A popular belief among the political observers skeptical of Russia’s stability is that if oil prices fall below 60 USD per barrel and remain there for more than a year, Putin’s regime will fall. However, IMR's economic advisor Igor Booth argues that the Russian government has a significant arsenal for fighting the potential economic crisis, no matter how serious it becomes. Only a small number of critical mistakes in economic policy could destabilize the country sufficiently to force the regime out of power.

 

 

A Safe Haven

The Russian opposition movement strategy rests on the assumption that a second wave of the world economic crisis will trigger protests outside of Moscow and help oust the ruling party. This is how it happens in Western democracies. Spain, Great Britain, Italy, and France have all recently seen governments fail due to economic turbulence.

However, within the rigid Russian political system, the country’s poor economic performance is insufficient to bring about regime change. A full-scale economic catastrophe would be required to make the Russian people oust Putin: a catastrophe resembling what happened in the 1990s, when paychecks weren’t issued for months, schools went without heat through the freezing winters, and the railroads were completely paralyzed.Are there any signs that such a catastrophe is imminent?

Inflation and unemployment, two economic variables directly influencing the public mood have never been lower. Unemployment is only 5.4%, while inflation is at a record low with 6% over the last year. Accelerated growth of pensions and salaries has halved poverty rates in Russia. Although a GDP growth of just over 4% isn’t very impressive, according to the IMF forecast, Russia might outperform Brazil, another large, resource-rich, semi-developed nation. The Russian budget is balanced; the country’s debt totals a mere 42 billion USD while the rainy-day fund has accumulated over 60 billion USD. The Russian banking system is far from collapse; central bank reserves in euros, dollars, and gold are among the largest in the world.

There is no direct threat of destructive economic policies in the future. Indeed, the Russian government is packed with highly-qualified economists, as is the newly-established presidential economic council.

All things considered, Russia looks like a safe haven in the unstable global economy. However, investors happen not to share this point of view, and capital continues to flow out of Russia while investments stagnate.

The Crisis Scenario

The new wave of the economic crisis will slow down Russian consumers and have a serious impact on exports and freeze investments. Consumer spending is the major force driving the current economic growth in Russia. Higher consumer credit interest rates, flat real wages, and shrinking savings affected by devaluation will all make people reluctant to spend more. A drop in the price of natural resources would shut down the Russian mining industry. Oil production might fall because of insufficient investment in developing new fields. Altogether, these factors will lead to sluggish economic growth—or none at all.

 

The Russian banking system is far from collapse; central bank reserves in euros, dollars, and gold are among the largest in the world.

 

The major trigger for a crisis in Russia would most likely be falling oil prices. However, the area most affected will be the market for less profitable export goods: coal, aluminum, steel, metals, fertilizers and wood. Dozens of regions dependent on these industries will face two-digit unemployment rates. The federal government will be forced to bail out many economically specialized cities in order to prevent spontaneous eruptions of social unrest.

The decrease in oil prices will mainly affect the federal budget. The Ministry of Finance is prepared for this scenario. Several weeks ago, the much-discussed “budget rule” was finally adopted. Now, instead of balancing the budget based on forecasted oil prices, the government will use the average over the course of the past three years. The resulting estimate for 2013-2015 will be about 10% lower than current oil prices.  This will make the Russian budget more capable of coping with revenue shortages. Any deficit could be financed by the government’s rainy-day fund or loans.

However, oil prices above $90 dollars per barrel are not guaranteed. During the previous economic crisis, at a certain point, oil prices dipped below 40 USD. To address this threat, the Ministry of Finance is working on a crisis budget, balanced at year-average oil price of 60 USD per barrel.

Regardless, exercises in balancing the budget are not enough to revive the economy. In order to gain a competitive edge, the Russian economy needs structural reforms. In the wake of the recent elections, the Russian government doesn’t have a popular mandate for reforms. Putin’s major campaign promise was stability” Most likely, his government will avoid any reforms that could hurt his core electorate. Unable to initiate change, the government will have to stick to economic tricks that create the illusion of stability but increase long-term economic risks.


