Life on loan. How the Russian economy overheated and what it threatens

BBC

9 min

August 8, 2023

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About the article

• Author, Olga Shamina, Victoria Safronova
• Position, BBC
• 2 hours ago

The Russian economy, contrary to forecasts, avoided a rapid and deep crisis. Now it is even growing - however, the reason is the abundant budget expenditures on the war. And this has already created problems: industry is working at the limit of its capabilities, prices are rising, and the structure of the economy is becoming simpler and more primitive. The authorities are actually living on borrowed time: the current stability may turn into a crisis and then stagnation.

“The problem of the Russian economy is not today, but tomorrow or even the day after tomorrow - when all the sanctions, all the restrictions [work - BBC ], when the margin of safety is exhausted. Then there will be a serious failure,” warns economist Alexandra Osmolina-Suslina.

But so far the margin of safety seems quite significant. In March 2022, economists expected a deep crisis and sharp impoverishment of the population, and already in August they predicted a recession stretched over several years, but no less deep. Since mid-spring 2023, economists have been changing their forecasts again - and again towards improvement.

Now, in most cases, they expect a slight fall or slight increase in Russian GDP in 2023, as well as a slow recovery in subsequent years.

Here are some examples. In October 2022, the International Monetary Fund expected the Russian economy to contract by 2.3% in 2023. And this was not a pessimistic forecast; on the contrary, the IMF improved it. Oil exports did not fall very much, nor did domestic demand, largely due to budget expenditures, the fund explained then.

Since then, the IMF has updated its forecast three times. In April, he already expected the Russian economy to grow by 0.7% in 2023 and 1.3% in 2024. In July, the forecast for this year changed again - the fund now expects growth of 1.5%.

In April 2023, the World Bank sharply improved its forecast for Russia: if in January economists expected a fall of 3.3%, then in April it was only 0.2%. In June, the bank maintained this forecast.

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Russian officials expect the Russian economy to grow by 1.2% this year, and by 2026, according to  Economic Development Minister Maxim Reshetnikov, the growth rate will increase to as much as 3%—a goal Vladimir Putin set for officials even before the war.

Even the Russian Central Bank, usually quite pessimistic, expects the country's economy to grow by 1.5-2.5% this year. Then the growth rate will decrease again to 0.5-2.4%.

True, the Central Bank is already describing signs of economic overheating - this happens when the economy grows faster than its capabilities, often due to active stimulation from the state.

When applied to Russia it looks like this. Demand from the population and the state is growing due to military spending. Business is not able to satisfy this demand: there are not enough employees and production capacity. All this leads to rising prices.

Overheating of the economy, in theory, can cause a crisis - just to avoid this, the Central Bank raises the rate and tightens monetary policy.

And the signs of overheating are really visible. Prices are growing quite quickly this summer - more than 0.7% in July. This is not very typical: in the summer a new crop hits the market and prices, on the contrary, fall. Business surveys show that companies are quite optimistic, but expect prices to rise. Economists also write about high production capacity utilization—this is confirmed by Central Bank data.

How the economy overheats

The secret of the strength of the Russian economy and the reason for overheating are the same - large budget expenditures. The Russian authorities are actively spending money on the war, and this money is distributed throughout the country’s economy - through salaries to contract soldiers and mobilized soldiers, payments to the wounded and families of the dead, and through state defense orders.

Those who received additional money begin to spend it - especially taking into account the fact that those who earn little in ordinary life often go to contract service and PMCs.

Thus, government military spending spreads across the economy—the reports call this “fiscal stimulus,” which is simply high government spending.

The IMF, which improves its forecast for the Russian economy time after time, explains its optimism precisely by this. Statistics on consumption, industrial production and construction turned out to be good this year - and this is precisely the effect of budget expenditures.

Industrial production rose more than 6% in the second quarter, led by manufacturing. And according to  Rosstat statistics , it is clear that industrial sectors that may be related to the war are growing very quickly: the production of finished metal products in June in annual terms increased by more than 45%, and the production of computers and optical products by more than 70%. From the calculations of economists it is clear that the defense industry  is the main engine of industrial growth.

A typical example is the Kalashnikov concern, which is under all kinds of sanctions. The concern stated that over the past two years the production plan has increased by 60% - and 100% of this is the fulfillment of the state defense order. This year the plan was fully implemented in the first six months of the year.

In June, industrial growth stopped month-on-month, as recorded by the Center for Macroeconomic Analysis and Short-Term Forecasting. But this is happening at the expense of all other areas of industry, for example, gas and oil production - the manufacturing industry continues to grow thanks to state defense orders.

“I have doubts that the numbers are really as good as they look according to official statistics, because growth is now largely driven by a sector that is not the most transparent and most prone to corruption,” says Ruben, an economist and professor at the Pompeu Fabra University in Barcelona. Enikolopov.

