Russia is running out of money. President
Vladimir Putin is taking a strategic gamble, depleting the Kremlin's
last reserve funds to cover the budget and to pay for an escalating war
in Syria at the same time.
The three big rating
agencies have all issued alerts over recent days, warning that the
country's public finances are deteriorating fast and furiously. There is
no prospect of an oil revival as long as Saudi Arabia continues to
flood the market. Russia cannot borrow abroad at a viable cost.
Standard & Poor's says the budget deficit will balloon to 4.4pc of
GDP this year, including short-falls in local government spending and
social security. The government has committed a further $40bn to bailing
out the banking system.
Deficits on
this scale are manageable for rich economies with deep capital markets.
It is another story for Russia in the midst of a commodity slump and a
geopolitical showdown with the West. Oil and gas revenues cover half the
budget.
"They can't afford to run deficits at all. By the end
of next year there won’t be any money left in the oil reserve fund,"
said Lubomir Mitov from Unicredit. The finance ministry admits that the
funds will be exhausted within sixteen months on current policies.
Alexei Kudrin, the former finance minister, said the Kremlin has no
means of raising large loans to ride out the oil bust. The pool of
internal savings is pitifully small.
Any attempt to raise funds
from the banking system would aggravate the credit crunch. He described
the latest efforts to squeeze more money out of Russia's energy
companies as the "end of the road".
Mr Kudrin resigned in 2011
in protest over Russia's military build-up, fearing that it would test
public finances to breaking point. Events are unfolding much as he
suggested.
Russia is pressing ahead with massive rearmament,
pushing defence spending towards 5pc of GDP and risking the sort of
military overstretch that bankrupted the Soviet Union.
The Stockholm International Peace Research Institute said the
military budget
for 2014 rose 8.1pc in real terms to $84bn as the Kremlin took delivery
of new Su-34 long-range combat aircraft and S-400 surface-to-air
missile systems.
It is to rise by another 15pc this year, led by
a 60pc surge in arms procurement. This is an astonishing ambition at a
time when the economy is in deep crisis, contracting by 4.6pc over the
last twelve months.
Mr Putin pared back the plans earlier this
year but has since restored the original target, telling a VTB Capital
forum this week that the economy has hit bottom and "things are looking
up."
Diplomats say the reality is that wars in Syria and Ukraine are eating into the budget. Cruise missiles are not cheap.
Mr Putin knows he cannot count on oil and gas any longer, belatedly
recognizing that shale technology in the US threatens to cap crude
prices for a decade or more, and has effectively destroyed Russia's
petro-power business model.
"Oleg Deripaska, chief of the aluminium group Rusal, said it is
wishful thinking to suppose that a cheap rouble can kick-start an
economy caught in a tangle of red-tape, crying out for root-and-branch
reform and the rule of law"
The Kremlin has gone back to the drawing board,
working from the Spartan assumption that oil will remain stuck at $50 a
barrel for the next three years.
It could be even worse. Russia's central bank warned in a report that it may take $30 oil to stop the US shale juggernaut.
The central bank’s “risk scenario” talks of a new era of sub-$40 crude
that would entrench the current depression. “Under these conditions, GDP
could fall by more than 5pc in 2016,” it said.
Mr Putin claims
to have an ace up his sleeve: Russia will fall back on industrial
self-reliance and import substitution. “Our policies are not frozen.
They adapt to circumstances,” he said.
The Kremlin is launching a
radical plan to slash imports across twenty key sectors within five
years, ranging from heavy machinery to electrical engineering,
photonics, cars, tractors, chemicals, pharmaceuticals, and food.
The targets are drastic. Reliance on foreign farm and forestry
machinery is to be cut by 56pc, food processing by 53pc, and engineering
equipment by 34pc. State procurement contracts will be steered to
companies that produce in the country, whether or not they compete on
quality.
But the switch-over costs money that the government
does not have. Viktor Semenov from the Belaya Dacha Group said his
agro-conglomerate is raking in big subsidies to grow lettuces in the
Siberian heartland of Novosibirsk, relying on heated greenhouses to
fight temperatures of minus 20 degrees.
"We're building 250
hectares of hothouses a year on my farms," he said. Whether it makes
sense is anybody's guess. The same vegetables could be imported more
cheaply from Turkey.
Trade experts are already shaking their
heads. Such a reflex usually means a country is going badly off the
rails, though Germany pulled it off with macabre success in the 1930s.
