The consequences of Putin’s big spend

CONTEXT

As is often the case with noisy political events, the sacking of Russia’s long-serving Finance Minister Alexey Kudrin on 26 September has highlighted a risk factor that was already visible to those with eyes to see. The risk in question stems from the precipitate deterioration of Russia's underlying fiscal position. At the same time Kudrin’s decision to throw in the towel pulls into sharper focus the political drivers of the fiscal loosening during the past four years. This, in turn, provides the essential background for answering the main questions addressed in this report: when Vladimir Putin resumes the presidency, how will the Russian government respond to this challenge and what will be the investment implications of that response?

What exactly is the risk and how great is it?

We believe that on a medium-term horizon of three to five years the key risk lies in the heightened vulnerability of Russia’s public finances to oil price corrections.

A good perspective from which to gauge this risk is a benign scenario in which the oil price avoids severe and lasting falls and in which the budget deficit financing strategies that we will be reviewing in this note work out satisfactorily. If left to run its course in this shock-free scenario, the present fiscal track would result in a near doubling of the proportion of public debt to GDP at a time when global markets have become much more sensitive to sovereign debt risk. However, the increase in debt is coming off such a low base – from 9.3 per cent of GDP at the end of 2010, which according to an official estimate will rise to 17 per cent by 2014 – that Russia will continue to seem something of a fiscal oasis compared with Europe, the US and many countries in Russia's EM peer group. Put another way, it will be several years before market worries about the sustainability of Russia’s debt path start to drive up real interest rates. During Putin’s next presidential term, the real risk will hinge instead on the ability to finance the federal budget deficit. If a depressed oil price undermines financing plans, leading to abrupt tax hikes or (more likely) some reneging on spending commitments, the resulting destabilization will be not only macroeconomic but also political.

The most telling snapshot indicator of this underlying vulnerability is the sharp annual increases in the average oil price at which the federal budget would balance. Chart 1 below highlights how this “break-even oil price” (as estimated by the Finance Ministry) has leaped up again even in the past year – from the range of US$105-109/bbl in the three-year budget projections made in 2010 to US$110-116/bbl in the draft budget for 2012-14, which was approved in its most recent form by the government on 21 September.

The fiscal outturn in 2011 will be flattered by the oil price surge caused by the “Arab spring”. However, the latest official forecast that the deficit will disappear altogether may yet prove somewhat optimistic: besides the possibility of recent oil price weakness on global growth fears persisting through Q4/11, Putin used his electioneering speech to the United Russia party congress on 24 September to announce a new 6.5 per cent increase in public sector wages from 1 October (following a similar hike last June). Looking further forward, the projected federal budget deficits for 2012-14 are lower than the equivalent forecasts contained in the 2011-13 budget enacted last year for the sole reason that the average oil price is now assumed to be around US$100/bbl compared with the US$75-79/bbl forecast one year ago.

Source: MinFin.

More revealing still, the oil price forecast has been raised even since the first draft of the 2012-14 budget was considered by the government in June, when it stood at US$93/bbl for 2012. One of Kudrin’s last initiatives as Finance Minister was to accompany the revised budget draft with a stress test based on a US$61/bbl oil price (this figure was chosen because it was the actual average price in 2009). Under present tax and spending plans, this produces deficits of around Rb3 trillion (US$94 billion) – which is in the range of 4-5 per cent of GDP – in each of the next three years. In such an environment, bond market financing could no longer be relied upon and the government would have to fall back on what remains of its Reserve Fund (that part of the old Stabilization Fund designated for last-resort deficit financing). The roughly Rb800 billion left in this fund is set to be supplemented at the end of 2011 by up to Rb1 trillion in proceeds from this year’s government bond issues no longer required to finance the current year’s deficit, which, as already indicated, will be at or close to zero (see Chart 2 below).

