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Russia’s new draft budget doesn’t include the expected cuts to government spending — why is that?

Source: Meduza

Russia’s Finance Ministry has developed a new draft budget for the next three years. It was created with a new reality in mind: the coronavirus pandemic has left Russia facing a severe crisis, one made worse by this year’s fall in oil prices. Like many other countries, Russia has increased spending in response to the crisis, creating a significant deficit in the budget. But now that this year’s one-time distribution of budgetary funds is coming to an end, the government faces a choice: spend heavily going forward, which will require dipping into the country’s reserves and borrowing trillions of rubles, or cut government spending. Initially, the Finance Ministry opted to make cuts, but then it changed its mind. There’s still a chance that the Russian economy will be able to recover quickly and cutbacks won’t be necessary.

Oil prices are going back up, so why is the budget running a large deficit?

The price of oil and gas crashed in the spring of 2020 because of the coronavirus pandemic, which caused a sharp decline in demand for fuel. Joint efforts from all of the world’s oil producing countries managed to bring prices back up a little. In August, prices exceeded $42 per barrel — the exact price that served as the basis for Russia’s 2020 budget. According to the budget rules, if oil prices exceed this benchmark, rather than spending on current needs, all the additional revenue is sent to the National Wealth Fund. If the price of oil is below $42, the National Wealth Fund makes up for the lack of funds.

However, now this mechanism can’t ensure budget stability: 

  • The government had to increase spending in excess of the plan. Entire sectors of the economy were shut down during the crisis, the number of unemployed people increased significantly, and the population’s incomes fell; the government (albeit not immediately) began spending significant amounts of money on supporting the economy and the population. The recovery plan suggests 5 trillion rubles (about $66.5 million) in spending; of which 1.7–1.8 trillion rubles ($22.6–$24 billion) will be paid from the federal budget in 2020.
  • The $42 per barrel price of oil doesn’t guarantee the implementation of the budget. The fact is that Russia is producing and exporting much less oil than before the crisis. This is a result of commitments within the framework of the OPEC+ deal, which was reached back in April, when oil prices first went negative.

OPEC+ is an agreement on oil production between the 13 members of the Organization of Petroleum Exporting Countries (OPEC; it’s leader and largest exporter is Saudi Arabia) and large oil suppliers who don’t belong to this organization, led by Russia. In recent years, OPEC+ hasn’t included the world’s biggest oil supplier — the United States — and several other oil countries. In April, during negotiations that involved the US, the OPEC+ countries were able to agree on record (by 11 million barrels per day) oil cuts, designed to prop up world oil prices, which had fallen into the negatives. The deal will remain in place until 2021.

  • The deal resulted in a record decline in oil production among the majority of oil-producing countries. Russia, along with Saudi Arabia, has been leading the way in terms of production cuts. Production increased slightly in August, but Russia was still producing 12.8 percent less oil than the year before. When the price of oil exceeded $42 per barrel in August, the Russian budget made “windfall gains” (around 25 billion rubles or $333 million by today’s conversation rates). However, it suffered three times the losses (75 billion rubles or $998 million) due to the decline in oil production. For comparison, Russia’s oil and gas revenues in August 2020 were 220 billion rubles ($2.93 billion) less than in August 2019, when the average oil price was a little under $60 per barrel and a significant amount of money was being put into the National Wealth Fund. 
  • In September, the price of oil fell below $40 per barrel again. In total, as economists predicted, Russia has made 3 trillion rubles ($39.9 billion) less from oil and gas than it did in 2019.
  • Finally, a fall in revenues from other sectors (not linked to oil and gas) have also contributed to the budget deficit — at both the federal and regional levels. While federal losses weren’t so high, many regions saw their finances suffer significantly: by summer the hole in the regional budgets reached almost 150 billion rubles ($1.99 billion), despite the increase in financial support from the center (which had planned an additional allocation of 300 billion rubles or about $4 billion).

According to the Finance Ministry’s predictions from July, all of this should have brought the federal budget’s deficit to 5 percent of GDP (more than 5 trillion rubles or $66.5 million by today’s conversation rates) by the end of the year. However, the law on the federal budget for 2020, which was adopted in 2019, had planned for a surplus of 0.8 percent of GDP. 

As such, at the end of July, the Finance Ministry announced that due to the deficit they were planning large-scale “budgetary consolidation” — in other words, they were planning to cut spending.

What cutbacks did they want to make?

In July, the Finance Ministry suggested cutting all unprotected budget items by 10 percent, cutting the weapons program by 5 percent, and getting rid of cost-of-living increases for civil servants all together. All of this would save 2.7 trillion rubles in 2021 ($35.8 billion) compared to the record “coronavirus” spending in 2020. They planned to continue the “consolidation” in 2022.

This sequestration plan drew sharp criticism from experts. During a crisis, you need to increase demand, including supporting the growth of investment. In an economy dominated by the government, only the state budget can do this (and the governments of developed countries are going to spend money on fighting the crisis until the economy recovers). At the same time, the Russian government isn’t providing businesses or the population any opportunities to increase demand: it not only refrained from lowering taxes, but is also preparing to introduce new ones.

