Debts suffocating Russia: why it is not profitable for the Kremlin to prolong the war in Ukraine

 

This is the BOMB!!!!!!!!!!!!

Craig Kennedy published research on Russia's hidden military debt.

The Kremlin financed military expenditures through extrabudgetary financing.

Banks issued preferential loans to defense companies — as a result, according to his calculations, Moscow's military expenditures will exceed the budget almost twice from 2022!!!!!!

 

This report examines Russia's strategy for financing the war against Ukraine. It assesses Russia's ability to sustain increased spending in the war and identifies vulnerabilities that Ukraine and its allies can exploit.

There are three key findings:

The Russian state is pursuing a two-pronged strategy to cover its growing military spending, supplementing its scrutinized defense budget spending with funding from an off-budget defense financing program that is similar in scope but overlooked by analysts.

Unlike federal defense spending, which remains stable, Russia's off-budget financing scheme has proven much more problematic to maintain.

This now presents Moscow with a financial dilemma that could affect its military budgets, while giving Ukraine and its allies valuable new bargaining leverage; This report outlines ways to exploit Moscow's growing financial vulnerability.

 

 

A summary of each of these three findings follows

budget indicators. It significantly exceeds the total revenues from oil and gas and the spending of the defense budget in the same period and is 6.5 times higher than the additional borrowing of the state.

 

According to an analysis of industry lending data, more than 70 percent of the growth in loans to the economy was in sectors related to war activities.

Not all loans to these sectors necessarily went to finance war goods and services. However, based on the analysis in this report, it is estimated that between 50 and 60 percent of the increase in corporate lending during the war ($207 billion to $249 billion) went to finance war operations through government off-budget financing. These are loans that the state forced banks to give, mostly to insolvent war enterprises, on preferential terms. On this scale, Russia's off-budget funding flow is roughly equal to the total expenditures flowing through the federal defense budget.

Between 2010 and 2022, the Kremlin used a similar off-budget financing scheme – albeit on a smaller scale – with the express purpose of covertly supplementing funds for its expensive rearmament program while publicly demonstrating support for fiscal discipline. The current scheme achieves a similar goal by allowing official budget spending to remain flat, creating a false impression of the sustainability of Russia's ability to finance the war.

In short, Russia's total war spending far exceeds official budget spending. The government subtly finances about half of these off-budget costs through heavy debt, forcing banks to make loans on "non-market" (non-commercial) terms to businesses supplying goods and services for the war.

Unlike the defense budget, which has been held at a stable level, it has become much more problematic to sustain Russia's off-budget defense financing scheme through the second half of 2024 - funding has grown to the point of causing inflation, pushing interest rates for borrowers out of the "real" economy to well above 21 percent and setting the stage for a systemic credit crisis. In the second half of 2024, the Central Bank of Russia (CBR) began to identify the state scheme of preferential lending to companies as a significant threat to Russia's economic stability. As the main source of monetary expansion, it caused inflation to rise in Russia. Worse, since this lending is strategic rather than commercial in nature, the Central Bank of Russia notes that it has been largely "insensitive" to rising interest rates, blunting the CBR's main inflation-fighting tool. So in order to cool down overall borrowing, the CBR says it has been forced to tighten much more aggressively than would otherwise be necessary.

 

High borrowing costs are causing financial difficulties for healthy companies in the "real" economy, prompting the Central Bank of the Russian Federation to express concern about the "risk of over-indebtedness of large companies". These risky companies likely include Gazprom, which has been borrowing on domestic markets at 22 percent and above to cover losses from the collapse of its core business - European exports.

The CBR also expressed concern about the state of large banks, which operate under significantly relaxed regulatory policies since the tightening of sanctions at the beginning of 2022. According to the CBR, some banks took advantage of the relaxed policy to lend "aggressively" without maintaining sufficient "short-term liquidity" and adequate "capital buffers".

In addition, banks' credit risk is likely to increase significantly as a result of the large volume of lending imposed by the government on companies with bad credit histories, which may struggle to service their loans, especially after cuts in defense spending. This creates the prospect of a systemically destabilizing pool of toxic debt spilling over into corporate credit markets.

