Russia Prepares to Slash Its Budget

Summary

In the coming weeks, the Russian Cabinet and state Duma will draw up proposals for cuts to the Russian state budget for 2015. According to Russian Finance Minister Anton Siluanov, the government could cut 10 percent of funding to all sectors except defense. This drastic proposal comes as new economic indicators show that Russia's economy is declining more quickly than expected. The budget cuts will exacerbate anxieties about Russia's economy and financial sector and threaten the economic well being of the Russian population, the Kremlin's elite, the oligarch class and the state's strategic projects. Thus, the Kremlin will prioritize various players and sectors while seeking a longer-term de-escalation with the West that could relieve some of the economic pressure on Russia.

Analysis

Russia began the year in serious economic decline and is expected to enter its second recession in six years in 2015. The decline has gained momentum in recent days with news that certain economic indicators are even worse than expected. The World Bank on Jan. 12 forecast a reduction in GDP growth for 2015 from -0.7 percent to -2.9 percent. The same day, Fitch Ratings downgraded 13 Russian firms, including LUKoil, Gazprom and Russian Railways, some of the country's largest. Moreover, the Russian currency has remained volatile in recent weeks, despite the Kremlin's cash injections of more than $80 billion thus far. On Jan. 14, Russia's Central Bank published a poll it had taken in December revealing that 48 percent of Russian citizens have been affected by the ruble's depreciation, and the Russian people's trust in the currency has fallen to a record low of 62 percent.

A host of issues have caused the decline. Russia already was facing a steep, cyclical industrial decline at the beginning of 2014. The standoff between Russia and the West over Ukraine sparked massive capital flight from Russia and halved foreign investment into the country. Moreover, international sanctions have limited Russian companies' and banks' access to dollars and foreign credit. Now, the price of oil has dropped and is in the neighborhood of $45 per barrel — less than half the price at its height in 2014. Russian Economic Minister Alexei Ulyukayev said Jan. 15 that Russia's GDP growth could plummet to as low as -4.5 percent if oil prices remain at current levels.

All these negative indicators are forcing the Kremlin to reconsider its current government budget. In a rare agreement between the finance and economic ministries, Siluanov and Ulyukayev have united their ministries in calling for a 10 percent budget decrease across all parts of the Russian budget except the defense sector. Siluanov made it clear that Russian President Vladimir Putin ordered that an exception be made for defense. The 2015 Russian budget expanded defense spending by 20 percent, against the wishes of more liberal ministers such as Siluanov, who has long pushed for defense spending cuts. Putin clearly has made defense spending the country's top priority as Russia continues supporting the separatists in eastern Ukraine and faces further NATO buildups along its periphery.

A 10 percent cut to all other parts of the budget is steep, but it will not put the Russian economy in a critical condition. Overall, the Russian budget for 2015 increased state spending by 12 percent, so a 10 percent cut would put spending on par with 2014 levels. However, the cuts will affect some key areas and could lead to social backlash.

Social Tensions

Regional and municipal governments have already cut social spending to areas such as healthcare. Further federal reductions will deepen the cuts to the healthcare system. In November, protests broke out Moscow over this issue. The city has been forced to shut down clinics and hospitals, and nearly 10,000 doctors are losing their jobs. Structural reforms to the education system were set to begin this year, but Siluanov said the proposed budget cuts will delay them.

Economic strains have also frozen infrastructure projects across the country. The third and fourth sections of the planned 500-kilometer (311-mile) ring road around Moscow have been postponed until an investor is found to pick up the $2.6 billion tab. This project was intended to help with transportation for the 2018 World Cup tournament, and Muscovites considered it a critical to alleviating the city's gridlocked traffic. It is unclear if the budget for World Cup stadium construction will be affected by the Russian economic crisis; if the stadium is not completed on schedule, it would be a public embarrassment for the Kremlin. However, other infrastructure projects, such as the $3.5 billion bridge between Russia and the annexed Crimean peninsula, are said to be immune to budget cuts by Putin's order.