But even if the government went on to raid all of the Rb2.7 trillion in the National Well-Being (NWB) Fund, which, in effect, is the sovereign wealth fund, the cupboard would be bare halfway through this three-year stress test scenario. At that point, some spending commitments would start being reversed. Although the initial cuts could be expected to fall on, say, military procurement programmes rather than direct social transfers, the squeeze would be tangible. The obvious effect would be on aggregate demand resulting directly from reduced government consumption and indirectly from the effect of such a shock in pushing up interest rates. (In our view, a fiscal shock of this kind is the main transmission mechanism from a lower oil price to lower growth. An oil price correction, which in itself is not enough to cause such a fiscal shock – even quite a material one down to, say, US$80/bbl – would have a milder effect on output than suggested by many analysts’ forecasts.)

Any such fiscal shock would also spell political destabilization since it would undermine the aura of Putin’s rule having rescued Russia from the painful 1990s, when such budget “sequestrations” were routine. Thanks to the well-stocked Reserve Fund, that aura survived the shock of 2008 with flying colours. But the relentless fiscal slippage since then could prevent a repeat of that successful performance in a fresh crisis.

How did it come to this?

The factual answer to this question is simple: in the political cycle now ending, Putin has made a series of large and irreversible new discretionary spending commitments – above all. on pensions and defence. The more interesting part of the answer involves interpreting Putin’s departure from the path of fiscal virtue. A correct reading of this negative turnaround is essential for our main call on what Putin will do about the fiscal problem during his next presidential term.

Pension spending surge . . .

At the height of the crisis that began with the global financial crash in late 2008, the reality of the long-term spending surge and consequent emergence of a structural deficit was camouflaged by the case for counter-cyclical stimulus and by the presence of some genuine automatic fiscal stabilizers, such as higher unemployment benefits. The single heaviest new permanent drain on the federal budget was first planned well before the crisis, in 2007: this is the increase in pensions of around 50 per cent introduced in late 2009 and early 2010, supplemented by a further 10 per cent hike in 2011. The dependence of the State Pension Fund on transfers from general taxation will start growing again from 2012 as a result of the part-reversal of this year’s (economically damaging) increase – from 26 per cent to 34 per cent – in the basic rate of payroll tax that finances the pay-as-you-go pension system (and other social security benefits). This transfer is officially forecast to rise by 2014 to Rb3.2 trillion or 4.6 per cent of GDP (this estimate will rise further because it was made last June before the average oil price assumption for 2012-14 was raised from US$95/bbl to US$99/bbl).

. . . now matched by military and police pay rises

This pension financing forms the bulk of the social transfers that have traditionally been the largest component (around 30 per cent) of all federal budget spending. But from now on, social spending will be matched by the scale of the combined outlays on the armed forces, police and other security and law enforcement agencies. In terms of formal budgeting, the main burden stems from hikes in military and police pay, costing a combined Rb1 trillion in 2012 alone. However, this pales in comparison with the commitment to spend Rb20 trillion on re-equipping the armed forces during the next 10 years. As Kudrin remarked in early September, this commitment is unfunded: in 2012, for example, the defence procurement budget is “only” Rb750 billion, supplemented by the contingent liability of state guarantees on Rb175 billion worth of bank loans to the military-industrial complex.

Putin’s doublethink

Although this spending surge is clearly linked to the forthcoming elections (and this applies in particular to this year’s announcement that military pay will be doubled), we believe that the more important part of the main explanation lies not in election tactics but in Putin’s vision of national strategy.

A condensed paraphrase of Putin’s various public remarks about these spending decisions over the years could run as follows:

Our recovery since the collapse of the 1990s and the national goal of being a sovereign, self-reliant, self-respecting and respected world power means that we cannot tolerate a state of affairs where the average monthly pension is below the officially defined minimum subsistence income [the 50 per cent pension hike was designed to close that gap once and for all] and where our armed forces are degraded.

If the above “quotation” reproduces the sense of Putin’s actual words, the second part of the rationale is implicit (but nonetheless clear):

We will take on this extra spending because we can.

In other words, Russia’s very low public debt and strong growth performance over the past decade make it possible and reasonable to proceed with this extra spending even if that means running budget deficits.

