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Jun 22, 2015 | 09:30 GMT

Budget Debates Reveal Russia's Weakness

Budget Debates Reveal Russia's Weakness
(ALEXEY DRUZHININ/AFP/Getty Images)

Forecast

  • Though the Kremlin has sufficient funds to keep the government budget and financial system relatively stable through 2015, disagreements over future government spending will continue to divide Russia's elite.
  • Despite objections from the Kremlin's financial circles, the Russian government will not cut defense spending in 2015.
  • Should the government decide to restructure the pension system, it would lead to anti-government protests.

With the Russian economy in its second recession in six years and its government revenues stunted by low oil prices, the debate in Moscow over government spending has begun earlier than usual. Typically such discussions are reserved for the end of the year, when the State Duma votes on the budget. But this year the Russian government has already held a series of discussions over its annual spending through 2018. And the numerous talks may be necessary, as Russia needs to resolve strong disagreements within its political elite over issues affecting important areas, such as pensions, the defense sector, large firms and regional governments.

The Russian federal budget deficit for 2015 is expected to be $40 billion — equivalent to 3 percent of the country's gross domestic product, a revision from the Russian Finance Ministry's January forecast of 3.7 percent and March forecast of 3.4 percent. The government's budget deficit for the period from January to May alone was $19.2 billion, according to the Finance Ministry. Russia's economic decline is expected to slow in the second half of the year as federal money flows into the system, capital flight slows and some minor investment returns to the country, according to central bank head Elvira Nabiullina. However, this will not close the gap in the federal budget.

Russia can draw from the total $508 billion it had in its reserve funds as of May 31 — down $91 billion from January, but up $2 billion from March 31. In addition, the 2015 budget has already been cut 10 percent in every area except defense, and the government has set up a $44 billion financial aid program from its emergency Reserve Fund.

Moreover, according to the state-owned Vnesheconombank, the Kremlin is skimming $12.6 billion from the Russian state pension fund — a tactic used during the 2009 financial crisis. These controversial measures have given the government enough resources to stabilize the government budget and spending, although government spending for state firms and sectors in 2015 is still the subject of heavy debate.

The Finance Ministry is now leading the discussion over Russia's 2016, 2017 and 2018 budgets. Thus far, the debate has focused on how to set up future budgets, where to make cuts and where to spend. Russian President Vladimir Putin and Prime Minister Dmitri Medvedev tasked the Finance Ministry to work with the Labor Ministry and the Economic Development Ministry to draw up strategies for future spending. The Finance Ministry approved four widely varying plans for budgets through 2018:

  • Plan 1: The government would cut $17 billion, or 5 percent, from the 2016 budget. This plan includes progressively smaller budget cuts through 2018 and avoids draining the Reserve Fund.
  • Plan 2: The government would only trim $1.2 billion from the 2016 budget, leaving massive cuts for later years. However, this measure likely would empty the Reserve Fund.
  • Plan 3: The government would spread spending cuts more evenly across the three years but would also drain the Reserve Fund.
  • Plan 4: In the most radical proposal, the government would embark on more comprehensive structural reforms, including deep cuts in social spending.

It is unclear whether the Kremlin will decide to spend Russia's large reserves in the short term or bear the economic pain now and plan for the longer term. Officially, the government has until December to decide, but any budget voted into effect would also be subject to amendment later. This year's budget underwent several revisions even after December 2014. 

Even more intense debates are occurring over the specifics of government spending. Beyond countless minor disagreements on issues such as taxes, there are three major areas under debate: pensions and the retirement age, defense spending and the beneficiaries of financial assistance. And as with most controversies in in the Kremlin, divisions over spending follow factional lines. Each of the groups responsible for financial decisions in the Kremlin — Putin and his ultra-loyalists, financial advisers, and the Federal Security Service — may switch loyalties in response to changing economic, security and political circumstances. 

Pensions and the Retirement Age

The topic of pensions is controversial in Russia. In 1998, the country was thrust into a deep and chaotic economic crisis, during which the government quit paying pensions for months at a time. Pensioners and their families engaged in mass demonstrations across Russia, then did so again in 2004, when the government restructured the state retirement fund. Since the crisis in the 1990s, any pension reform risks provoking unrest.

The Pension Fund of Russia is the primary pension fund for the country and currently holds more than $77.9 billion, according to Valeri Vinogradov, head of the Center for Pension Market Information Communication. Salary payments to the Pension Fund of Russia technically go into two funds — one that pays current pensions and one that is accumulative. The government has used money from the latter to finance projects in the past, reasoning that the funds are not conventional deposits because they remain invested for an average of 25 years. However, the government still has to cover the deficit every year. According to data gathered by Bloomberg, this year Moscow will have to pay $52.9 billion to the Pension Fund of Russia to cover the shortfall.

