WASHINGTON—Could the Central Bank of Russia finally be running out of options? This question has been asked before, in part under the belief that Western countries’ immobilization of Russian assets abroad would severely constrain the institution. While that argument proved premature, there is now increasing evidence that monetary and regulatory policy cannot shield the Russian economy indefinitely from Ukraine’s uptick in drone strikes, from stronger international sanctions, or from its self-imposed weaknesses.
The Central Bank of Russia remains the most competent player in the system governing Russia’s wartime economy. On July 24, it cut its key rate for the tenth consecutive meeting, from 14.25 to 14 percent, despite raising its inflation forecast by 1.5 points that same day. With inflation threatening to reignite, the central bank will be very reluctant to cut rates any further, despite severe stagnation and a year-on-year contraction of gross domestic product (GDP) in the first quarter of this year.
Inflation may have temporarily subsided, but Russia’s bulging deficit continues to swell despite higher oil prices. The Kremlin has a variety of workarounds to make up for insufficient income, including its well-publicized pressure on banks to extend cheap loans to industry. But these measures are creating new problems in the banking sector. The latest data from the Central Bank of Russia show that the Kremlin continues to privilege war-linked sectors, while public documents and intelligence suggest that bad loans are accumulating on balance sheets, raising the risk of a banking crisis.
Higher oil prices have not eliminated the deficit
As of April, Russia’s fiscal deficit had ballooned to 5.8 trillion rubles, double the level recorded during the same period in 2025 and already exceeding the 3.8 trillion-ruble deficit projected for the entire year. The culprit, alongside a 16 percent increase in war spending, is depressed energy revenue. The closure of the Strait of Hormuz this year has created some opportunities for Russia to sell its oil at higher prices, but those gains have been offset by lower export volumes.
Entering 2026, sustained Ukrainian drone strikes knocked 30 to 45 percent of Russia’s refinery capacity offline, causing domestic fuel shortages and reducing seaborne product loadings. Western sanctions have also tightened, with a lower European Union oil price cap and new measures targeting shadow-fleet enablers. As a result, Russia’s oil and gas revenues from January through June fell to just 64 percent of their level two years ago. A sweeping US sanctions bill, backed overwhelmingly in the Senate, could reach US President Donald Trump’s desk as early as this autumn, putting further pressure on Russia’s revenues.
A deficit of 2 percent of GDP may be manageable for an economy with access to international capital markets, but not for Russia. With the liquid portion of the National Welfare Fund largely depleted, the Kremlin has turned to taxation, raising the value-added tax rate from 20 to 22 percent in January and significantly lowering the threshold for businesses required to pay it. It has also leaned on domestic banks for loans at far cheaper rates than the high key interest rate would dictate, getting in the way of a coherent monetary policy.
Preferential war lending blunts monetary policy
Headline inflation alone probably understates the pressure the Central Bank of Russia is under. Although official annual inflation sits at only 6 percent, household inflation expectations remain at 13 percent. Labor shortages caused by Russia’s military draft and by significant and ongoing battlefield casualties are a main driver: Official unemployment is at a record low of 2.1 percent, far below its pre-war natural rate around 5 percent. Sanctions also restrict Russia’s access to imported machinery, technology, and intermediate goods.
The cheaper credit offered to sectors that support the war effort keeps them solvent but cannot quickly create more labor or machinery. The result is an inflationary subsidy policy that forces Russia’s central bank to keep its key interest rate high for all other sectors as growth stalls.
Since the beginning of the war, a State Defense Order signed by Russian President Vladimir Putin has allowed the Kremlin to instruct selected banks to extend defense contractors “preferential financing on terms established by the Government.” This has led to a ballooning volume of concessionary lending, as finance expert Craig Kennedy documented in January 2025. Our own calculations show that the policy has also blunted monetary transmission.
Between mid-2023 and October 2024, Russia’s central bank raised rates from 7.5 to 21 percent, but the increase did not pass through evenly across sectors. Over the following seven months, during which the key rate sat at 21 percent, retailers and wholesalers took long-term loans at an average of 24.9 percent, while manufacturers paid only 12.2 percent. A statistical analysis of the past three years shows that, for every one-percentage-point increase in the key rate, long-term borrowing rates rose by about 1.13 points for wholesale and retail firms, 1.23 points for mining companies, and 1.13 points for electricity producers. For manufacturers, however, long-term borrowing costs rose by only 0.20 points. Notably, manufacturers’ short-term borrowing costs tracked the key rate almost exactly, with a coefficient of 0.99. Only investment credit was insulated—precisely the segment covered by Russia’s preferential lending.
Lending volumes tell a similar story. War-linked sectors accounted for 48 percent of corporate lending in 2021 and 58 percent by 2025, while consumer-facing industries fell from 31 to 20 percent. Lending growth was concentrated in the sectors one would expect: a 265 percent increase in chemicals, 183 percent in basic metals, and 129 percent in fabricated metal products, which includes weapons and ammunition. Conversely, lending growth to small and medium-sized enterprises fell from 30 percent annually in 2024 to negative territory by June 2026.
A politically pressured loan is one a bank would likely not have otherwise made. The war-linked loan book is therefore increasingly stocked with weak credits that may never be repaid. Meanwhile, the civilian economy is struggling to survive under high borrowing costs. The Central Bank of Russia’s 2025 report found that the share of corporate funding held by firms earning less than three times their interest bill jumped from 42 percent in 2024 to 67 percent a year later. A European intelligence report puts problem loans at around 10 percent, sharply higher than in 2024—a warning sign of a potential banking crisis.
The true figure could be much higher. Since the war began, lending has shifted from short-term to long-term loans, allowing banks to delay recognizing losses on weak borrowers. Many potential nonperforming loans may therefore remain hidden until they mature, are restructured, or borrowers finally default.
Ukraine’s drones are closing in. But can they move the needle?
Subsidizing war-linked firms through concessional lending rates forces Russia’s central bank to compensate by keeping its policy rate higher than it otherwise would be to meet its inflation target. Russian consumers and nonmilitary sectors will feel the brunt of this is higher inflation, adding stress to an economy whose outlook is already bleak.
Ukraine’s drone campaign began with refineries but has expanded to warehouses belonging to online retail giants. Wildberries, Russia’s largest online retailer, was targeted early on, in part because it has provided key inputs to the military industrial complex. According to Russian media, pick-up points for the retailer saw revenue drop by 15–20 percent in July. As of late last week, Wildberries’s competitor Ozon has also come under attack.
Shortages of civilian goods carry political weight in Russia. In 1990, just over a year before the collapse of the Soviet Union, widespread protests were triggered by cigarette shortages. Could today’s addictive commodities—subsidized gasoline, tablets, and smartphones—play the same fateful role? Russian officials will likely continue to blame an external enemy for both the danger and the disruption, strengthening the argument for continuing the war. Russian newspapers continue to run headlines like “The West is dreaming of Russia’s collapse.” Yet even in a country where voicing a negative opinion of the government can land one in jail or worse, Putin’s popularity has fallen somewhat in recent polls.