Russia has come out of the recent financial crisis fairly well and has $600 billion in cash reserves, though these funds are not meant for the current budget but rather for a true crisis. Currently, the Russian government projects it will run a 1.5 percent budget deficit in 2012 — as long as oil prices stay near $100 a barrel.
But the Finance Ministry is concerned with three things. First is that Russia (and its budget) cannot rely on oil prices to stay high. Oil and natural gas revenues make up approximately half of the government's revenues. Russia cannot commit to high spending for the next eight or so years since it is dependent on such a high oil price and energy prices are very unpredictable.
Second, the Finance Ministry wants to make sure that Russia is prepared should the European financial crisis worsen. Russia's Sberbank prepared a report the week of May 27 examining the effects a Greek withdrawal from the eurozone would have on Russia: a 2.1 percent drop in gross domestic product (GDP), a 6.7 percent rise in inflation, oil falling to $80 dollars per barrel, capital outflow up to $95 billion and a 10 percent devaluation of the ruble.
The Finance Ministry's third concern is to keep Russia's budget deficit fully balanced through 2015 — meaning Russia needs to cut some federal spending.
With global financial instability and slight decreases in oil prices, the Finance Ministry recently revised its estimate from earlier in 2012 to say that Russia's federal revenues will fall by at least 0.8 percent of GDP in 2013 compared to previous estimates. So with less money than it had expected to have, the Finance Ministry wants to plan now for budget cuts through 2020.
Finance Ministry's Proposal
The Finance Ministry is proposing that in order to cut $125 billion, Russia should cut the bulk from security — meaning the defense budget — while maintaining spending on education, health care, housing, utilities and such. Now the new Russian government has many more economists and financial minds compared to the previous governments, which were either more balanced or at times dominated by security hawks. Currently, there are even financial minds in charge of the defense and energy ministries. This financially oriented Kremlin is more concerned with ensuring that Russia does not crumble if something happens that is outside Russia's control, like a eurozone collapse or falling oil prices.
The Finance Ministry's proposal is a large shift from what Putin proposed just before the election in March: a spending increase on defense that would expand the 2014-2020 defense budget from $650 billion to $770 billion total. Putin said the increase was critical to counter NATO's planned ballistic missile defense efforts in Europe, and overhaul the military in order to confront modern threats. But many critics, particularly those in the Kremlin's financial circles, are worried about how to finance the current budget, let alone an expansion.
Russia must decide what its priorities are and if it can afford the current course of the Russian defense industry.
Russia's Defense Industry Dilemma
The Finance Ministry's proposal is already facing strong resistance, particularly from Deputy Prime Minister Dmitri Rogozin, who holds the Kremlin's security portfolio. Rogozin knows that Russia's overall stability is based on its ability to secure the country — an incredibly expensive undertaking.
Russia's military requirements have always outstripped its demographic and economic means. Russia is such a vast territory that its defense requires not only a large military in terms of manpower but also a large amount of conventional military equipment and a significant nuclear force. Russia is also still attempting to manage and optimize its military since its unraveling after the end of the Soviet Union — which is also expensive.
Russia's massive defense industry faces many issues, but four are key:
Russia's defense sector is infamous for graft, inefficiencies and grossly misallocating funds. Though it has improved somewhat under current Defense Minister Anatoly Serdyukov, graft is still a major problem. Russian Chief Military Prosecutor Sergei Fridinsky said a fifth of the state's defense spending is stolen, and as much is estimated to be lost due to inefficiencies in the Russian military industrial complex.
Russia has plans to replace 70 percent of Russian military equipment within the next five years. Russia has already replaced 30 percent of the equipment, but it will take an incredible amount of focus and cash to fulfill the rest of the pledge. This means new intercontinental ballistic missiles, space systems, air defense systems, submarines, aircraft and ships, among other things. But many Russian military projects (such as the Yasen nuclear attack submarine project) are years behind and are over budget.
The Russian defense industry exists today due to two decades of strong defense exports. Russia is the world's second-largest arms exporter, accounting for $10.7 billion of arms contracts in 2011 — nearly a 20 percent increase since 2010. Most of that money has gone into sustaining this industry. But this is largely late-Soviet technology. Russia lacks the intellect behind true innovation and has estimated its profits from exporting arms will start to decrease in 2014 with more competition on the global market, especially from China. Therefore, Russia must focus on the higher end items with which Russian products are competitive and distinct in the marketplace, such as the S-400 anti-aircraft weapon system.
Russia is already having problems filling its ranks. In 2011 and 2012, Russia failed to meet its military quota for conscripts by an estimated 20 percent. Russia is currently trying to correct its demographic crisis in its military ranks by signing more soldiers from contract than conscription. However, this is an expensive undertaking since contract troops cost more. There is also a decline in the quality of troops, which the government is trying to fix with better housing and benefits.
Plan Thus Far
Russia is making some headway in trying to combat these problems. According to Serdyukov, graft and corruption in the military is down by 20 percent. Russia has also started to shift its thinking on defense spending. Over the past few years, Russia has given up on trying to build all of its military equipment itself and has started looking abroad to purchase specific items. It has accepted that it is sometimes more efficient to purchase some types of equipment abroad on time and on budget (such as Mistrals from France or armored vehicles from Italy). It also hopes to import some of this expertise, as is the case with France building the third and fourth Mistrals in Russia.
There is little direction for the Kremlin on how to provide sufficient funding for current military reform and procurement objectives. It needs every dollar just to continue struggling to achieve as much as possible, as it has done for the last decade.
Like any country in a budget crunch, Russia needs to make choices, and those choices can be constructive for reform but they can also exacerbate existing problems. Putin announced May 30 that the Kremlin was coming up with a new Russian Federation Defense Plan through 2016, which will lay out the priorities for the defense sector. This is expected to be drafted and approved by December 2012 and will focus on the military industrial complex's priorities, training, production, alliance structure, military pay and financing. In this announcement, Putin laid out the lofty goals of increasing military pay threefold and producing new large military equipment.
But Russia needs cash to do all this — something the Finance Ministry is not sure it can afford. In the end, Putin and other Kremlin members could reject the Finance Ministry's proposal; it would not be the first time. However, this leaves Russia in a very vulnerable position, in which it is committing itself to the continuation of a large defense plan at the expense of financial stability — a choice it has made before.