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Russia almost tripled its defense spending to finance its invasion of Ukraine.
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Defense firms are busy — but high inflation and interest rates past 20% have left them struggling.
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Russia may end up having to bail them out or nationalize them.
In Russia’s defense sector, demand is surging — but its companies are struggling all the same.
The Kremlin is seeking ever more weapons for its attack on Ukraine.
But sky-high interest rates are leaving companies struggling to turn a profit, a prominent CEO recently said.
Sergei Chemezov, CEO of the defense conglomerate Rostec, sounded the alarm in an address to Russian senators in late October.
He said “record” interest rates were “eating up” the profit from its orders.
Debt trap
He said clients tended to pay 30%-40% of an order’s value in advance, leaving the firm to borrow the rest.
That debt, he said, was so expensive that it canceled out any profit on the work.
“If we continue to work like this, then most of our enterprises will go bankrupt,” he said.
A few days after he spoke, Russia’s central bank hiked its main interest rate further still, from 19% to 21%.
Rostec is not alone in its predicament, economic analysts told Business Insider.
Rising interest rates and export bans were eroding Russian defense companies’ profits across the board, they said, making the Russian state the only guarantor of revenues.
Sustaining the war machine
Since launching a full-scale invasion of Ukraine about two and a half years ago, the Kremlin has taken a slew of measures to keep its defense sector pumping out tanks, ammunition, drones, and missiles.
It restructured its economy to prioritize the war, imposed export bans, tapped its national wealth fund, and strengthened trade with non-Western countries.
Its defense budget soared, from $59 billion in 2022 to $109 billion in 2023.
It’s heading for an estimated $140 billion in 2024, with a draft budget forecasting $145 billion for 2025.
That figure would represent 6.3% of Russian GDP, the highest share since Soviet times.
That spending has consequences, said Roman Sheremeta, an associate professor of economics at the Weatherhead School of Management at Case Western Reserve University.
“The government pumped enormous sums of money to support the war efforts,” he told Business Insider. “And the Russian reserves have been almost depleted.”
The liquid assets of Russia’s national wealth fund dropped by almost half, from 8.9 trillion rubles (about $91 billion) before the war to 5 trillion rubles (about $51 billion) at the end of last year, Bloomberg reported in January, citing Finance Ministry data.
“The Kremlin cannot afford defense companies to go bankrupt,” Sheremeta said.
A ‘death spiral’
While huge defense expenditures have contributed to economic growth in Russia and averted a recession, they also fueled inflation.
When it hiked the key interest rate to 21%, Russia’s central bank said its mission was to tame inflation.
In September, Russia’s annual inflation rate rose to 8.6%, far above its 4% target.
Sheremeta described the situation as a “death spiral,” where war spending begets more inflation, which requires more war spending.
“What is even worse for those companies,” he said of the defense firms, “is that they cannot export due to sanctions and sell their weapons for US dollars or Euros.”
Daniel Treisman, a professor of political science at the University of California, Los Angeles, and a research associate of the National Bureau of Economic Research, said Russia could end up with hyperinflation.
“As the budget deficit rises in the face of military costs, the need to cover part of it by printing money will drive prices ever higher, and the Central Bank will have to hike interest rates further to slow them,” he said.
A crisis point — but not yet
The experts BI spoke to both said Russia could sustain its spending for a year or more before a crisis point.
Some see even more runway.
Iikka Korhonen, the head of research at the Bank of Finland Institute for Emerging Economies, said defense companies won’t be allowed to go bankrupt, and would instead be restructured or bailed out.
Russia has done that before, saving indebted defense firms in 2016 during an earlier financial crisis.
If that doesn’t fix the problem, “other sectors will be cut” to keep defense firms going, Korhonen said.
Julian Cooper, Professor Emeritus at the Centre for Russian and East European Studies of the University of Birmingham, made similar remarks.
“If some defense companies cannot fulfill their obligations, the Kremlin can simply nationalize them,” Sheremeta said.
Konstantin Sonin, a professor at the University of Chicago Harris School of Public Policy, forecast a dark economic future ahead for Russia due in part to “borrowing” funds from the future.
In an op-ed for Project Syndicate earlier this month, Sonin wrote that massive investment in military production at the expense of key public spending programs may strengthen Putin’s hand in the short term.
“But it sets a time bomb under longer-term economic development,” he wrote.
“Whenever the Ukraine war ends and Russia returns to international trade (beyond raw materials), all the nationalizations of recent years will come back to haunt it,” he wrote.
Read the original article on Business Insider
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