Russian war economy: going up before going down?

Russia’s economy is paying growing costs for its expensive war against Ukraine. With Trump back in office in the United States, the new American administration is busy with reaching a quick deal to end the devastating war that harmed not only Ukraine but also Russia. The weakness of Russia’s economy could be a decisive factor to force it into negotiations – on the West’s terms, rather than those of the aggressor.

“He should make a deal. I think he’s destroying Russia by not making a deal,” Trump told reports about Putin. “I think Russia is going to be in big trouble. You take a look at their economy. You take a look at their inflation in Russia.” Later, Vice President JD Vance also added that the US could tighten their sanctions if Russia refuses to make a deal.

In contrast, the mood in the Kremlin is different. This month, Prime Minister Mishustin reported to Putin on the state of the Russian economy. He highlighted the strength of economic growth, driven by expanding industry, record-low unemployment and rising wages. Inflation and labour shortages were acknowledged as minor issues, but nothing to be concerned about. “The country’s economy successfully overcame the unprecedented pressure of sanctions, unlike many of the countries that introduced them,” he stated.

However, a report prepared that same day by the Economy Minister for Mishustin painted a different picture. It warned of mounting economic risks, including lower oil prices, growing budget constraints and worsening corporate debt. “A scenario where economic slowdown leads to a technical recession much faster than inflation eases is becoming increasingly likely,” the report stated.

Russia’s rapid economic growth is heavily fuelled by war spending rather than sustainable productivity. Meanwhile, rising wages have contributed to soaring inflation, which the Central Bank has struggled to contain. Both citizens and industrialists are feeling the pressure – food prices are climbing, and doing business is becoming less profitable. Some economists caution that Russia may not just be muddling through but slowly slipping towards stagflation, a dangerous mix of economic stagnation and high inflation.

As the peace negotiations are about to start, both Ukraine and Russia are working to strengthen their bargaining positions through military and diplomatic efforts. However, the economic front is equally critical. Russia is not only trying to contain internal imbalances to sustain its war effort but is also ramping up information campaigns to promote the image of a resilient economy despite sanctions. But is Russia’s economy truly as strong as its leadership claims, or are mounting troubles beginning to pose a serious threat to the government?

Collapse that did not happen

Since the start of the full-scale war in Ukraine, the international community has imposed numerous punitive measures against Russia in response to its aggression. Both the G7 and the EU implemented sanctions aimed at draining Russia’s war coffers – including cutting Russia off from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system, freezing $300bn in assets in Belgium and capping oil prices, as well as targeting the shadow fleet used to bypass sanctions.

Despite predictions of economic collapse, Russia’s economy has defied expectations. In December, Putin claimed that the economy was not only growing but was doing so sustainably. “Russia has become a much stronger country during the last two years. Why? Because we have become a truly sovereign country,” he concluded.

While Russia’s GDP initially shrank by -2.1% in 2022, the downturn was short-lived. The economy rebounded, allegedly growing 4.1% in 2023 and 4.5% in 2024, according to the Russian Prime Minister. However, these numbers go against the previously reported data. In his report, he also noted that real incomes rose by 8.4% and wages by 8.7% in 2024. Meanwhile, unemployment hit its historic low of 2.5% in 2024, down from 4.4% in January 2022. The economy was rapidly expanding, and Russians had more money to spend – despite 9.52% inflation.

According to Alexander Kolyandr, writing for CEPA, Russia’s economic resilience can be attributed to several factors. The departure of at least 1,200 international companies reduced competition for domestic businesses, allowing them to gain higher profits. Meanwhile, sanctions and capital controls trapped about one-fourth of Russia’s financial capital within the country, forcing wealthy Russians to reinvest domestically. Additionally, soaring public spending, increased demand for defence, and a shrinking labour force have driven up wages and consumption, further fuelling economic activity.

Russia has also relied on high energy prices, its market-oriented structure and a resilient banking system to stay afloat, explains Alexandra Prokopenko, a non-resident scholar at the Carnegie Russia Eurasia Centre. She argues that state spending has been the primary driver of growth, accounting for 10% of GDP between 2022 and 2024. Yet, this image of resilience may be misleading.

