War, Deficits, and the Russian Economy: An Uphill Battle to Nowhere

Exclusive Interview with Former Russian Deputy Minister of Energy Vladimir Milov

With the ruble under pressure and Russia’s economy facing growing strain, attention is shifting from the battlefield to the “financial front”. Much ink has been spilled on the topic, but even respected Western economic outlets have only scratched the surface. Unsatisfied with such analyses and seeking deeper answers, we spoke with Vladimir Milov, former Russian Deputy Minister of Energy, economist, energy expert, close ally of Alexei Navalny, and Vice President of the Free Russia Foundation. In this exclusive interview, Milov breaks down the fundamentals of Russia’s economy and what the coming months may hold.

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Question (Q): Let’s start with a recent trend that’s on everyone’s lips: the Russian rouble plunging to uncomfortably low levels. What does it mean in general terms, and what are the short and medium-term implications for the Russian economy?

Answer (A): Ruble plunge is mostly indicative of a broader set of problems and challenges for the Russian economy, rather than a thing in itself. Everything was falling in the recent couple of weeks - MOEX stock exchange index, RGBI Russian government bond index, more or less under the same trend. Russian markets are gloomy ahead of the upcoming Central Bank's board meeting on December 20th, where the Bank will now most definitely raise the interest rate again, from current 21% to possibly 23% or even 25%, as some of the most recent projections suggest. Central Bank began to hike interest rates in July 2023 with purpose to calm down inflation, but it had not only failed to do so - moreover, inflation is continuing to rise after one and a half years, reaching as much as nearly 0,4% per week in November.

Central Bank previously hinted that it would react with toughest signals possible to the signs of persistent inflation, which is why everyone is depressed - tight monetary policies are clearly going well into 2025. Nobody was prepared for such a long period of high interest rates, and the Russian economy is rapidly slowing down - in the first quarter of 2024, GDP growth was 5,4%, but its down to 3,1% in the third quarter, and the Central Bank's baseline scenario projection for 2025 is just 0,5-1,5% - but it may be even worse, given the most recent trends of persistent inflation and slowdown in business activity depressed by high interest rates. With the current economic picture, everyone expects that the worst is yet to come - which, I believe, is the main reason behind ruble's collapse.

Some are suggesting that other factors also contribute to plunging ruble rate, including the recent U.S. sanctions against Gazprombank and dozens of other Russian banks, which will severely complicate export-import payments. This factor probably contributed as well, but these are not the first banking sanctions imposed against Russia - however, the ruble was in such a bad territory only in March 2022, in the immediate aftermath of Russia's full-scale aggression against Ukraine. Clearly more fundamental factors are at play here than merely some new sanctions - which is also proven by the fact that all other market indicators are falling with similar trajectory, not just the ruble.

Ruble depreciation will contribute to inflation even further, as Russia is continued to be heavily reliant on imports - this is a kind of self-sustaining spiral. I also strongly disagree with those who say that cheaper ruble is "good" for exporters and the budget. Exporters have yet to make good use of devaluing ruble - which they can't do, because Russia is under all sorts of embargoes, and China and other Global South countries are not opening their markets to most Russian goods. As to the budget, the effect is much more complex than many consider: on one hand, budget gets more rubles from export revenues due to ruble depreciation, while minimizing ruble-nominated costs. On the other hand, though, higher inflation and costlier imports will, in my view, more than offset these budget-positive effects.

I think we have to look at the situation in a more complex way. Sharp ruble depreciation is a mere illustration of Russia's deepening economic woes. Nearly three years since the beginning of Russia's full-scale invasion of Ukraine, Russian economy is stranded. No new sustainable economic model has been found. Import substitution is not working. China is only buying our most basic commodities at heavy discounts, while keeping its market closed for other Russian goods. There's no investment or technology coming into Russia from China and other Global South countries. Everything is dependent on state subsidies - but the government's financial reserves are running thin. if you listen to industry and business speakers at the most recent economic fora, there's an endless stream of begging - we won't survive with state subsidies for this, state support for that, we haven't got technology, haven't got investment, haven't got profitability, haven't got workforce. etc. Makes one wonder - what have you got then?

On top of that, inflation - which is also a symptom of deep Russian economic difficulties. Inflation is a direct product of Western sanctions: as per Central Bank, key reason behind inflation is the output gap- when supply fails to catch up with demand, due to lack of investment and access to technology for manufacturers, and also lack of workforce caused by the war. Inflation causes Central Bank to raise interest rates - which fail to calm it down, but instead force businesses to wind down, as current interest rates are killing the economic viability of most of sectors of the economy. A never ending spiral. No wonder markets and ruble are down.