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The growing wartime economy and overheated industry also have a downside - a huge hole in the budget. Since the beginning of this year, economists have been talking about budget risks as one of the main ones for the Russian economy.

At the end of June, the accumulated budget deficit amounted to almost 2.6 trillion rubles - this is less than in previous months, but these are still huge numbers. The reasons for the record deficit are still the same: falling oil and gas revenues and record spending.

Costs appear to have remained fairly high in June. But incomes increased slightly, which helped reduce the deficit. One  explanation  is the dividends that Sber paid to the state and growing revenues from taxes on imports of goods from China.

“The budget is deficit and will definitely be deficit for a couple of years. And it is simply impossible to maintain costs at the same level as they are now,” says Osmolina-Suslina.

The economy will not be flooded with money, she is sure. “They have been accumulating for some time, and now there are still some reserves. As long as they exist, it’s a year or two, provided that everything remains as it is now,” she explains.

The National Welfare Fund had just over 13.3 trillion rubles at the beginning of August. And he even grew a little this year. Osmolina-Suslina partially explains this by the weakening of the ruble - the National Welfare Fund is denominated in foreign currency. In addition, the government might have reserves that it could spend.

“This is not exactly a flood of money, simply because there is no money. There are not enough of them to fill them with,” Osmolina-Suslina describes what is happening in the Russian economy.

“The potential for fiscal stimulus has been exhausted. Expenses may be higher, the government can borrow more from the market, there is a significant reserve of liquid assets of the National Welfare Fund, but the real “budgetary” constraint is inflation and physically limited resources, primarily shortages in the labor market,” says Alexander Isakov, economist at Bloomberg Economics for Russia. .

Isakov is actually talking about the overheating of the economy, which the Central Bank noticed. That is, the Russian economy has found itself at a point where its sustainability and stability are associated with active spending by the state. But they can no longer ensure its growth - they can only further load the war-related sectors. However, the authorities cannot refuse these expenses, because they clearly do not intend to end the war, which means that the budget deficit will not disappear anywhere, and the industry will continue to work at increased speed.

Military restructuring

After the start of the war and the introduction of the first sanctions, the head of the Central Bank, Elvira Nabiullina, announced the beginning of the process of economic restructuring.

More than a year later, we can already see what this new Russian economy will look like: a vast defense sector supported by government funding; the class of “ young rich ”, that is, those who went through the war and made money from it; as well as a group of those who have suffered greatly from the war and need government help; as well as massive imports from China and constant attempts to circumvent sanctions.

Economists interviewed by the BBC do not see much promise for this new economic model: life will gradually become poorer, the economy will increasingly depend on those few countries that are willing to do business with Russia, and the public sector will grow.

“Some kind of restructuring is taking place, but to say that there has been a qualitative shift... Have you learned to produce yourself instead of using imported parts? I think that no, this could not have happened in a year, or in two. Rather, there was a reorientation of the economy towards other markets, from European to Asian,” this is how Osmolin-Suslin describes the new restructuring.

“For all normal production - cars, consumer electronics and so on - everything fell. Moreover, the economy not only fell, but became generally more primitive. In fact, it is now more expensive to produce a worse product,” explains Maxim Mironov, professor of finance at IE Business School in Madrid.

Isakov says that Rosstat data shows how employment is changing: people are leaving industry and trade to work in the public sector, which includes the defense industry.

“Structural transformation involves an increase in the share of the public sector, including in the employment structure, a decrease in competition and the consolidation of certain sectors - in particular, light and automotive industries, due to the departure of some competitors and a slowdown in sustainable economic growth rates from 2-2.5% to about 1%,” explains Isakov.

“This regrouping, as they say, involves a loss of quality. Even if we are losing less quantitatively than we thought some time ago, we are losing much more qualitatively. And measuring this quality is quite difficult: it cannot be seen in statistics,” notes Oleg Buklemishev, director of the Center for Economic Policy Research.

Buklemishev says that in some areas the situation has been set back 20 years to what it was before the arrival of foreign investors in Russia and the development of modern enterprises. He cites the automotive industry as an example: before the war, cars were actively assembled in the country, but now they are mainly imported.

***

The current economic stability in Russia actually turns out to be a life on borrowed time, for which one will then have to pay.

“The Russian budget is now spending at an accelerated pace. More than people thought and more than budgeted. We are looking at the plan for 2023 - it is seriously overfulfilled in terms of expenses and, accordingly, in terms of the budget deficit. Therefore, budget expenditures are growing and the economy is growing. But you'll have to pay for it. This is stimulating current growth at the expense of the future,” explains Enikolopov.

The margin of safety that the Russian president likes to brag about may not be all that great—and this is evident from the budget problems.

“Everything suggests that at some point there will be a price to pay for this. And this moment is not nearly as distant as it seems. Because the budget deficit has opened up so much that it is clear that this is not a problem of the three-four-five-year future, but of the next or subsequent year,” says Enikolopov.

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