After a horrendous start to the year with excruciating new oil sanctions that led to the largest January deficit on record, the Kremlin is starting to sound increasingly optimistic about the health of the Russian economy by the end of the year.

Russia is going through a “large-scale macro transformation,” but the “worst is over,” Prime Minister Mikhail Mishustin said on September 28 during the Moscow Financial Forum.

“The Russian economy is undergoing a large-scale transformation. The unilateral disruption of the previous economic ties by the Western partners exacerbated many problems, but the most difficult period has passed,” he told Russia’s collected liberal macroeconomic team at this annual event.

The growth forecast has been upgraded several times this year and is currently 2.8%. However, after the collapse of oil and gas revenues following the imposition of the twin crude and oil products sanctions on December 5 and February 5 that saw the budget deficit hit is full year target by the second week of March. Independent analysts were certain that Ministry of Finance (MinFin) would miss its 2% of GDP  taregt by a wide margin with many predicting a deficit of 3-4% and some as much as 12% of GDP. 

Russian Finance Minister Anton Siluanov stuck to his guns and predicted that oil revenues would recover in the second half of the year and the 2% target was still obtainable, although over the summer he wobbled a bit and brief began to talk about a range of 2% to 2.5%.

However, speaking at the forum, Siluanov sounded a lot more confident as his prediction of rising oil revenues has come to pass. Russia’s budget went back into profit in August with a whopping RUB800 trillion surplus, about three times higher than an average month, as oil export revenue to Asia – a four month round trip -- began to arrive in the state’s coffers and Siluanov is now predicting the state will end the year with a deficit of “2% or less”. (chart)

"Revenues - both oil and gas and non-oil and gas - exceed our planned targets, parameters and expenses. Therefore, the federal budget deficit will definitely not be higher than 2%, and possibly lower. Everything will depend on the volume of expenses that will be made for the period remaining until the end of the year. The deficit will not exceed our planned figures," he firmly said.

The fresh flow of money streaming into the treasury has boosted economic activity with indicators like the manufacturing PMI index staying well above the no-change 50 mark for most of this year. (chart)

Russia’s industrial production and retail sales data for August suggest that activity remained fairly solid, and Capital Economics thinks the economy is on track for GDP growth of 2.5% this year, slightly ahead of the official 2% forecast, the analysts said in a note.

Data released on September 27 showed that industrial production growth picked up from 4.9% y/y in July to 5.4% y/y in August (chart) and that retail sales growth edged up from 10.8% y/y to 11.0% y/y (chart) as the economy continues to adjust to the new realities and benefits from a “military Keynesian boost” that is the result of massive state spending.

"The estimate [for GDP growth of] 2.8% looks rather realistic," Minister of Economic Development Maxim Reshetnikov told the forum, adding that growth will slow slightlyin 2024-2025 to 2.3% and to 2.2% by 2026. But the forecasts that Russia would fall into a deep recession have already proven to be false, and “none of the Western experts expected that.”

Investment activity and the recovery of consumer spending have become the key growth drivers for the economy, he said. Nevertheless, the Russian government plans to continue improving the country’s financial sovereignty, and it wants to speed up the switch to a wider utilization of the ruble in its international trade.

The share of rubles in Russian exports totalled 41% in July, while in August and September it may grow even higher, Reshetnikov said at a plenary session of the Moscow Financial Forum.

“We are expanding the network of direct correspondent accounts in the national currencies between the banks of Russia and the friendly countries, and the list of the currencies of the friendly countries that are trading on the Moscow Exchange,” he said.

The government and the central bank also prepared a step-by-step plan for launching trans-border settlements through the blockchain technology with utilization of digital financial assets, he added. Russia launched a digital ruble pilot scheme in the middle of August that could eventually provide an alternative to international trade settlements that by passes the SWIFT system.

Huge defence spending hikes

Of course the war in Ukraine was lurking behind all the gushing statements on the good economic performance and has massively distorted the nature of both the economy and state spending. Where the private sector and consumption were driving economy two years ago, now it is state procurement and investment that are the engine of Russia Inc’s growth.

