ECONOMIC REVELATIONS: RUSSIA IS WORSE OFF THAN WE THINK

There’s been a lot of news from several sources recently exposing a huge problem inside the Russian financial system that stands to have an economic impact – and it appears to be making itself felt already this year. It is so fundamentally dangerous to the Russian financial system and wider economy that it could actually precipitate a major crisis at any time.

The Davis Center at Harvard University, amongst others, outline a very significant but informal arrangement established by the Kremlin – not the Central Bank – to force fund the armaments industry.

THE PLAN

This worked by the Kremlin going to the commercial non-state owned banks, and leaning on them forcefully to make unsecured ‘off-budget’ loans to armaments companies whether or not the company wanted them.

The purpose was to fund the weapons industry and avoid public scrutiny of the national military budget – but was absolutely in addition to the publicly announced annual military expenditure. In effect the Kremlin was covering up the fact it was spending the national military budget and another 50% more than that, to pursue the invasion of Ukraine each year.

The original intention seems to have been to assume this was a short lived plan and the war would of course have ended in Russian victory by now, but that hasn’t happened. The state military budget continues to rise and the Kremlin, stuck in a loop of expense it can’t otherwise fund, has continued to press companies to take loans through private banks.

The scale of these loans is estimated to have passed the $250 billion mark (21 to 25 trillion roubles). That amount is said to be the sum forced on armaments contractors alone. As much as another $50 billion may have been forced on support and ancillary industries.

IMPLICATIONS

What has in effect happened, is that the Kremlin has pumped what we used to call ‘printed’ money into the economy. Quantities that on this scale absolutely shift economies of the size of Russia’s, which is roughly equal to Canada or Italy. In crude terms, it’s as if someone dropped every single person in Russia $1,736 each – a vast sum of money in a country where the average income is $13,500. For your average American it would be like waking up and finding $15,000 in your bank account.

The loans have gone to pay higher salaries, and new production lines. As with any outrageously large amount of money that appears in the economy, especially with interest rates rising, people spend it, which raises demand, which raises inflation which raises salaries and the cycle drives itself ever upward. We now know why real inflation is in reality in the low 30% range and interest rates are at 21%, and should probably be 25%. Those two figures are the type of range economists would expect to see with inflation at that rate.

However this is much worse than that in terms of implications. The Central Bank interest rate is 21% – and has been politically pegged at that by Putin – a fatal mistake to interfere in an otherwise independent decision by the bank, that needs a free hand to set policy as it needs to. That means inflation is not being checked; it was barely being affected as it was because of the hidden loan policy. The Central Bank is becoming a hated institution, driven by complaints and lack of understanding from the Russian Duma, and vilification of the only sane economist in the country, Elvira Niabulina, is weakening her power to do anything.

Even more of a problem is the soaring indebtedness of industry. They are spending 25% of their incomes on debt servicing. Their profits are minuscule or non-existent, they are being forced to borrow at rates in the high 20’s and even low 30’s percent. They are in effect being driven to bankruptcy.

SHORT TERM IMPLICATIONS

Over the next month a growing sense of disquiet, which has already started to surface, will grow even more unhappy. Rumors that the Central Bank was about to limit cash withdrawals at around 10,000R per day (US$98), and freeze deposit accounts (which basically means the government is in effect saying it has no cash and you couldn’t get your money even if you wanted it), had to be forcefully denied only in the past few days. Yet most Russians know a denial like that means it’s almost certainly got some merit to it.

If people try and get their cash out all at once, causing a run on the banks, the government simply doesn’t have the money to prop up the private banks, so it would be forced into doing what it said it wasn’t going to do, and limit cash withdrawals and debit card expenditure.

MEDIUM-LONG TERM IMPLICATIONS

Russia simply cannot afford to force more money into the industry. The Central Bank doesn’t have the means of supporting that amount of lending and current borrowing. It would have to advise the Kremlin to make huge tax rises, hike interest rates further, “print” money to make more available with disastrous inflationary consequences, or face bankruptcy.

