Last week, a Bloomberg piece concerning the role of defense procurement orders as a 'boost' to the Russian economy caught my eye. As far as I can tell – and based on the quotes and structure of the piece – the analytical conclusion is that much stronger than expected demand for military goods, equipment, and services have gone a long way to offset the initial pain of sanctions, the brief period in which the ruble exchange rate collapsed, and broader slowdown in consumption. This graphic including sectoral year-on-year data as of July lead the charge:
Pharmaceuticals are a no-brainer. There have been significant supply shortfalls for the entirety of the pandemic, with the enhanced difficulty of importing necessary medications prompting a rush on production as higher levels of inflation have given the industry more room to pressure the government into allowing larger price markups. Prices are negotiated with a complex set of formal instruments designed to limit the scale of potential relative price increases and informal agreements. Finished metal goods, however, are almost certainly all military in nature. Light automobile production has plummeted, most consumer durables are imported or import-dependent, and even before sanctions, goods such as refrigerators intermittently faced supply crunches on inputs. A later chart made clearer the gap between manufacturing activity and consumption:
The idea that these datapoints imply stronger than expected performance is actually counter-intuitive despite the beginnings of some recovery in imports. Manufacturing activity is significantly outperforming consumption as indicated via retail, with a large surge in mortgage issuances driven by the Central Bank's rate cuts. In June, mortgage takeup rose 68-70% month-on-month back up to 220 billion rubles with similar increases in total issuance of credit from banks that reached 675.3 billion rubles. For context, the surge in mortgage demand driven by the low-rate mortgage programs backed by federal money given to banks was largely over by the end of last year. Come December 2021, it was expected that incoming interest rate hikes linked to the Central Bank's own belief that the economy was overheating could reduce demand as much as 30%. In December, the key rate set by the Bank of Russia was at 8.5%, 1% higher than where it currently rests. Worse, banks were beginning to ease the conditions under which they'd lend because of much weaker demand on the primary market vs. the secondary market, with the comparatively small pool of investors able to play the market looking at housing as a comparatively safe and, crucially, real asset that could survive shocks such as the pandemic. It is vital to note this because of how large an expense homes are relative to buying consumer durables and most services. As such, it's not a great sign that so much of the consumption activity still taking place is highly exposed to interest rates.
Some of this year's figures also reflect yesterday's budget priorities. Before the surge in spending triggered by the invasion, the defense budget was being increased in real terms while spending on the 'national economy' (capital investment) was being pared back and social spending commitments had broadly failed to keep pace with inflation since COVID began. Crucially, defense spending doesn't cover domestic security which is its own share of the budget, putting the degree to which what has clearly become regime security rather than strictly national defense was overtaking other areas:
This underlying trend does relatively little to explain the manufacturing data after March, but it does set up a huge portion of federal procurements in Q1 that would have proceeded apace after the initial invasion. There are two glaring problems, however, with any argument suggesting that military spending is "boosting" the economy based on high level economic figures. First, military kit has a relatively low multiplier effect across the economy. Bullets, shells, and missiles can only be used once and much equipment is replacing existing kit breaking down or being abandoned, but more importantly the money and economic activity created through their production is limited to specific industrial towns and cities and entirely at the whim of the federal budget. Second, the regime's budgetary politics and refusal to think outside the box mean that military spending is displacing potential spending elsewhere that could lift the economy's productive capacity or, at minimum, enhance its ability to export to new markets and reorient all exporting industries away from Europe.
Not all growth is created equal. Demand wholly reliant on state spending that is consumed by the state with limited capacity to generate self-sustaining demand and investment elsewhere is not what the Russian economy needs right now. It also comes at a time when the budget is under mounting pressure and deficits face growing headwinds from a looming Bank of Russia pivot:
As noted here, monthly oil & gas revenues in ruble terms have fallen from 1.8 trillion in April down to 672 billion as of August (ignore the USD bits for now since real exchange rates are increasingly difficult to assess as a reflection of purchasing power). As crude oil prices have fallen, the capacity of oil & gas revenues to offset the loss of revenues from taxes on consumption and incomes has largely evaporated. The following two charts from Ilya Matveev captured the dynamics really well:
Unsurprisingly, the deteriorating fiscal balance is now triggering talk from the Ministry of Finance of a budget "sequester" whereby 10% of expenditures not considered 'ring-fenced' – pension payments, civil servant salaries, and healthcare spending are off the table for now – would be cut for 2023. In practice, that suggests cuts to capital investment deemed not essential or otherwise contested by enough interest groups to make killing a given project the easiest solution to resolve a political conflict. Revenues from the non-resource sectors of the economy are down 14% in nominal terms year-on-year and 30% in real terms, with Putin reportedly prepping the cabinet and ministries with a warning that they ought to plan for budget difficulties.