Putin’s Tricks

#1 Break the piggy bank

It would be naïve to think that Putin’s Kremlin will leave any financial reserves behind in its wake. All available resources will be spent on remaining in power for as long as possible. The opposition, which wants to oust the regime, should be prepared to deal with a broken budget, zero reserves, and heavy debt burden. It will be similar to the hostile take-over scenario from the corporate world. While on the defensive, the management does everything it can to quit the corporation on a golden parachute, leaving behind a devastated corporate structure.

The legitimate way to finance budget deficit is spending the Reserve Fund, which is currently worth 60 billion USD. The Ministry of Finance has plans to grow its rainy-day fund 4.4% by the end of the year. This is enough to fill in a decent-sized hole in the budget for about a year. Another 85 billion USD are in the National Wealth Fund. Though this fund is not supposed to be spent in the short term, there is little doubt that the government will suck money out of it if needed in order to stimulate the economy or fix the budget.

Overall, the government has accumulated enough savings to finance a budget deficit for two years of low oil prices. On top of that, the government has a lot of room to increase sovereign debt since it is currently next to negligible. Former Finance Minister Alexei Kudrin believes that the government would be better off if it started issuing bonds immediately while the sovereign debt market is still open. In the event of other European nations defaulting on their debt, it would become very difficult for Russia to borrow at any price.

Besides sovereign funds, which are at the government’s direct disposal, there are also the International Reserves of Russian Federation, controlled by the Central Bank of Russia. The amount they hold, 500 billion USD, is excessive any measure. For instance, the Official International Reserves of Canada, another large export economy, are below 66 billion USD. Even in Western countries, central banks now heavily invest in government bonds. If necessary, the Russian government will find a legitimate way to dip its hand into the Central Bank’s pockets as well.

The combination of borrowing and maintaining reserves is enough to smooth over several years of crisis for Putin’s core electorate, which mostly consists of retirees and people otherwise dependent on public sector salaries. However, the Kremlin is likely to be reluctant to spend its reserves all at once.

#2: Break somebody else’s piggy bank

The Russian federal budget subsidizes the national pension system with its deficit amounting to 2.3% of the GDP. To reduce this heavy burden, the Ministry of Finance proposes raising the retirement age. Currently, it is 55 for women and 60 for men. Though this is a sound solution to the pension fund crisis, it probably won’t be implemented any time soon since Putin has repeatedly stated that the retirement age wouldn’t be raised. He knows very well that raising the retirement age can catalyze protests, which is what happened recently in France.

A much more politically secure solution would be to reverse pension reform. Currently, a part of the social tax goes to the old solidarity pension system, which will be paying out the majority of pensions for the foreseeable future. A smaller part is transferred to individual pension accounts and invested in financial assets to fund the future pensions of people under 45. According to one of the proposals currently under consideration, these 6% will be returned to the solidarity pension system and used to pay current pensions.

 

"The majority of voters were retirees. Many of those who voted for Putin will soon pass away. I carried several people to the second floor in my arms so that they could vote," said 29-year-old Tomsk State University student Denis Karagodin, who observed the presidential elections.

 

This elegant solution to a pension crisis would minimize the political risks for the ruling party. Older and less well-off citizens, Putin’s core supporters, will benefit from the restoration of the solidarity system. Relatively young, educated middle-class citizens will have to save for their pensions themselves. However, most of them probably won’t see the effects of these unfavorable changes right away. Even more importantly, they rarely vote and are unlikely to vote for Putin and his party anyway.

#3 Drop some ballast

The budget, although loaded with protected payments to government employees and pensioners, has room for yet another maneuver. The grandiose rearmament program could be cut and delayed without any consequences for the economy. In fact, the government has already showed signs of moving in this direction. It might also cut subsidies to utilities, railroads, and housing, as well as some costly capital investment projects. All these measures could be orchestrated with minimal immediate effect on any sensitive social groups.

#4 Raise taxes

Gazprom’s record profit margins provide a good clue for where to look for additional tax revenues. The government might continue to increase taxes on natural gas production and exports.