Pensions are one of the most politically sensitive parts of the Russian budget. During the 2008-2009 recession, the government diverted funds from pensions to plug holes in the economy and the state budget. Approximately $6.9 billion in pension funds were used to help the economy in July 2014, though these funds were replaced. In December, the Kremlin passed new laws on pensions that will take effect this year, though it is unclear how the new calculations set forth in the laws will work in practice. The government's use of pension funds has drawn masses of protesters to the streets, much like during the 1998 financial crisis.

Overall, the Kremlin is making a gamble in cutting budget funds meant for or directly tied to the Russian people. Putin rose to power amid economic turmoil by making a series of promises to Russians that included better quality of life, improved national security and a stronger international position for the country. All three social contracts are increasingly in question. The Russian people are currently blaming the West for sidelining Russia on the international stage and for national security threats to the country such as the Ukraine crisis and NATO's maneuvers, and Russians can withstand a fairly high level of economic decline and financial uncertainty. However, the longer and deeper each crisis becomes, the more likely it is that the Russian people's support for the current government, and particularly Putin, will decline if it does not disappear.

The Elite, Oligarchs and Big Russian Business

Putin has to maintain support not only from the Russian public but also from among his inner circle and the Russian elite. The current economic malaise means less revenue for the elite and their firms or business empires. Thus, members of this group are scrambling for more assets, revenue and leverage. This has pitted members of the elite against each other in the debate over how the Kremlin should allocate the government's reserve funds (the currency reserves and welfare and wealth funds), which stand at $398 billion — down from $599 billion in mid-2014.

One of the most important disagreements within the Kremlin is over the future of Rosneft, the state oil giant. Rosneft has some $35 billion in debt, an amount the oil firm was hoping to roll over or refinance. However, the sanctions against Russia have limited Rosneft's access to dollars and credit, and with oil prices plummeting, the firm's revenues will decline sharply this year. Rosneft has asked the Kremlin for $40 billion in financial assistance. The more liberal members of the Kremlin elite are against this, proposing instead that Rosneft privatize just less than 20 percent of its company to raise funds — a measure that Rosneft chief and Kremlin elite Igor Sechin opposes. 

A power grab appears to have occurred recently among the elites in the military-industrial sector. Sergei Chemezov, chief of major industrial company Rostec and one of Putin's close allies in the Politburo, placed one of his loyalists as head of the United Aircraft Corp., giving him a near-monopoly on Russia's military-industrial complex. Chemezov has long wanted to control the United Aircraft Corp., which oversees numerous military-industrial firms including aircraft manufacturers Sukhoi and Tupolev. Stratfor expects Putin to continue rewarding his closest loyalists like he did with Chemezov as tensions grow among the elite over who controls the larger and more lucrative assets and as growing financial stress continues to affect Putin.

The Kremlin has been distributing funds to some state firms, such as state banks VTB, VEB, GazpromBank and Sberbank, which are set to receive some $16 billion in financial assistance and capital boosts. However, the state banking system is particularly tangled in Western sanctions, and private banks and oligarch-owned banks are declining swiftly. The Russian banking sector's profits slid 14 percent in 2014. Stocks in Russia's largest banks, Sberbank and VTB, have declined 18 and 14 percent, respectively, since the start of the year. The Russian banking sector has $100 billion in loans due in 2014, and the international issuance of Russian debt fell from $53 billion in 2013 to slightly less than $10 billion in 2014.The Kremlin will have to continue picking and choosing which firms it will assist. It has already set limits on Russian banks' net foreign exchange and set up Central Bank supervisors to oversee Russian banks' currency trading.

The Russian oligarchs — not to be confused with state-linked "silovarchs," who oversee large business empires, such as Sechin and Chemezov — are also in a crunch. Most of the oligarchs' wealth has plummeted; in December, when the ruble was at its most volatile, the 20 richest oligarchs lost some $10 billion in 48 hours. Many oligarchs are downsizing their empires. For instance, Alfa Bank chief Mikhail Fridman is closing his firm's U.S. offices and cutting jobs in its European branches. Also, Mikhail Prokhorov, former owner of Norilsk Nickel and Polyus Gold, is selling his U.S. basketball team, the Brooklyn Nets.