So far this year, the government has taken $12.5 billion from the fund, using it for projects such the construction of the Yamal liquefied natural gas facility and for economic development in Crimea. But other groups want to access the pension fund as well. Russian energy company Rosneft, for example, has proposed the government use the fund to extend credit to replace the company's Western financing, much of which has been cut off because of sanctions. Or the funds could be used to counter inflation, particularly food inflation, by making investments in regional agriculture, as central bank head Nabiullina has suggested.

Repayments to the Pension Fund of Russia typically come from the government's budget surplus. With the 2015 government budget running a deficit, the Reserve Fund will cover any pension fund repayments this year. But now there is a debate on how to cover the pension deficit over the next three years. Economic Expert Group chief Yevsey Gurvich said the Reserve Fund could be drained in two to three years if it remains the only source used to plug the pension deficit, while Medvedev has proposed using the National Welfare Fund to make up the deficit.

Traditionally the government's last resort, the reappropriation of welfare funds would require the Finance Ministry's approval. Finance Minister Anton Siluanov is against the idea, saying he would only consider the plan if the government immediately raised the retirement age — a politically unpopular move. Siluanov and his mentor, former Finance Minister Alexei Kudrin, have long pushed to alter the retirement age from 55 for women and 60 for men to 65 for both. Russia's pension fund is seeing a progressive decline in contributions as the number of working-age Russians falls. Last year, $5.9 billion of future pension savings instead went toward paying current pensions, according to Siluanov. Raising the retirement age might help alleviate some of the stress on the system.

However, 80 percent of Russians are against raising the retirement age, according to an April poll by Russian Public Opinion Research Center. Putin in particular has spoken out vehemently against it, as the move would hurt his popularity. A strong pension system was one of the promises Putin made to the Russian people when he came to power. Putin and Kudrin clashed over the issue in the president's April question-and-answer session with the public, in which Putin eventually admitted that Kudrin was "of course theoretically correct" that some kind of reform was necessary. As a compromise, Medvedev has proposed raising the retirement age of deputies and state officials.

Though the Russian Cabinet had met to discuss pensions just a week prior, Putin held a one-on-one meeting with Chairman of the Pension Fund Board Anton Drozdov on June 8 to discuss more ways the fund could help the government. The pension issue remains unresolved.

Defense Spending

Russia has a long tradition of prioritizing defense spending, even in periods of financial difficulty. Russia currently spends 4.8 percent of its GDP on defense — more than double what NATO guidelines say members should spend. In comparison, the United States spends 3.3-3.5 percent of its GDP on defense. Russia's defense expenditures amount to 20.6 percent of the government's budget, not including Interior Ministry forces. And by unofficial estimates, Russia's total spending on security-related items is even higher, at 34 percent of the federal budget.

Russia's original 2015 budget expanded defense spending by 20 percent, though the government eventually revised this to a 10 percent increase. Yet the Kremlin has been forced to postpone its ambitious $770 billion, 10-year rearmament program as well as cut funds for minor agencies, such as Russia's Fund for Future Developments, by 10 percent.

Overall, however, defense sector spending has been largely untouched. At a May 21 meeting, when Putin and his Cabinet discussed the Finance Ministry's proposals for future budgets, there was no mention of cutting defense spending. Former presidential economic adviser and current Kremlin critic Sergei Guriev said that during this year's Victory Day parade rehearsal, when the new T-14 Armata tank stalled, people joked that the real proof of the new tank's power was its ability to completely destroy an entire national budget. 

In January, Siluanov called for the government to be "more realistic" about defense spending. But since then, the finance minister has been relatively silent on the issue. Siluanov's predecessor, Kudrin, left the government in 2011 after a public feud with his superiors over increasing defense spending, so Siluanov is treading carefully.

Despite the budget gap, as NATO builds up its military presence in Russia's borderlands, defense spending will remain a priority for the Kremlin. The government needs funding to support the separatist movement in eastern Ukraine and to hold military exercises along its border with NATO territory. Not only that, but the Russian defense sector is trying to make up for years of underinvestment in the 1990s. If the Kremlin does not invest in the defense sector now, Russia's conventional military capability will weaken, making the next economic winter even more disastrous for the military.

Should the Russian economy continue to decline, the government may be forced to consider a more substantial cut in defense spending. Siluanov even drew up a proposal on June 2 that would cut funding in 2016 for the state program for naval shipbuilding and the Federal Space Agency.