Q: With Russia’s central bank interest rate at 21%, inflation concerns are rising among Russian businesses, sparking debates about stagflation and even potential regime instability. On the other hand, some people point at Turkey, with inflation peaking at 85% in 2022 and 75% in 2024, saying that it has avoided obvious catastrophic outcomes. How valid are comparisons with Turkey, and what is your perspective on this issue?

A: Russia resembles Turkey only in terms of high inflation, the rest are vast differences. Turkey is an internationally open economy, which is not only not under any sanctions, but on the contrary, enjoys a customs union agreement with the European Union, and net positive foreign direct investment inflows, unlike Russia. It also has skilled workforce and good demographics - everything Russia hasn't (in fact, Russia even imports workforce from Turkey). Had Turkey found itself in the Russian circumstances - tough international isolation, lack of access to international investment and technology, demographic catastrophe and wild shortage of workforce, huge burden of war spending, no access to markets, etc. - things would have been drastically different either.

However, I strongly argue against normalizing the economic situation of Turkey. High inflation seriously undermines business confidence, investment, and future development. Inflationary growth today is essentially a growth stolen from tomorrow. Turkey would feel it, yet. Moreover, the most complex manufacturing and technology industries are the most sensitive to high inflation, as they often have the longest investment cycles, and high inflation strongly undermines viability of long term sophisticated projects, and reduces the availability of long term affordable financing. Interestingly enough, in Russia, the sector which probably suffers the most from high inflation is the military producing industries - because they have long production intervals, and when they finally deliver their products to the government, the amounts of payment agreed a while ago become trashed by inflation. Current Putin's economic model led by the military industries is particularly sensitive to inflation, in a negative way.

Q: For those closely following Russian politics, there seems to be a growing debate between the Central Bank and industrial circles over monetary policy. The tension has reached a point where some are suggesting that Central Bank Governor Elvira Nabiullina should be replaced. Could you explain the nature of this conflict?

Elvira Nabiullina Governor of the Bank of Russia. Source: Free Russia Foundation

A: This debate is rather stupid, sorry to say. Both sides are actually right in their own way. To relax the tight monetary policies and to lower interest rates means to enter the hyperinflation territory - in this, Central Bank is right. But to continue interest rate hikes means to kill the real sector of the economy, where most companies simply don't have sufficient profitability to borrow at current interest rates (Central Bank's 21% interest rate translates into 25-30% commercial loan rates). In this regard, industrial lobbyists are right, too.

What both sides prefer not to notice and not to mention though is the "elephant in the room" - the war against Ukraine, which is the root cause of all the problems. War is the cause of extreme military spending, which fuels inflation. War is the source of output gap that the Central Bank is correctly mentioning as a key inflation driver , as explained above. War is the cause of record-breaking labor shortage - and the list goes on. Ending the war would solve most issues - military spending will be cut, workforce will return from the front, industries may regain access to international markets, cheap foreign loans and technology, should Russia vacate all occupied Ukrainian territories, surrender war criminals, compensate damages inflicted to Ukraine.

Central Bank is well aware of the root causes of inflation, but is pretending like they operating in a normal economy, when inflation can be regulated simply through monetary means - you reduce the credit through higher rates and sterilize cash through making bank deposits attractive, and extra monetary pressure recedes. But we have a different situation: inflation is driven by budget spending on the war, the output gap caused by sanctions' impact on industries, the labor shortage. How all these factors are supposed to be influenced by Central Bank rate? Zero influence, as we can observe - Central Bank began its rate hikes a year and a half ago, in July 2023, but at end-2024, inflation is only accelerating, reaching nearly 0,45 per week in end-November - an equivalent of over 1,5% per month, or around 20% per year. The policy clearly isn't working.

Lobbyists are also pretending to live in a parallel reality. They keep saying "let's have higher inflation, but we'll have access to cash - see, Turkey is doing OK with high inflation". No, its not doing OK, as mentioned above - and the consequences of high inflation for the Russian industry will be much tougher.

Its quite weird to watch the debate between the two false narratives, none of which mentions the real cause of the problems - the war. The choice between Central Bank's policies and the ideas of industrial lobby is a false choice. There's no good way forward for the Russian economy if either path is followed - Central Bank will freeze the economy with growth-prohibitive rates, but relaxing them would lead to hyperinflation. Ending the war remains the only viable option - but its not on the table. At least, not yet.

