from a higher corporate and income taxes introduced in 2024. It comes in force next year and thirdly it comes from a sheer fact that the Russian economy is growing, so when you see a growing economy, you effectively see a higher amount of collected taxes, be it VAT, sales tax or any other tax that the growing economy produces. Three sources, ah less money on roads, bridges and infrastructure, more money from new taxes, and more money from the growing economy.
Gabuev. Sasha Prokopenko, you were one of the very few economists who early last year predicted that the government would have fiscal room to increase the military budget in 2025. And when many people said like, “Oh, Russia is at the peak of its defence spending” and the goal for, for example, Ukrainian armed forces is really to reduce the Russian gains on the battlefield and that at the top of the Russian military spending, and then probably in 2025 Mr. Putin will realize that he doesn't have fiscal room to continue to finance this war and he will start to crawl out of the hole that he has dug for himself. You were the one who was saying like “Wait a minute, they actually will find the money to not only finance the war in 2024 levels, but also increase that”. So, if you remember the tv-series “Scrubs”, you have all the right to dance that “I told you so” dance.
Prokopenko. I told you so, I told you so, I told you so.
Gabuev. Very nice. And indeed, you did. So, here's my question to you. What is your expectation now, a Prokopenko prophecy, on how much fiscal space they will have for how many years? Is it again a one-off or is it something that we are likely to see in the medium term? Let's say next year and two years after and I know like the war it's all contingent and there are too many moving elements on the table but give us your best guess.
Prokopenko. Sasha, thanks for the question. I don't have a crystal ball, and I don't have all data provided to calculate further expenses. But what's obvious and clear for me, that Russia is entering a period of strategic restructuring of its arms forces, which according to our dear colleague Dara Massicot, could last up to eight years, from 8 to 10. It doesn't mean that the whole-time frame from 8 to 10 years, military expenditures will remain elevated. But for a coming year or two, the military needs replenishment of personnel and weapon stocks. Civil enterprises and facilities need air defence and electronic warfare systems for defence against dronesб since the war is going on and we don't see ending of this unfair and bloody war. In previous two years, the Kremlin coped by partial mobilization, repairing existing equipment and attracting new recruits with high payments. We also know that Russia increased production capacity at existing defence plants, and they are operating 24/7, basically at their maximum capacity, meeting the needs of the war against Ukraine. However, except for drone production, these efforts have reached their limits by early 2024. This means that military industry complex requires additional investments. There are no other sources except state budget where these investments could come from. So long as the Kremlin has stable commodity revenues and a competent economic team, we shouldn't underestimate the increased repressions at home, it may well continue to finance the conduct of the war or the large-scale rebuilding of military capacities for the foreseeable future. My best guess that for coming 12-18 months, Putin has enough resources at his disposal to continue what he's doing. But we already from this budget draft see that for the Kremlin, it becomes harder and harder to manage all three variables of the equation. So, continue to spend money on military, continue to sustain social payments, which increased heavily like during the last 2.5 years, and work on macroeconomic stability since inflation is accelerating in double digit, and key rate helps a little to tame it.
Gabuev. Thanks, Alexandra. And that's the trilemma that you wrote about in January in the Foreign Affairs. You cannot maintain an equilibrium between the increased military spending, high social payments and obligations, and maintaining the microeconomic stability, low inflation and low debt. At some point the trade offs will kick in and we'll talk about that but I have a question to Alexander, how do you explain that despite all of the sanctions, the oil price gap, the increase transaction costs who to clear payments because we hear, from many business people that sometimes transaction costs constitute up to 10% of the price, that's already included there, because clearing a payment between Russia and China is very complicated because of the sanctions. How do you explain that the Russian budget still has enough commodity and other revenues. What are the key ingredients here that the incoming cash flow is still net positive and sufficient to finance the war effort?
