The stochastic war continues to escalate into a brutal tit-for-tat missile war with both sides continuously rolling out new and improved weapons that could eventually lead to a direct clash between Nato and Russia.

Ukrainian President Volodymyr Zelenskiy has given up on expecting any real material help from his Western allies and quite sensibly has thrown himself into building up his own defence sector – a goal personified by the appointment of the now ousted Defence Minister Mykhailo Fedorov.

But as Ukraine’s weapons get better, so do Russia’s. and Russian President Vladimir Putin is afraid to use them. The key issue is that increasingly Ukraine’s new weapons are being made by factories on EU territory. At some point Russia will decide that this is no longer a proxy war. Indeed, in the first worrying sign of this mission creep that will led to a missile strike on a weapons factor located in Poland or Denmark is the Kremlin is increasingly dropping the term “special military operation” and using the word “war” (война) instead. Putin used that word for the first time in his May 9 Victory Day remarks, Reuters reported.

Hitting at consumers

The war has taken a third direction. The first-year military targets and ammo dumps were hit, but for the last two years it’s become industrial assets in the crosshairs. Now retail and transport are being bombed.

The war is slowly expanding. Ukraine has taken the fight into Russia and is clearly now systematically hitting all of Wildberries’ logistic hubs. It’s now an open question of if the company will survive this.

At the same time the hits on the oil refineries continue. The last concrete number I saw is oil refined products production was down by 13.5%, according to Sergey Vakulenko, an independent energy analyst, but that was two months ago. Yesterday some of the investment banks reported they think it’s down by half now. Of course this doesn’t really affect the Kremlin’s income as what they can’t process, they just exports as crude. Russia made $160bn from oil exports last year, enough to cover 84% of defence spending by itself.

Janis Kluge, fellow at the Stiftung Wissenshaft und Politik (SWP), Eastern Europe and Eurasia Group just released a nice note looking at credit card payments at petrol pumps that shows is both probably worse than it seems and very uneven. What is going on is the Kremlin is moving what petrol there is to Moscow where the pumps are working as normally, but draining the regions. The Crimea is in a particularly bad way, with no petrol at all and now is facing rolling blackouts.

You know what Russian President Vladimir Putin is going to do: the punishment strategy. The heavy bombardment of Kyiv and other cities has already begun. (US talking head Laura Looner is in Kyiv at the moment.) But Russia is already expanding its target list and also taking out warehouses, supermarkets, petrol stations and especially ports.

Both sides are trying to cripple the other, but as Russia continues to have the advantage of plentiful and accurate missiles, whereas Ukraine has run out of air defence ammo, I don’t see how the AFU can win this confrontation.

In a little reported story, Ukraine has cut its wheat exports by a third as strikes disrupt logistics. Ukraine has six working ports, but Odesa is by far the most important and is under heavy attack, the second most important theatre after the Donbas.

At the same time, a Liberian-flagged LPG tanker caught fire after being hit by three Russian drones during the night of July 20-21. This one was worrying as it was sailing approximately 20 nautical miles southeast of Sfântu Gheorghe, within Romania's Exclusive Economic Zone (EEZ) but outside its territorial waters – a Nato territory grey zone. The vessel was en route from Alexandria, Egypt, to the Ukrainian Danube port of Reni.

Paying for more

Ukraine remains cash strapped. The IMF signed off on the next $690mn Extended Fund Facility (EFF) tranche, but MinFin reports there is already a $20bn hole in this year’s budget thanks to expanded military spending. Ironically everyone makes a big fuss over Russia’s “overspending” on defence which is blowing up the budget deficit, but Ukraine suffers from exactly the same problem.

The difference is that Ukraine is entirely reliant on external funding and its EU mates are already tapped out. However, things on the funding front are going badly in Russia too. Yesterday, the Ministry of Finance (MinFin) cancelled an OFZ bond auction for about $20bn worth of bonds as no one wanted to buy them. The problem is investors are afraid that the CBR will reverse its monetary easing – it has cut 575bp since last year – and start hiking again due to an uptick in inflation in the last two months: CPI rose from a year-low of 5.2% to 6.02% now.

