Russia's economic growth accelerated to 5.4% year-on-year in May, according to Federal State Statistics Service and has more or less recovered from the shocks following the imposition of sanctions. Growth remains stymied, but Russia is now growing faster than many of the EU countries that have sanctioned it thanks to the Keynesian boost of massive military spending.

Acceleration in wage growth and falling unemployment … Overall, while the headline data gives a very positive picture of a rapid economic recovery in Russia, it is important not to overestimate the importance of that since to a large extent the good figures are a reflection of big declines in output seen one year ago. However, two macro trends should be viewed as a reason for concern: these are the acceleration in real wage growth and a continued decline in the unemployment rate. These tendencies together show that structural problems in the Russian economy are getting deeper and more acute – such problems as a lack of labour due to falls in migration inflows and poor demographics. That, in turn, puts rising pressure on wages – a factor that potentially could become one of the main drivers for inflation.

… are a matter of concern in the long term. Potentially, these structural problems could be exacerbated by the risk that stems from the attempts by the government to bring its finances back into balance. Such moves would lead to the slashing of non-critical spending items – such as funding various investment and construction projects. Such efforts would inevitably translate into a slowdown in the economy – a scenario that could start to evolve already by the start of 2024.

The Russian economy is set to completely reverse last year’s slump. Manufacturing and construction lead the way, alongside retail. In a broad sense, all three sectors are beneficiaries of the war.

The defence sector, working in three shifts, is boosting production: in June, for example, the biggest increases were in finished metal products (+45.8% y/y); computers, electronics and optics (+71.6% y/y), radar equipment (+75.4% y/y) and electrical equipment (+32.1% y/y). Production capacities are running at their maximum.

Construction is primarily driven by discounted mortgages: currently, 51% of loans come with state support, up two percentage points since April. Overall, the mortgage portfolio of Russia’s top 20 banks was up 3% in May.

Retail growth has been driven by increased salaries and social handouts (some of which are connected to the war). Real incomes are up in regions that are home to military factories and where reports suggest there are large numbers of contract soldiers (for example, Buryatia, the Jewish Autonomous Okrug and Chechnya).

Public social spending will continue to support the economy – at least until the end of the 2024 election cycle. However, there is one important factor that could halt the slide of the economy into recession – this is the government’s expanded social spending. In their most recent communications on economic policy, President Putin and his Cabinet officials said that in their growth policies, they want to prioritize support for domestic demand. This means that government will continue to boost its spending on public wages and pensions: it already announced that in October 2023 the salaries of the military and security personnel will be increased followed by a similar move in January 2024 on the wages of other public employees. As the latest data suggests, real wages have already seen a massive rise of over 10% Y/y in April and the trend will likely continue in 2H23 and 1Q24, especially if one takes into account the start of a new political cycle in Russia (next presidential elections in Russia should take place in March 2024).

The nation’s finances have inevitably been influenced by the war and the upcoming elections. Despite problems at the start of the year, things have improved in recent months. The budget deficit fell from its April peak of 3.4 trillion rubles to 2.6 trillion at the end of June, after the budget went back into profit in May.

In addition, economic growth has led to a rise in non-energy taxation revenue and spending fell.

Finance Minister Anton Siluanov has promised the annual budget deficit will not exceed 2.5% of GDP, but there is still a high risk that it will increase above its current level.

Without spending cuts, the government has a range of measures to combat the deficit. First, it can increase taxes in 2024. Borrowing could also plug the deficit. There is liquidity in the banking sector available.

The Kremlin could also increase withdrawals from the National Welfare Fund. Over the past six months, doing this has helped plug a 507bn ruble hole in the budget, the Finance Ministry reported. In total, the fund has 6.8 trillion rubles of liquid assets left, specifically gold and yuan. By the end of next year, 2.3 trillion rubles should remain (according to the Finance Ministry).

Western sanctions mean the Russian economy is securely insulated from global shocks. If there is no sudden fall in oil prices, or anything similarly catastrophic, there is enough money to maintain current spending for about two years.

Rosstat published a report on the state of the Russian economy as of late May 2023. Industrial production indices suggest a significant drop in oil and gas production, albeit from a high base in early 2022 (65.6%). Coal production experienced a similar drop. Several industries that were early sufferers from Western sanctions and the breakdown of Russia’s trade links (carmaking, timber production, pharmaceuticals, and machinery) were still producing between 80% and 90% of their output in the first five months of 2022, albeit their fall seems to have stabilised somewhat.

Finance Ministry suggested a 10% cut across the so-called unprotected expenses of the budget on July 7 (anything other than social payments, education, health care, debt service and transfers to regions, and likely de facto security and military expenses) in 2024.

The Russian government cut expenses in a similar way last year and in 2020. The cut suggests that the government does not want to create novel political risks by withdrawing funding from certain programs completely, as some have suggested, nor does it think that raising taxes further (e.g. by making the surtax on the business sector—the commonly named “war tax” recently adopted by the Duma—permanent) would provide a solution.

A counter-proposal that would have included issuing more debt was reportedly opposed by the Central Bank for fear of limiting access to financing for the private sector. The fact that this is happening ahead of an election year shows how falling revenues and rapidly rising (though opaque) war-related expenses force the government to pull purse strings tighter, despite optimistic forecasts at the beginning of this year.