Moscow's Hidden War Debt: A Crumbling Financial Foundation for Sustaining the Invasion

While much attention has been given to Moscow’s official defense budget, a more opaque and risk-laden funding scheme has operated under the radar, contributing equally to the war effort. However, this mechanism is now under immense strain, threatening to unravel Russia’s financial stability and alter the course of the war.

The Two-Track Strategy: Concealing the True Cost of War

Since the full-scale invasion of Ukraine in February 2022, Russia has relied on a dual-track financing model:

1. Official Defense Budget – The highly scrutinized, seemingly sustainable war expenditure that analysts have deemed resilient.

2. Off-Budget Financing Scheme – An overlooked but equally substantial funding mechanism relying on forced bank lending to war-related businesses under preferential terms dictated by the state.

Under legislation passed on February 25, 2022, Russian banks were compelled to extend loans to defense contractors and other war-related enterprises. This resulted in a staggering $415 billion increase in corporate debt, of which an estimated $210–$250 billion directly funded the war effort. Unlike traditional government borrowing, these loans do not appear in the official budget, creating an illusion of fiscal discipline.

While this scheme initially allowed Moscow to sustain its military expenditures without alarming external observers, its growing burden is now fostering economic instability, manifesting through inflation, soaring interest rates, and increasing financial distress among businesses in the "real" economy.

Financial and Economic Consequences: A Looming Crisis

As the scale of off-budget financing ballooned, unintended consequences began to emerge:

• Inflation and Interest Rate Hikes: The Central Bank of Russia (CBR) has identified this lending scheme as the primary driver of monetary expansion, fueling inflation and forcing aggressive interest rate hikes to over 21%. High borrowing costs are crippling non-military sectors of the economy, pushing even major corporations like Gazprom into financial distress.

• Weakening of Russia’s Banking Sector: With regulatory oversight loosened due to wartime exigencies, Russian banks have overextended themselves, lending to uncreditworthy enterprises without adequate capital reserves. This increases the likelihood of a systemic banking crisis triggered by widespread defaults.

• Toxic Debt Accumulation: The state-mandated lending has created a massive pool of risky loans concentrated in the defense sector. If war-related expenditures decline, many of these loans will default, leaving banks burdened with non-performing assets.

Past instances of similar off-budget financing—such as in 2016-17 and 2019-20—ended in state bailouts. However, the current scheme is on a vastly greater scale, potentially requiring a bailout amounting to half of Russia’s 2024 federal budget. This could significantly constrain Russia’s ability to sustain its war efforts and future rearmament.

Strategic Implications for Ukraine and Its Allies

The increasing strain on Russia’s financial system presents an opportunity for Ukraine and its Western allies to apply strategic pressure. Moscow now faces a dilemma: prolonging the war increases the likelihood of an uncontrollable financial crisis, while seeking a ceasefire might necessitate unfavorable concessions.

Key measures that Ukraine and its allies can implement include:

1. Reaffirming Western Resolve in a War of Attrition: A clear demonstration that Western resources will outlast Russia’s can deepen Moscow’s financial anxieties. This includes renewed funding and military aid for Ukraine, alongside intensified sanctions enforcement.

2. Categorically Ruling Out Sanctions Relief in Ceasefire Negotiations: Ensuring that sanctions relief remains off the table prevents Russia from prolonging the war in hopes of economic concessions. This will reinforce the reality that continued conflict only exacerbates its financial predicament.

3. Maximizing the Impact of Energy Sanctions: The ratcheting up of sanctions on January 10, 2025, should be followed by further tightening of restrictions on Russian energy revenues, depriving Moscow of vital resources to cover its growing debt obligations.

Conclusion: The Growing Fragility of Russia’s War Economy

Moscow’s reliance on off-budget financing has become both a crutch and a liability. While initially allowing the Kremlin to obscure the true cost of the war, the scheme has now reached a tipping point, posing systemic risks to Russia’s financial and economic stability. By leveraging this emerging vulnerability, Ukraine and its allies can undermine Russia’s war effort and strengthen their own negotiating position.

As economic pressures mount, Putin faces a stark choice: continue financing the war at the risk of financial turmoil or seek a ceasefire under increasingly unfavorable terms. The West must seize this moment to shape the battlefield—not just with weapons, but with economic strategy and financial warfare.