The weight of the war weighs (finally!) on the Russian economy

After a thousand days of war, we can be concerned about the difficulties on the military front for Ukraine. But opposite, in Russia, there is also bad news. The resilience of the Russian economy has so far confounded analysts, since its invasion of Ukraine in February 2022. Despite being subject to one of the harshest sanctions regimes of the post-Cold War , it experienced its fastest expansion in more than a decade. Russia grew by 3.6% last year and is expected to maintain that pace in 2024. But the central bank has just raised rates to 21%, a level not seen in two decades; markets expect it to reach 23% by the end of the year. A warning of difficulties to come.

Public spending is increasingly difficult to maintain. Russia's budget, unveiled in September, planned to increase defense spending by a quarter next year. In total, annual spending on defense and security is now expected to reach 17 trillion rubles ($170 billion), representing more than 40% of all public spending and 8% of Russia's GDP, the the highest amount since the Cold War.

The cost is significant, but not unusual for a country at war. U.S. defense spending, for example, was 8 to 10 percent of GDP during the Vietnam War. During World War II, the great powers devoted 40 to 60 percent of their total economic output to military purposes.

But the heavy expenses remained financeable. In the early 1940s, British policymakers successfully waged what they called “a 3 percent war,” keeping interest rates at roughly that level. The US Federal Reserve maintained its rates at 2.5% over the same period. These low borrowing costs helped keep high deficits affordable. In contrast, in Russia, the yield on ten-year sovereign debt rose from around 6% before the war to 16%.

The conscription of prisoners and the hiring of North Korean soldiers are unconventional indicators of a vibrant labor market, but in fact Russia's unemployment rate is only 2.4 percent. Moscow is mobilizing all capacity for the war effort, and the economy is showing all the classic signs of overheating. Annual inflation exceeds 8%… requiring interest rates to be raised, even if it means increasing borrowing costs.

In the 1940s, America and Britain controlled inflation through a combination of large increases in personal taxes, designed to curb household spending as much as raise revenue, and through rationing. In today's Russia, such measures would be deeply unpopular and hardly compatible with Vladimir Putin's propaganda.

There is another reason why the country was forced to tighten monetary policy. For most of World War II, neither Britain nor America had to worry about the external value of their currencies. The dollar benefited from its safe-haven status, while the US “Lend Lease” program provided Britain with military equipment and resources such as oil and foodstuffs virtually for free. If Britain had not had an ally with America's deep pockets and industrial capacity, willing and able to supply two-thirds of its imports, the fall in the value of sterling would have become a military problem.

The problem for Vladimir Putin is that he has no equivalent ally in the United States. China has become Russia's largest trading partner, supplying a third of all imports and more than 90% of microelectronics used in drones, missiles and tanks. However, this support is not offered for free.

Russian officials must therefore closely monitor the value of their currency against the yuan; this year it fell by 10%, reaching almost its lowest level since the start of the war. Unlike its World War II allies, Russia faces external vulnerability. It is this vulnerability, more than inflation, that has pushed interest rates to record levels.

Until recently, the Russian government had managed to protect the economy from rising borrowing costs. Various programs have made it easier for households to suspend debt payments and for businesses to borrow at lower subsidized rates, with the government stepping in to compensate for banks' lost revenue. But these programs are becoming unaffordable. A mortgage subsidy program, which allowed borrowing at a cost of just 8%, ended on July 1. Mortgage loan volume halved the following month. Business bankruptcies increased by 20% this year. The Russian Union of Industrialists and Entrepreneurs indicates that business investment plans are on hold for next year due to excessively high borrowing costs.

Rising interest rates will dampen business and consumer spending. The IMF expects Russian economic growth to slow sharply to 1.3% next year. The combination of falling investment and loss of manpower at the front is taking its toll. The need to maintain the value of the ruble to pay for crucial imports is a vulnerability for the Kremlin, which could soon undermine its ability to fight. Putin may be hoping that Donald Trump keeps his promise to end the conflict. Waging a 3% war is one thing, a 21% war is another.