How Russia has changed its economic model to meet the needs of war

Vyacheslav Butko, economist, economic advisor at the Kyiv Security Forum

Figures that show a significant deterioration in the economic situation in Russia hide a change in its economic model, which is now geared to meet the needs of war.

Statistics on the Russian economy are encouraging. GDP growth in the first quarter (year-on-year) was 1.4%, compared to 5.4% in the first quarter of last year. In January-May, the budget deficit amounted to RUB 3.4 trillion, which is RUB 2.67 trillion or 4.7 times more than in the first five months of last year. Between January and May, the Russian budget revenues grew by 3.1%, while expenditures grew almost seven times faster - by 20.7% - due to massive advance spending on the military-industrial complex and a decline in oil and gas revenues, which fell by 14.4% in the first five months of the year compared to the same period last year. Civilian production declined by an average of 0.8% per month in the first quarter. There are signs of economic stagnation, with a possible transition to recession. This was confirmed by Economy Minister Reshetnikov at the St. Petersburg Economic Forum on 19 June: "According to the numbers, we are cooling down. According to the current feelings of business and indicators, I think we are already on the verge of a recession."

However, what is happening in the Russian economy is a natural consequence of the policy of structural transformation of the economic model launched three years ago. The Russian authorities had to:

- increase output in the military-industrial complex and related sectors and ensure the flow of resources there;

- do so in a way that would avoid a noticeable qualitative and quantitative decline in consumption, and in a way that would bear at least a large part of the burden (in a somewhat veiled form).

That is, to provide a powerful budgetary impetus and redistribute resources in favour of the military-industrial complex. Looking back over the past three years, it looked like this:

- powerful budgetary funding for the military-industrial complex and some other sectors is opened up, while the key policy rate of the Central Bank of the Russian Federation is reduced (in April 2022 - 20%, in September - 7.5%);

- the reduced rate leads to the population taking out consumer, car and mortgage loans and making appropriate purchases with borrowed funds;

- cash flow leads to a surge in inflation;

- the CBR raises the rate. The first step was in July 2023 - to 8.5%, and then in several steps the rate increases, first to 16% in January last year and to 21% since October (in early June this year, it was symbolically reduced to 20%);

- at the same time, the Russian authorities continue to pump budget money into the military-industrial complex and related sectors (as well as construction), increasing output and providing those working in these sectors with a sharp increase in income;

- inflation does not decline because the Russian government pumps money into the economy and resources go to the military-industrial complex and related sectors, creating a shortage of money and other resources in the rest of the economy, and this shortage is compensated for by rising prices;

- rising prices ‘eat up’ the excess income of those employed in the industries financed from the budget, and this balances the consumer market - there are no commodity shortages.

At some point, such a policy could not but lead to a slowdown or decline in all sectors, except for those financed by the government - the military-industrial complex and related sectors. But this is part of the task of structural transformation. There was to be no long-term growth in the Russian economy, no growth in the welfare of the population - there was to be growth in production in a narrow sector of industries and outstripping productivity growth in the incomes of those employed in that sector. Those who do not work in the military-industrial complex and related sectors and cannot maintain their usual standard of living, and who cannot pay back their loans after the interest rates rise, will be forced to work in the military-industrial complex or look for second or third jobs. That is, either increase output in the military-industrial complex and related sectors or reduce consumption (thereby balancing supply and demand in the consumer market) if there is no way to find additional work.

The Russian economy has been divided into two parts - one part (the military-industrial complex and related industries, as well as the sectors that support and service them) is absorbing resources from the other (civilian industries) and will continue to do so to finance the war. The reduction of non-military sectors of the Russian economy benefits military needs - less demand for resources (capital and labour) in the civilian economy makes these resources cheaper for the MIC and related industries. It also encourages those with reduced income to join the army or the military-industrial complex.

The growth of the Russian economy over the past two years was mainly due to fiscal expansion, which was funded by energy exports - the Russian government increased fiscal stimulus amid export revenues that rose in 2021-2022. This led to high growth rates in 2023-2024 and overheating of the economy, which triggered an inflationary surge. The overheating of the economy as a result of strong fiscal stimulus was so severe that a return to the natural growth trajectory (for Russia, the average annual GDP growth was 1.1% over the fifteen years before the war) would inevitably require a strong economic slowdown and a reduction to previous periods.

However, along with the optimistic trends and figures, we need to be aware that Russia has rebuilt its economy on a military footing. To put it mildly, this is not encouraging. But it is more productive to see the reality than to indulge ourselves in hopes of Russia's imminent economic collapse.