Four signals regarding Russian economic problems in the “war of attrition”

A worker on the production line of Vibrotechnik in St. Petersburg. Photo: Shutterstock

The strategy chosen by the Russian Federation against Ukraine appears to be a “war of attrition”. The Russian leadership expects that time will play in its favour and that both the Ukrainian economy and the unity of the international coalition will not stand the test of time. However, one question remains open: is the Russian economy ready for a “long-term” confrontation on its own? Against the background of news about the high revenues of the Russian budget from the export of oil and oil products, as well as the allegedly limited effectiveness of sanctions, one has the impression that the Russian economy is in excellent shape and is successfully avoiding serious problems. The objective situation, however, indicates that “not everything is so clear-cut.”

The first signal is a stable budget deficit

Despite the uninterrupted flow of oil funds, the Russian government is unable to balance its budget. The reason for this is the unprecedented growth of military expenditures, which have already reached 8.7 per cent of GDP. In other words, the cost of arms exceeds revenue. In addition, it is important for the Kremlin to maintain the impression of stability and life without war inside the country, which also requires investment in social policies, infrastructure projects, etc.

In 2023, the Russian Federation’s budget deficit amounted to 3.24 trillion roubles (37.7 billion US dollars). In 2024, it is expected to be 2.12 trillion roubles (nearly 25 million US dollars). Although it is predicted that the deficit in 2024 should be smaller than in 2023, this phenomenon is largely caused by favourable energy price conditions. If in 2023 the oil and gas sector provided 8.82 trillion roubles for the budget, then in 2024 the finance ministry primarily forecast an expected income of 11.5 trillion roubles (approximately 130 billion US dollars).

It is interesting that in June this year, such optimistic estimates were slightly revised so that oil and gas should bring in about 10.98 trillion roubles to the budget, which will be reflected in an increase in the deficit from the previously planned figure. Therefore, expectations regarding permanently high oil prices are not always reliable. 

The second signal is critical dependence on energy carriers

Revenue for the Russian budget in 2024 is expected to reach the level of 37.18 trillion roubles (434 million US dollars). Nearly one third (29.53 per cent) is revenue from the oil and gas sector alone. The Russian finance ministry squeezes as much as it can out of the income of energy companies with taxes. Despite this, attempts to extract more from the oilmen will simply lead to upheaval. There is already a confrontation between the finance ministry and the heads of various corporations, where some want to take more for the state budget, while others want to keep their own income. Thanks to the political patronage of the Kremlin, the financial bloc of the government is currently winning this competition. The ability of Russian companies to circumvent sanctions and the favourable international environment allow for a stable situation which is acceptable for both the finance ministry and oil producers.

However, the situation in 2025 may change for the worse. The United States plays a key role in ensuring sanctions against the Russian oil complex and wider compliance with these restrictions. Due to the fact that this is an election year, American regulators are not acting as tough as possible so as not to provoke a spike in oil prices for the domestic American market. The fact is that Russian oil is often sold much higher than the price cap and sanctions so far have not restrained the high level of revenue going into the Russian budget. However, 2025 is decisive in view of the fact that the administration of the US president-elect will be in a position to toughen sanctions in relation to Russian oil.

A more active involvement from the US will have several effects that are problematic for Russian exports. Those who are not afraid of American sanctions will have the opportunity to demand a greater discount from the Russians. This means that the income margin will decrease and those who felt free at the time will find themselves relatively restrained. In this way, they will be more careful with Russian oil and this will also be reflected in its price. Thus, even in conditions where China and India will continue to purchase large purchases of Russian oil, a decrease in their real value will finally create problems for the Russian side of the economy. Either the finance ministry will not receive important revenues or the oil producers will have to further limit their profits.

While oil is trading at 75 US dollars per barrel or higher, albeit with problems, the Kremlin will manage to balance the interests of the state budget and oil producers. However, any drop in its price lower than 60 US dollars, and possibly even lower, will finally allow the implementation of the US plan to reduce Russian profits and put the Russian economy in an awkward position. Thus, it appears that 2025 will be the most suitable year for this.

If Kamala Harris wins the presidency, she will be in a better position to act more decisively and drive Russian oil into a corner. Should Donald Trump return to the White House, it is reasonable to expect active support for American oil production, which would increase the supply and push the price down. Both options do not look particularly attractive for the Russian budget and will partially impact long-term war plans. Certainly, it will not be possible to compensate for the potential decrease in the price due to the volume of sales, since the Russian Federation deliberately places itself within the framework of the OPEC+ rules on reducing production. In this scenario, the critical dependence of the Russian budget on the taxation of oil and gas revenues will be able to manifest itself destructively in the next year. A long war would require income diversification, and Russia continues to have problems with that.

