David Lubin
Russia’s economic dilemmas give Trump important leverage in negotiations on Ukraine. But will he use it?
Putin’s government considers inflation an existential threat. But Trump’s preoccupation with China may prevent the US exploiting Russian weakness.
The Russian economy is facing considerable stress due to the effects of its war in Ukraine. That gives US President-elect Donald Trump an important tool in negotiations to end the war, through more aggressive sanctions and energy policy.
The question is whether the new US administration will be willing to exert that pressure, or whether Trump is too keen on pursuing friendship with Moscow as a way of isolating Beijing.
The world’s tightest monetary policy?
The clearest indication of the economic difficulties Moscow faces is the fact that the Russian central bank is currently implementing what could be described as the tightest monetary policy in the world.
The Turkish central bank’s policy interest rate of 47.5 per cent looks way higher than Russia’s at 21 per cent. But the best way to capture the restrictiveness of a monetary stance is to consider the ‘real’, or inflation-adjusted, interest rate.
Since Turkish inflation is currently just below 45 per cent, the ‘real’ Turkish policy rate is around 2.5 per cent. Yet Russian inflation is running close to 9 per cent, which renders the real Russian policy rate at something over 10 per cent – exceptionally high by any standards. These days only Brazil’s inflation-adjusted policy rate, currently just above 6 per cent, comes anywhere close to Russia’s.
That analysis yields different results when considering the expected inflation rate, but the underlying point holds: Russian monetary policy is, by global standards, exceptionally tight. Why does the Russian central bank need to keep interest rates so high? For two reasons above all: an overheating economy, and a shortage of dollars.
Russia’s war economy is growing way faster than its potential, thanks to a surge in defence expenditure and a concerted effort to ensure that Russian civilians are shielded from feeling the full costs of the war.
The rise in direct spending on defence and internal security will account for 43 per cent of all government expenditure this year, according to the 2025 draft budget. But other kinds of spending have also risen sharply, including on pensions and publicly-funded infrastructure. Additionally, state-subsidized lending has supported a hefty supply of cheap credit to the economy, further boosting activity.
Meanwhile, the supply of Russian labour is highly constrained thanks to Putin’s addition of nearly 500,000 soldiers to his war effort since 2022, and the simultaneous flight of human capital – mostly young and skilled – out of the country. All this is taking place against a background of underlying demographic change which is shrinking Russia’s labour force.
The result of all this is excess demand for labour, which has resulted in unsustainably high wage growth. For most of last year, wage growth has been running close to 20 per cent, a rate unseen in the past 15 years, and a huge challenge to the Central Bank’s 4 per cent inflation target.
And since Putin has long considered inflation to be an existential threat to his legitimacy, he’s given plenty of freedom to the Central Bank’s governor, Elvira Nabiullina, to tighten monetary policy and rein in inflation.
Falling convertible currency inflows
Yet economic overheating is not the only source of inflation that Nabiullina needs to worry about. Russia’s balance of payments is also a source of risk, thanks to the war’s effect on the currencies that Russia receives for its exports.
IMF data show Russia’s exports to advanced economies – who pay in hard currencies – had fallen to around 10 per cent of the total in late 2024, from over 50 per cent in early 2022. In dollar terms, that means Russia’s income in convertible currencies has fallen from nearly $300 billion a year in early 2022 to less than $60 billion now.
Meanwhile, Russia’s trade with countries that don’t pay in convertible currencies has risen sharply. Until it stopped publishing the data early last year, the Russian central bank reported that nearly a third of Russia’s trade was settled in renminbi, which implies that none of Russia’s trade with China is generating dollars.
Nor are Russia’s exports to India, now Moscow’s second-biggest trading partner. According to Denis Manturov, Russia’s deputy prime minister, some 90 per cent of Russia’s trade with India is either settled in rupees or roubles.
The collapse of convertible currency inflows, together with the inflation induced by the economy’s overheating, has wreaked havoc with the foreign exchange market in Russia. The rouble has depreciated against the dollar by over 20 per cent in the past 12 months.
And it is this loss of the rouble’s external value that is the biggest driver of Nabiullina’s decision to hike rates so high: Russia’s inflation-adjusted policy rate tracks the rouble’s dollar exchange rate very closely indeed.
The consequence of such high interest rates is that the economy will slow, perhaps very sharply. Putin therefore faces an acute dilemma: to back the central bank’s effort to keep inflation low at the risk of a recession; or to keep the economy on fire and let inflation rip.
It is this dilemma that gives leverage to the incoming Trump administration. By acting to restrict Russia’s access to foreign exchange, the US can heap more pressure on the rouble and make Putin’s choice a more painful one.
One obvious option would be for the US to tighten sanctions on the Russia’s ‘shadow’ fleet of tankers that helps Moscow evade the G7’s oil price cap. To date, the US has only sanctioned 39 tankers, compared to the UK’s 73.
In addition, Trump’s commitment to increasing oil supply could have a notably damaging effect on Russia if it happens quickly.
The market is already braced for the oil price to fall in 2025, and Moscow will have reason to worry if Trump works fast to make lower prices a reality. One indicator will be how fast the administration aims to increase oil production by 3 million barrels of oil per day, as promoted by Scott Bessent, Trump’s pick for treasury secretary.
The issue isn’t really Trump’s ability to pressure Putin, but rather his willingness to do so. Since Trump’s grand strategic objective is to ‘un-unite’ Russia from China – a kind of photographic negative image of Nixon’s effort to distance China from the USSR in the 1970s – his desire to tighten the screws on the Russian economy might be limited.
Ukraine’s future, therefore, depends in large part on whether Trump’s commitment to pressure Russia is constrained by his desire to prevail in competition with China. The new administration should think carefully: Putin may well fear inflation more than increased weapons deliveries to Kyiv. And failure to wield US economic power in negotiations on Ukraine might be seen as weakness in Beijing.
