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Nov 3, 2015 | 09:15 GMT

Russia Prepares to Tighten Spending in 2016

Russia Prepares to Tighten Spending in 2016
(IAN WALTON/Getty Images)
Forecast Highlights

  • Though the Russian government has cut its spending for the second year in a row, it will still need to use its reserve funds, which could deplete resources for any future emergencies.
  • Moscow will have to continue to assist Russian regional governments, since many of their subsidies have been curtailed and their debts are mounting.
  • For the first time since 2011, the Kremlin will not increase defense spending, meaning it will have to make cuts elsewhere to meet its increasing defense obligations.
  • Overall, the Kremlin will keep the country relatively financially stable this next year, staving off financial, social and defense problems until later.

After months of battles over the details in the Russian Cabinet and among the Kremlin elite, the Russian State Duma is currently debating the 2016 federal budget. The draft submitted to the Duma shows the Kremlin's priorities for the next year, as well as the constraints on Russia both internally and externally. How Russia spends its limited resources this year will affect the country far beyond 2016.

The Russian government decided to draft a full budget only for the year 2016 rather than devise a traditional three-year budget because of what it deemed "unpredictable economic volatility" caused by low oil prices, a weak currency and Western economic sanctions. Russia is officially in a recession, with GDP growth projected to fall 3.9 percent in 2015. In January, the government was forced to slash its budget by 10 percent in all sectors and ministries except for defense. However, if current conditions hold, Russia's Economic Ministry forecasts that the country's GDP growth will rise 0.7 percent in 2016, and the Kremlin is hoping for an even brighter outlook as it lobbies Europe to lift its sanctions on Russia.

The 2016 budget also has a different tone than previous budgets. Of note, the draft budget is set on oil prices remaining at $50 a barrel — an adjustment the government had to make early on in the 2015 budget, which originally was set on oil prices of $65 per barrel. And, as with the 2015 budget, the draft 2016 budget includes large cuts across the board, including education and in ministerial and presidential offices. There are three areas of particular concern in the draft budget that could have far-reaching effects for Russia: spending the Kremlin's reserves, supporting regional governments and spending on defense.

Russian Reserves

Whereas the Kremlin did not factor in a budget deficit in 2015, the Russian government is counting on running a 3 percent budget deficit ($40 billion) in 2016, with the stipulation that if the deficit runs higher the government will cover the discrepancy with its reserve funds. Between Russia's three financial reserves — the central bank's currency reserves and the government's National Wealth Fund and National Reserve Fund — Russia holds approximately $515.43 billion. Before the end of the year, the government will use $38 billion out of its $70.51 billion National Reserve Fund to plug the current budget deficit and give financial assistance to regional governments, big banks and selected state firms.

This leaves approximately $32 billion left in the fund going into 2016. The National Reserve Fund — nicknamed the rainy day fund — collects surplus revenues from energy exports, so oil prices would have to rise above $50 a barrel for the fund to be replenished. Russian Finance Minister Anton Siluanov said Oct. 27 that with the current draft of the 2016 government budget, the National Reserve Fund would be depleted by the end of 2016.

Russia's other reserve funds — the National Wealth Fund (worth $73.66 billion) and currency reserves ($371.26 billion) — technically are not used to cover government spending. The National Wealth Fund is meant for large infrastructure projects, and the currency reserves are meant to maintain currency and market stability. In mid-2015, many large Russian firms, such as Rosneft, petitioned the government to bend the rules and give them financial assistance using money from the National Wealth Fund. However, so far this year the government has not touched it. The Kremlin could tap into the currency reserves, but doing so would give the government less to work with should the ruble or the Russian markets destabilize again. From early 2014 through mid-2015, the government injected approximately $144 billion from its currency reserves into the currency and markets. Such injections have dropped off in the second half of 2015, though there is no certainty of continued relative stability next year.

Siluanov has suggested tightening the budget further to eliminate the likelihood of a large budget deficit and the potential draining of Russia's rainy day funds. However, other ministers and political elite who want access to these diminishing funds have dismissed the finance minister's concerns.

The Regions' Obligations

Meanwhile, many Russian regional governments are in difficult situations as well. In 2015, federal aid to regional governments has fallen by half. The federal government had pledged a debt bailout program and emergency tax provisions in mid-2014, but much of this aid was never realized. The Kremlin will continue to support regions deemed strategic, such as the North Caucasus regions, Kaliningrad, Crimea and the Far Eastern regions. However, next year's budget will see more cuts in various support programs for several of Russia's regional governments, many of which are mired in debt.