In parallel with such statements runs another thread in all Putin’s public presentation of policy: his attachment to fiscal conservatism. In his speeches on the economy, Putin frequently evokes the success of the counter-cyclical fiscal policy of the 2000s (he displays a clear awareness that this is the policy success for which he can claim most credit, unlike the good luck of higher oil prices) and the danger spelled by fiscal profligacy to national sovereignty (which lately has been driven home by allusions to Greece and other fiscally challenged Western countries).

These contradictory tunes recall what Alexander Solzhenitsyn termed the “doublethink” of the communist period, in which citizens went along with the propaganda while maintaining, in another part of their conscious brain, their own view of reality. In our opinion, this Putin doublethink helped keep Kudrin at his post throughout this period of risky fiscal expansionism. That is, Kudrin seems to have counted on Putin’s fiscal discipline instinct regaining the upper hand – partly under his (Kudrin’s) influence, based on his friendship with Putin dating back to their days as colleagues in the St Petersburg city government of the early 1990s, but mainly on the strength of their shared policy triumph of the Stabilization Fund. A striking piece of evidence of this came in the context of his ill-fated statement in Washington D.C. that he would refuse to serve in a Medvedev-led government because of disagreements over fiscal policy: in the same breath, Kudrin said that “Putin has a very keen feeling for problems and reacts to them in a very serious way”.

In short, Kudrin’s approach boiled down to damage limitation in the short run with a view to repairing the damage as soon as circumstances allowed. In early September he spoke (at a conference organized by Reuters) of the prospect of a new reform drive after the election, starting with “a fundamental review of all tax and spending”. This, incidentally, was the speech that gave rise to speculation that Kudrin was set to become prime minister after Putin’s expected return to the Kremlin. Regardless of whether Kudrin himself expected such a promotion or was simply looking forward to continuing as Finance Minister under Prime Minister Putin, his hopes of securing an early fiscal adjustment were clearly based on the influence he could bring to bear if he went on reporting directly to his old friend Putin – as opposed to Medvedev or anyone else.

The fiscal risk management menu

There are three main ways of addressing Russia’s increasing fiscal vulnerability and/or financing the chronic deficit financing requirement in the range (depending on oil price outturns) of anything up to 5 per cent of GDP per year. In descending order of effectiveness and sustainability, these are:

• A fundamental adjustment – that is, a package of tax rises and spending cuts sufficient to remove the structural budget deficit

• Bond market financing

• Privatizations

1. Up-front adjustment

This was Kudrin’s recommended approach. His recommendations were set out in his last two major public statements as Finance Minister – the Reuters conference speech mentioned above and a speech to the State Duma on 21 September. They boiled down to a call to take the unpopular steps required to return the public finances to a stable footing. His preferred measure was to reverse some of the defence and social spending commitments, but if that was not possible (and Kudrin clearly had little hope of achieving that), taxes would have to rise. Kudrin stressed that he was against higher taxes in principle but that they were the lesser evil compared with macroeconomic instability. At the investment conference he signalled that these steps should, or even would, be taken at the outset of the new political cycle, when new elections (hence populist pressures) would be at a safe distance in the past. In the Duma, he played down that part of his message, while also presenting an increase in the pension age (another constant Kudrin refrain) as an alternative to tax rises.

Raising the pension age is no panacea . . .

In our view, tax hikes and reduced state pension obligations are not alternatives but a necessary combined means for any effective adjustment. Put another way, a raised pension age is a pre-condition for balancing the budget (because the total number of pensioners will steadily increase while entitlements will be inflation-indexed at least); but it is not a sufficient condition – either in the short or the long term. The reason for this is that everyone of pensionable age receives his/her pension entitlement even if he/she remains in work, as many pensioners do. Currently, pensioners comprise 29 per cent of the economically active population. Were the pension age to be raised by five years, this same level would be reached by 2024 (if not earlier, given that any such change would in practice have to be phased in gradually).

The same effect of postponing rather than solving the problem would result from a more radical decision to raise the pension age by 10 years. But such a step would lead to other problems. Quite apart from the general social discontent that this reform would cause, the financial benefits would probably be diluted by the incentive for the large contingent of working pensioners to avoid legalized payrolls (why contribute to pension and social funds if the pension age is close to average life expectancy?).