Kolyandr. Well, I would probably say that it's a divine intervention. Unfortunately, it's much more humane. As we've heard so many times from the horse's mouth, basically from Mr. Putin himself, Russia is fighting the global economic and political order and he's trying to amass support for his crusade against the global economy. However, it's the same global economy that effectively saves him and his budget. Russia is able to sell its oil and gas to the non-aligned states, in other words, the states that do not support the sanctions regime, with a certain ease. It wasn't possible back in the, I would say, 70s, when Western sanctions and embargoes left the Soviet Union with nowhere to go. Now, the power of procurement of the Russian oil, effectively the global oil, is not concentrated only in the Western world. Technology is also not concentrated there. Russia is able to sell its oil to other places to procure microchips or machinery from other places. Effectively, it's the same European and American microchips, which are now exported to countries like Turkey, China, the United Arab Emirates, Uzbekistan, Kazakhstan, and the rest. And from there, they nicely travel to Russia and find their place in Russian military and production facilities. And I would say it's a combination of lukewarm attitude towards the sanctions, the globalized economy, which Russia is promising to fight, but which it also greatly enjoys. And the overall desire of the Western politicians not to cause any financial trouble on their population because of Russia. All that combined leaves Russia with a sizable oil revenue. If I'm not mistaken, it's still about one third of the state budget revenue. It also keeps Russian economy running on expensive, but not outrageously expensive, important components, microchips and the rest. And the economy is still going on despite the sanctions. And there is another part of the sanctions story which we somehow did not mention, which is capital flow or rather the lack of it. If you look back to the years when I was young and you were extremely young, for years, Russia run a pretty sizable trade surplus. In other words, it was able to sell more oil and gas and spend only part of that money on imported cars, washing machines, microchips and the rest. To keep this balance, ah Russia had a huge capital outflow. In other words, people were buying dollars, people were buying property abroad, people were traveling abroad for their holidays or city breaks, and they were even buying foreign stocks and shares. When the war started in Ukraine, all that suddenly stopped. Russia was left with trade surplus and a small capital outflow. So, the engineers of those sanctions without really planning it locked capital inside Russia, which allowed the Russian economy to pay for more expensive imported goods and to keep the war machine going. I think that, when we are looking back at the at the sanctions regime, that was one of the mistakes, which allowed Russia to continue its economic flourishing despite the sanctions and the war, and there is absolutely nothing bizarre strange or unique in in an economy growing amid the war, if you look back at any large war and any large country waging that war, you'll see an economic growth especially at the beginning towards the middle of the war, because the state spends more, economy runs at full throttle, produces more products, returns more taxes, so whenever there is a war there is usually growth of economy, unless you have carpet bombing of everything around you.
Gabuev. Thanks. Sasha, I think that in your writings, you also focus a lot on the structural limitations to the economy, because the key rate that's in double digits, very close to 20%, doesn't signal a very healthy economy. There is also a question of availability of workforce given how much the front lines pull military age man, but that's also men who could work in factories in construction and in many areas where Russia really needs labour. Could you talk about what, in your view, constitutes the major lines where the Russian economy still feels constrained? What are the constraint factors? And whether the Kremlin and your contacts in the Russian government, in the Bank of Russia are aware of those limitations and how they plan to cope with them?
Prokopenko. Well, great question. There are two serious limitations to Putin's current economic model. First, an internal one, as you correctly mentioned, is labour market, which is extremely tight. And the external one, the second one is sanctions. So, the literal absence of workers on the market with unemployment rate, which now I think 2.4% or even 2.3%, where is the button, will hamper the ability of military-industry complex to increase output, despite the new capacities that have been put in place. Sanctions limit the possibilities of technical array equipment of enterprises, hinder the import of components and well, they are a bottleneck in terms of transactions. All of these developments now look to me like borrowing from the future generations, but it also clear that the Kremlin does not see this as a problem. The constant injection of money into army and the security forces exacerbate existing imbalances in the Russian economy. And simply put, the Russian leadership prefers to build up military power instead of taking care of long-term economic stability. But the Kremlin's logic here looks like “When the problem starts, we will solve them then”. And there are also a group of consistent supporters and in government circles of the idea of ah demand management through the budget channel, where military spending will be the main driver of economic growth. And because of the figures of economic growth right now, they have some sort of approval that they are right. And look, “We are fulfilling economy with the money via military industry complex, and we see growth, Russia economy haven't felt since recovering from the global financial crisis”. It is a quite powerful group, including industry lobbyists like Manturov and Chemezov, who are direct beneficiaries of this budget spending. And economists among Russian economic bloc like Maxim Oreshkin, Defence Minister Andrei Belousov is a strong supporter of this idea. I think Alexei Dumin also likes this. They are powerful voices. And Siluanov, who wants balanced budget, and Nabiullina, governor of the Central Bank who is in charge of inflation, they are not able to have a really real solid pushback to this group so one thing which I want to point at is that put the rest of the economy along to increased military demand requires constant or better growing demand on the output of military industrial complex. And the ongoing war with Ukraine is one of the factors of such demand. Restoration of military potential could be another one, but any domestic demand for a defence industry is finite and it well we can calculate when it ends. Good news here that it's not indefinite. And export profit um prospects for defence industry, ah I think they are quite grim given the expanding sanctions. So, export couldn't work on smugglers, on schemes, and on constant pressure on transactions. So, consequently, once the domestic demand is exhausted, the economy will face another shock and another structural reorganization. So, basically, Kremlin now puts economy on the path of a potential artificial crisis in the coming five or seven years. Just one more thing, that haven’t been voiced on this podcast, but it's very important for policymakers and for everyone to understand that end of the war doesn't mean end of military spending. So, this will remain elevated regardless of ending the war. And that's what Europeans and the US s allies of Ukraine need to be prepared.
