RUSSIA’S ECONOMY: BRACE FOR IMPACT

Over the course of the NATO summit I’ve had chance to spend a good deal of time with someone I regard as one of the most insightful economists in his field. Military economics and making wars and defence budgets work has been his often unappreciated specialism for decades. Of late he’s found he’s back in fashion as the reality of war planning and defence spending are back on the front burner.

Our conversations go deep, we’re both blessed with eidetic memories and near instant recall, so we keep the facts to hand and the reasoning must be razor sharp.

It was inevitable the Russian Economy would be our subject, we almost tripped over each other trying to be the first to start. This is the summary of our conversations.

UNDERSTANDING THE RULES OF THE RUSSIAN ECONOMY

Firstly, everything is smoke and mirrors. When the Russians talk of GDP growth it’s because they have selected a certain set of figures – usually unspecified and mostly fake – to create the illusion of growth when its not real and to exaggerate it when it is. It’s all about persuading the Russian population that everything is fine, there’s nothing to see here. The fact it causes Russia’s supporters to go along with it as gospel is a positive side effect in the propaganda war.

When Russians talk of a potential recession and a decline in GDP, its because things are so bad they have no choice but to admit there is a problem even when they really don’t want to have to admit it, but it is that bad. This was made quite clear in St Petersburg last week before they tried to walk it back.

Interest rates are real. Inflation’s published rate is not real.

Russia’s banking sector is broken and has been forced into such a situation by the government.

The money is running out.

CORE REALITIES

SBER Bank, the largest corporate lender in Russia, and the biggest investor bank in new startups and expanding business enterprises, admitted that in the past 12 months it had not lent a single ruble to a new business or loaned money for a business expansion. That’s truly shocking. But as it happens its born out by another statistic that might shock you, given the fact Russia is at war and you would think demand is high; steel production has fallen almost 4% year on year, and domestic construction steel use has fallen by 24%. Basically nobody is building housing, offices and most notably, factories. Existing projects have stalled or been canceled as money to fund building has run out.

The reason is that base rate interest rates remain at 20% – which translates to 24-34% in the retail banking market. The banks have been forced to loan everything they had to the war industries and they have nothing left. In fact they’re almost certainly insolvent by any real measure – if Russians started going to the banks to get their cash out the banks would be closing their doors in a matter of minutes because they don’t have the cash reserves to pay it back.

The state forced lending to the weapons manufacturers at rates considered unsustainable and its understood that many loans are in arrears or frozen, unlikely to ever be repaid. When the war ends as all wars do, it will mean these industries have nothing to make and their only client, the state, will let them shutter without paying back their debts – because it will have no choice. Again, an impending crisis for the banking sector.

While some of this money came from the state ‘printing’ money, much of it was stripped from the banks own coffers. The banks are in no position to further bail out themselves or the government, let alone businesses. The public will have to face limited access to their own money as happened recently in China – not a popular move.

Inflation is not at 9-10%. Real inflation is around 30-35%, food inflation is higher and product dependent. You don’t need interest rates of 20% to cut inflation to 9%. Rule of thumb is around 33-50% of the inflation rate is a good interest rate to reduce inflation.

Wage growth continues to spiral out of control because inflation and interest rates are so high, which both stoke inflationary pressures. Because the high salary inflation remains a strong pattern it has dire consequences longer term

Pay is artificially inflated through state action. High pay is being subsidized in the military industry by the state.

Recruitment bonuses, high salary, death benefits are all state funded and running into billions per month, which in turn feeds a frenzy of inflationary spending by recipients who are often families seeing more money in a couple of months than they might have earned in 20 years. Inflation encourages them to spend it rather than save it, but the decline in Russian non-war domestic manufacturing is so severe that means imports, and sanctions make that difficult. That has led to a big increase in alcohol consumption and a boom in eating out at restaurants, whose prices have spiked because of food inflation and the inability to find staff.

Labour shortages. The demand for labour vastly outpaces supply. Some 4.5 million unfilled jobs exist although that’s dropping quickly as domestic factories and service industries loose customers and close. It’s not leading to much unemployment yet because the redundancies don’t equal demand. Sooner or later that situation will reverse.