In November 2024, the Central Bank of the Russian Federation announced a long-awaited timetable for strengthening banking regulatory policy, which shows how troubled bank loan portfolios have become, and in December it unexpectedly delayed its tightening plans.

Russia's off-budget defense funding schemes turned toxic twice - in 2016-17. and again in 2019-20. Both times the state had to take over large amounts of bad debts. Given the scale of today's off-budget lending scheme, the potential financial aid could be extremely burdensome for the state – in total half of Russia's entire federal budget for 2024. This could limit the government's finances in the long term, including its ability to fund future rearmament, provided, of course, that Russia does not receive significant sanctions.

 

Broadly speaking, it has now become apparent that Moscow's heavy reliance on off-budget bank financing to finance the war is creating the conditions for a systemic credit crisis. By raising interest rates, it creates financial difficulties for companies in the "real" economy. And by piling significant amounts of debt on war-related companies that are likely to eventually lead to bankruptcy, banks risk being overwhelmed by a wave of toxic debt. Not surprisingly, at the end of October the CBR publicly called on the government to end its concessional financing scheme. But that would undermine the country's ability to maintain current levels of war funding without significantly increasing official defense spending.

 

3) In late 2024, the Kremlin realized the systemic credit risks associated with the off-budget defense financing scheme. This has created a dilemma that is likely to strain Moscow's military calculus: the longer it relies on the plan, the greater the risk of a devastating credit event that undermines its image of financial stability and weakens its negotiating leverage. Moscow's new financial dilemma offers Ukraine and its allies unexpected bargaining leverage. There are two key steps well-informed negotiators can take to exploit Moscow's growing financial vulnerability.

On October 28 last year, Vladimir Putin convened a meeting of senior officials, including the head of the Central Bank of Russia, to discuss issues related to the "structure and dynamics" of Russia's "corporate debt portfolio." Since then, he has publicly shown increased sensitivity to the level of defense spending and the use of soft loans by the state to achieve "strategic goals." In addition, there continues to be a negative news stream of growing financial difficulties in both the corporate and consumer sectors.

Unlike the risk of slow inflation, the risk of credit events such as corporate and bank bailouts is seismic: it can materialize suddenly, unpredictably, and with significant disruptive force, especially if it becomes contagious. For now, Moscow is unlikely to worry that a major credit event could destabilize the government. Or even prevent him from supporting increased war spending. He may still be able to forgo significant increases in taxes and government borrowing, although he clearly does not want to.

A bigger concern for Moscow is that a worsening credit environment in Russia could lead to events that dispel the widespread misperception, masterfully promoted by Moscow, that Russia's military finances are stable and not at significant risk. This misperception gives Moscow valuable leverage in future negotiations. Moscow's practice of manipulating perceptions of defense spending for political gain is not new—it was widely practiced in Soviet times as part of a broader campaign of reflexive control.

Moscow is now faced with a dilemma: the longer it delays a truce, the greater the risk that credit events will spiral out of control and weaken Moscow's negotiating leverage.

This is a serious enough concern to factor into Moscow's ceasefire calculations. Specifically, it could stimulate Moscow in two ways:

 

i. Prioritize the easing of revenue-limiting sanctions as a condition for a ceasefire. This would provide much-needed additional funds to restructure the large, toxic corporate military debt, as well as re-weaponize finance.

ii. Promote a ceasefire sooner rather than later to reduce the risk that a credit event will weaken its bargaining power. However, if Moscow believes that much greater sanctions relief can be achieved by resuming hostilities, it may be willing to take that risk.

Ukraine and its allies can take advantage of Moscow's financial dilemma by resorting to two measures:

Moscow's financing problems will only intensify, especially if coalition countries more fully apply the powerful energy sanctions instruments at their disposal. With continued determination and a clear understanding of Moscow's vulnerabilities, Ukraine and its allies will be able to realize the full potential of their negotiating leverage, avoid unnecessary concessions, and reduce the long-term risks associated with Russian revanchism.