Moscow. When Russia launched its full-scale invasion of Ukraine four years ago and the West responded with sweeping trade restrictions and sanctions, many predicted that the Russian economy would collapse within months.
Output was expected to contract sharply. That did not occur. Buoyed by high levels of state spending on armaments – financed by the sale of what were at the time exceptionally expensive energy exports – the economy recovered swiftly from an initial shock recession. The surge in defence expenditure spilled over into other sectors and into household incomes, pushing overall growth back into positive territory.
In the two years that followed, Russia expanded more rapidly than many advanced Western economies. Last year, however, momentum weakened. Growth slowed to around one per cent, and forecasts for the current year are no more encouraging. The International Monetary Fund projects expansion of just 0.8 per cent. Like much of Europe in recent years, the country is now stagnating.
Yet headline growth figures – convenient though they are for comparison – fail to capture the true condition of the Russian economy. The deceleration in output is merely the visible crest. The more serious structural weaknesses lie beneath the surface.
A two-speed economy
Military expenditure as a share of GDP has more than doubled since the invasion. Such production does little to raise living standards. A substantial portion of the funds is effectively destroyed on the battlefield. Yet the surge in spending – from around 3.6 per cent of GDP before the war to an official figure of more than seven per cent today, with some estimates putting it closer to nine – has had a profound effect on the wider economy.
State orders enabled companies to hire additional staff and increase demand for materials and intermediate goods from suppliers. The effects filtered through the economy and into household incomes, allowing consumers to spend more. In 2023 and 2024, real wages rose on average, supporting stronger consumption.
The multiplier effect, however, is temporary and has the adverse consequence of driving up prices. Moreover, the redistribution of funds has been, and remains, highly uneven – both across sectors and between regions.
Strategic industries deemed vital – above all those linked to armaments – operate under the Kremlin’s protection. The state channels substantial investment into them, demand for their output is assured and they are better placed to attract skilled labour. They also enjoy preferential access to bank credit on favourable terms.
The central bank’s key interest rate stands at a steep 15.5 per cent, a level that constrains much of the private sector. Owing to state support, however, the defence industry is shielded from the full impact.
The remainder of the economy must largely fend for itself. Some branches perform better than others, yet elevated borrowing costs are broadly stifling entrepreneurial activity.
Sanctions drive persistent inflation
The Russian central bank continues to hold interest rates in double digits, chiefly in response to stubborn inflation, which has lingered in the domestic economy since the end of the pandemic. Although official figures had shown a temporary downward trend, inflation accelerated again in January to six per cent year on year. Several economists believe the true pace of price increases is higher. They point to the fact that the central bank’s key rate stands well above the officially reported inflation rate.
Three main factors lie behind price pressures in Russia. First, sanctions have made imports of Western goods more costly. Many products now reach the country through intermediary states – such as Kyrgyzstan, Turkey or Armenia – with each additional link in the chain adding its own margin.
The second factor is fiscal expansion. The injection of state funds into the defence sector has supported growth, but it has also fuelled higher prices.
The third factor is the increase in value added tax from 20 to 22 per cent. It is worth recalling that at the beginning of last year corporate income tax was raised from 20 to 25 per cent.
The picture is further complicated by the cooling of the domestic economy, which is now slowing wage growth. In the initial years after the invasion of Ukraine, pay rose more quickly than prices. That gap is now narrowing as wage increases and inflation begin to converge. Given the uneven pattern of economic growth across sectors, many workers outside defence-related industries are likely to see their purchasing power erode.
Russia feels the strain of lower oil prices
As growth cools after two years of unusually strong expansion, price pressures may gradually ease. Absent further tax increases, inflation could continue to decline in the coming months. The central bank expects it to settle within a range of 4.5 to 5.5 per cent this year.
Stagnation, however, weighs on the state budget. When activity slows, tax revenues no longer rise at the pace seen during periods of rapid growth.
An even heavier blow to the public finances is the subdued global oil price, as supply continues to outstrip demand. Over the past year a barrel of Brent crude has traded at roughly $60 to $70. Russian grades are sold at sizeable discounts. The official differential is about $10, yet some economists believe the gap is wider, with Russian oil fetching closer to $40 for much of the year.
Bloomberg, citing the analytics firm Argus, reported that discounts on Urals crude at the point of export have reached as much as $30. By the time the oil arrives in India, however, the discount narrows to around $7.50. It remains unclear how much of the difference accrues to Russian producers and how much to Indian intermediaries.
The federal budget is calculated on the basis of an oil price of $60 per barrel. When prices fall below that threshold, the shortfall is typically financed from the National Wealth Fund, which accumulated reserves during periods of higher prices. Matters are further complicated by a strong rouble, which reduces exporters’ revenues in domestic currency terms.
Although the Fund’s overall value has not yet declined dramatically, the more pressing issue is the sharp fall since the start of the war in the share of liquid assets that can be readily deployed to cover budgetary needs. Those liquid holdings now amount to around two per cent of GDP, while the official deficit forecast for this year stands at 1.6 per cent of GDP. Last year the shortfall reached roughly 2.6 per cent, despite an initial plan of just 0.5 per cent. Many analysts therefore expect the gap to widen further this year.
Russia is effectively shut out of international capital markets and cannot borrow from foreign investors in the manner of most advanced economies. The deficit must therefore be financed either from reserves or through heavier burdens on domestic taxpayers. Large-scale borrowing at home would also prove expensive if it were to attract sufficient demand. Domestic banks are offering interest rates of up to 18 per cent on fixed-term deposits.
Over the precipice?
Russia’s current economic position is far from encouraging. The Russian analyst Alexandra Prokopenko of the Carnegie Endowment for International Peace likens the state of the economy to that of a climber in the death zone. She may survive there, but only for a limited time.
According to her, small and medium-sized enterprises outside the military sphere – notably those in consumer industries – are being starved of oxygen: ‘The problem is what the military sector produces: grenades that explode, tanks that burn. (…) None of this creates what could be called lasting value.’ She compares the process to a climber’s body ‘burning its own muscles to keep warm.’
If Russia remains in this position for an extended period, the price of the military boom and the preservation of moderate economic growth will be the decline of non-military sectors.
It could therefore be said that making peace is in Russia’s interest. Another Russian economist, Vladislav Inozemcev, has been arguing this for some time.
That does not mean peace at any cost. The Kremlin retains sufficient financial resources to wait and negotiate the best possible outcome – especially if it believes its adversaries are also suffering.
Donald Trump has seriously damaged relations with Europe in pursuit of his own vision of American interests. Meanwhile, Europe has not only harmed itself with sanctions against Russia, which cut both ways (and the question of whether it is suffering more remains debatable), but also through its green policies. The impact is evident in the performance of the industrial heart of Europe – the German economy, which has been teetering on the brink of stagnation and recession for the past three years.
Global oil prices are not fixed, and there are many triggers that could push them sharply higher. Early in 2026 geopolitical tensions, particularly between the United States and Iran, have contributed to prices rising by about 15–20 per cent and Brent crude exceeding the $70 mark – its highest in six to seven months – amid fears of supply disruption linked to the standoff over Iran’s nuclear programme.
If this trend persists, it could breathe new life into the Kremlin and increase its room for manoeuvre.