Though tax rates in Russia are relatively low, the taxpayers’ low income levels prevent the government from extracting much more from them. For example, when raising the marginal rate of compulsory social insurance in 2011 didn’t bring in the anticipated revenues, the government cut back the rate for the next financial year.

The government might try to increase local taxes. Regional governors, who are once again elected by the people, will probably be forced to increase local taxes. To balance municipal budgets, property taxes will be linked to real estate market prices. While gradually introducing these taxes, the government will try to shield the most sensitive social groups with appropriate subsidies.

#5 Devaluation

Unlike the crisis of 2010 when the Central Bank of Russia lost about 200 billion USD of international reserves  while trying the support the failing ruble, Russian financial authorities have now embraced the more flexible managed float. The ruble is allowed to fluctuate within a loose and ever-extending margin. Without much intervention from the Central Bank, the ruble has depreciated by over 10% in the past four months. The depreciation will continue if the oil prices continue to fall.

 

The Bank of Russia (or the Central Bank of The Russian Federation) is Russia's main federal bank. Its functions are described in the Russian Constitution (Article 75) and in the Federal Law on the subject. The Bank of Russia was founded on July 13, 1990, on the basis of the Russian Republic Bank of the State Bank of the USSR. Its history can be traced back to the State Bank of the Russian Empire.

 

Devaluation will compensate for the decline in raw materials prices. Nominated in rubles, export revenue will change less because for each dollar, exporters will receive more rubles. Consequently, tax revenues from exports will also decrease, although not as much as prices for natural resources.

Devaluation won’t have much of an effect on Putin’s core electorate, which chiefly consumes cheap local goods. The resultant spike in inflation might be negligible because of the imports’ insignificant share in the consumer price index (CPI) basket. Most food, which constitutes the major component of Russia’s CPI basket, is produced within the country. Russia’s economic reaction to the 2009 devaluation was a 50% import drop and no inflation. At the same time, the cheap national currency will be a natural protection for some industries (i.e. the automotive and heavy machinery industries). These industries might increase their share on the domestic market by taking the place of more expensive import goods.

#6: Hands-on management

To curb the rise of social unrest, in 2008-2009, the Russian government provided cheap credit and tax breaks for anchor companies in cities with narrow economic specializations in exchange for the companies not laying off their work forces. There were several televised cases of Putin himself arriving (by helicopter) to struggling cities and resolving local crises with seemingly brutal renunciations of local oligarchs, although in fact  he was often propping them up with cheap credit and government privileges.

To Putin’s credit, he made a number of advancements in resolving the crisis in the biggest Russian city with a narrow economic specialization. Tolyatti, an automotive city on Volga with a population of 700 thousand, has long been the site of economic unrest and shows the lowest election results for the ruling United Russia party. AvtoVAZ, the flagship of the Russian automotive industry, whose  headquarters are in the city, received generous public financial support in recent years, hired a new professional management team, reduced its excessive work force, and developed several less clunky car models. The plant is now owned by the Renault-Nissan alliance and the city’s mayor is affliated with the opposition movement—a pretty rare case for contemporary Russian politics. If something goes wrong there, the international company and the independent mayor will be held accountable, and not Putin’s administration.

Another one of Putin’s signature tricks of hands-on management is personally making deals with European leaders and the CEOs of international companies. Although the current state of the financial markets doesn’t favor Russian assets, Putin might succeed in selling blocks of state-owned companies to international oil and mining behemoths who are used to dealing with authoritarian regimes. Besides personal guarantees from Russian leaders, international investments are likely to be protected by sophisticated deal structures, with reliable collateral on each end. Such structures will help overcome foreign investors’ justified mistrust of the Russian government.


Traps in Putin’s Path

This arsenal of economic tricks doesn’t guarantee the Russian government an easy life. In times of global economic turbulence and diminishing popular support,  the price of making mistakes in economic policy will be unprecedentedly high.

Like most nations today, Russia needs to navigate between austerity and growth-stimulating economic policies. The Russian government is also particularly vulnerable to high-level lobbying from special interest groups, leaders’ personal mistakes, and the pitfalls of an overly centralized power structure.

