Could Russia's war economy and defense spending make it weaker?

• The government's finances may face significant imbalances due to Russia's war-oriented economy and plans for increased military spending.
• Analysts say Russia's 2025-2027 budget plans risk damaging growth and competitiveness.
• In 2025, the draft budget anticipates a significant increase in defense spending to 13.5 trillion roubles ($145 billion), which represents a 25% rise from the previous year and accounts for 6.3% of GDP.

Analysts warn that Russia's war-oriented economy and plans for increased military spending could lead to significant financial imbalances within the government.

Last week, the Russian government, led by Prime Minister Mikhail Mishustin, approved a draft budget for the years 2025-2027 that projected a significant increase in defense spending to 13.5 trillion roubles ($145 billion) in 2025, representing a 25% rise from the 2024 level and equating to 6.3% of GDP, as per the translated document by Reuters.

Russia has restructured its domestic economy to support its military production and evade international sanctions that limit its access to military equipment, components, and arms since launching a full-scale invasion of Ukraine in 2022.

Since the war began, Russia's military-industrial complex has grown significantly, fueling its war machine.

The draft budget proposes that Russia will spend approximately 40% of its total government budget on national defense and security in 2025, which is more than twice the amount allocated for social needs such as pensions, according to Reuters.

The latest spending plans indicate that Russia is aiming to continue its war on Ukraine, which could result in economic and social risks for the country, including a decline in living standards and high consumer prices.

According to Andrius Tursa, Central and Eastern Europe advisor at consultancy Teneo, the country's intentions to maintain military spending at similar levels until 2027 indicate that it has enough financial resources and political will to continue expanding and reconstituting its armed forces, in contrast to an increasingly uncertain outlook on the Ukrainian and Western sides.

Although the government's political rhetoric and optimistic forecasts suggest that the economy will continue to militarize with increased state spending, it may be challenging to sustain this trend in the medium to long term, according to the expert.

According to Tursa, the economy is currently running at full capacity, and Russia may face sustained inflationary pressures in 2025 due to labor shortages resulting from ongoing military recruitment and the departure of migrant workers, as well as rising government spending and tax increases, such as those on housing and utility tariffs.

Dissatisfaction over living standards 'could erupt'

Currently, Russia's annualized inflation rate is 9.1%, and its central bank predicts that "underlying inflationary pressures will remain high overall" as it raised its key interest rate by 100 basis points to 19%.

Capital Economics' senior emerging markets economist, Liam Peach, predicts that Russia's budget plans will not address the demand-supply imbalances, resulting in continued price pressures.

The government's debt servicing costs will continue to rise due to inflation and high sovereign bond yields, despite personal income and corporate tax hikes being part of the 2025 draft budget.

The likelihood of another interest rate hike by the central bank, to 20%, this month is increasing, according to Peach. However, the broader point is that a prolonged period of high interest rates will continue in Russia as long as the government prioritizes the war effort.

Teneo's Tursa stated that while Russian authorities may see military expansion as a means of promoting economic and technological advancement, the significant increase in military spending could lead to a reduction in investments in other areas such as education, healthcare, and infrastructure. This, in turn, could have a negative impact on the quality of public services and hinder economic growth and competitiveness in the long run.

If public life declines, it could lower the standard of living for most Russians, and although it may not cause immediate mass protests, Tursa cautioned that public dissatisfaction with living standards could eventually surface, particularly if Putin's grip on power weakens.

Russia claims that Western sanctions have made it more self-sufficient and that private consumption and domestic investment remain resilient, even though international sanctions have targeted critical Russian industries and sectors due to the war.

The Finance Minister, Anton Siluanov, stated that oil and commodity exports to India and China, as well as alleged sanctions evasion and high oil prices, will contribute to 27% of the total state budget proceeds in 2025, with oil export revenue accounting for 27% of this amount.

Despite Western nations' efforts to isolate and punish Russia for its invasion of Ukraine, the International Monetary Fund predicted in its spring economic outlook that Russia's economy would grow faster than all advanced economies this year, with a forecasted growth rate of 3.2%.

The IMF will release its revised forecasts on Russia next week, which may affect the country's draft budget based on an assumed 2.5% GDP growth in 2025.