Editor's Note: This is the first installment in a two-part series on Russia's ongoing budget negotiations.
Summary
The Russian Cabinet is currently negotiating conflicting proposals for the 2013-2015 government budget. The Cabinet must decide the budget by September, the deadline for sending the budget to parliament. Russian President Vladimir Putin will then approve the budget by October. The government is struggling with two main issues: financing a budget if oil prices fall and deciding where to cut spending under the more frugal proposed budget.
The issue of spending cuts has polarized the Kremlin, particularly regarding the repercussions of cuts to either social or defense budgets. Cuts to either sector could cause problems for the country's social stability and national defense. However, without spending cuts, Moscow faces even larger problems maintaining stability in the long run.
Analysis
Russia's gross domestic product has steadily grown over the past few decades. In 1995 the GDP was $44 billion, compared to nearly $1.7 trillion in 2011. Russia owes the majority of its financial gains in the past few years to high energy prices. Oil and natural gas profits constitute between 38 percent and 50 percent of the government's revenues, depending on the year. Moscow has reaped the benefits of all-time high natural gas prices for the past five years and high oil prices for the past four years. It has been able to pay off all of its international debt, get its budget deficit down to 0.1 percent of GDP, save up $500 billion in foreign exchange reserves (with an additional $500 billion rumored to be stashed away as well) and create rainy day funds with about $150 billion.
Russia's growing revenues have also allowed government spending to increase substantially. Russia's budget has steadily grown every year since the mid-1990s, but the increases since 2005 have been especially large. The 2011 budget was 66 percent larger than the 2005 budget. This has allowed the Russian government to increase spending on national defense, law enforcement and security, housing and communal services and socio-cultural activities. The Kremlin has spent its increased cash on a slew of populist programs, increasing support for the government during the 2000s. But the Kremlin has also invested in large infrastructure projects, such as massive upgrades to the natural gas pipeline system to Europe, that will help sustain Russia in the future.
On the surface, the state of Russia's finances seems unstable, mostly because of the massive crisis next door in Europe and the uncertainty in the Russian investment climate. The U.N. Conference on Trade and Development forecasted that Russia's foreign direct investment will grow by 22 percent in 2012 to reach $53 billion, the third-highest amount ever. However, most economists predict capital flight from Russia to be between $70 billion and $90 billion for 2012 — numbers similar to those during the 2008 financial crisis in Russia.
Despite the uncertain investment climate, the Kremlin's real concern is that continuing to expand the budget depends on high oil prices — something that cannot be reliably predicted. Many factors are currently keeping oil prices high, as they have been for many years now. But it is not certain that the high prices will continue, with consumption possibly falling in Europe due to the economic crisis and tensions in the Middle East now becoming the status quo and thus no longer contributing volatility to energy markets.
The Russian Finance Ministry estimates that to hold the current spending level, oil must be benchmarked at $117 on average for a barrel of Brent crude. The Kremlin has emergency measures in place should oil fall to $80 per barrel and additional measures if it falls to less than $60 per barrel, but with the vast spending increases in recent years, such measures would not be enough.
Now the Finance Ministry is creating more robust and planned budget options for those lower price points. Russia's new finance minister, Anton Siluanov, is leading the attempt to get the budget under control and is following the example set by his predecessor, Alexei Kudrin. Siluanov is proving that he has the mind to tackle Russia's financial problems even though he knows doing so will set him at odds with many of the more defense-oriented Kremlin members in the security sector.
Siluanov came up with a new fiscal rule: The Russian budget deficit is not allowed to exceed 1 percent of GDP with oil prices more than $93 per barrel starting in 2013, and any extra money made off the higher oil price would go directly into the rainy day funds. Under Siluanov's plan, if oil prices fall to $60 a barrel, the budget deficit would still only come to 3.6 percent of GDP, which is not too high compared to many Western countries.
The second part of Siluanov's plan, which will facilitate the first part, is that the Russian budget would have to be cut for the first time since 1998 — something unthinkable to most Russians, particularly those in the Kremlin. Siluanov and his economic team are simply trying to ensure the stability of the country amid the uncertainty of future oil prices, but they face three key problems.
First, it is unclear whether Siluanov can get the rest of the Kremlin, particularly members of the security establishment, to even agree to any cuts. The recent years of wealth and free spending have spoiled the Kremlin. The next issue is where to cut the budget. In Russia, it is difficult to find the right balance between government spending on social programs needed for domestic stability and defense needs to ensure national security. Finally, Siluanov's plan does not account for the massive government spending promises that both Putin and Prime Minister Dmitri Medvedev made during the election season. So the Kremlin has made very large promises to increase spending — not decrease it.
