7 min read

Bust A Cap

Bust A Cap

The stunning success of the Ukrainian military's counteroffensive in Kharkiv oblast' and reports of further attacks gaining ground in Luhansk and Donetsk have grabbed everyone in Eurasia-world's attention over the last few days. Leaving operational details to military analysts far better equipped than I am to comment intelligently, the significance for Russian domestic politics is equally important as grasping the context in which the Ukrainian military planned its actions. Big picture, one can readily infer that the deliberate effort to build up expectations of an operation around Kherson was intended to thin out the front elsewhere and create opportunities to attack on more even terms. Politically, a victory was desperately needed to ward off any pushback in the West against the continued supply of material. Equally, it created space to better procure financial and economic assistance given the dire straits of the country's finances. Here are nominal comparisons for defense spending vs. social and economic spending (my understanding is the latter includes state-backed capital investments) from the consolidated budget on a monthly basis for January-July:

Hryvnia, billions

The increase in defense spending is astronomical, tempered only by the punishingly high levels of inflation now being experienced. I highly doubt official data captures them effectively. Current aid commitments, as large as they may appear, are inadequate to the scale of the country's economic needs. Military assistance in particular runs into trouble because it does not effectively circulate through the economy. Handing over a long-range missile system, the ammunition to use it, and training for the soldiers using it does zilch for the national balance of payments, ensuring the solvency of pensions, or continuing to pay the salaries of public services that are vital:

Now comes the worrisome part. We have to wait and see what exactly the Russian military comes up with to respond. Even with the considerable constraints and weaknesses that were exposed in the last week, there is no reason to assume that the General Staff is incapable of learning or adjusting, and equally there is no reason to assume that the Kremlin has any intention of letting this go lightly. There's no way to spin a humiliating loss of this magnitude and the referenda to line up the annexation of the LNR and DNR are now DOA. Disrupting the annexation plans were surely an objective the Ukrainian military had to have considered given the political challenges of retaking territory intensify were they to be legally incorporated into the Russian Federation. Yet more egg on the faces of political technologists milling around Sergei Kirienko, mumbling and looking at their shoes for inspiration before going back to their bosses.

This comes at the same as Russia has begun formally offering discounted crude oil to India to circumvent any potential enforcement of the G-7's oil price cap. Granted, the discount may not be as large as the G-7 hope and some of this is Russian exporters jockeying with competitors in Iraq for market share, but it points to a problem Russia has no matter what the G-7 do. The very act of them talking about it gives importers a reason to demand discounts in the first place. Were it a market significantly tightening at the moment, buyers would have less power. But OPEC's August report captures the underlying problem, if not with the most depth given their approach to forecasting. OPEC is forecasting China's GDP growth bullishly at 4.5% y-o-y:

China Quarterly GDP Growth, y-o-y

For God knows what reason, OPEC is spinning a yarn about China's growth returning to trend in H2 of this year, probably because of lockdowns easing. That simply does not add up given the immensity of the slowdown in the property market. While much of that can be attributed to financial troubles for developers leading to banks shying away from lending, it does not capture the scale of the contraction in mortgage issuances taking place at the moment. Michael Pettis succinctly captures the problem in context with worries about China's current account surplus shrinking on weakening global demand:

"This is one of the main problems with an over-reliance on a trade surplus to generate demand. As we saw in 2009-10, anything that causes a drop in foreign net demand forces Beijing to choose between a surge either in debt and non-productive investment or in unemployment."

They're still choosing the latter, which will depress China's capacity to lift oil demand growth into next year.

Losses on the battlefield and a worsening macroeconomic outlook for non-food commodities markets outside of natural gas (politically-induced scarcity) and coal (reacting to natural gas and heatwaves) create two-fold problems for officials in Moscow borne out of Russia's dependence on foreign demand. First, the political legitimacy of a system that relies on demobilization, atomizing the public's social and political identities and consciousness to inculcate apathy, and things being "good enough" has no answer for the retreat in Kharkiv. No amount of pretty talk or talk show insanity can hide it, nor can the regime easily back down given its own tightrope walking to court nationalists without giving in entirely to them. Second, the influx of commodity-linked revenues for the budget driven chiefly by the strength of the United States' economic recovery and fiscal response to COVID are over, as are the excess oil revenues from the initial sanctions shock after February 24. Whatever they do next requires a new framework. Yet the old shibboleths remain:

Growth of M2 Money Supply, Light Blue = other deposits Orange = transferable deposits Purple = cash Black = money supply

The Central Bank is backing the more optimistic outlook from the 'economic bloc' within the government citing consumer data (a bit questionable), which funnily enough rests on a credit expansion. Yet we can see from the chart above that the expansion of the money supply in 2020, assuming an ultra-orthodox rendering of price (in)stability, fostered rising inflation through 2021 despite the large slowdown in the growth of money in circulation. Inflation certainly has a large role to play here as well, but the surge in borrowing – money supply in this case is about credit – is keeping levels of consumption afloat, not supporting an expansion of investment or an increase in aggregate demand.

Instead, the relative stability seen from the end of February through to July is actually a result of comparable declines in demand and supply. That produced greater price stability than otherwise expected. Now demand is weakening such that supply is at risk as damage mounts to production of various kinds, nor can a surge in borrowing overcome physical constraints on imported components. Despite these underlying issues, technocrats are still selling the idea that they can crowd in private investment to get their boom. That's where the Kharkiv offensive and fighting around Kherson start to matter. Any given business or investor needs attractive market conditions – opportunities for growth, good margins, and so on – and needs to be able to secure their investment reliably. We all know those two factors aren't great at the best of times in contemporary Russia. But further than that, businesses and investors need some form of inducement to invest, to decide that risking capital today for potential future returns it worth more than holding their money and packing their bags for Europe.

March 2021 saw the regime begin to openly browbeat corporate heads to get moving in a quiet campaign to mobilize capital, one that was relatively unsuccessful but did presage a relative rise in industrial investment in H2 of last year. That is a far more difficult sell in an environment where the Russian military is not securing expected gains on the battlefield, where the competence of the military and security establishment are in question, and where there is no discernible "light" at the end of the tunnel to justify sacrifices for the state today. If there was psychological comfort in a notional victory creating space for some sort of agreement with the West, that is evaporating. Worse, it likely heralds a new phase of domestic politicking as the social forces political technologists tried to harness to power through the invasion begin to turn on them. It was bad enough that the chairman of the board of Lukoil might be killed in the hospital via defenestration when things were static, but the balance of military power still favored Russia. Imagine the risks to doing anything if you have a substantial amount of capital now.


  1. The FSB is now communicating to the public that it's successfully foiled terrorist attacks planned by the SBU or partisans in Kherson and Crimea. I expect more of these stories to emerge to save face . . . and distract the public from developments such as Aleksandr Tkachev, former head of the Ministry of Agriculture, becoming the nation's largest landowner after buying out the country's second-largest producer of sunflower oil.
  2. Indonesia is also apparently looking at importing Russian crude oil and product supplies after Russian exporters reportedly offered 30% discounts against the market benchmark. If Russia's plan to circumvent a price cap is to cap its own prices to induce buyers to close contracts, then it's working.
  3. After the significant loss of tanks on the Kharkiv front, Uralvagonzavod's tank factory at Nizhny Tagil is reportedly moving to a 24-hour work schedule, presumably to replace losses fast enough to help offset the degree to which the Ukrainian military has gained the initiative. That means 12-hour shifts during the week, 8-hour shifts on the weekend. I'm reminded of Donald Rumsfeld's cautionary reminder that you go to war with the army you have, not the one you wish you did. If military output has to ramp up to offset losses on the front in the weeks and months ahead, that's going to affect civilian production eventually.
  4. For any nerds curious, the Bank of Russia's latest release on financial flows across the economy is a good read from last week with some clear takeaways. Inflows are generally dropping, if slowly, outside of exporter earnings. In other words, the Russian economy is becoming more dependent on external demand at precisely the moment it shouldn't be.

Like what you read? Pass it around to your friends! If anyone you know is a student or professor and is interested, hit me up at @ntrickett16 on Twitter or email me at nbtrickett@gmail.com. Always happy to look at any freelance opportunities pertaining to Russia, Eurasia, energy and commodities, or my old love foreign policy.

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