Russia Economy Set for Sharp Slowdown After Second Quarter

Russia’s overheating economy fueled by massive Kremlin spending on its invasion of Ukraine may be about to cool sharply amid mounting constraints on key sectors that have bolstered growth until now.

Labor resources are practically exhausted amid fierce competition for recruits between the military and businesses that’s also likely to limit further expansion of defense-related industries. The construction and banking sectors are no longer shielded from the impact of very high interest rates now that most state-subsidized mortgage programs were wound up last month.

Gross domestic product jumped 4% annually in the second quarter, according to a Federal Statistics Service preliminary estimate published on Friday. But growth is likely to slow to half that level over the rest of the year, according to economists surveyed by Bloomberg.

The estimate shows “a last growth spurt before Russia’s economy starts to markedly cool,” said Alex Isakov, Russia economist at Bloomberg Economics. He expects Russia’s growth to slow to around 2% in the second half of the year, and reach 0.5%-1.5% next year.

The government massively increased spending in the wake of the February 2022 invasion, pouring money into the military and defense industries and acting to cushion domestic businesses against the impact of sanctions imposed by the US and the European Union.

That caused the economy to overheat to a degree unseen since before the 2008 global financial crisis, according to Bank of Russia Governor Elvira Nabiullina, in response to the huge surge in domestic demand.

“Reserves of labor and production capacity are almost exhausted,” Nabiullina said.

The central bank last month hiked the key interest rate by 200 basis points to 18%, the highest since the early weeks of the war, to counter risks of stagflation as price growth continued to accelerate.

Unemployment, a key sign of overheating, has declined to a historical low in Russia of 2.4%, and below that of any of the Group of Seven states.

Businesses now have a shortage of more than 2 million workers, according to the Federal Statistics Service. The Bank of Russia shut down its own fleet of armored cash-collection vehicles because so many of the employees switched to working in defense factories, the RBC news site reported Thursday.

Demands from the military for new recruits to join the war continue to add to labor pressures, particularly as government officials are sharply increasing recruitment bonuses for new volunteers to replenish the army’s ranks.

Read more: Russia’s War Fuels a Wage Spiral That Threatens Army Recruitment

Economic activity in June showed signs of cooling across most sectors with construction growth at the lowest level for that period since 2020, according to the Economy Ministry.

Expansion in manufacturing driven by military orders was half the level in June compared to May. Wholesale trade including energy sales slowed to less than 2% growth from double-digits in previous months, the Economy Ministry data show.

Policymakers are hoping the signs of a slowdown in June and July indicate a cooling in domestic demand, according to minutes from the Bank of Russia’s last rate-setting meeting. Another explanation – increasingly severe limits on production capacities – would indicate that inflationary pressures remain elevated despite the bank’s efforts to curb them.

The June data could be a one-off, making it too early to tell if the slowdown has started, said Tatiana Orlova, economist at Oxford Economics. Growth should ease in the second half of this year after the monetary tightening and the end of a popular mortgage subsidy program, which is likely to hit construction, she said.

Capital investment in Russia remains high, potentially testing the boundaries of economic growth in the longer term, according to central bank forecasts. Sanctions have prompted investment in domestic production of aircraft parts, equipment, electronics, and components in response to demand, said Ildar Mukhamediyev, director of local procurement platform TenderPro LLC.

“Companies in Russia are not reducing their investment activity,” he said, citing a survey by his company that showed a 70% jump in the number of capital projects started in the first seven months of the year compared to the same period in 2023.

Capital investment is only part of the long-term growth story, according to Orlova at Oxford Economics. Labor and technology constraints may be harder to solve as Russia’s war grinds through a third year.

“Russia’s growth potential is hampered by several problems, such as low population growth, high unit labor costs, and a very poor investment climate,” she said.