Standard and Poor's estimates that the Russian regional governments' debt will exceed $100 billion this year. Most of the debt is short term, with payments due before 2018. S&P believes that one Russian regional government, Novgorod, defaulted on its debt payments to Russia's VTB bank, though the Russian Finance Ministry has not confirmed this. Moscow's Higher School of Economics also estimates that 20 regional governments have secretly defaulted. The Finance Ministry has published a list of the top 30 regions at risk for default, with Krasnoyarsk topping the list. Russian media outlet RBC estimates that many of the regions are behind in their federal tax payments. Moreover, Russia's energy firm, Gazprom, has stated that of the 83 regions, only 15 are up to date on their payments for natural gas.

In the last months of 2015, the regional governments owe approximately $7 billion in debt repayments, and the Kremlin is dipping into the National Reserve Fund to help them out. In addition, the Kremlin has ordered big Russian banks — VTB, VEB and Sberbank — to offer settlement solutions to prevent any further defaults. It is unclear how much of a burden these banks can take on, though, since they are already receiving state financial assistance during this recession.

But with no additional assistance programs or funds earmarked for most of the regional governments in the 2016 draft budget, there is a question of whether the regional governments with high debt will be able to handle their repayments in 2016. And if it is true that some regions are not paying their federal taxes, the Kremlin could crack down on them as it has done in previous economic crises. If the Kremlin does pressure the regions to catch up on their delinquent taxes, then they will have to pull money from other areas. In the 1998 economic crisis, many regions quit paying schoolteachers and state workers for months, leading to protests. Teachers, doctors and state employees have already held small demonstrations against no pay or salary reductions, but not of the same magnitude as the protests in 1998.

The Kremlin understands the need to balance between meeting federal demands and preventing social instability, and the regional governments are caught in the middle. This could be one of the reasons Siluanov believes the Russian government will have to drain its rainy day funds in 2016.

Defense Spending

Finally, a critical shift in the Kremlin's budgetary planning is the flat growth in defense spending. Russia's defense budget had risen steadily every year since 2011. The Kremlin had planned on expanding defense spending from the 2014 budget to 2015 by 20 percent but only increased spending by 10 percent because of financial constraints. However, defense was the only government sector that did not see its budget cut. The 2016 budget will increase the defense budget by only 0.8 percent, to 3.145 trillion rubles. (This amount is half of 2015's budget of $83.7 billion; however, the ruble plummeted by nearly half during the past year and most of the Russian defense industry's expenses are in rubles, not dollars).

With the defense budget remaining fairly flat, it will be tricky to decide how to allocate the funds, especially since Russia's defense obligations have expanded during the past year in Ukraine and Syria, along with more military exercises, countermeasures to NATO's expanding presence and the planned 2020 Rearmament Program. Russia was able to handle the financial burden in 2015 but only because these obligations were not constant throughout the year. For example, Russia did not launch its military operations in Syria until September. However, with a similar budget in 2016, something must be cut for Russia to meet all of its obligations.

Defense spending can be divided into five areas: personnel, maintenance, training, operations and procurement (mainly investment in military technology programs). The military has already said that under the 2016 draft budget, it would not reduce personnel and that military salaries would rise to account for another 2 percent of the budget. Allotted funds for maintenance likely will not be cut either, since the increase in operations requires sufficient military equipment.

The training and operations portions of the defense budget were greatly expanded in 2015 as well, with a post-Soviet record number of exercises along with operations in Ukraine and Syria. Russia can get creative with how it allocates funds for each operation and training by dipping into budgets outside defense spending, such as the national security budget or funds held off the books.

Russia will also likely continue holding a high number of military exercises this next year as NATO expands its presence in the country's borderlands. However, it is not clear how intense Russia's operations will be in Syria or eastern Ukraine in 2016. The Kremlin said in September that Russian military operations in Syria will likely last four months, meaning they will end in January. Moreover, the cease-fire in eastern Ukraine is holding relatively well, and Russia could scale back its presence there in a bid to ease EU sanctions. Still, Moscow needs to have the funds ready to ramp back up in either Syria or Ukraine should its situation change either with Washington or Kiev, creating uncertainty over how much will be allocated for operations in 2016.

It is unlikely that Russia could expand its military adventurism while maintaining spending on procurement and maintenance. However, procurement is the one area where the Kremlin could limit spending in 2016. Russia launched an ambitious Rearmament Program, with the goal of spending $770 billion between 2011 and 2020 (an average of $77 billion a year). The program is intended to give the country's military nearly all-new equipment across all branches after a decade of neglect following the fall of the Soviet Union.

The program is already far behind; Russia spent $38 billion in 2015, its highest yearly investment yet. It is likely the program will be cut further in the current draft budget, since it is the only area where spending is considerably flexible. The Kremlin and the Russian military will have to decide where to focus their spending priorities, with no new mass purchases of equipment likely. This will eventually degrade the Russian military and how it operates at home and abroad as its equipment ages.

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