Gabuev. Thanks. And I think that you both agree that Western sanctions play a role and could play a role. Alexander, you have written a very interesting piece a couple of days ago for Carnegie Politika “West Seeks to Increase the Cost of Russia Sanctions Evasion”, where you talk about the mechanism that the West is trying to put in place for making the sanctions more efficient. What's your view of what the Western governments could do better on the sanctions front to make this crisis that Alexandra is talking about, to shift it a little bit to the left and to make it sooner, constraining the resources available to Mr. Putin in waging his criminal war against Ukraine and confronting the Russian government with the really hard trade-offs that would not favour increased war spending?
Kolyandr. I would probably have a two-fold answer. One of them would be a little bit wider and another part would be much more precise. So first of all, if you ah look back at what Adam Smith, the founding father of the modern economy, was writing what almost 300 years ago, he famously said that there are three main sources of production: the land and its resources, capital, and labour. To target get Russia and to make Russian economy less capable of supporting this criminal war, I think the Western countries should read Adam Smith or rather reread it and target those three pillars. Land and resources mean, in the Russian case, more targeted sanctions against revenue from exported oil and that can be achieved by tightening sanctions against shadow fleet and imposing more transaction costs basically to make Russian oil revenue a little bit a little bit less. Secondly, when it comes to labour, the West should, in my view, target all the exports that increase productivity, be it the newest software or some super sophisticated machinery for production. And it also, I think, should target a Russian labour market, offering effectively emigration for those specialists, especially when it comes to the IT engineers, scientists, and people like that, offering them some employment outside of Russia, despite their perceived support of the regime or annexation of Crimea. It doesn't matter from the point of view of the economic equation taking them out of the labour market and taking their abilities away from Russia would increase costs. And thirdly, something should be done to facilitate capital outflow from Russia. On a much narrower agenda, I think what the European Union and the United States are doing at the moment, fighting the circumvention of technological export is the right thing to do. They basically are targeting, in the case of the United States, they are targeting financial go-betweeners and financial companies that facilitate illegal export of technology to Russia. And in the European case, and you know Europe is usually lukewarm to any kind of secondary sanctions. But Europe is able, and that's what they are doing, they task their own exporters, their own companies with due diligence and responsibility to make sure that their export going to another country would not end up in Russia. I would say if there is a Western government who is ready to listen to my advice, in order to make Putin struggle with financing the war, you should address capital, labour market, and Russian oil revenue. And when it comes to protecting the export sanctions, just target the most important parts of it, target the technological expert, not the luxury goods, and target the exporters with the task of, you know, being responsible for the end users.
Gabuev. Thank you so much, Aleksandar Kolyandr, the non-resident senior fellow at CEPA and Aleksandar Prokopenko, a fellow at the Carnegie Russia Eurasia Center and our leading in-house economist. My major takeaway from this pretty sobering and grim conversation is that Vladimir Putin will have money to finance this war for the next 12 to 18 months. He is riding a wave of expanding economy which is not unique to Russia and many of the economies throughout history, that are waging the war are experiencing this wartime expansion. He has a pretty favourable external environment. He has buyers for his goods. But ah there are mounting internal structural constraints that will push this economy into the wall. And the West has a lot of agency in designing the sanctions the way that the cost of prosecuting this criminal war will come faster to Russia and then the Kremlin will have to face some very painful choices that hopefully will reduce its appetite to continue to pound Ukrainian cities with deadly missiles and bombs. We'll have to continue this conversation. I'm very grateful for you for finding the time to join me and please stay safe.
