Russia’s economy is overheating

As summer draws to a close, we decided to take a look at some of the biggest issues facing the Russian economy. Despite wartime pressures, the economy has not collapsed (it has even given President Vladimir Putin a few chances to gloat). But there are also obvious problems. First and foremost, the rapid growth in military expenditure, coupled with a labor shortage, is overheating the economy.

Crisis in the labor market

The labor shortage in Russia was one of the biggest economic challenges for the government last year. And things have only gotten worse since then. Every month brings new record lows for unemployment (it was 3.1% in June — prior to the war, Russia had never seen less than 4.4%). In absolute terms, 73.6 million Russians had a job in June (the highest figure for at least the last five years).

Russian companies in all industries (from auto services to IT) complain of labor shortages. A recent survey uncovered record-breaking levels of staff shortages in manufacturing, with 42% of firms reporting they did not have enough people. Not long ago, the Interior Ministry admitted to having a chronic shortage of personnel. And the Moscow Metro is struggling to find enough staff to keep the trains running. A metro worker died earlier this month when he fell onto the rails after dozing off on his third consecutive day of overtime.

The reasons for this crisis are obvious. Labor shortages are a result of the war in Ukraine, mobilization and emigration — factors that magnify the effect of Russia’s preexisting demographic problems. At the same time, the number of jobs keeps growing due to an economy that has been artificially stimulated by military spending.

In recent years, employment levels in Russia have been maintained by pulling unemployed people back into the labor market. Now, though, unemployment is so tiny that this is not even a potential solution, according to Rostislav Kapelyushnikov, the assistant director of the Center for Labor Research at Moscow’s Higher School of Economics.

The labor shortage is helping to drive two of Russia’s most pressing economic problems: soaring inflation and a tumbling ruble. In particular, it is driving up wages faster than production. In the second quarter, real disposable incomes (adjusted for inflation) were up 5.3% compared with the same period last year. Real salaries went up 13.3%. Russia has not seen anything to match May’s wage increases for 15 years.

And rising wages are driving domestic demand that is outstripping the country’s ability to boost production. This adds to inflationary pressures and leads to a weaker ruble via greater demand for imports, according to the Central Bank. For more on the problems caused by Russia’s shift toward a “war economy,” see our previous analysis.

Specter of a recession

The economic statistic that Putin loves to cite is GDP growth. The economy last year contracted 2.1%, but it grew 4.6% in the second quarter of this year. “Sure, for a few months in the middle of last year, things were very difficult. But ever since the third quarter [of 2022] Russia has seen economic growth,” Putin boasted earlier this week.

But this rapid growth is down to two things — public spending (mostly on the military) and a dovish monetary policy. However, as the Russian currency tumbles, the Central Bank has turned more hawkish and is again raising interest rates. Following a dramatic slump in the ruble last week, it hiked the rate by 350 basis points, taking it to 12%. That helped Russia’s currency, but it has significantly increased the danger of Russia entering a recession in the coming months — from 6 to 21%, according to calculations by Bloomberg.

Bloomberg 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.

Interest rates on short-term borrowing remain lower than 12%, which suggests that the market expects a rate cut in the next three months, Bloomberg reported. However, if expectations start to turn toward the 12% rate remaining in place for longer, the likelihood of recession in the next six months could double to around 40%.

Experts at the Center for Macroeconomic Analysis and Short-term Forecasting have also written about the threat of recession. “The weakening ruble (and rising prices for imports) plus the hike in the Central Bank’s base rate could reverse the emerging upward trend,” they warned in a report published last month.

Real estate bubble

Possible problems in the mortgage market remain a hot topic of discussion. In previous years, the government’s discounted mortgage program — opposed by the Central Bank — has helped to heat up the real estate market. The prospect of getting a mortgage at a discounted rate (sometimes even lower than the base rate) pushes people into buying property. As a result, demand for real estate is soaring and supply is lagging. This leads to rising real estate prices (up 21% across Russia on average last year). In December, Putin extended the program until July 2024, while raising the discounted rate from 7% to 8%.

As real estate prices rise, developers turn to dubious tactics — for example, issuing “0.1% mortgages” (they compensate for the reduced rates by increasing the size of the loan). This practice was outlawed by the Central Bank last year.

Even so, the volume of preferential mortgages being issued has risen 30% in a year, according to Tatiana Orlova, an economist at Oxford Economics. And the range of borrowers keeps increasing, which heightens the risk for the banks.

“Subsidized mortgages support explosive growth in the construction sector,” she warned. “At some point, the growth in mortgage will inevitably slow and the construction sector could be left with a vast surplus of unsold apartments.”

Exodus of foreign companies

The Russian authorities continue to nationalize foreign businesses and economists interviewed by The Bell see this as a threat to future economic growth. At present, the nationalization of assets owned by individuals from countries deemed to be hostile toward Russia follows one of two paths: either they are taken into state administration, or Russian tycoons snap them up at discounts of at least 50%.

This year, the Kremlin seized assets from four major foreign companies. First, Russia’s Federal Property Management Agency was given control over Germany’s Uniper and Finland’s Fortum. Both were big players in the Russian electricity sector. In reality, they will be taken over by people from state-owned oil giant Rosneft, whose head Igor Sechin is chairman of the board of state electricity company Inter RAO. Then, Putin decreed the nationalization of dairy company Danone Rossiya and Baltika Brewery (owned by Denmark’s Carlsberg). Danone is now headed by Yakub Zakriyev, Chechen leader Ramzan Kadyrov’s nephew and former Chechen agriculture minister. The brewery’s new boss is 70-year-old Taimuraz Bolloyev, who ran the company between 1991 and 2004.

Russia’s last major redistribution of business assets was after the collapse of the Soviet Union. Whatever we might say about the methods of the 1990s, this historic transfer was from inefficient owners to more productive ones, according to Ruben Yenikolopov, a research director at Russia’s New Economic School. Now the country is seeing the reverse process — assets are being acquired by inefficient owners selected because of their proximity to the Kremlin. “The war is an excuse to grab property,” said Yenikolopov. “As in 1937, when people would inform [on their enemies] to get an apartment, now people are accused of being a foreigner so that their property can be seized on the cheap.”

In the long term, this nationalization will lead to the stagnation of the Russian economy, warned Oleg Itskhoki, a professor at the University of California in Los Angeles. Ineffective management could lead to a fall in output that will undermine GDP growth.

Further reading

A Sickly Ruble Reveals What Putin Will Not, our regular contributor Alexandra Prokopenko writes at Bloomberg

How Ordinary Russians Are Adapting to the New Reality. Sitting tight and waiting until things sort themselves out