The latest 2024 budget includes massive increases in military spending that has overtaken social spending for the first time. Russia approved its first full wartime budget for 2024 on September 23 that sees a whopping 1.7-fold increase in military spending to RUB10.8 trillion ($112bn), or 6.8% of GDP, up from RUB6.4 trillion and more than the RUB7.5 trillion earmarked for social spending.

An increase in Russia’s defence spending is an “absolute imperative,” Russian Presidential Spokesman Dmitry Peskov has said.

"It is obvious that such an increase is absolutely necessary, because we are in a state of hybrid war that has been unleashed against us. We are continuing the special military operation, and this requires great spending," Peskov said about the draft budget.

Russia’s spending on defence is more than triple Ukraine’s UAH1,164bn ($32bn), or a whopping 20% of GDP. Clearly, Russian President Vladimir Putin intends to go all out against Ukraine in 2024 and is preparing for a long war.

To finance these huge expenses the government will have to find an additional RUB7 trillion in revenue from somewhere compared to 2023. That means inflation will inevitably accelerate and the Central Bank of Russia (CBR) will before to keep growth-killing interest rates high, hence the forecast for slowing growth in the next could of years.  But Siluanov told the forum that the funds reserved in the draft budget for the next three years would be enough for all planned purposes.

He added that the slogan "Everything for the front, everything for victory" was among the budget’s priorities.

Defence spending is being raised by almost 70% next year as Russian President Vladimir Putin makes it increasingly clear he is preparing for along war. With Moscow's "special military operation" now dragging through its twentieth month, both sides have been digging deep and procuring weapons from allies in preparation for a protracted conflict.

The announcement came as Nato chief Jens Stoltenberg and the defence ministers of Britain and France visited Kyiv, where President Volodymyr Zelenskiy lobbied for more air defence systems.

"We need to get through this winter together, to protect our energy infrastructure and people's lives," Zelenskiy told Stoltenberg, warning of a fresh campaign of Russian strikes after last year's strikes left millions short of water and heating. Ukraine has invested $2.3bn in the restoration and defence of its energy infrastructure ahead of winter which is due to start in the next month or so.

Defence spending in 2024 is also set to total around three times more than education, environmental protection and healthcare spending combined, according to AFP calculations.

"The focus of economic policy is shifting from an anti-crisis agenda to the promotion of national development goals," the Finance Ministry said in budget draft document.

While the military spending will bring a short-term boost to Russia’s economy, analysts say the distortion in investment goals will lead to long-term stagnation. But Putin and other high officials have largely shrugged off the economic effects of the Ukraine offensive, arguing that Russia has weathered the storm of Western sanctions and will deal with the stagnation problems later.

Russia's Central Bank warned this month that economic growth was set to slow in the second half of 2023, while ordinary Russians feel the pinch from rising prices that will probably get worse in the coming years.

Deficit of 2% or less and no borrowing

The federal budget deficit in 2023 will not exceed 2% of GDP, which is in line with planned indicators and is a remarkable achievement if it comes to pass, Siluanov told reporters about this during the Moscow Financial Forum.

According to the Finance Ministry, the Russian federal budget deficit in 2024 will amount to RUB1.595 trillion ($16.4bn), or 0.9% of GDP, which is notably down from the RUB2.9 trillion deficit pencilled in for this year.

In 2025 the deficit will fall further to RUB830bn ($8.5bn), or 0.4% of GDP, in 2026 to RUB1.536 trillion ($15.8bn), or 0.8% GDP. Prior to the war Russia has run a budget surplus every year for almost two decades.

In another surprise, Siluanov said the government would not need to borrow to fund the budget this year. MinFin has some RUB6.8 trillion available in the National Welfare Fund (NWF), the sovereign rainy day fund tasked with covering budget short falls – more than twice what is needed to cover this year’s anticipated shortfall  -- but has been reluctant to tap the fund, prefer to cover at least part of the hole by tapping the some RUB17 billion of liquidity in the banking by selling Russian Finance Ministry’s OFZ treasury bills to raise funds.