Every government needs accurate data about what’s happening in its economy. On the one hand, aggressive budget and monetary stimuli could bring about inflation, as well as various financial and real estate bubbles (and defaults). On the other hand, austerity measures might kill anemic economic growth and lead to social unrest.

The Kremlin's decisions will ultimately be based in its previous experience such as it is. The 2008 crisis was largely unanticipated by Russian leaders. Now the government prefers to overreact to any negative signs, thus strengthening markets’ pessimistic expectations. At the same time, during the previous crisis, the Russian government demonstrated effective crisis management strategies, quickly flooding the economy with public money. As a result, many people haven’t even noticed the 8% drop in the GDP. The approaching crisis might not be as acute, but this time, the government can’t afford to spend money without counting.

Because financial resources are limited, the government needs to spend them more efficiently. This is a challenging task in the absence of transparent democratic procedures. Dmitry Medvedev, now the Prime Minister, has attempted to make up for the absence of many democratic institutions with his so-called “open government” that mainly entails numerous committees of specialists, business leaders, NGO heads, academics, journalists and even some members of the opposition.

These structures are likely to produce a lot of discussion and even specific recommendations, but they won’t be able to stop powerful oligarchs from channeling budget resources into their own projects and companies. The opportunistic behavior of “well-connected” businessmen could hollow out budget, which may lead to Putin being unable to fulfill his promises to his electorate, which expects further rises in pensions, salaries, and social welfare.

The most striking example of ineffective public spending from the 2008-2009 financial year was the construction of the gigantic bridge to Russky Island, which has a population of around five thousand. Normally, infrastructure projects at least create jobs. In this case, a market-minded contractor hired the majority of the work force—everybody from engineers to construction workers—from abroad. The recent project to expand Moscow’s administrative borders might be a similar project. Many experts agree that the whole project and especially the peculiar form of Moscow’s new borders were most likely shaped by the business interests of powerful stakeholders.

 

A fire at the construction site for the bridge to Russky Island, December 2011

 

The increasing scarcity of budget resources will trigger ruthless competition inside the ruling clan. Many businessmen tied to the current regime might consider the coming crisis their last chance to make money through government influence. They will do their best to secure new public contracts, cheap credit, or sell their assets to the government or state-owned corporations at bargain prices.

The Kremlin’s centralized, hands-on management style may be efficient in implementing a limited number of relatively straightforward decisions, but this rigid system is incapable of processing large quantities of information without making mistakes.

For example, during the previous crisis, Vladimir Putin, then Prime Minister, concentrated on bailing out the Soviet automotive giant AvtoVAZ. To protect the domestic market, the government banned the import of right-hand drive vehicles from Japan. This decision cost thousands of jobs in car dealerships in the Russian Far East. Furthermore, the government spent billions on subsides to deliver AutoVAZ vehicles from the Volga region to the Far East. Nevertheless, the Far East consumers, used to Japanese quality, didn’t buy any of the discounted cars. The bottom line is that public money was wasted, jobs were lost, and the struggling automotive producer gained nothing from it.

 

On April 4, 2012, Vladimir Putin launched the production of the Lada "Largus," and even signed the hood of the first model manufactured

 

The number and the cost of the government’s economic mistakes could accumulate rapidly. Within the centralized management system, information isn’t freely exchanged. As a result, those who have a better access to decision makers attract more government resources while those who really need help often don’t get anything. This time around, every government mistake will be scrutinized and discussed on social networks and Internet media, multiplying the public relations damage for the government.

Putin’s administration has all the necessary resources to prevent serious economic unrest in the next six years. To secure personal power, Putin needs to strengthen discipline among the elites (the bureaucracy, siloviki, and the oligarchs) and rely more on his competent economic ministers instead of his own populist instincts. The demonstrative persecution of leaders just recently considered a part of Putin’s establishment (Sobchak, Gudkov, and others), counterbalanced by liberal developments in the new economic policy hint that Putin’s new course will involve the combination of strict discipline within the ruling class and responsible macroeconomic policy.