The oligarchs know the Kremlin and Putin are unlikely to prop up their empires because the state firms and elite will have priority for financial assistance, even though the oligarchs gave the Kremlin financial assistance during the previous crisis, injecting billions into the Russian currency and markets on Putin's order. Interestingly, Putin held an elaborate Christmas banquet in Moscow, and Prokhorov, Rusal founder Oleg Deripaska, Norilsk Nickel owner Vladimir Potanin and metals tycoon Alisher Usmanov were in attendance. At the dinner, Putin reportedly discussed giving the oligarchs amnesty from prosecution for capital flight if they were to move their cash and assets back to Russia, though it is unclear who will comply with the Kremlin directive.

During the last recession, Putin was able to force the oligarchs to forfeit some of their wealth without much risk of bankrupting the oligarchs or their firms. This time, the oligarchs and their empires are at risk of bankruptcy — or close to it. Thus, Putin does not have the freedom to pressure them this time around unless he is willing to bankrupt another sector of the economy and destabilize the many regions that depend on the oligarchs.

The Kremlin is also deciding which strategic projects it will continue to fund. Although the budget cuts will affect some presidential pet projects such as the Moscow Highway, the Kremlin is still determined to continue or launch many large and expensive strategic projects. Already, the it has provided some $2.6 billion to natural gas firm Novatek, which is developing the first liquefied natural gas project on the Yamal Peninsula. However, the fate of Gazprom's large-scale strategic projects is uncertain. Gazprom has already canceled its South Stream pipeline to Europe, though it claims the decision was made for political reasons. The natural gas giant has planned or is constructing several very expensive but highly strategic energy projects in order to maintain Russia's position as a major energy supplier and improve Russia's ability to export energy supplies to other regions, such as Asia, to lessen Moscow's dependence on the European market.

Gazprom: 

Gazprom has seen a fair amount of financial stability despite the current economic downturn and sanctions against it. However, the longer the crisis and sanctions last, the harder it will be for Gazprom to maintain its health. The sanctions limit Gazprom's ability to raise cash internationally for its projects. The current Gazprom budget for 2015 does not account for all the strategic projects planned, nor does it account for the decline in oil prices, which affects natural gas prices. Gazprom has already reached out to China seeking help with the Power of Siberia natural gas pipeline project. Beijing has plans to give the Russian firm $50 billion (a $25 billion loan and a $25 billion pre-payment for natural gas supplies), but it is not clear when those funds will start flowing. If the Kremlin is set on supporting certain strategic projects, it will have to give them priority in deciding how to spend funds from Russia's reserves.

Minor Relief in Sight?

As Russia weathers these financial and economic storms, some amount of relief could lie ahead. The European Union's sanctions against Russia are set to expire in stages this year. Stratfor forecasts that Russia will start de-escalating tensions with the European Union over Ukraine so that the bloc does not expand or extend the current sanctions. An expansion or extension of the sanctions would require a unanimous vote among the bloc's 28 members — something that is unlikely unless Russia makes an overtly hostile move against the West or Ukraine. In addition, diplomatic leaks from Brussels to Russia's Itar-Tass news agency said that seven EU countries — Austria, Hungary, Italy, Cyprus, Slovakia, France and the Czech Republic — were in favor of lifting the sanctions. The sanctions will be discussed in the European Union's meetings in January and March.

However, even if the European Union lifts its sanctions against Russia or allows them to expire, the United States will not necessarily rush to follow suit. Washington is keen on keeping the pressure on Russia, although it is unlikely to expand the sanctions because it does not want to crash the entire Russian economy. Additionally, even if the EU sanctions are lifted or expire, investment will not necessarily flood back into Russia. Western sentiment about Russia's financial and economic stability and viability will remain low throughout the year. The real driver of the Russian economy right now is oil prices, which are not expected to rise into the triple digits as they have in years past. Thus, the Kremlin will have to continue choosing its budget priorities in order to alleviate pressures throughout the country while the state struggles to maintain control. 

Natural Gas Europe is pleased to provide this article in cooperation with Stratfor, a Natural Gas Europe Knowledge Partner.  For more visit http://www.stratfor.com/   Follow Stratfor: @stratfor on Twitter | Stratfor on Facebook