Brain drain. Over 1.7 million Russians have escaped to other countries and they’re nearly all younger, well trained and qualified who want no part in the war or modern Russia. Their talents have been welcomed by foreign governments and they have not returned. That’s despite the Russian government blocking paying citizens who worked overseas for Russian companies. They just found other jobs.

THE CRASH IS COMING

How do we know?

The red flashing light are everywhere. When the finance minister says a recession is around the corner then tries to walk it back, you have a problem that’s keeping him up at night. The central bank made it clear it was lowering interest rates from 21% reluctantly and not on its own volition.

We know that investment in manufacturing is dead.

We know that the housing industry – a real sign of a growing economy is in free fall decline and getting worse. 24% down YOY is a slump. Irony is, it’s likely to drive more recruits into the army from the building trade as they lose their jobs.

We know inflation is high.

We know that the state has no money left in its emergency fund, nor do the banks.

We know that things are so desperate, the state is seizing assets – this week alone it took over Russia’s largest grain exporter, Domedodovo Airport and a metals trading company. It did this based on the need to re-sell the assets and that the owners were dual national Russians and/or traced back to foreign owners. It should raise $13 billion.

The coming crisis is going to be a catastrophic collapse Russians will be stunned by.

The Russian state’s income and outgoings don’t match. You know where that goes in the end. If you spend like a drunken sailor you’ll end up broke. Russia is heading toward broke. Its oil incomes are unreliable and in the lower range it cannot sustain.

Take away the oil revenue. Imagine the war ends. Those on over inflated salaries in the war industry are quickly laid off. They can’t get jobs in the civilian industries because most of the manufacturing shuttered, unable to pay the high salaries in the war industry, they couldn’t compete. Unable to sell abroad, sanctioned, high inflation, even keeping their prices low wasn’t enough.

Imagine the army shedding as many as 400,000 men into the economy. What will they do? No jobs, their high incomes gone, their families desperate and now without the life style they had just weeks before.

The state has no money to support all of these people, the banks are teetering on the brink of insolvency, sanctions are unlikely to lift quickly. Tax revenues from recycling money paid as salaries will vanish.

In short there will be financial crisis, industrial collapse and a whole host of other really bad problems that all this comes with. Russians will suddenly see the reality they live in as the smoke clears and the war’s costs finally come due.

Putin’s answer is to obscure these facts as much as possible for as long as possible and try and bluff it out. That’s worked for a while, and will until some unexpected straw breaks the camels back. When Russians realise their savings are just a notional sum on a computer screen and they can’t manifest them as cash, and that reality spreads, as fast as such things do, it will be a bad day for the Russian economy.

The fact is the runway has run out, the V1 point has been reached and the plane cannot fly, its now whether or not it falls off the runway into the sea and everybody aboard goes down, or it screeches to a halt with its engines ripped off and the passengers are looking for the pilot for some answers about the unsalvageable wreck. Only to find that he used an ejector seat to save himself and they’re on their own. This time the international community won’t be there to save the day either. Why should it anyway?

The doom on Russia is coming. It need not have been like this but it is. They did it to themselves. Now they will have to sort it out – and we should let them because only by suffering do they seem to learn.

It’s hard to appreciate that Russia’s economy pre-war was doing well. Overly commodity based very long term prospects were poor, but it was starting to diversify and had novel industries developing carbon neutral technology and manufacturing processes.

All of that has gone. The war has sucked the life out of the economy and it’s been transformed into a shadow of its former self.

Perhaps the worst part about Russia’s war economy is it’s not even very good as a war economy. The fact is it’s failed to produce new factories or weapons on the scale it needed to, it’s simply failed to deliver anything like the quantity to sustain armour or vehicle production, artillery and so on. Partly because it needs foreign equipment to make the factories work, Russia doesn’t know how to make these machines themselves and Chinese knock offs just don’t cut it for precision manufacturing. Notably the Chinese don’t sell the Russians the good stuff.

The end is coming. I don’t know anyone in this field who thinks it’s sustainable for more than a few months now. The price of oil is a determining factor. The lower it goes the faster Russia falls.

Be encouraged, be certain. Russia will lose this war at home as its economy collapses. It’s just a matter of when.

The Analyst

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