Most central banks are cutting interest rates. Not so Russia. Last month, authorities rates increased to 21%, the highest level in two decades; markets expect them to reach 23% by the end of the year. The change is even more unusual because it occurs in times of war, when central banks are typically reluctant to suppress economic activity.
Russia’s economy has baffled analysts since the country invaded Ukraine in February 2022. Despite facing one of the strictest sanctions regimes in modern history, it has experienced its most rapid expansion in more than a decade. Russia enjoyed 3.6% growth last year and is expected to maintain that pace this year. However, rather than being a show of strength, the central bank’s decision to raise interest rates is a warning of trouble ahead.
Government spending is increasingly difficult to sustain. Russia’s budget, presented in September, included a plan to increase defense spending by a quarter next year. Together, annual spending on defense and security (a separate budget line covering intelligence services) is now expected to rise to 17 trillion rubles ($170 billion), an amount that represents more than 40% of the entire budget. government spending or 8% of Russia’s GDP. Defense spending alone will account for 6% of Russian national income, the highest since the Cold War.
It’s a lot, but not unusual for a country at war. US defense spending, for example, was 8-10% of GDP during the Vietnam War. During the Second World War, the great powers dedicated between 40 and 60% of their total economic production to military purposes. The crucial difference lies in monetary policy. British policymakers in the early 1940s strove, and mostly succeeded, to combat what they called “a 3% war” by keeping interest rates close to that level. The US Federal Reserve kept rates at 2.5% during the same conflict. Lower borrowing costs helped keep large deficits manageable. By contrast, in Russia, the yield on ten-year sovereign debt has risen from around 6% before the war to 16%.
The recruitment of prisoners and the hiring of North Korean soldiers is an unconventional indicator of a booming labor market, but it is one nonetheless. The Russian unemployment rate is just 2.4%. Spare capacity has been exhausted and the economy is showing all the classic signs of overheating. Annual inflation exceeds 8%. Although raising interest rates is the classic response, it raises borrowing costs. In the 1940s, United States and Great Britain They kept inflation under control through a combination of sharp increases in personal taxes, designed more to contain household spending than to raise incomes, and rationing. In today’s Russia, such measures would be deeply unpopular and difficult to reconcile with Vladimir Putin’s propaganda.
And there is another reason why the country has been forced to tighten monetary policy. During most of the Second World Waris Great Britain ni Eunited states They had to worry especially about the external value of their currency. The dollar benefited from being seen as a safe haven, while the United States’ Lend-Lease program provided Britain with both military equipment and resources such as oil and food, doing so virtually free. If Britain had not had an ally with the deep pockets and industrial capacity of the United States, willing and able to supply two-thirds of its imports, then the fall in the value of the pound would have become a military problem.
Putin’s difficulty is that he lacks such an ally. China has become Russia’s most important trading partner, providing a third of all imports and more than 90% of microelectronics, which are used in drones, missiles and tanks. However, that support is not offered for free. Russian officials should therefore carefully monitor the value of their currency in yuan terms; This year, the interest rate has fallen by 10%, reaching close to its lowest level since the war began. Russia, unlike the allies in the Second World War, faces external vulnerability. And that, more than inflation, is ultimately what has pushed interest rates to all-time highs.
Until recently, the Russian government had protected the economy from higher borrowing costs. A variety of schemes made it easier for households to suspend debt payments and businesses to borrow at lower subsidized rates, with the government stepping in to compensate banks for lost income. However, there are signs that those programs are becoming unaffordable. A mortgage subsidy scheme, which had allowed borrowing at a cost of just 8% when official rates were much higher, ended on July 1. Mortgage volumes halved the following month. Corporate bankruptcies have increased 20% this year. The Russian Union of Industrialists and Entrepreneurs, a trade body, believes investment plans for next year are being put on hold due to high borrowing costs.
Higher interest rates will limit spending by both businesses and consumers. The IMF expects Russian economic growth to slow sharply to 1.3% next year. Even the VEB, the state development bank, has reduced its growth estimate to 2%. A combination of lower investment and loss of frontline labor is taking its toll. The need to maintain the value of the ruble to pay for crucial imports is a vulnerability for Putin, and one that could soon take a toll on his fighting ability. He may be waiting for Donald Trump to make good on his promise to end the conflict. Fighting a 3% war is one thing; a 21% war is quite another.
© 2024, The Economist Newspaper Limited. All rights reserved.
