The warning signs for Russia’s economy are flashing red

Fueled by massive military spending and steady oil exports, Russia recorded some of the highest growth rates among major economies over the past two years. But in recent weeks economic indicators have been flashing red: Manufacturing activity is declining, consumers are tightening their belts, inflation remains high and the budget is strained.

Russian officials are now openly warning of the risks of a recession, and companies from tractor producers to furniture makers are reducing output. The central bank said Thursday that it would debate cutting its benchmark interest rate later this month after lowering it in June.

The sputtering of Russia’s economic engine is unlikely to alter President Vladimir Putin’s war objectives, as his strategic focus on neutering Ukraine overrides concerns for the broader health of the economy, analysts say. But the slowdown exposes the limits of his war economy and indicates that sanctions, while not dealing a knockout blow, are increasingly taking a toll. If sanctions tighten further or oil prices dip, Russia’s economy could start to totter.

In that, the downturn undermines Putin’s bet that Russia can outlast Ukraine and the West, showing that Moscow would struggle to finance the war indefinitely.

“The growth model based on military spending alone is broken," said Janis Kluge, a Russia economics expert at the German Institute for International and Security Affairs. “Capacities in the civilian part have to shrink, freeing up workers so that the war machine can continue to grow. That’s not sustainable."

Russian Economy Minister Maxim Reshetnikov warned last month that Russia was teetering on the “verge of a recession." Finance Minister Anton Siluanov called the situation a “perfect storm."

Putin, for his part, dismissed suggestions that the war is stifling the economy. In an echo of Mark Twain, he said that the reports of its death “are greatly exaggerated." But the Kremlin leader also warned that a recession or stagflation “should not be allowed under any circumstances."

After a brief recession in 2022, military spending—the highest since Soviet times, at over 6% of gross domestic product this year—propped up Russia’s economy and dulled the impact of Western sanctions. That compares with around 3% of GDP in the U.S. and around 2% in Germany last year.

Spending on the military and security makes up about 40% of Russia’s total government spending this year. Russia’s ability to reroute oil exports to China, combined with Beijing’s support in supplying electronics and machinery, delivered an additional economic boost.

That made Russia an economic paradox: The most sanctioned major economy in the world was growing faster than the U.S. and most other advanced economies.

But the sugar rush from the military spending created runaway inflation, pushing the central bank to raise interest rates to a record 21% to try to tame it. Higher rates increase borrowing costs for businesses, reducing investment and expansion plans and squeezing profits.

The comedown has already started.

In the first quarter, Russian GDP grew by 1.4% compared with a year earlier, official data shows, down from 4.5% in the fourth quarter of 2024. Russia’s manufacturing sector contracted at its sharpest rate in more than three years in June, according to S&P Global’s purchasing managers’ index. Sales of new cars in Russia dropped nearly 30% in June year-over-year, according to the Association of European Businesses.

Businesses across the country are feeling the brunt.

Rostselmash, Russia’s largest producer of agricultural machinery such as tractors and combine harvesters, said in May that it would cut production and investment and pull forward its mandatory annual leave for its 15,000 employees due to lack of demand.

In Siberia, electricity grid operator Rosseti Sibir has said it was on the verge of bankruptcy due to its high debt load. The company had to halt investments, and it proposed tariff hikes for industrial users in several Siberian regions.

Some analysts say the banking system is also increasingly unstable.

The risks grew from a government decision after the invasion to control war-related lending at major Russian banks, according to a recent report by the Washington, D.C.-based Center for Strategic and International Studies. The state could direct banks to offer preferential loans—on state-determined terms—to Russian businesses involved in the war effort. With high interest rates having risen since then, companies that can’t meet their obligations could potentially force the government to absorb the losses.

Other analysts say that the Russian banking system remains stable and well capitalized, CSIS noted. Still, in May the Moscow-based Center for Macroeconomic Analysis and Short-Term Forecasting wrote in a report that the risk of a protracted systemic banking crisis in 2026 was “moderate" and growing.

The economic woes increase pressure on the Kremlin by shortening the financial runway it has to fund its fight in Ukraine. The government has been running a budget deficit throughout the war and projects it will continue for at least two more years.

That provides an opening for the West if it manages to agree on powerful new sanctions on Moscow.

Oil prices—which have been generally lower this year despite the turmoil in the Middle East—present another risk for Russia, which relies on energy sales for around a third of its budget revenues. The price of Russian crude has been consistently below the level assumed in this year’s budget. Russia’s oil-and-gas revenue in June fell to its lowest level since January 2023, Finance Ministry data showed on Thursday.

“Falling oil prices and tightening of the sanctions regime would be more keenly felt in the current situation," said Alexandra Prokopenko, a former Russian central bank official who is now a fellow at the Berlin-based Carnegie Russia Eurasia Center. “The risks are high."

Write to Georgi Kantchev at georgi.kantchev@wsj.com