Russia’s economy is still putting in surprisingly good results but analysts say that it’s come off the boil and growth could start slowing from here as the effects of fighting a war begin to bite.

Russia’s unemployment rate just fell to a new all-time low of 3% and the latest data on economic activity in Russia during July paint a picture of robust retail sales performance on the back of rising real and nominal wages that are fuelling consumption.

But those are both partly effects of the war. Hundreds of thousands of young men have been sent to the front line, draining the labour pool that in turn has pushed up wages as companies offer higher salaries as they become increasingly desperate to hire qualified or skilled workers. At the same time, the Central Bank of Russia’s (CBR) success at controlling inflation has also pushed up real wages, which adds to the consumption momentum.

However, RosStat numbers also show the productive part of the economy is coming off the boil. Russia will still put in a good performance this year, ahead of expectations, but the long-term problems that sanctions cause are starting to become visible.

“The latest activity data for Russia for July suggest that retail sales maintained solid momentum, while industry has come off the boil in recent months. We think that the economy as a whole will record relatively strong growth of around 2.3% this year, but we expect growth to slow sharply in 2024,” Liam Peach, an emerging market economist with Capital Economics, said in a note on August 30.

Capital Economics analysis suggests Russia’s economy will probably post relatively strong growth of approximately 2.3% for the current year, ahead of the CBR’s own 2% forecast, however, Peach anticipates a significant deceleration in growth as we move into 2024.

“Retail sales data for July showed that growth edged up from 10.0% year on year in June to 10.5% y/y. This was above the consensus expectation for a slowdown to 9.3% y/y. We estimate that this is consistent with an increase of around 0.5% in SA month-on-month terms. This is only a touch slower than the pace of growth earlier in the year and suggests that positive real income growth continues to provide support to consumer spending,” says Peach.

The problem is the distortions that the heavy military spending has introduced into the economy, which the higher consumer consumption can’t fully offset.

The rise in manufacturing has been driven by those industrial branches that benefit from higher military spending such as metal products, electronics, electrical machinery and equipment, and manufacture of vehicles other than automobiles. During the first six months of this year almost three quarters of the over 6% y/y growth in manufacturing came from these four branches, the Bank of Finland institute for Emerging Economies (BOFIT) recently reported.

The recovery in private consumption from the spring 2022 slump has continued. In the second quarter of this year household spending on purchases of goods and services, as well as retail sales, was up 9-10% y/y in real terms from last year’s downturn and roughly at the same level as in spring 2021. Real household incomes continued to rise and were up a few percent from two years earlier. The rise in real wages accelerated, BOFIT reports.

Despite the good news, the threat of a Russian recession is rising. This rapid growth is down to two things – public spending (mostly on the military) and CBR Governor Elvia Nabiullina’s recent unorthodox experiment, her dovish monetary policy that kept rates too low for too long to weaken the ruble so that it could generate more rubles for the budget. That ultimately went wrong when it weakened too far and hit RUB100 to the dollar, causing a mini-currency crisis in August.

The crashing Russian ruble forced the CBR to do an about-face and put in a 350bp rate hike on August 15, taking the prime rate to 12% but successfully halting the ruble meltdown. The higher rates will weigh on growth going forward.

Nabiullina’s experiment was to try, at the same time, to rein in inflation, keep rates low to encourage growth, and artificially weaken the ruble to generate more ruble cash for budget spending. She lost control of the situation and ended up having to do a fiscal handbrake turn that did a lot of unnecessary damage to the economy. 

Bloomberg recently assessed the likelihood of a recession on the basis of the difference between the yields of five-year and three-month government bonds. The sudden rate hike flattened the yield curve but also reduced the spread between these securities’ yields. And this indicates a greater risk of recession, according to Bloomberg.

Some of these problems seem to be already showing up in the economic statistics. Data regarding industrial production for July reveals a moderation in growth, shifting from a y/y rate of 5.8% in June to 4.9% in July, reports Capital Economics.

The contraction within the mining sector, for example, eased to -1.5% y/y, while manufacturing production witnessed a slowdown to 9.5% y/y. RosStat reported a 0.1% decrease in industrial production on a seasonally adjusted m/m basis, marking the second successive monthly decline. Particularly noteworthy was the substantial deceleration in basic metals manufacturing, a significant segment within the Russian industry landscape.

“Taken together, the activity metrics for July signal a gradual deceleration in Russia's economic momentum, particularly within the industrial sector, following a robust first half of the year,” says Peach. “This narrative aligns with the latest manufacturing Purchasing Managers' Index (PMI), which shows a decrease in momentum. These trends suggest that the impetus derived from the earlier surge in government spending is gradually tapering off. As the budget deficit undergoes a controlled reduction, we expect further fiscal tightening in the upcoming months, which could withdraw a crucial pillar of support from Russia's economic prospects in 2024.”

Everyone has much more bullish expectations for economic growth this year than they started the year with. Indeed, in the days before the 350bp hike, Nabiullina released an ebullient report saying that Russia was on a “stable growth trajectory” suggesting that the worst was past, and the deputy governor also floated for the first time the idea that it might be possible to reduce the long-term inflation target from 4%, where it has been for years, to 3%.

Both those ideas were well and truly scuppered only two days later. Nabiullina’s handbrake turn has put Russia’s economy back several years.

What is happening now is the bull forecasts for the end of this year are being joined by more pessimistic forecasts for next year. At the start of rate hike week Nabiullina was forecasting 2% growth for this year at the top of the CBR’s forecast range, and 2.5% next year.

However, Capital Economics’ Peach may have raised his 2023 forecast to 2.3% but he has dropped his 2024 forecast to 1.3%, which now looks more realistic. Nabiullina has not commented on whether she will revise her 2024 outlook since she hiked rates, but the CBR’s August macroeconomic survey is out soon and there will be another monetary policy meeting in September when she will have to comment, and it is very likely that she will have to revise her game plan.

“Although we recently revised our GDP growth projection for the current year from 1.5% to 2.3%, we remain sceptical that Russia's economy can sustain this pace for an extended period without additional fiscal stimulus or persistent inflationary pressures. Our forecast indicates a slowdown to 1.3% growth in the following year,” says Peach.