Russian election notes: Back to the fiscal-oil price risk

Sifting through this week’s Russian election-related headlines from the point of view of investment risks, we identified a clear economic highlight – one that has to do with fiscal policy.

The story came into focus on 13 February, with the publication of the latest installment – on social policy – of Vladimir Putin’s election platform. The centre-piece is a promise to hike salaries in education and healthcare. Putin himself costed this commitment at 1.5 per cent of GDP. Sberbank economists have since put the number a little lower, at 1.23 per cent of GDP by 2018, with an aggregate additional budget outlay of Rb5 trillion (US$170 billion) over the six years of Putin’s prospective second term.

The ‘big spend’ continues

This big new long-term burden on the budget comes on top of the huge commitments – above all, with regard to pensions and defence – that Putin has made since the 2008 crisis. So there is no let-up in “Putin’s big spend” (the title of our recent analysis of fiscal risks, available to TS subscribers). The rationale also remains unchanged: if Russia is to achieve its national ambitions, pensions must not fall below subsistence levels; the armed forces and police must be properly paid and equipped; and – to highlight the main intended beneficiaries of this pre-election commitment – so must doctors and teachers in higher education, who are to be paid twice the regional average salary by 2018.

In the previously published economic policy part of his manifesto, Putin reaffirmed his traditional commitment to fiscal discipline, saying that spending appetites must be restrained to match available revenues. The reality is and will continue to be different, however: over the next six years spending regarded as essential and strategic will simply be mandated and financed … well, by some combination of (in order of preference) higher-than-expected growth, larger budget deficits and higher taxes.

The relentless increase in spending pressure on the public finances will also be felt in the short run. This is because of pre-election sweeteners, including chunky items such as a fuel price freeze, which entails compensating oil companies by means of reduced excise duties on oil products and which will cost the budget about US$1 billion in foregone revenues; fuel subsidies for the agricultural sector’s spring sowing season totalling US$1.2 billion; writing off tax debts owed by individuals , which requires another US$1.2 billion; and an immediate 30 per cent increase in teachers’ pay in 2012-13 (cost: US$6 billion). Irina Lebedeva, TS Economist for Russia/FSU, estimates the total cost of all these measures in 2012 at 0.35 per cent of officially projected GDP. None of this is provided for in the 2012 Budget Law, which already includes some obvious election-year features (such as a doubling of military pay) and, partly as a result, envisages a substantial deficit of 1.6 per cent of GDP assuming an average oil price of US$100/bbl.

How will all this play out in policy terms after the new government is formed in May? Senior officials are already talking about serious tax hikes, including in VAT and even income tax. I predict this will not happen. Tax increases will be limited to higher duties on alcohol and tobacco as well as on luxury goods such as powerful cars. The main policy line will be to set about financing the prospective 2 per cent of GDP budget deficit in the hope that the deficit will be reduced or even, as was the case last year, eliminated altogether – thanks to the actual oil price exceeding the official forecast.

To this same end of deficit reduction, privatizations will be resumed. A notable event this week was the press coverage of a letter to Putin from Minister for Economic Development Elvira Nabiullina that, in effect, rebutted the arguments against privatization made by Igor Sechin, the powerful Deputy Prime Minister, in an earlier missive to Putin. And we will also see one of the periodic pushes on the investment climate agenda (including a continuing anti-corruption campaign) aimed at long-term increases in investment and growth, which would make the budget spending commitments all the more affordable.

A ‘fair weather’ policy

All this might seem quite an attractive prospect but for one thing: it is a policy combination that works only in “fair weather”. A sharp oil price correction would radically change the picture. In normal market conditions, financing annual budget deficits of 2-3 per cent of GDP should not be too difficult or expensive, given Russia’s very low sovereign debt stock. But a falling oil price would expand that deficit; and with domestic liquidity squeezed and foreign investors (re-)alerted to Russia’s main macroeconomic vulnerability, deficit financing would become much more challenging. At the same time, the market window for privatization would close; and resorting to tax hikes would further undermine business confidence and hence the prospects for investment and growth.

So if oil fell below US$70/bbl for more than a year, some of Putin’s spending binge would have to go into sharp reverse and his already depleted political capital would drain away. If anything, the present oil price strength on the back of Middle East tensions despite ever weaker demand fundamentals, accentuates rather than allays this vulnerability. This builds up expectations that the oil price will fall sooner or later and that the fall could be all the more precipitate off the present high base.

To conclude: Russian assets will look most attractive not only when political risk is perceived to have been reduced following Putin’s election as president but also once the oil price has corrected and is perceived to be well supported in the medium term at comfortably over, say, US$80/bbl. We can be reasonably confident about the first condition. As for the second, while it does not seem too far-fetched, the wait and accompanying uncertainty could easily drag on.