Russia’s wider problem is that the new sanctions issued by the outgoing Biden administration, apparently with the tacit support of the new administration, have just cut the legs off the oil export industry. They haven’t been called ‘Armageddon” sanctions for nothing. It’s taken time for Russia to trap itself into its own doom loop for these sanctions to work. By buying up every rotten old tanker to get around the sanctions and the western price cap, they have now become dependent on them. With Russian insurance companies sanctioned, individual tankers and their owners sanctioned, the only way to export that oil is through using legitimate western tankers – and there are none available because they’ve all been contracted or bought up, shipping legitimate oil that’s not Russian, by mostly western companies.

In addition to the fact that Russia has lost another $73 billion in income, the isolation of every one of its 270 tankers as little more than high risk storage depots is another huge financial burden. Even its friends won’t take Russian oil now.

The banks themselves have a liquidity problem. No bank has all of its cash deposits available, but most operate on the basis of 10% if they have any sense. So much forced money has been lent, that Russian banks have nothing like that to hand, and even a low level run on them could be fatal. They’d rapidly run out of cash and be forced to close their doors. You can imagine what the public will think about that.

Russia faces a cascading credit crisis. In order to stay afloat and avoid bankruptcy, the industries that have borrowed money will need more money as they race to stay afloat. The banks have lent everything and more than they should, so they can’t. The public get nervous and start to take money out of their accounts the banks don’t have – and they have no bonds or assets left to sell – and nobody to buy them if they did. Credit facilities just dry up, lending stops, businesses close, jobs are lost, and we have a 2008 level event in a country that has so little income left because its cut off from its oil revenues, it can barely get through a day. The military stops getting paid, the factories stop, even emergency government measures to force them to open and keep working soon fold up as workers refuse to work for no pay. Within a short time the entire country looks like Germany in 1929. The entire system just shuts down.

Even if the government nationalized everything and returned to a communist era level of state ownership, there’s still no money to make it work. There has to be value, there has to be hope, there has to be production of goods and services that people want. Russian companies are not going to just transform from war time production to peacetime goods people want overnight, regardless of what the government says or does. Unemployment will be rife. Demobilized soldiers will be a huge problem. Discipline and order will break down. Independence movements in areas that have long wanted to escape Russian domination will break away. It took Russia ten years last time to get over the last massive economic shock. The 1990’s aren’t referred to as ‘the lost years’ for nothing. This time it will be worse.

ITS EFFECT ON THE WAR

Putin knows how bad this could get. He needs the new US administration to believe it when he says he has won and they should just let him have what he wants for peace, because that would be quick and easy. Their aim is to convince us they’re winning, they have all the balls and bluster to try and make that work.

Hopefully someone has made it clear to the new Administration that all of the balls are in their court. The Russians have a tenuous military advantage, but it’s stretched to breaking point in so many ways – as Kursk is demonstrating. The Ukrainians are grinding them down to the gums on the frontline, and have devastated their key economic driver, the oil industry. Add the sanctions to that. Russia just doesn’t have the money to keep going through all of 2025.

Putin will insist he’s won, he will push his demands to the insane levels he thinks he can get away with, but what he wants is his money on deposit back and sanctions lifted. What he concedes for that he hopes will be the insane demands, so that he keeps what he really wants.

My concern is the new administration is run by ill-educated inexperienced and largely ignorant people with a bias that taints their willingness to believe in realities, some have been supportive of Russian talking points. Putin is after them. He thinks if he can persuade the right people he will get out of this better off than he might have otherwise. His biggest mistake will be thinking that the Americans can impose a deal on Ukraine – he needs to be disabused of that fact now.

The economics of Russia are what has Putin hoisted on his own petard. It’s what will finish him – if we hold our nerve and the Americans in the garbled weirdness of the new administration, realize they can actually win this and look good doing it.

The Analyst

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