Russia-Ukraine Special Report 11DEC23 12:45 PST - Russian Economy is Hot, Hot, Hot!

Can too much of a good thing be not so good?

Yes.

While Russia is 3 to 4 months past the point when many predicted that sanctions and the isolation of the Russian economy would start to bite, Russian economists are running out of metaphorical rabbits to pull from their hats.

First and foremost, there are gaping holes in the sanctions against Russia that have helped extend the runway, and those holes have gotten bigger since March 2022. Avoiding sanctions has helped Russia expand its war production capability while limiting access to the most advanced technologies.

What appears to be right but is on the brink of going wrong?

• Russia's demographic crisis is accelerating. The country was already in crisis before 2020, and one theory of why Russia invaded Ukraine was that inhaling 42 million people would help address the problem. A combination of COVID deaths, a brain drain that started after February 24, 2022, men avoiding conscription and mobilization, over 450,000 Russian troops in Ukraine, and high combat losses has brought unemployment to about 2%. Two-percent? That's fantastic! The problem is there are so many unfilled jobs that even in an economy where more and more jobs are with state enterprises, there is wage competition. Healthy inflation is good, salaries growing at 15% a year is not good. Those costs get passed down to everyone.
• Russia's nationalistic policies, a weakened rouble (more on that in a minute), and forced mobilization of newly minted citizens are causing some non-citizen workers to leave, worsening the labor shortage.
• Russian economists have been masterful at stabilizing the rouble, but they are running out of tricks. In March 2022, Russia froze currency exchange within the country (there are huge gaps), helping create artificial demand. The decision to only accept payments for oil, natural gas, and coal in roubles also increased demand for the Russian currency. Both of these steps helped raise the value of the rouble, and it looked pretty strong by the fall of 2022. But as the demand for Russian oil and gas contracted and even BRICS nations didn't want to pay in roubles, the currency fell to 102 to $1 USD. To solve this problem, the State Duma passed a measure that forced 43 large Russian corporations to sell their foreign currency holdings for roubles, creating artificial demand. As that process continued in the fall of 2023, the rouble returned to 89 for $1 USD but is falling again. Once the forced exchange is completed, there aren't many tricks left.
• The 2024 Russian budget is dedicating 39% of federal spending on the books to the Ministry of Defense and internal security. There is more "state secret" spending, and then each federal district and republic will spend additional capital toward the military. Russia can continue to sell its gold reserves to raise money, but it has mostly burned through its 2022 war chest of available cash. Russia can't sell too much gold, as it would collapse the price. The increased state spending will drive up inflation, which is rising again.
• While the 2024 budget did have some steep cuts to social spending, other programs had funds added because of the upcoming sham elections. This is placing additional inflationary pressure on the Russian economy.
• Internal inflation is starting to impact "regular" Russians for the first time. We had reported last year that outside of St. Petersburg, Moscow, and a handful of larger cities, the average Russian has never been to Starbucks, got a Domino's Pizza, or bought a new iPhone every year. These brands leaving had no impact on the population. But over the summer, the price of motor fuel hurt farmers, trucking, and the average Russian, and now the price of sugar and eggs is skyrocketing, with eggs at a similar price to Western nations. The average Russian makes about $1 an hour. Prices of staples are rising 10% to 15% every 60 days, and the average Russian is competing with government defense spending - 450,000 soldiers have to eat and use a lot of fuel.
• To control inflation, the central bank raised interest rates from 8.50% to 12% in an emergency decision in August. Then, in September, the rate was boosted to 13% and then bumped up another 200 basis points to 15%. Another increase is expected on December 15. The interest rate increase did nothing to arrest inflation because demand for loans didn't decrease. Ironically, as homeowners worried about future rate increases, there has been a rush by first-time buyers to get new loans and for others to refinance existing debt. This led to another problem.
• Russian citizens are drowning in debt. Over 20% of Russians are dedicating 80% or more of their income to pay off existing debt obligations. The number of Russians with delinquencies is also increasing. It is unclear if a tipping point has been reached that the people on a debt-fueled treadmill will continue to seek loans even as interest rates keep going up.
• OPEC has a declared policy of not letting the price of a barrel of oil fall below $80 a barrel, and they've struggled to meet that goal. OPEC extended an existing 1 million barrels a day production cut last month and cut another 1 million barrels. The price of oil went down, not up, after the announcement! Why? Because of China. China's economy is weakening, and as demand slacks, other nations aren't picking up the difference. For Russia, oil at $70 a barrel brings the discounted rate for Urals crude under $60 a barrel. Russia's economy is still fueled, literally, by the sale of oil, natural gas, refined fuels, coal, and uranium. A weak rouble and low prices hurt tax revenue. India has scaled back purchases because their refinery infrastructure is not optimized for Russian crude, so even at a discount, the oil ends up costing more.

Russian economists are trying to stave off hyperinflation, and we're being told they've done an admirable job of turning the dials to maintain relative stability. The problem is the labor shortage will only get worse. Wage pressure will only get worse. The scarcity of resources will only get worse. The demand for loans isn't slowing down despite the rate hikes. Government spending reaching Soviet levels adds additional inflationary pressure. After these 43 companies finish converting their foreign reserves to roubles, there aren't many magic tricks left to create artificial currency demand.

While Russian GDP is expected to grow from between 1.8% to 3.3% in 2024, inflation is projected to grow at 15%. That assumes that the central bank can keep turning the dials. Coupled with low oil prices and the United States growing its lead as the largest oil-producing nation on the planet, additional OPEC cuts will reach a point of being self-defeating. Do you force the price of a barrel of oil to $80 by cutting so deep that to get there, you're actually making less money?

While Vladimir Putin may have a lot to celebrate at the end of the week, the lights on the economic control panel are changing from green to amber, and amber lights are turning to red. The problem with hyperinflation is it is very hard to control without brutal austerity. That's a card the Kremlin can't play because austerity would come from social service spending first, and Moscow isn't going to cut military spending.

While the average Russian has a bad case of learned helplessness, the average babushka, the most fearsome force on earth, is going to lose patience if the cost of eggs, sugar, oil, and flour keep rising, and Soviet-era lines to buy core staples become part of the ordinary routine.

A weakening rouble and internal hyperinflation could be a real problem in the coming year, and some things, like China's economic issues weakening demand for hydrocarbons, can't be manipulated away.