This could be a problem. The CBR is due to meet tomorrow and CBR governor Elvia Nabiullina is under a lot of pressure to cut again by a token 25bp, but she will probably leave rates flat. If she hikes, as the textbooks say she should, that will cause a storm.

Still, this should be a temporary problem as overall inflation has been on a downward trend, but if military spending keeps rising and the economy keeps slowing then Russia’s funding will get tighter. But bottom line is that Russia still has plenty of money in reserve as just what’s left in the National Welfare Fund (NWF) is enough to cover the shortfall. And there is currently $722bn in reserves, the CBR just reported – mostly in yuan and gold. That is UP by $140bn since the start of the war. That is before MinFin hikes taxes again. Bankova is a lot more desperate. The IMF just advised the government to cut its emergency 50% profit tax imposed on Ukraine’s banks as the government hunts for more revenue, warning that it will ultimately destroy the banking sector if it doesn’t.

Tactics and theatre

As for the war proper. While the Armed Forces of Russia (AFR) is making progress in Donbas and pounding Odesa, the AFU is making progress with turning the Crimea “into an island” where it has concentrated most of its efforts. Still, cool as this is, strategically I don’t see how it helps to win the war. Loosing, or even just shutting down, the Crimea would be a psychological victory for Zelenskiy, but like the Kursk incursion last year it doesn’t really change the balance of military power.

There is a lot of theatre in this war. For example, the General Command just announced a Ukrainian F-16 shot down its first Russian fighter jet – another PR victory. But look at the numbers. Ukraine got its first F-16 – a supposed gamechanger – in August 2024 and since then has managed to shoot down zero Russian planes because Bankova doesn’t dare use them as there are so few. Russia currently has some 350 advanced jets in the air.

The chairman of the US Joint Chiefs of Staff, Dan Kaine, said during a Senate hearing: "We recently witnessed the first air combat in which a Ukrainian F-16 shot down a Russian fighter jet. Over the past few years, thanks to the support of many partners, Ukraine has significantly strengthened its echeloned defense system."

The reality is Ukraine’s partners sent it a total of 39 jets, one of which crashed in the first month. And even that number is unclear as no one has officially said how many jets were sent. That is the real measure of Westner support.

Made in Ukraine

 It’s no wonder that Zelenskiy has thrown everything into setting up and expanding domesttic production which now accounts for 60% of Ukraine’s needs, according to the president. And there is progress there too as I'm clipping an expanding list of defence JVs, some based in Ukraine and others in EU countries under the so-called Danish model.

The relagtively long and growing list includes of projects that have been annoucned since the start of this year includes:

· Feb 5–6 — Poland: PM Tusk and Zelenskyy sign a letter of intent for joint weapons/ammunition production at facilities in both countries, plus cooperation on digital infrastructure, robotics and unmanned systems.

· Feb 12 — France: Letter of intent for joint weapons manufacturing in both countries (Defense Minister Fedorov/French counterpart Vautrin), alongside the Mirage 2000 transfer and AASM Hammer bomb supply.

· Feb 16 — Germany: First German-Ukrainian JV for drone production opens in Germany (target: 10,000 UAVs this year). Three more Ukrainian firms — TAF Industries, Airlogix, Tencore — sign MOUs with Wingcopter, Auterion and Fernride respectively to form JVs there; Zelensky says 10 such JVs are planned by year-end.

· Mar 13 — Romania: Bilateral agreements on joint drone production in Romania plus an energy-sector partnership.

· Mar 18 — Denmark: Fire Point (maker of the Flamingo cruise missile) begins building a chemical plant in Denmark for missile components (engines, fuel, bodies); phase one due 2026, full operation 2027.

· Mar 24 — Romania: €200M in joint defense projects (mainly drones) funded under the EU SAFE program.