Q: In early October, the Russian government announced a sharp increase in its 2024 federal budget deficit, raising it from the initially projected RUR 1.6 trillion to RUR 3.3 trillion - more than doubling the original figure. Could you explain, in simple terms, what a federal budget deficit is and how such a significant increase could impact the Russian economy?

A: A deficit means that the government spends more than is covered by budget revenues. When the current revenues aren't sufficient to finance the budget expenses, the government has to find money to finance the deficit elsewhere. Unless the government chooses to cut expenses, there are two ways to finance the deficit: borrow money, or spend the remaining financial reserves.

In the current circumstances, borrowing is difficult. Russia is cutoff from the international financial markets, and can't ask neither the Western governments nor the IMF for help. Notably, this is what Russia normally did when it found itself in a deep systemic crisis: in the last years of existence of the Russian Empire during World War I, or of the USSR during 1980s, our government heavily borrowed money in the West, which somehow prolonged the existence of an empire (but not for too long). Now, this option is not available, and neither China nor other countries of the Global South are interested in providing loans to Russia. China doesn't even agree to give a permit to the Russian government to issue yuan-nominated Russian state bonds.

Russia can still borrow domestically - which it tries to do to fill the gap between budget revenues and expenses. But under such high interest rates and with growing state bond yields (recent yields at 10-year OFZ state bond auctions exceeded 17%), it makes no sense: government spends more on servicing the expensive debt than raises from the market through OFZ bond placement. According to the Russian Ministry of Finance, after 10 months of 2024, Russian government spent 1,3 trillion rubles more on repaying and servicing the debt than raised through OFZ auctions. Under the current high rates and yields, borrowing doesn't make much sense.

The only option remaining is the depletion of the state's financial reserves. In the beginning of the full scale invasion of Ukraine in February 2022, liquidity portion of the National Wealth Fund - the state's rainy day fund - was 8,8 trillion rubles, but that is down to just 5,5 trillion rubles ($56 billion) as of November 1st, 2024, contracting by over a third.

On the background of that, the budget deficit for 2024 is planned to reach 3,3 trillion rubles by the end of the year (usually most of the deficit spending is done in December to close the financial year), or 60% of the remaining liquidity part of the National Wealth Fund. We don't know exactly how much of the National Wealth Fund money will be spent on covering the deficit of 2024, but it is reasonable to assume that the Fund will be significantly depleted by January 1st - probably to no more than $25-30 billion remaining. We will know precisely by mid-January.

I personally believe that the government would choose not to spend these remaining reserves on further financing the budget deficit, but rather to keep them as extra cash required for future shocks. This is the actual purpose that the Fund was meant for from the beginning, and Russia faces serious shock threats - like the oil price collapse scenario, which may seriously undermine state's finances (the 2025 federal budget is drafted basing on a forecast of average Russian crude oil export price of $69,7 per barrel).

In that case, Russia won't be able to finance huge budget deficit from the National Wealth Fund again, as it did in 2022-2024. Notably, during these past three years, federal budget deficit always exceeded 3 trillion rubles, despite Ministry of Finance's initial plans to keep it largely within 1,5-2 trillion ruble corridor. For 2025, they are planning a modest 1,2 trillion ruble deficit again, which is totally unrealistic - the deficit will certainly explode again. The problem is not just military spending, which is constantly growing - the current intensity of the war requires far more money than Putin initially plans. Another major issue is the growing interest spending due to high interest rates. Federal budget subsidizes not only mortgages for households, but also a wide array of loans for enterprises - recently, Economic Minister Reshetnikov said that the total expenses of the federal budget exposed to interest risk (where interest rate subsidies will grow along with the Central Bank's rate) is 17 trillion rubles, or over 40% of the total planned expenses for 2025. Finance Ministry was citing growing interest expenses as key driver behind unexpected growth in federal spending in 2024, a major contributor to budget deficit far exceeding planned limits. Given the expectations of further Central Bank rate hikes, it is impossible to keep the federal budget deficit within the planned 1,2 trillion ruble figure in 2025.

The Central Bank of Russia. Wikicommons

But Russia clearly won't have the financial reserves available anymore in 2025 to finance deficits of the 2022-2024 magnitude; borrowing, as explained above, doesn't work. There's also another, non-liquidity portion of the National Wealth Fund also available - another $82 billion which is invested in various bonds and shares, mostly of Russian state companies. (This figure also includes $3 billion hastily lended to Victor Yanukovich before Euromaidan revolution in late 2013 - which are non-recoverable, but they remain accounted for in the National Wealth Fund on paper.) Most of these funds are technically recoverable, but not immediately - some of the companies which received financing from the Fund through issue of bonds are currently experiencing major difficulties due to Western sanctions, like Novatek or Sibur. Some of the shares controlled by the Fund can be sold (like Sberbank's shares), but a massive sale will badly affect their price, and the government will lose some of the book value of National Wealth Fund's assets. Same, basically, is true for gold, which accounts for about 40% of the liquidity portion of the Fund - massive selloff may negatively affect prices.

