Russia's Fraying Financial Safety Net Hangs by a Thread

8 MINS READJan 19, 2018 | 09:00 GMT
With its emergency reserve fund used to cover budget shortfalls now drained, the Kremlin has a few other avenues for managing the country's financial woes.

With Russia's rainy-day fund used to cover budget shortfalls exhausted, the Kremlin has fewer options to manage its financial problems.

(IAN WALTON/Getty Images)
  • The Kremlin has drained the Reserve Fund, which was used to help address budget deficits, and now is left to rely on its National Wealth Fund, which is intended to provide for Russia's future and guarantee its pension system.
  • Russia, facing increased U.S. sanction pressure and on the brink of a recession, must address the financial crises in its banking and defense sectors and among its regional governments.
  • The recent rise in oil prices relieves some of the pressure on the government, and increased borrowing on the international market and sizable foreign exchange currency reserves will help Russia stave off destabilization as pivotal elections approach.

Russia's sovereign wealth reserves, once bloated by years of abundant petroleum revenue, are today just shadows of their former selves. And on Feb. 1, the country's Reserve Fund, designed to help the government balance its budget, will officially disappear as it is legally recombined with the National Wealth Fund, a separate pot of money that backs up Russia's pensions. But the merger is a move in name only. It will come after the country's Finance Ministry appears already to have drained the Reserve Fund's remaining $17 billion in cash to plug a looming budget hole. With Russia's financial security blanket wearing thin, the question as national elections approach will become whether its people will continue to trust the current administration to manage the country's increasingly shaky finances.

In 2008, Russia split its sovereign wealth Stabilization Fund into two separate pools of money — the Reserve Fund and the National Wealth Fund — giving each its own focus. The two funds were to collect the financial windfall from Russia's large oil and gas revenues. The Reserve Fund would act as a kind of rainy day reserve to help the federal government pay for budget deficits. And the National Wealth Fund was set up to provide a safety net for government-funded pensions and to make investments in development projects guaranteeing Russia's long-term economic future. Pensioners represent a key demographic for President Vladimir Putin's administration. They currently constitute about 40 percent of the electorate, and importantly, they are much more likely to vote in elections. Reassuring them that the country would not follow the path it did in the 1990s, when financial destabilization led to the pension funds drying up, has been one key to Putin's longevity in office.

When the economy was rocked by the global financial crisis in 2008-09, the government tapped the Reserve Fund and spent $118 billion over the next three years — more than three-quarters of the money available — to bail out banks, shore up faltering companies and cover the federal budget deficit. Higher oil prices starting in 2012 allowed it to again build up the fund, which had reached $88 billion by 2014. But by the middle of that year, lower oil prices and an industrial slowdown combined with sanctions imposed by the West drove Russia into a deep economic recession, leading the Kremlin to again draw down the fund to help balance the federal budget. During 2015, the Kremlin pulled nearly $46 billion from the fund, followed by an additional $37 billion in 2016. By the end of 2017, the fund had been depleted, accelerating the Kremlin's decision to close it altogether.

Russia's Depleted Funds

A Rocky Recovery for the Russian Economy

The Russian economy officially pulled out of recession in 2017, and it was expected to settle into a period of stagnation for the foreseeable future. But there are danger signs on the horizon and some indications that the country may have slipped back into recession at the end of last year, despite an oil price rebound brought on by the OPEC production cut and increasing global demand. While the Finance Ministry says the country's gross domestic product (GDP) grew by 1.7 percent last year — an increase over 2016 — statistics for the economic fourth quarter have not been made public yet. A report issued Jan. 11 by JPMorgan Chase, however, says that the economy contracted during each of the last two quarters of the year, technically putting the country back in recession.

Several additional developments will add strain to the Russian financial picture. It does not appear that the sanctions imposed by the West will be lifted this year, and in fact, the United States will likely expand its sanctions regime, cutting off lending to Russia's major economic sectors and the government, and stripping the country's oligarchs of their assets abroad. Furthermore, Russia's regional governments are drowning in debt and will need $50 billion to $150 billion over the next three years to stay afloat. Russia's banking sector is also in crisis. With one-third of its institutions forced to close over the past three years and a further third likely to fail, merge or need bailouts in the coming years, the banking industry will require $50 billion to $100 billion to cover bailouts and restructuring. Meanwhile, a manufacturing slowdown in Russia's defense industry, a major contributor to its economy, will require another bailout this year. Last week, oligarch-owned Alfa Bank (Russia's seventh-largest) said it would steer away from funding orders by the defense sector, because it expects sanctions to further hamper the industries' finances. This will leave the state to foot most of the bill. Russia also is continuing to expand its footprint throughout the world and fund operations in Syria, Ukraine and North Korea — a strategy that does not come cheap.

Economic Discontent in an Election Year

The economic pain of recession and the country's financial problems provide the backdrop for key national elections this year. Putin will run for a fourth term in March, and regional elections — including one to pick the mayor of Moscow — will be held in September. To manage the outcome and combat the country's rapidly increasing poverty levels, the Kremlin will spend on targeted information campaigns, will increase the salaries of government workers and will raise the minimum wage. It also plans to boost spending on health, education and infrastructure by 1.5 to 2 percent of GDP, using proceeds derived from the increase in oil prices in the past month. The economic and financial issues plaguing Russia have been the primary drivers of an uptick in protest activity this past year. Of the more than 1,100 protests recorded across the country, more than two-thirds were focused on such issues as salary nonpayment or decreases, unemployment or the loss of savings.

Now that the Reserve Fund is depleted, public focus will turn to how the Kremlin uses the National Wealth Fund to manage the country's financial woes. With the merger, the wealth fund can now legally be used to paper over budget holes, perhaps jeopardizing its mission to secure the pension system. The government is considering drawing $25 billion — one-third of its assets — out of the fund in 2018. It will be limited to accessing up to two-thirds of the National Wealth Fund's balance, with the rest tied up in investments such as infrastructure projects, state bank shares and Ukrainian Eurobonds. If that fund should be drained, Putin and his government would essentially be reneging on his promise to secure the financial future of the Russian people.

But before it comes to that, the Kremlin has a few options it can exercise. If the price of oil, which topped $70 per barrel in January, levels out or continues to rise, it would give the government some breathing room. The national budget was set with the assumption that oil would remain near $40 per barrel, and any revenue beyond that could flow into its currency reserves and National Wealth Fund. This could flush a relatively large amount of cash into the Kremlin's hands. The country's large energy firms — in particular, oil giant Rosneft — are pushing back on the Kremlin's grab for revenue, because they would prefer to increase their own revenues instead. Rosneft could keep its expanded oil profits abroad to circumvent the Kremlin, but that maneuver would intensify the political struggle between Putin and Rosneft's chief, Igor Sechin — arguably Russia's second-most powerful man. The Kremlin is also looking to international markets in a bid to raise about $18 billion in sovereign debt, but the United States is seeking to limit Russia's ability to do so. However, Moscow has been reaching out to alternative markets in the Middle East and the Asia-Pacific in its search for possible lenders.


Russia: Central Bank Foreign Exchange Reserves
Russia also holds a relatively large reserve of foreign currency, worth about $356 billion at the end of December. Those foreign exchange reserves are intended to be used for external trade, not to bolster the domestic economy. Putin reiterated those intentions in a recent interview. However, the Kremlin has bent that rule during past crises, such as during the 2009 recession when its reserves fell by a total of $210 billion, partially due to ruble volatility but also as a result of Kremlin spending. So despite Russia's bleak financial picture this year, the Kremlin has some tools at its disposal to prevent the destabilization that would translate into an even tougher election year.

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