“In most of the cases I have known import substitution policies have
failed. They degrade the economy," said Pascal Lamy, former head of the
World Trade Organisation.
Russia has pockets of excellence -
currently on display in the Syrian theatre - but the engineering and
industrial base of the Soviet era has largely been hollowed out by an
overvalued rouble during the commodity boom.
It has been a textbook case of the Dutch Disease. Many of the best
engineers and technicians have emigrated in a chronic brain-drain.
Russian economists say it is far from clear whether the country can
suddenly pirouette and manufacture the machines itself.
Vladislav Inozemtsev, from the Center for Post-Industrial Studies in Moscow, said the
likely outcome
is a retreat into autarky and pauperised decline, ending in withdrawal
from the global trading system. “This way leads us towards a
quasi-Soviet economy detached from the world and, at the same time,
proud of its autarky; towards a deteriorating economy which compensates
for the drop in living standards with pervasive propaganda,” he wrote.
Mr Putin is counting on a 50pc devaluation since early 2014 to restore
lost competitiveness and ignite a manufacturing renaissance. Having
presided over a destructively-strong rouble for a decade, he has now
embraced the virtues of a weak currency with the zeal of the converted.
Oleg Deripaska, chief of the aluminium group Rusal, said it is wishful
thinking to suppose that a cheap rouble can kick-start an economy caught
in a tangle of red-tape, crying out for root-and-branch reform and the
rule of law.
“We should stop looking at the exchange rate and give some thought to
the economic policy we really need. Nobody is going to borrow at 12pc in
hard currency to invest,” he said.
The chief effect has been to
shrink the Russian economy in global terms. “GDP was $2.3 trillion at
the peak. It is now $1.2 trillion, and I fear we are going back to the
level of 1998 when it was $700bn,” he said.
This would be
smaller than Holland ($850bn) or half the size of Texas ($1.4 trillion),
a remarkable state of affairs for a country vying for superpower
military status in Europe and the Middle East.
Igor Sechin, the
head of oil giant Rosneft, said devaluation is a false strategy, adding
sarcastically that if it was so good to halve the rouble from 30 to 60
against the dollar, why not just keep going and push it all the way to
100. “That would be a dream wouldn’t it?” he said.
In a sense,
Mr Putin has little choice. He cannot afford burn through foreign
reserves to defend the rouble. They have already fallen from $520bn to
$371bn. Standard & Poor's said two-fifths of this money is
ear-marked for other functions and cannot be deemed "usable".
“We are rapidly approaching the fateful mark where of 50pc of the
average Russian family's income will be spent on food. We have again
become a country of poor people"
Ivan Starikov, the former deputy economy minister
These reserves look large on paper but are near the
minimum safe levels needed to uphold confidence and to cover foreign
debt redemptions of Russian companies, running at $12bn to $15bn a
quarter.
What is clear is that Russia’s attempt to reinvent
itself as an industrial tiger will take years to bear fruit, if it is
possible at all. The early evidence is dismal, though Ford has announced
that it will start building engines for the Fiesta later this year at
its Russian joint venture in Elabuga.
Non-energy exports plunged
by 25pc in the third quarter. “This is a vivid illustration of the
economy’s deep recession and lack of competitiveness,” said Eldar
Vakhitov from BNP Paribas.
“Theoretically, rouble weakness
should have supported competitiveness of non-oil exports; in reality, it
did not help at all,” he said. Russia's capital stock is so badly
eroded that the devaluation may leak into price rises and 'stagflation'
without boosting output.
Elvira Nabiullina, the central bank
governor, said the floating rouble had acted as “shock absorber” when
the crisis hit. It is a pre-condition for recovery, but is not enough in
itself without deep reform. “We have to swallow the bitter pill,” she
said.
What is disturbing is that companies have seen a rise in windfall
profits of almost 40pc this year from devaluation but investment has
dropped by 6.7pc. They are paying off debt and battening down the
hatches instead. “Why are they not investing? This is the main question
for economic policy in Russia,” she said at the VTB Capital forum.
Polls suggest that Mr Putin remains popular but the full force of the
crisis has only started to hit home, and he can no longer keep putting
off the choice between guns and butter. Real incomes have dropped by
9.8pc over the last year. Food prices have jumped 17pc.
Ivan
Starikov, the former deputy economy minister, said the true inflation
rate is near 30pc. “We are rapidly approaching the fateful mark where of
50pc of the average Russian family's income will be spent on food. We
have again become a country of poor people,” he said.