So, basically, Russian government has more or less run out of viable options to finance massive budget deficits from 2025 on. It may find second-best solutions for some time, but not for too long. On top of all, in the lack of foreign and private investment, and on the background of expensive credit driven by Central Bank's rate hikes, Russian state budget became a "Mother Goose" of sorts for most enterprises and projects, which rely heavily on government's support to go on. This is too much pressure on the federal budget, which prompted Finance Minister Siluanov to state last week that "the era when budget provided stimulus to everything is over".

Some time in the near future Putin will have to reconsider the budget policy of 2022-2024 - he can't afford to run wild deficits any more, state's funds are rapidly depleting. The choice is to either massively scale back military activities (stop the war), or to find costly second-best solutions which will have massive negative repercussions. One option is to raise taxes - on top of the 3 trillion ruble tax hike already effective from January 1st, 2025, which will dramatically hurt investment and economic recovery already. The cost of tax increases will be curbed investment and end of economic growth. Another option - to let the monetary policy loose, and switch to emission financing of the deficit. No need to mention that this would propel inflation to new highs, likely even surpassing Turkey, and more resemblant of the Russian situation of early 1990s.

Q: According to multiple Western media reports, Russian research groups, and Ukrainian intelligence, Russia's military is recruiting approximately 25,000 to 30,000 individuals per month. The majority are working-age men, drawn directly from the labor market. Are there reliable models or calculations that can quantify the short- and long-term economic impacts of this labor force depletion?

Military recruitment poster in Belgorod, Russia

A: I strongly doubt these numbers are true. Had Russia recruited 30,000 men to war on a monthly basis, that would have meant drafting over 700,000 men over the course of two years, or over 1 million men in three years. While the impact of the war on the labor market is significant beyond doubt, there was no such wipeout of manpower from the market as minus nearly 1 million men in the past three years. That would be within 4-5% of the total middle-age male population, given that the total number of men aged 20-40 in Russia is just around 20 million. (You often hear the figure of 140+ million Russian population, which creates an impression of an unlimited manpower, but that figure is misleading, as the population significantly consists of women and elderly people.) Of these 20 million, about a quarter already serves in the army or security agencies, at least 1 million have waivers from drafting (basing on MoD data), about a third are either abroad or medically unfit for military service (it is known that Russian MoD sends even medically unfit men to war, but millions of Russians have issues like bad eyesight, etc., which makes them unfit for service anyway, they simply won't be able to fight). That leaves a much narrower space for recruiting people even on a commercial basis - less than 10 million men aged 20-40 are actually available for being drafted for money. 30,000 per month taken out of that limited manpower pool for a prolonged period of time won't go unnoticed.

I don't know where the 30,000 monthly figure comes from - maybe intelligence somehow confuses conscription center visits with actual drafting. In any case, I estimate that the total number of men recruited for the war hasn't exceeded 500,000 (on top of the military personnel numbers already available in February 2022). Higher figures are hardly possible mathematically.

But even such scale of drafting is already disastrous for the labor market. Exact numbers are difficult to tell, but the numbers and estimates from several reliable sources suggest the following:

- There are currently around 2-3 million vacancies at the labor market, according to various estimates, and this number is steadily growing;

- Most industries - including manufacturing, agriculture, logistics, retail trade, utilities, IT - report shortage of jobs measured in hundreds of thousands, or from 10% to over 50% of the total workforce depending on the sector;

- Various surveys of enterprises suggest that 75-80% of them indicate employee shortages as number one constraint for their performance, and Central Bank's monthly "Monitoring of enterprises" bulletin, regularly surveying from 12,000 to 15,000 enterprises, indicates that the availability of employees index is the lowest ever on record, worse than in the 1990s.

Central Bank indicates shortage of employees as the key factor constraining output growth, which, in turn, is considered to be the key factor behind the persistent output gap (failure of supply to catch up with demand growth) that is a key driver of inflation.

This is a key reason why Putin, contrary to many forecasts, hasn't called for a second wave of mandatory mobilization since Autumn 2022. This is not to say that he can't do it, but this would be such a disastrous hit for the labor market, that the Kremlin would really think twice before even considering a second wave of mobilization seriously.