The third signal is the reduction of the financial cushion and the absence of sources of external credit

At first glance, the Russian budget deficit does not seem terrible compared to other countries. For example, in France it is at the level of more than five per cent of GDP. Yet Russia does not have guaranteed tools to compensate for a long war. If Ukraine maintains its economy on the basis of lending and aid, the Russians simply do not have such an opportunity. China, the only potential financial partner, not only shows little willingness to open credit lines for Russia in the future, but even now behaves very cautiously in simpler matters of banking interaction, so as not to run into sanctions. The only Russian financial cushion it currently has is its gold and foreign exchange reserves – approximately 300 billion US dollars which are frozen and unlikely to ever be returned.

The liquid part of the so-called National Development Fund may reach critically low levels as early as 2026. The fund has really already helped hold the budget together since the full-scale invasion began, but even it is reaching its limits. At the beginning of 2024 the volume of the development fund amounted to 11.92 trillion roubles (139 billion US dollars). However, its structure consists of both long-term assets (investments in infrastructure, bonds, etc.) and real liquid assets. The latter is the “physical money” that the finance ministry disposes of in order to quickly close gaps in the budget. The estimated value of these liquid assets is five trillion roubles (approximately 56.73 billion US dollars).

It is not difficult to calculate that with a budget deficit at the level of 26 billion dollars in the current year, the fund may lose up to 45 per cent of its liquidity to compensate for the deficit. If we take into account the intentions of the Russian authorities to use the fund also for infrastructure projects and so-called social investments in 2026, its liquidity may consistently move in the direction of zero.

The fourth signal is the absence on the horizon of specific instruments for increasing budget revenues, besides raising taxes

While the fundamentally important oil and gas sector is reaching maximum performance and its further expansion has limited potential, any new increase in the tax burden on oil seems dangerous. The Russian oil sector is already subject to unprecedentedly high requirements for budget deductions from income. Ambitious projects like the “Power of Siberia 2” pipeline remain only on paper and do not promise any additional source of income. The LNG market functions only within existing projects, such as “Yamal LNG”. Other projects like “Arctic LNG 2” are effectively at the stage of “final failure”, which means there are no opportunities to increase revenue due to limited infrastructure.

Discussions about geopolitical transit routes like the Northern Sea Route also, in practice, remain unresolved. Due to a lack of technology, Russia cannot provide itself with high-class vessels that will navigate the route year-round. Thus, the lack of revenue has forced the finance ministry to implement tax reform which is designed to extract more funds from businesses and the population to partially cover the needs of the budget. For example, the increase in income tax from 20 to 25 per cent has the potential to raise an additional 1.6 trillion roubles (approximately 18 billion US dollars) for the budget.

No matter how hard the Russian leadership strives to demonstrate financial stability and distance its own people from the war, the government is already forced to reach into the pockets of its citizens. It is becoming clear that financial cushions and oil revenue do not cover all current needs. If in 2022 Russia was unable to avoid physical mobilization to support the war, then in 2024 it will not be able to avoid economic mobilization to support the budget.

Delayed effect of sanctions

For the sake of objectivity, it is worth noting that the sanctions have not yet had an immediate destructive effect that would drive the Russian leadership into a corner. However, the systematic increase in national defence spending, which in 2024 should be 70 per cent higher than in 2023 and reach almost 11 trillion roubles (128 billion US dollars), as well as efforts to maintain social investments and develop infrastructure projects, are greatly depleting Russian funds and reserves. Already in 2024 the Russian authorities have had to increase the tax pressure on the population and carry out a kind of tax mobilization. This will be only the first stage; the continuation of the war will require new taxes. At this rate, additional increases and the introduction of new taxes are not far off. For example, in the future we may see how for all salaries a general “war tax” could be instituted.

In 2026 the liquid assets of the National Development Fund may drop to 0.5 per cent of GDP, and in some scenarios even lower. The restraining barrier between the war and the wallet of the Russian people is dynamically decreasing, and the supporters of Russian aggression, in the literal sense of the word, will have to pay more for it at their own expense. Simple calculations give reason to believe that in 2024 and 2025, the Russian economy will still be able to maintain the war and military expenditures at a stable level. However, the cumulative effect of the aforementioned four signals calls into question Russia’s ability to wage a long-term war.

If now the effect of sanctions is not as noticeable as Ukraine would like, starting next year, and especially in 2026, the destruction of the Russian economy will intensify. First and foremost, this will happen under the condition of stricter actions by the US after the 2024 elections in the matter of compliance with sanctions, and a drop in the price of Russian oil to 60 dollars per barrel or lower. Such measures have the potential to become the first “black swan” event that, along with other factors, will finally make the price of the war too high for Russia.

Anton Naichuk is the Director of the Eastern Europe Council based in Warsaw.

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Russia, Russian economy, Russian invasion of Ukraine, Russian sanctions