“Over the past two years, Russia’s economy has operated like a marathoner on fiscal steroids- and now those steroids are wearing off,” she warns.

From short-term resilience to mounting problems

Russia’s economic resilience may be short-lived. Its economic growth is likely to be a short-term phenomenon, fuelled by soaring government spending on defence, where only those sectors connected to the army are expanding. There is no genuine increase in productivity, and the current growth is unsustainable. The economy is slowing down, low unemployment claims are misleading and inflation is much higher than the official data and growing. In contrast to the government’s optimism, Russia’s Central Bank projected only 1.5% growth for 2025, while the IMF gave an even lower estimate of 1.3%.

Prokopenko suggests that economic activity is indeed slowing down while industrial facilities are already operating at 81% of their capacity, with 73% of enterprises reporting labour shortages. In other words, businesses are reaching their productive limits, and the economy is overheating.

The Bank of Finland described the situation as unprecedented, emphasising that the economy cannot keep up with demand and will inevitably slow down. Moreover, technology sanctions and high interest rates have severely impacted Russia’s key manufacturing sectors. For example, between 2022 and 2024, the United Shipbuilding Corporation planned to build 108 planes, but only produced seven. Many of the components could not be imported from the West anymore.

The record-low unemployment rate is also misleading, as labour shortages persist, with 1.6mn job vacancies remaining unfilled. This is particularly concerning given that between 650,000 and 2mn Russians remain abroad and approximately 850,000 have been killed or wounded in the war. The government has further tightened immigration rules since the Crocus City Hall attack in March 2024, and its efforts to force foreign workers into military service have discouraged more Central Asian migrants from coming to Russia.

Meanwhile, the US has ramped up pressure on Russian oil exports, which account for about one-third of the country’s budget revenue. This January, the US Treasury imposed sanctions on Russian oil companies and 183 vessels belonging to the ‘shadow fleet’. Freight costs for shipping Russian oil have risen by at least 50%, and experts warn that Russia could soon face a “shipping crisis.” This could push India and China to import more oil from the Middle East, Africa and the Americas instead. Given that these two nations have played a crucial role in helping Russia redirect its energy exports from Europe to Asia, any decline in exports would further strain Russia’s war budget and create additional economic risks.

At the same time, Russia’s soaring spending on defence has worsened budget deficits since 2022, reaching 2% of GDP in 2024. Compared to January last year, the deficit surged 14-fold to 0.8% of GDP due to a staggering 73.6% increase in spending. Nearly half of this spending is allocated to defence and security, and Russia’s defence budget is expected to rise to 7.5% of GDP this year – more than “all of Europe combined.” This growing expenditure is likely to widen the budget gap and drive inflation even higher.

To cover these deficits, the government has been tapping into its National Wealth Fund (NWF), a reserve funded by high oil revenues. However, the fund has been rapidly depleting, with its liquid share of GDP shrinking from 7.2% in 2022 to just 2.8% today. The coffers are now even drier. The Russian Central Bank has warned that in a worst-case scenario- characterised by slow growth, high inflation and low commodity prices- the NWF could run out of liquidity as early as 2025. Additionally, $300bn of Russia’s foreign currency reserves remain frozen in Belgium at Euroclear, preventing the government from using them to finance deficits. In response, Moscow has been forced to raise taxes, moving away from a flat income tax system in favour of progressive taxation and higher corporate tax rates.

The Central Bank has also been struggling to contain inflation, which has been fuelled by excessive government spending and rising wages. Inflation reached 9.5% in December 2024-more than double the bank’s target. However, Russian experts estimate that real inflation is likely much higher, ranging between 22% and 25% on average. The situation is further exacerbated by the weakening ruble, which has lost at least 15% of its value since February 2022.

To combat inflation, the Central Bank raised interest rates to 21% in 2024 – a level not seen since 2003. This, in turn, drove up interest rates for commercial bonds to between 27% and 30%, as companies competed with more secure state bonds. Despite the skyrocketing costs for the private sector, businesses have been borrowing despite double-digit rates. The corporate debt increased by 21.8% by October 2024 further contributing to inflation.