To give you an idea about how bad the labor market situation really is, just a reference to the discussions at the annual "Russian Industrialist" forum held in St.Petersburg on November 26-28, 2024: one of the main ideas on how to ease labor shortage problem is hiring teenagers under 18 and pensioners to work. No kidding, you can enjoy this charming discussion in the Russian business media yourself.

Q: To maintain a steady flow of recruits into its army, Russia is offering cumulative sign-up bonuses exceeding 3 million roubles per person. A simple calculation on a napkin: 3 million roubles multiplied by 250,000 recruits annually - yields a staggering 750 billion roubles just for a sign-up, a substantial sum even by Western standards. How sustainable are such payouts?

A: National Wealth Fund basically consists of excessive taxes on oil and gas industry collected in the previous years, when oil prices were much higher, and the budget hasn't suffered from extreme war-driven deficits. But its rapidly depleting, as I mentioned above. The liquidity portion of the National Wealth Fund shrunk by over a third as compared to February 2022, and is now only 40% of the total amount of the Fund (it was as high as 60% of the Fund when the full scale invasion of Ukraine started, the Fund had significantly higher liquidity back then). Just the 2024 federal budget deficit alone makes up 60% of the remaining liquidity assets of the Fund, meaning that a good half of it - if not more - will be spent before January. The remaining assets are much harder to recover, they are not cash.

Q: Given all of the above, what is your current short- and mid-term forecast for the Russian economy? What key factors should people be watching, and what major changes or events do you anticipate in the near future?

A: My forecast is quite grim. There are no sources of good news for the Russian economy on the horizon, only bad news. It was hoped by Putin that some time by now, end-2024 or early 2025, Russia will find a new economic model to substitute former dependence on the West, and will move forward apart from just depleting the remaining scarce reserves. But the new model wasn't found. Import substitution is not working: Russia is significantly cut from international technology, and its own corporations are lazy corrupt monopolies, also inheriting a lot of Soviet manufacturing culture, which fundamentally has no idea what competitiveness or client orientation is. We can't manufacture competitive products in such a hostile environment, unfriendly to private initiative and innovation. Russian domestic market is too small to ensure commercial viability of new products - be it smartphones, cars, airplanes, etc. - but China and other countries of the Global South refuse to open their markets to us. As a result of decoupling from the West, Russian non-commodity and non-energy exports are now about a quarter lower than they were in 2021 - and new markets of the Global South are not opening for our products (imagine we could even produce a competitive one). Putin hoped that China would bail him out financially and share technology with us, but it doesn't want to. The only lifeline is the remaining government's cash reserves, but they are running thin quite fast.

You mentioned stagflation earlier, but I think that may even turn out to be not the worst possible scenario - Russia may face recession instead. Stagflation means low or zero growth, a stagnation of the economy combined with high inflation. But Russia in the current situation faces probably a more rapid output contraction prospects than anticipated - given the fact that most enterprises have low or zero profitability, and are not ready to withstand high interest rates for a protracted period. But war-driven inflation is not reacting to Central Bank's interest rate hikes - which means that the Central Bank may raise the interest rate significantly at its next meeting on December 20th, to 23%, 25%, or even beyond. Everyone's looking now at this Central Bank's December meeting as some sort of end-of-the-world date, like, remember, people did with regard to some Maya calendar doomsday date a few years ago.

Whatever happens on December 20th, its clear that the Russian economy is marooned. It was expected in 2022 that, some time by now, Russia will firmly stand on its feet, developing successful import substitution, a single market with China, etc. None of this is happening. We're still reliant on everything imported, workforce was heavily depleted by war, all this fuels inflation, attempts to calm it down through high interest rates only cool down the economy. Everything depends on the state money, but these are running scarce. A dead end.

Putin may continue the present course for some time, but 2025 will be some kind of moment of truth for him. He won't be able to afford another high-deficit budget. He has to decide what to do with inflation/economic cooling scissors, whether he would go full monetarist and watch his industries die under pressure of high rates, or he lets it loose like Erdogan did. The clock is ticking regarding the workforce and military personnel shortage crisis, either. We're not there yet - but at some point soon, Putin will have to seriously reconsider continuation of the war. Bad state of the Russian economy doesn't provide many possibilities for continuing.

Additional Links and Sources:

1. Free Russia Foundation. Think Tank
2. November Report
3. Expertsouth article
4. The Central Bank of The Russian Federation