In 2017, when the government drastically cut spending due to the ongoing financial crisis, this (along with the poor investment climate) led to the stagnation of the economy and a decrease in the population’s real incomes. In 2020, the government had two options for solving the budget deficit problem without reducing expenditures:

  • Increase government debt by borrowing money from the market. Until 2020, the debt didn’t exceed 14 percent of GDP, which is a very low figure. Experts believe that it could be significantly increased.
  • Spend more money from the National Wealth Fund than the budget rules allow (the government has already refused to comply with the rules in 2020 because of the crisis). According to these rules, which were adopted to stabilize the budget in 2017, money in the National Wealth Fund can be spent in two cases only: to cover lost oil and gas revenues if the price of oil falls below a particular benchmark ($42/barrel in 2020), or for public investment if the National Wealth Fund exceeds 7 percent of GDP. This latter boundary was reached just before the crisis. That said, the fund’s volume is still higher — 11.7 percent of GDP as of the end of August. The crisis hasn’t diminished its size: before August, falling revenues due to the drop in oil prices were covered from other sources. In addition, it’s affected by differences in the exchange rate — the National Wealth Fund’s funds are held in foreign currencies, as such its equivalent value in rubles goes up in the event that the ruble falls. 

The Russian government doesn’t really like either of these options. Officials are afraid to borrow large amounts of money — it brings back memories of the default of the 1990s and “dependence on foreigners.” They don’t want to spend money from the National Wealth Fund, because it will be useful for the future “economic take-off” that the authorities want to organize: the refusal to use money from the reserve actively can only be explained by the desire to keep the size of the National Wealth Fund above 7 percent of GDP, in order to spend the surplus on investments in infrastructure and other government projects after the crisis, experts say. The government’s main ideologue, First Deputy Prime Minister Andrey Belousov, is a supporter of such investments.

By September the Finance Ministry had changed its tune. What happened?

The new, three-year draft budget, obtained by Kommersant, envisages spending in 2021 exceeding the level set by the budget adopted in 2019 by 300 billion rubles (or about $4 billion). Compared to the pre-crisis plan, a 600-billion ruble ($8-billion) decrease in spending is expected in 2022. 

The Finance Ministry explains that the easing of budget policy is due to the fact that in 2020, the Russian economy will fall by less than was expected back in July (4 percent of GDP versus 5 percent). The budget deficit also won’t be as large — the same 4 percent of GDP (a little over 4 trillion rubles or $53.3 billion), rather than the 5 percent of GDP that was predicted two months ago. 

Economists think that Russia’s relative success at navigating the crisis (the US economy is projected to fall by 5.7 percent, while EU economies are projected to fall by 9 percent) is due to the fact that in Russia, the share of sectors most affected by the coronavirus — paid services and small business — is smaller than in developed countries.

In addition, the Finance Ministry agreed to borrow money on the market more actively. According to Finance Minister Anton Siluanov, the federal government’s total debt will approach 20 percent of GDP. Building the debt up further is dangerous, he says: firstly, it will reduce the supply of money available on the market to private companies; and secondly, it will increase the share of the state budget that will have to be spent on servicing the debt, which, in turn, will negatively affect spending on other budget items.

Moreover, the government expects to receive additional revenues through “tax initiatives.” Siluanov didn’t specify if he was referring to the taxes on deposits and dividends withdrawn from foreign accounts proposed over the summer, or to some other levy.

At the same time, it seems like the money from the National Wealth Fund won’t be spent very actively — it will be saved for future government initiatives instead. But money will be “transferred” within the budget: for example the Finance Ministry didn’t abandon the idea of a freeze on indexing civil servants’ salaries, and it also decided to take money from some state programs, such as the “digitalization” of the economy, in order to spend it on more pressing aims during the crisis. It seems like there isn’t any talk of making cuts to the weapons program anymore.

Does that mean they won’t cut government spending in 2022?

It’s possible that cuts won’t be needed in 2022 either. According to the OPEC+ deal, Russia’s oil production quota is supposed to increase in several stages in 2021. If global demand for fuel recovers at the same time, then the price of oil will remain quite high, and Russia will be able to return to its pre-crisis policy: collect surplus profits from the sale of oil and gas in the reserve — thereby rapidly decreasing the budget deficit. However, another fall in oil prices after the end of the OPEC+ deal is entirely possible: since it’s impossible to make accurate long-term or even medium-term forecasts on oil prices, this scenario must be taken into consideration.

The debt market could pose another problem. Sanctions could be brought against Russia again — this time over the poisoning of opposition figure Alexey Navalny and the Kremlin’s support of Alexander Lukashenko’s (Alyaksandr Lukashenka) regime in Belarus. The threat of sanctions has already caused the ruble to drop, and the government can’t sell its bonds to foreign investors. 

As such, a repeat of the crisis situation of 2014–2018 is quite possible: with low oil prices and no opportunity to borrow large amounts of money or receive foreign investment due to sanctions, the Russian government will be forced to spend its reserves and then (or at the same time), cut budget expenditures. This will lead to a new period of economic stagnation. 

Text by Dmitry Kuznets

Translation by Eilish Hart

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