Russia’s hidden war financing strategy, which has forced banks to extend €210–230 billion in risky loans to defence contractors, is threatening to destabilise the country’s economy, according to a report by Craig Kennedy, former vice chairman at Bank of America Merrill Lynch. This covert scheme, designed to match Russia’s official military budget, is fuelling inflation, straining the banking sector, and increasing the risk of systemic economic collapse.
Kennedy’s analysis, published in the Substack newsletter Navigating Russia, reveals that the off-budget financing programme was enacted on 25 February 2022, the day after Russia launched its full-scale invasion of Ukraine. Under this scheme, Russian banks have been compelled to provide loans on preferential terms to defence-related businesses, many of which have poor creditworthiness. These loans have effectively doubled Russia’s war budget but at a steep cost to its financial stability.
A Dual-Track Approach to War Funding
The Kremlin’s strategy relies on two funding streams: the highly scrutinised federal defence budget, which has remained at manageable levels, and an off-budget mechanism that operates in the shadows. The latter has led to an unprecedented 71% rise in corporate borrowing since mid-2022, totalling €385 billion—approximately 19.4% of Russia’s GDP.
Kennedy estimates that 50–60% of this increase, or €210–230 billion, has gone to fund war-related activities. This off-budget funding stream is equal in scale to Russia’s official defence budget, effectively doubling the financial resources available for the war while masking the true cost from public scrutiny and international analysts.
Mounting Economic Pressures
While the off-budget scheme initially helped Moscow maintain an image of financial resilience, its adverse effects are becoming increasingly apparent. By late 2024, the Central Bank of Russia (CBR) identified the scheme as a major contributor to inflation, forcing it to raise interest rates to over 21% for non-defence sectors. This has caused severe financial strain on regular businesses and households, exacerbating economic inequality and undermining overall economic growth.
The banking sector, too, is under pressure. Many Russian banks have eased regulatory standards to comply with state demands, resulting in insufficient liquidity and inadequate capital buffers. As the volume of non-performing loans rises, the risk of widespread defaults and bank failures looms large. Kennedy warns that if defence spending is reduced or the economy slows further, these loans could evolve into a pool of toxic debt capable of destabilising the entire financial system.
Moscow’s Emerging Dilemma
Faced with these economic challenges, the Kremlin is reportedly reassessing its financing strategy. A meeting convened by President Vladimir Putin in late 2024 highlighted concerns about the structure of Russia’s corporate debt portfolio. According to Kennedy, Moscow now faces a critical dilemma: prolonging the war increases the risk of disruptive financial crises, while scaling back could weaken its negotiating leverage in any potential peace talks.
The report emphasises the seismic nature of credit event risks, such as corporate and bank bailouts, which could materialise suddenly and with significant consequences. Unlike the slow-burn effects of inflation or declining GDP, these risks pose an immediate threat to Russia’s ability to maintain an image of financial stability.
Strategic Opportunities for Ukraine and Allies
Kennedy’s analysis suggests that Russia’s financial vulnerabilities offer new leverage for Ukraine and its allies. To exploit this, he recommends a two-pronged approach:
- Demonstrate Western Resolve
Western allies should reinforce their commitment to Ukraine through additional funding, arms supplies, and stricter sanctions enforcement. By making it clear that Western resources far outweigh Moscow’s, this approach could further strain Russia’s finances and weaken its confidence in sustaining a prolonged conflict. - Deny Sanctions Relief in Ceasefire Negotiations
Ukraine and its allies must categorically rule out any sanctions relief during ceasefire talks. Maintaining this firm stance would eliminate Moscow’s incentive to prolong hostilities in hopes of gaining economic concessions. Robust sanctions enforcement would also limit Russia’s ability to recover and rearm after the war, preserving long-term leverage in any comprehensive peace settlement.
A Critical Juncture
Russia’s hidden war debt has reached a scale that threatens not only its economy but also its strategic position in the war. As Moscow grapples with the dual pressures of financing its military operations and averting financial collapse, the situation presents a rare opportunity for Ukraine and its allies to shift the balance in their favour.
By maintaining resolve and leveraging Russia’s economic vulnerabilities, the West can apply pressure that may accelerate Moscow’s decision-making towards a ceasefire. This strategy not only strengthens Ukraine’s position in potential negotiations but also mitigates the long-term risks of Russian revanchism.
