From decline to overheating: Russian industry thrives amid military fever

In April, industrial production growth exceeded 5% year-on-year, approaching the record pre-war rate of growth. However, part of this growth can be attributed to the base effect, which witnessed a significant decline in April 2022. The growth in manufacturing was largely driven by government contracts and military needs, while the growth in consumer import substitution has been less robust. Simultaneously, high labour demand, payments of various kinds, and consumer lending have stimulated household consumption. As a result, the military-defence sector of industry has been growing, while private demand has been driven by consumers. Consequently, civilian industry has not yet responded to the growth in consumer demand with an adequate increase in output. The Central Bank has warned that the Russian economy, which has just emerged from a downturn, now faces the risk of overheating, which would lead to accelerated inflation. To address this anomaly in the 'war economy,' there would need to be an increase in either imports or consumer sector lending, but this also carries with it the risk of overheating. If these risks materialise, the regulator will have to raise the key rate.

Growing in times of war

Industrial production in Russia witnessed an impressive growth of 5.2% year-on-year in April 2023, according to Rosstat. The first month of industrial growth, March, saw a modest figure of 1.2%. However, the figure from April is close to the growth rates observed in the Russian economy prior to the war, and was the highest in almost 15 years.

Nevertheless, a significant portion of the current growth can be attributed to the low base effect of April 2022, when the economy was severely impacted by the war and sanctions. This is especially true for the extractive industries, which carry significant weight in industrial production and GDP structure. The extractive sector experienced the largest decline since the full-scale invasion of Ukraine during April 2022 but subsequently stabilised somewhat. Accordingly, the April 2023 data appears favourable against this background. However, the Telegram channel 'Solid Figures' suggests that the high figures also reflect rising oil production. The gigantic figures of the current deficit have compelled the government to seek additional revenue and expand oil exports, which, according to the International Energy Agency, exceeded 8.3 million barrels per day in April. This is roughly 1 million barrels per day higher than the average for 2022. However, data on oil production is now classified, largely to conceal the actual production volumes from Russia’s OPEC+ partners (Saudi Arabia has already made complaints to Russia about this). Thus, the growth in the extractive industries is a result of the low base effect, on the one hand, and the government's need for additional revenue amid relatively low oil prices and a price ceiling, on the other.

Generally speaking, if we exclude the base effect, industry grew by a seasonally adjusted 1.7% compared to the previous month, according to Rosstat's calculations, and 0.7% according to calculations by the Telegram channel 'Solid Figures.' However, the manufacturing industry, which experienced an 8% growth by April 2022, demonstrated a great deal of variation in values. Figures ranged from a decline in machinery and equipment production (-18%) and wood processing (-10%), to an increase in the production of finished metal products (30%), electrical equipment (29%), and electronics and optics (24%). Within the latter sector, the subcategory of 'navigation device manufacturing' saw an annual growth of 61%. There is no doubt that a significant portion of this substantial surge is associated with defence contracts and meeting the needs of war (as evidenced by the 47% increase in the production of special clothing). This explains the unnatural disparity in the dynamics across sectors, which reflects the induced stimulation of certain industrial sectors.

It is difficult to assess the contribution of war and defence contracts to industrial growth due to the involvement of a wide range of non-obvious goods (such as canned food, medications, reinforcement for protective structures, etc.). Undoubtedly, import substitution is also a component driving industrial growth, which has resulted from the expansion of domestic production as foreign companies depart from the Russian market and imports become more expensive. However, the growth in the corresponding economic sectors and segments has been much more modest. For example, furniture production declined by 4.5% year-on-year in April 2022 but grew by 14.5% in April 2023.

Dynamics of Russian industrial production in specific sectors, 2022-2023, % (100% = January 2021)

Income reaches consumption

However, alongside high demand from the public sector, another factor driving the growth of the Russian economy is the revival of consumer activity, as analysts at the Central Bank have highlighted in their latest issues of 'Trends in Focus' and 'Regional Economy'. Previously, they had described the dynamics of household demand as 'restrained,' but these are now 'confident.' The reason for this shift lies in the increase in real wages and incomes, as well as the activation of retail lending and a 'reduction in anxiety levels.'

According to Rosstat data, unemployment in Russia reached its lowest point since monitoring began in 1991, standing at just 3.3% in April. In the face of a labour shortage, on which Re: Russia has previously reported, and an expanding demand for labour in state-stimulated sectors, employers are being forced to raise wages. The Ministry of Economic Development has forecast a 5.4% growth in real wages for 2023. Based on Rosstat data, the growth amounted to 2.7% year-on-year in March, following 2% growth in February and 0.6% in January. Another contributing factor to income growth is the earnings of contract servicemen and various military payments, which have had a particularly noticeable impact on consumption in the provinces.

Following significant growth in 2022, the savings rate is now gradually decreasing, while the issuance of loans, including unsecured consumer loans, is increasing, according to analysts at the Central Bank. As a result, based on Rosstat data, in the first quarter of 2023, citizens spent a greater share of their income on goods and services compared to the pre-pandemic years 2017-2019, reaching 89%. This figure was only higher in the first quarter of 2022, when consumption was booming. As a result, retail trade turnover increased by 2.4% in the first quarter of 2023 compared to the fourth quarter of 2022, according to Rosstat. The footfall in shopping centres has begun to increase. However, the growth in trade is primarily being driven by the increased consumption of non-food products, which can be attributed to the effect of pent-up demand: in 2022, amid uncertainty, consumers postponed many purchases. At the same time, the 'Regional Economy' report states that 'shoppers still preferred products and services in the more affordable price segment.'

All these trends were expected to continue into the second quarter, according to the authors of the 'Trends in Focus' report. The Consumer Sentiment Index, calculated by the Central Bank based on the 'inFOM' survey, although declining in May after six months of growth, remains at a nearly five-year high level. However, data from 'Sberindex,' cited by the Telegram channel MMI, indicates that, in May, the growth in Russians' spending on goods and services slowed down in nominal terms and declined in real terms.

Military-consumer overheating

However, analysts at the Central Bank have expressed valid concerns, suggesting that industry is unlikely to be able to meet the growing demand in full. The expansion of production is limited by the same labour shortage, as well as a lack of capacity, investments, and technology. According to the April survey of enterprises conducted by the Gaidar Institute for Economic Policy, cited in the 'Trends in Focus' report, the number of staff available to industry is currently at an all-time low, while capacity shortages are nearing the record levels of 2008.

If production fails to adjust to the expanding demand in time or if it is not covered by the expansion of imports, the economy may enter a phase of overheating, warn the authors of the report. Analysts point to signs of accelerating inflation and predict that this trend will intensify. Indeed, inflation is on the rise across nearly all categories, with the only noticeable decrease observed in fruit and vegetable products.

'The expansion in the scale of production of goods under state orders as part of the aggregate demand in the economy also increases GDP. However, its impact on the overall volume of goods and services produced for private consumption and investment is only indirect and is time-delayed,' write the Central Bank analysts. In other words, the rapid growth of the military-industrial complex does nothing to cover workers' incomes with a mass of consumer goods, and this will directly lead to price increases.

To address this anomaly in the 'wartime economy,' the authors of the 'Trends in Focus' review note that it is necessary to increase either imports or lending to the consumer segment of the manufacturing industry. However, they also acknowledge that this is a pro-inflationary factor. The Central Bank analysts warn that 'against the backdrop of growing consumer demand and the weakening of the ruble, inflationary risks are increasing, which may... require the implementation of a more stringent monetary policy’.