Financial Assistance

Another issue that has emerged in debates over state spending is who will receive financial assistance from the government. Many of Russia's institutions are struggling financially in the recession. Sanctions limit many large Russian firms' access to credit, and foreign investment in the country declined by 40 percent in 2014. And while Russia's large reserve funds may be enough to resolve the central government's deficit, other groups — large companies and the defense and banking sectors, for example — are asking for aid as well.

The more Russia's reserve funds are used for other entities, the less the government will have to protect itself. The Russian government is already using money from the Reserve Fund to cover its deficit. The Kremlin announced a $35 billion "anti-crisis" plan on Feb. 3 that mostly uses funds from the National Welfare Fund to help other financially troubled firms and sectors. Meanwhile, Russia's central bank is approving loans to many of the sectors, banks and state firms in need. Thus far, the Kremlin's plan has staved off any major crises in needy sectors and businesses.

However, Rosneft and the majority of Russia's regional governments continue to petition for funds: At the start of 2015, Rosneft held $42 billion in debt, half of which was due in the first quarter of the year. Sanctions on the firm have made it difficult to access foreign funding. Initially, Rosneft was able to use its savings and issue $10.9 billion in new bonds guaranteed by the central bank on Dec. 12 to help cover its debts. But in recent months, Rosneft applied for a $25 billion bailout from the Kremlin and has only received $5 billion. There are deep divisions in the Kremlin on how to handle the oil giant, which is run by Russian Federal Security Service elite Igor Sechin.

On April 21, Rosneft sent a letter to the office of Deputy Prime Minister Arkady Dvorkovich, saying that if Rosneft did not receive financial assistance from the Kremlin by June 1, it would start delaying field production, starting with the Russkoye and Yurubchenko-Tokhomskoye fields. But instead, Dvorkovich's office has been pushing for Rosneft to privatize 19.7 percent of its shares — something Sechin is firmly against. Privatization would open his board up to more foreigners, and Dvorkovich's scheme likely would not get Rosneft the amount of funds he wants. The Finance Ministry, too, has opposed Rosneft's use of money from the National Welfare Fund, but said Putin will ultimately make the decision.

Meanwhile, Rosneft is also looking for alternative ways to pay its debt. On June 3, the firm announced that it is forming a business plan that would exclude assistance from the National Welfare Fund while its applications to the government are under review. The company struck a deal in February with Dutch oil trading firm Trafigura for advance payments for oil and said in May that it is developing non-dollar financing with China. Rosneft is cobbling together a set of alternatives that may give the firm some relief this year, but it is unclear how long the company can delay repaying its debts.

The Russian regional governments are reaching out to the Kremlin for more funds as well. The regional governments have enormous financial obligations to the federal government: Only 37 percent of the income generated in any given region stays in that region, with the rest going to the federal budget. And though the central government does return some of those funds, it never returns more than 20 percent.

Because they hand over so much of their revenue to Moscow, most of Russia's regional governments have some level of debt. But in recent years, those debts have skyrocketed. Estimates put Russian regional government debt at $103 billion in 2015, up from $35 billion in 2010. With sanctions cutting deeply into foreign investment and Russia's overall economy stagnating, foreign direct investment into the regions has fallen by 70 percent on average, according to Russian ratings agency Expert RA. And yet, even as regional governments are losing revenue locally, Moscow is not filling the gap: cash transfers from the federal government to the regions have fallen by 25 percent.

In February, the government did approve a $1 billion subsidy to the regions to maintain employment. On June 2, Minister of Economic Development Alexei Ulyukayev proposed providing tax exemptions to the regions, but Siluanov's group opposes the measure unless the regions also make spending cuts. On June 9, the government named six regions as "special economic zones," where laws favor investment. The Kremlin is considering 12 more regions for special economic zone status, and another 20 regions have submitted applications.

The central government knows that regional stability is crucial to the stability of the federal government and of Russia overall. But because regional contributions provide so much of the federal government's revenue, bailing out the regional governments can turn into a vicious cycle. Some in Putin's camp want to give the regional governments more assistance, while members of the more financially-minded camp point out the problems with that policy.

During times of economic hardship in Russia, fierce debates over spending have often revealed the country's underlying vulnerabilities. The Russian government has maintained its stability for 15 years of economic prosperity and is now scrambling to hoard its shrinking financial resources. While it has several options for alleviating its deficit, whether now or later, it will eventually have to make realistic spending cuts. Until then, the budget controversy will continue to divide the Kremlin.

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