Russia’s economy is on course to expand by 2.2% this year and growth is expected to stay above 2% for the following two years, according to the Central Bank of Russia (CBR), yet the West’s extreme sanctions have imposed a real cost that will slowly start to strangle the economy, analysts at Capital Economics say.

The sanctions have not worked as expected, leading Prime Minister Mikhail Mishustin to declare that “the worst is over” at a recent economic conference in Moscow. But the West has hurt the export of Russia’s money-making raw materials. The game of whack-a-mole continues, and Russia has had a good six months as it finds new export routes for its goods – for now.

“The squeeze on Russia’s budget and current account positions has eased over the second half of this year, largely thanks to a rise in oil prices. Higher energy revenues next year should help to limit the impact of a surge in military spending on the fiscal and external positions,” Liam Peach, an emerging market economist with Capital Economics, said in a note.

“Even so, a large fiscal stimulus is coming ahead of next year’s election and at a time the economy is clearly overheating, which will add to inflation pressures and require additional interest rate hikes from the central bank,” Peach added.

While the budget is back in profit since May after Russian Finance Minister Anton Siluanov correctly predicted that oil revenues would recover in the second half of this year, the sanctions have imposed a real cost.

Russia's fiscal and external positions deteriorated sharply this year. The federal budget deficit widened to a peak of almost 5% of GDP in the second quarter on a twelve-month sum basis, and the current account surplus shrunk to a two-year low of 4% of GDP (from 12% last year) as the energy price boom unwound. We warned earlier in the year that this could lead to a weaker, higher inflation and interest rates, which has materialised, says Capital Economics.

"The situation has improved in recent months. The latest figures show that the budget deficit narrowed to 3% of GDP on a 12-month basis in October," Peach said.

Meanwhile, the current account surplus continued to rebound in October from its low in the second quarter, helping it to stabilise around 3.5% of GDP.

"The narrowing of the budget deficit has been driven by a slowdown in government spending after front-loaded measures taken earlier in the year and a marked rebound in revenues," the report added.

"A large part of this reflects higher oil prices, with Urals crude oil hitting $80 per barrel last month (from an average of $55 per barrel in the first half of the year). Russia has largely been able to circumvent the G7 oil price cap and ship its oil above $60 per bbl in recent months."

"The depreciation of the [Russian ruble] has helped too, as this raises the local currency value of energy tax receipts. Russia’s energy tax revenues surged in October by 30% year on year, a much larger rise than would have been expected based on the value of oil prices alone."

"The big surprise on the fiscal side has been the 30% year-to-date surge in non-energy tax revenues. These are likely to come in at 12% of GDP this year, 1.5% higher than in 2022 and one of the highest levels in recent years."

"It’s not entirely clear what lies behind this, but likely reflects a combination of a rebound in domestic demand, deferred payments from 2022 and higher taxes on business profits,” says Peach.

As a result, the pressures that had built up on Russia’s fiscal and external positions a few months ago have eased. And this has helped the ruble to rebound to a four-month high against the dollar, to RUB90.

But risks to the economy remain significant. One of those risks is the stance of fiscal policy and the likelihood of a surge in government spending in 2024 due to the war. The finance ministry outlined in its recent budget plan a 16% y/y rise in federal spending next year, with defence spending surging by 70% y/y (from 3.9% of GDP to 6.0%).

"We argued in our Focus this year that if President Putin wants to devote more resources to the war effort, the path to maintaining macroeconomic stability becomes incredibly narrow. A surge in military spending will have consequences at a time that Russia’s economy is overheating and demand-supply imbalances are so acute. Russian industry is largely operating at its capacity and labour shortages remain significant,” says Peach. “The central bank is rightly concerned about the inflationary impact of a large fiscal stimulus in this environment.

"The good news for Russia is that this increase in spending is likely to come alongside an additional boost to revenues from high oil prices. We think it’s plausible that energy tax revenues could rise by 1% of GDP in 2024 and that oil export revenues come in 1.5% of GDP higher next year than this year. This should limit the impact of the fiscal stimulus on the budget and current account. We forecast the budget deficit to stabilise [at] around 3% of GDP next year and expect the current account surplus to rise to 4%.

"Even so, the fiscal stance will still be highly expansionary, which we think will keep GDP growth strong in the coming quarters and add to inflation (which we expect to breach 9% y/y in the first half of next year),” adds Peach.  

"Preserving macro stability in this environment of rising military spending will depend on oil prices staying high and the government undertaking some non-war fiscal tightening in an election year. This looks unlikely to us until the second half of 2024, so it will keep pressure on the central bank to deliver more monetary tightening in the coming months,” Peach concludes.