Russia’s defense sector is operating on overload, but firms are warning of bankruptcy

• Russia nearly tripled its defense spending to fund its invasion of Ukraine.

• Defense firms are busy, but high inflation and interest rates above 20% have left them struggling.

• Russia may end up having to release or nationalize them.

In Russia’s defense sector, demand is growing – but its companies are struggling just the same.

The Kremlin is increasingly looking for more weapons for its attack on Ukraine.

But skyrocketing interest rates are making companies struggle to turn a profit, a prominent CEO said recently.

Sergey Chemezov, CEO of defense conglomerate Rostec, sounded the alarm in an address to Russian senators in late October.

He said “Record” interest rates were “eating” the profit from his orders.

The debt trap

He said customers tend to pay 30%-40% of an order’s value up front, leaving the firm to borrow the rest.

That debt, he said, was so expensive that it canceled out any profit from the work.

“If we continue to work like this, then most of our businesses will go bankrupt,” he said.

A few days after he spoke, Russia’s central bank raised its prime rate even morefrom 19% to 21%.

Rostec is not alone in its situation, economic analysts told Business Insider.

Rising interest rates and export bans are eroding the profits of Russian defense companies across the board, they said, making the Russian state the sole guarantor of revenue.

Supporting the war machine

Since launching a full-scale invasion of Ukraine about two and a half years ago, the Kremlin has taken a number of measures to keep its defense sector pumping out tanks, munitions, drones and missiles.

He restructured his economy to prioritize war, imposed export bans, used his national wealth pool, and strengthened trade with non-Western countries.

Its defense budget has increased, from $59 billion in 2022 to $109 billion in 2023.

He is heading towards a estimated at 140 billion dollars in 2024, with a draft budget that provided $145 billion for 2025.

This figure would represent 6.3% of Russia’s GDP, the largest share since the Soviet era.

That spending has consequences, said Roman Sheremeta, an associate professor of economics at Case Western Reserve University’s Weatherhead School of Management.

“The government pumped in enormous amounts of money to support the war effort,” he told Business Insider. “And the Russian reserves were almost exhausted.”

Liquid assets of Russia’s sovereign wealth fund fell by almost half, from 8.9 trillion rubles (about $91 billion) before the war to 5 trillion rubles (about $51 billion) at the end of the year past, Bloomberg reported in January, citing data from the Ministry of Finance.

“The Kremlin cannot afford defense companies to go bankrupt,” Sheremeta said.

A “death spiral”

While huge defense spending contributed to economic growth in Russia and avoided a recessionthey also fueled inflation.

When it raised the key interest rate to 21 percent, Russia’s central bank said its mission was to control inflation.

In September, Russia’s annual inflation rate rose to 8.6 percent, well above the 4 percent target.

Sheremeta described the situation as a “death spiral” in which war spending begets more inflation, which requires more war spending.

“What’s even worse for those companies,” he said of defense firms, “is that they can’t export because of sanctions, and they sell their weapons for US dollars or euros.”

Daniel Treisman, a professor of political science at the University of California, Los Angeles and a research associate at the National Bureau of Economic Research, said Russia could reach hyperinflation.

“As the budget deficit grows in the face of military costs, the need to cover some of it by printing money will drive up prices, and the Central Bank will need to raise interest rates further to slow them down,” he said .

A tipping point – but not yet

Experts BI spoke to both said Russia could sustain its spending for a year or more before a tipping point.

Some see even more runway.

Iikka Korhonen, head of research at the Bank of Finland’s Institute for Emerging Economies, said defense companies would not be allowed to go bankrupt and would instead be restructured or bailed out.

Russia has done this before, bailing out debt-ridden defense firms in 2016 during a previous financial crisis.

If that doesn’t solve the problem, “other sectors will be cut” to maintain defense firms, Korhonen said.

Julian Cooper, professor emeritus at the University of Birmingham’s Center for Russian and East European Studies, made similar remarks.

“If some defense companies cannot meet their obligations, the Kremlin can simply nationalize them,” Sheremeta said.

Konstantin Sonin, a professor at the University of Chicago Harris School of Public Policy, predicted a dark economic future for Russia due in part to “borrowing” funds from the future.

IN A op-ed for Project Syndicate earlier this month, Sonin wrote that massive investment in military production at the expense of key public spending programs could strengthen Putin’s hand in the short term.

“But it puts a ticking time bomb on long-term economic development,” he wrote.

“Whenever the war in Ukraine ends and Russia returns to international trade (beyond commodities), all the nationalizations of recent years will come back to haunt it,” he wrote.

Read the original article on Business Insider