Higher borrowing costs are expected to increase bankruptcy rates, as debt-reliant companies struggle to stay afloat. Analysts initially predicted that interest rates would rise beyond 21%, but the Central Bank faced pressure from politically connected industrialists to hold off on further hikes. For instance, the head of Rostec, a state-owned defence conglomerate responsible for producing about 80% of Russia’s military equipment, warned that such high borrowing costs make business unprofitable. He further stated that exports of long-production-cycle products, such as aviation, air defence systems and shipbuilding, might have to be halted altogether. Lower profits in Russia’s defence industry could increase demands for state subsidies, putting additional strain on the budget, as well as undermining its production of weapons.

The year of reckoning?

Last year, Russia’s Central Bank governor, Elvira Nabiullina, acknowledged that the country’s labour force and production potential were almost exhausted. Coupled with potentially slowing economic growth and persistent inflation, Russia could be headed towards stagflation. A few months later, she addressed parliament, stating that Russia was not experiencing stagflation due to a timely “substantiated monetary policy.” This month, Prime Minister Mishustin proudly announced that the Russian economy has adapted to the looming economic challenges.

However, with multiple bad omens on the horizon, the economic outlook is neither entirely rosy nor disastrous. While Russia’s economy has shown resilience in the short term, that does not mean it is immune to crises. Economists – both domestic and Western – already warned that Russia’s economy may indeed be heading towards stagflation, with slowing economic growth and rising inflation are key indicators to keep an eye on.

This year is also expected to be pivotal for peace negotiations. While Russia aims to claim more military successes in Ukraine to strengthen its negotiating position, its economy remains another front it is struggling to manage. In war, a collapsing effort will eventually lead to economic collapse, but the reverse is also true; a weakening economy could undermine Russia’s position both at the frontline and in negotiations.

Low-quality economic growth, driven by defence spending, combined with soaring inflation, could exacerbate Russia’s troubles – especially if oil revenues continue to dwindle. With most of its foreign currency reserves frozen and its National Wealth Fund running low, while having limited capacity to issue sovereign debt on global markets, Russia faces rising costs in sustaining its war economy on borrowed time.

Finally, the US, Europe and their allies need to step up sanctions to further pressure Russia’s economy, ensuring that stagflation is not just speculation but an impending reality. However, this will not be an easy task. The new US leadership is unlikely to solve the war problem in just one day or even three months, as promised. There is also a real risk that Trump could soften his stance on Russia by pushing to end the war in Ukraine as soon as possible – on preferable for Russia terms. Meanwhile, Europe is grappling with multiple crises, such as the rise of the far right, war fatigue and mounting sovereign debt, to name a few.

If Russia’s economy is given a respite – whether through the partial lifting of sanctions or continued profits from energy sales –  it could strengthen its military and stabilise its economy. The question remains whether Russia can achieve this quickly, but what is certain is that we should not underestimate the economists of a country that has been waging a full-scale war against one of Europe’s strongest armies, backed by the entire West, for the past three years.

The weakness of Russia’s economy also presents Trump with an opportunity to force real concessions from Putin. If he wants “quick” solutions to the war, he needs tools that can be deployed immediately – without the delays of complex projects like pushing Europeans to seize $300bn in frozen assets. Targeting Russia’s oil revenues could be the key tool in further destabilising its economy.

This month, US special envoy for Ukraine and Russia, Keith Kellogg, confirmed that tightening sanctions on Russian oil production and exports is already on the table – unless the Kremlin agrees to negotiate. Draining Russia’s war coffers would thus further strain its economy, depreciating the Ruble and further fuelling inflation, while the costs of sustaining high government spending would only rise.

If Trump truly seeks “peace through strength,” his administration must step up pressure on Moscow, not ease it. Failing to exploit Russia’s economic weakness would be a strategic mistake- contributing not to “peace through strength”, but to “peace for our time”.

The views expressed in this #CriticalThinking article reflect those of the author(s) and not of Friends of Europe.