This is where underappreciated sanctions pressures, mortgages, and the consumption problems indicated by the "boost" from defense spending collide. The go-to measure to avoid what the Kremlin would otherwise see as excessive (or inflationary) borrowing is to mobilize assets and FX reserves from the National Welfare Fund to finance spending. But the combined effects of USD/Euro central bank sanctions, cut offs from SWIFT, and generally toxic rep that Russian banks and the ruble have makes it difficult to buy rubles using those FX reserves, which themselves were accumulated as net foreign assets. Since it's hard to convert FX into rubles, the Ministry of Finance has taken to claiming rubles on its balance sheets through sleight of hand, effectively printing rubles into existence without any real transaction taking place while pretending otherwise. The risks grow as the budget surplus shrinks. At the same time this is happening, Bank of Russia governor Elvira Nabiullina believes that the Bank has run out of room to cut interest rates and maintaing its neutral stance citing strengthening pro-inflationary factors overtaking deflationary ones across the economy. In practical terms, that means rates will go up in the near future as this view is broadly shared by the Ministry of Finance and likely reflects concerns over the move to use money emission to address budget shortfalls. If rates rise 1% off their current levels, it's safe to assume mortgage (and housing) demand will sag off like they were late last year given real incomes are lower than they were then and most households have run through a lot of savings in the last 18 months. Rises in rates will also hurt purchases of cars, to the extent that's still a relevant market, and other consumer goods at a time when Russians are taking out record numbers of new credit cards to cover expenses.
If housing demand goes down, then the cumulative effect of continued real terms increases in defense spending with real terms cuts to capital investment and other spending elsewhere will worsen. The "boost" is set to choke private consumption, especially as tax increases would have to either hurt business investment (bad) or consumers' spending power (worse). Spending cuts would be even worse by killing demand. Military spending is not a lifeline for the Russian economy. It's starving it of capital it needs elsewhere. When Neera Tanden once said this is deficit politics, this was the hellscape she (bizarrely) had in mind. The cost of constraints, be they real or imagined, will fall heaviest on households and sectors of the economy most desperately needed to generate more tax revenues through (gasp!) growth. The more credit is needed to keep consumption afloat, the more pain any increase in interest rates can wreak while also increasing the nominal cost of sovereign borrowing. As Mos Def laid it down:
Gotta handle business properly, boost up my economy
Store it up and get my mom some waterfront property
Yesterday was not for me but nowaday it's time for me
The streets is watching me, I watch back, that's the policy
Good luck with that when every marginal ruble increase in revenue is set aside to keep the production of military goods with quick expiration dates going and the streets are watching whether or not you want to draft their kid or brother for a war that's increasingly incomprehensible.
- Parallel imports are reportedly picking up pace, with the first 3 and half months of the legal regime for them leading to 1.3 million tons/$9.3 billion of imports supporting consumer goods consumption. It's expected the total volume will reach $20 billion by year end. That's relief, sure, but always important to remember that parallel imports almost always entail markups since the third party exporters now they have Russian importers up against a wall.
- Luhansk is now rushing through a referendum to join the Russian Federation in the next week, which goes to show that the 'center' preventing mobilization cannot hold. This is a very worrying sign that the path to mobilization is clarifying by inertia as different interest groups and individuals jockey to force decisions within the Kremlin that Putin would normally defer and muddle away from.
- The Ministry of Finance wants to extend the "credit holiday" for SMEs through March of 2023. Translation: they can't spend to generate demand, so instead want to freeze the cost of credit for businesses suffering from the hit to consumption to keep them afloat. They tried that in 2020 and it helped, but did nothing to deal with falling real incomes feeding into lower revenues and profits. My best guess is that this is keeping businesses afloat, but more like papering over the problem.
- The government is reportedly looking to take an additional 1.4 trillion rubles in budget revenues from oil & gas exporters in 2023 by raising export duties and the new system around MET. How? No idea given exports to Europe are already gone for gas and about to take a big hit for oil that will drive output down at a time when the price outlook doesn't scream massive rally in the year ahead. Seems like they're going to do whatever they have to so they can delay raising taxes on households.
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 email@example.com. Always happy to look at any freelance opportunities pertaining to Russia, Eurasia, energy and commodities, or my old love foreign policy.