Siluanov says this year’s target on oil and gas revenues will be surpassed, as oil prices rise towards $100 a barrel and the oil sanctions are increasingly acknowledged to have failed. A recent report by Global Witness found at some 70% of Russia’s traded oil is being sold at market prices outside of the sanctions regime – largely to buyers in Asia. That means budget expenditures can largely be funded without borrowings on the market, Siluanov told reporters at the Moscow Financial Forum. Siluanov’s prediction that oil and gas revenues will recover in the second part of this year, appear to have come true.

"This year we expect solid oil and gas revenues, with the target on oil and gas revenues to be surpassed. In this respect I think it is absolutely economically feasible that expenditures will be financed using oil and gas revenues, without using borrowings on the market," he said. "We have decided to limit borrowings this year, to cut the program by around RUB1 trillion," he said. Typically, MinFin borrows around RUB3.5 trillion from the market by selling OFZs.

Oil and gas revenues of the Russian federal budget may increase in 2024 by almost 30% compared to 2023 - from RUB8.86 trillion ($91.6bn) to RUB11.5 trillion ($118.9bn), according to the Main Directions of Budget, Tax, and Customs Tariff Policy for 2024 and the planning period of 2025 and 2026, Tass reported on September 29.

In 2025, the ministry expects a further increase in oil and gas revenues to RUB11.8 trillion ($121.97bn), and in 2026 a decline to RUB11.4 trillion ($117.8bn).

The document also stated that, taking into consideration exchange rate dynamics and tax legislation revisions, the percentage of oil and gas income in 2024 is estimated to be 6.4% of total GDP, up from 5.3% in 2023.

At the same time, the Ministry of Finance anticipates that by 2026, the share of oil and gas earnings in GDP will fall to 5.6% due to price stabilization and a rise in the share of oil output from preferential tax treatment fields.

Inflation target to remain 4%

With budget revenues and the deficit sorted, the main bugbear to the economy remains inflation, which will be hard to control and will cause pain as prices will inevitably rise.

But chairwoman of the Central Bank of Russia Elvira Nabiullina is as competent as Siluanov and equally adamant that she would hit her targets. Despite the already apparent upward pressure on prices, she was also sticking to her long-standing inflation target of 4% she told the Moscow Financial Forum, despite calls to increase it. (chart)

Ironically, just before a mini-currency crisis in August where the ruble weakened to RUB100 to the dollar, Nabiullina announced that Russia’s economy was back on a stable economic trajectory and the CBR had even floated the idea for the first time of reducing the CBR’s inflation target to 3%. That talk was immediately abandoned after Nabiullina was force to put through an emergency 350bp rate hike on August 15 to halt the ruble’s collapse.

“I can't help but react to attempts to change the inflation target. The worst thing is to change the inflation target: then the benchmarks disappear altogether – neither the exchange rate nor inflation,” she said.

The chairwoman also said that the ruble exchange rate would have been weaker now if the regulator had kept the key rate at 7.5–8.5% instead of hiking it to its current 13%. (chart)

The ruble remains weak and there has been talk to the CBR returning some of the currency controls, but the ever super conservative Nabiullina is moving very cautiously. Russian authorities need to “act very carefully” in the currency regulation, “otherwise business will start circumventing restrictions,” she said.

“I think we need to take into account the following: we all talk about how well we did last year, but it was our business that did well, it adapted. And we should be very careful saying “the situation has changed, let's build barriers”. And what will happen to the business that built these chains? How will it handle this? It will start to circumvent the restrictions, we had it in the late 1990s - early 2000s,” she said.

Macro forecasts of the central bank are more conservative than those of the Economic Development Ministry, she said, but there is nothing terrible in their divergence, it is important to clarify them on time, Nabiullina added.

Several exports commentating on the disappointed muted impact of sanctions on Russia’s economy have noted one of the failures of the sanctions regime was to underestimate the quality of Russia’s liberal economic management team.