· Mar 30 — Saudi Arabia/Qatar/UAE: Defense cooperation agreements signed; Qatar's includes a 10-year defense partnership with joint industry projects.

· Apr 1 — United States: Ukrainian UAV maker General Chereshnya partners with Wilcox Industries to jointly produce FPV and interceptor drones at Wilcox's facility in Newington, New Hampshire.

· Apr 2 — Romania: Ukrainian companies confirmed to join localized drone production in Romania under the SAFE initiative (~€200M).

· Apr 8 — Croatia: General Chereshnya signs a cooperation memo with ORQA to build an underground component factory in Ukraine, plus mass production in Croatia.

· Apr 20 — United States: Bell Textron opens a Ukraine subsidiary ("Bell Textron Ukraine") for helicopter assembly, maintenance and repair.

· Apr 23 — Poland, Germany, Italy, Sweden, France: Missile manufacturers from all five express interest in forming JVs with Ukraine (talks, not yet signed).

· Apr 28 — Norway: Agreement to jointly produce mid-range strike drones in Norway, Norwegian-financed, all output transferred to Ukraine's military.

· Apr 28 — Poland: Tusk announces cooperation to help Poland build a drone fleet, with a "Polish model" defense-industry plan due by June.

· May 1 — Finland: TAF Industries and Summa Defence Plc sign an MOU on drone production, considering a JV and production facilities in Finland.

· May 4 — France/Denmark: Tencore and French Shark Robotics form two JVs to develop/produce military and civilian ground robotics — production in France, a service/production base in Ukraine.

· May 5 — Latvia: Zelenskyy signs a "Drone Deal" cooperation agreement with Latvia's PM at the NB8 summit.

· May 5 — Greece: Naval-drone co-production talks stall over disputes on usage/control rights.

· May 13 — Germany: "Brave Germany" joint defense-tech program launched (Fedorov/Pistorius) for long-range drone development; separately, Kyiv and Berlin confirm six joint weapons-production projects underway.

· Jun 3 — Canada: New JV "Airlogix-Sentinel" formed between Ukraine's Airlogix and Canada's Sentinel Research and Development for reconnaissance UAV production.

· Jun 10 — Latvia/NB8: Follow-up "Drone Deal" plus €109M for naval drones announced at the Ukraine-NB8 summit in Estonia.

· Jun 12 — Europe (MBDA): MBDA (UK/France/Germany/Italy/Spain missile consortium) signs a strategic partnership memo with Ukrainian Armored Vehicles on Deep Strike and UAV-countermeasure tech.

· Jun 22 — Czech Republic: Ukrainian Armored Vehicles and AviaNera Technologies (Czechoslovak Group) sign a partnership to jointly produce drone/missile engines, with future JVs envisaged.

· Jun 22 — Europe (MBDA): MBDA signs an MOU with Ukraine's Luch Design Bureau to jointly develop missile tech, including the Neptune-2 long-range cruise missile.

· Jun 22 — Germany: Diehl Defense explores localizing production of the Flamingo cruise missile at its German facilities.

· Jun 22 — aggregate: Ukraine reports having signed nearly 20 defense co-production agreements with five EU countries, with Germany the leading partner.

It’s pretty impressive but there are two big problems with this list: few, if any of these projects will come online until next year at the earliest; and they are mostly in Nato territory.

At some point the Kremlin will deem these factories ”legitimate military targets,” which of course they are as if we are honest, Russia is in a proxy ar with Nato. We can only carry on pretending it’s a straight Ukraine-Russia for so long. And then Russia may hit them… That is why today’s Romania tanker strike story is so unsettling. We are already creeping in this direction.

It’s no wonder the Kremlin is hardening its line. Bloomberg reported yesterday that Putin has withdrawn his offer to give up some territories in any ceasefire deal, and he seems to be locking into going for a military victory in this increasingly brutal tit-for-tat missile war. I'm sure there is no more chance of a ceasefire this year as Putin is gong to play his Kutuzov-card again and is waiting for winter to do its work.

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