Russia's Economic Slowdown and Its Implications for Defense-Linked Sectors

Russia’s economy is navigating a precarious crossroads. Preliminary data from Rosstat reveals GDP growth slowed to 1.1% in Q2 2025, a stark contrast to the 4.0% expansion recorded in the same period in 2024 [1]. This deceleration underscores mounting fiscal pressures, particularly in defense and energy sectors, which are central to Moscow’s wartime economic strategy. While defense-linked industries have shown resilience amid broader economic contraction, investors must weigh the risks of overreliance on state-driven spending against the fragility of an energy-dependent model.

Defense Sector: Resilience Amid Strategic Overextension

Defense and security spending now accounts for 41% of Russia’s total government expenditure—the highest share since the Cold War—reflecting a prioritization of military needs over civilian infrastructure and social programs [4]. This has fueled growth in defense-linked sectors: “miscellaneous transport equipment” and “finished metal products” saw output surges in H1 2025, compensating for earlier weaknesses [2]. Defense-linked firms, including engineering and manufacturing conglomerates, reported revenue increases of up to 200% in the first half of 2025, driven by state contracts [1].

However, this growth is not without risks. The war in Ukraine has pushed combined defense and national security budgets to 17 trillion rubles in 2025, straining fiscal resources [4]. Labor shortages and inflation, exacerbated by high interest rates (21% as of August 2025), are eroding productivity in non-military sectors, creating a “two-speed economy” where defense thrives while civilian industries stagnate [6]. Analysts warn that this imbalance could lead to long-term structural weaknesses, including reduced innovation and export diversification [5].

Energy Sector: Eroding Revenues and Unsustainable Leverage

Energy remains the cornerstone of Russia’s fiscal model, yet its foundation is crumbling. Oil and gas revenues dropped 30% year-on-year in May 2025, contributing to a 4.88 trillion ruble ($61.1 billion) budget deficit in just seven months—surpassing the annual target of 1.7% of GDP [3]. Reduced export volumes, logistical bottlenecks, and sanctions-driven price discounts have eroded the budget base [3]. The Central Bank’s 21% key interest rate, aimed at curbing inflation, has further burdened energy firms reliant on domestic borrowing [6].

To bridge the gap, the government is tapping into its National Wealth Fund and issuing ruble-denominated bonds. Yet these measures are seen as short-term fixes. According to a report by AInvest, the energy-dependent fiscal model is “on the brink,” with declining commodity prices and Western sanctions creating a “perfect storm” of revenue volatility [3]. For energy firms, the risks are twofold: falling global demand and the government’s prioritization of defense spending over energy infrastructure investments.

Broader Economic Implications for Investors

The interplay between defense and energy sectors reveals a broader fiscal dilemma. Nearly one-third of Russia’s largest companies reported losses in H1 2025, with non-defense sectors like coal mining, utilities, and transportation among the hardest-hit [1]. Meanwhile, the war-driven economic model has pushed inflation and tax burdens to unsustainable levels, further constraining household and corporate spending [6].

For investors, the key question is whether defense-linked firms can sustain their growth trajectory. While state contracts provide a buffer, the lack of private investment and innovation risks creating a “bubble” in military-related industries. Conversely, energy firms face a dual challenge: navigating geopolitical headwinds while competing with global energy transitions.

Conclusion: Navigating a High-Risk, High-Stakes Environment

Russia’s economic slowdown has created a paradox: defense-linked sectors are expanding even as the broader economy contracts. For investors, opportunities exist in firms with direct ties to state defense contracts, but these must be balanced against systemic risks, including fiscal overextension and energy market volatility. The coming months will test the sustainability of Moscow’s wartime economic strategy—and the resilience of its corporate sector.

Source:
[1] Russia's GDP growth slows to 1.1% in Q2, says Rosstat, [https://www.reuters.com/markets/europe/russias-gdp-growth-slows-11-q2-says-rosstat-2025-08-13/]
[2] Defense Drives Russia's Industrial Growth as Civilian Production Contracts, [https://www.themoscowtimes.com/2025/06/27/defense-drives-russias-industrial-growth-as-civilian-production-contracts-a89587]
[3] Assessing the Fiscal and Strategic Risks to Russia's Energy-Dependent Budget, Oil Price Slumps, and Sanctions, [https://www.ainvest.com/news/assessing-fiscal-strategic-risks-russia-energy-dependent-budget-oil-price-slumps-sanctions-2508/]
[4] Russia, Under War Spending Pressure, Set for More Austerity and Tax Hikes, [https://www.reuters.com/markets/asia/russia-under-war-spending-pressure-set-more-austerity-tax-hikes-2025-08-20/]
[5] Why Russia's economic model no longer delivers, [https://www.bruegel.org/analysis/why-russias-economic-model-no-longer-delivers]
[6] The Risks of Russia's Two Speed Economy in 2025, [https://www.wilsoncenter.org/blog-post/risks-russias-two-speed-economy-2025]