. . . while planned and possible tax increases are inadequate or counter-productive

To achieve long-term budget stability and provide decent retirement incomes, all aspects of the pension system need overhauling; and we believe this must include fresh hikes in payroll taxes. The collateral damage to investment and consumption from just such a hike was visible in early 2011, with SMEs faring worst. Fresh Rosstat data on Q2/11 GDP were notably lower (3.4 per cent year on year) than the earlier Ministry of Economic Development estimate of 3.7 per cent. The difference is attributable to weaker-than-average growth in small businesses.

Unless present spending commitments are reduced, similar hikes – with similarly negative side-effects for the investment climate – will be required in other taxation, with all taxes being possible candidates except for those on the already over-taxed oil sector. The one firm tax rise planned for 2012 is on the tobacco and alcohol excise duty – although this cannot, in our view, justify the projected increases in non-oil revenues as a percentage of GDP (see Table 1 above). The implicit assumption would appear to be that the higher oil price will stimulate overall growth and that higher nominal GDP will boost budget revenues from all sectors not only in nominal terms but also as a percentage of GDP. The trouble with this assumption, however, is that it does not square with the government’s own latest macroeconomic forecasts for 2012-13 – which, despite the higher projected oil price, estimate slower real GDP growth relative to last year’s forecast with inflation unchanged (contained inflation will have a net neutral effect on budget spending and revenue). It is more likely that in reality, overall budget revenues will fall as a percentage of GDP.

2. Bond market financing

This year has seen an important and positive development in the form of the Finance Ministry tapping only the domestic bond market to finance the budget deficit (originally forecast at 3.6 per cent of GDP). Gross issuance of these bonds (OFZ) in the year to date already exceeds Rb1 trillion.

If continued, this trend will bring benefits in the short, medium and long terms.

• In the short run, even if the fiscal rationale for this bond issuance has been overtaken by the effect of the higher oil price, the monetary benefit is real. By absorbing domestic liquidity in this way, the Finance Ministry has lent valuable support to the Central Bank’s (CBR) counter-inflationary efforts (namely, hiking interest rates and allowing the ruble exchange rate to float more freely), which are bearing fruit in the accelerating decline of headline CPI (now below 8 per cent in annualized terms and on course to end the year not far above the CBR’s originally stated target of 7 per cent).

• Further progress with this transition to inflation targeting – hence much-reduced volatility in real output and asset prices (our November 2010 report The big test for Russia’s new monetary policy set out this fundamental re-rating driver in detail) – will require a deeper domestic financial market as the necessary transmission mechanism for the policy rate to be effective as a nominal anchor. The Finance Ministry’s expansion of the OFZ market is working towards that goal not only in general but also in the concentration of the bulk of this year’s new issuance in the middle to longer end of the yield curve (maturities of five to seven years).

• In the long term, a pre-condition for financial deepening – essential for steadier and sustainable investment-led growth – is keeping interest rates positive in real terms and anchored by the OFZ as the central “risk-free” instrument. At the time of writing, the weighted average OFZ yield is moving into positive real territory. The immediate cause of this positive strategic development is the negative market conjuncture. An important test to watch as risk aversion eases will be whether the Finance Ministry’s debt management team will try to drive yields back down into the familiar negative real territory or, on the contrary, keep nominal yields relatively stable as inflation continues to fall.

Even if market conditions improve, yield contraction will be held back by the rapidly tightening liquidity in the banking system. In light of this, the Finance Ministry has announced a reduced issuance plan for Q4/11.

Easier access for foreign investors

Looking forward to 2012 and beyond, there will once again be a substantial budget deficit to be financed; and the Finance Ministry plans a material net increase in domestic public debt of Rb4.4 trillion – or nearly US$150 billion, which is only slightly less than the total amount of Russian Eurobonds now outstanding (including state, municipal and corporate bonds). Given that lower inflation will keep liquidity in the domestic financial system tighter than in 2011, softer domestic demand for OFZs will need to be offset by attracting more international investors to this market.

One key practical step in this direction has already been taken: as a result of new regulations due to enter into force in early 2012, it will be possible for OFZ trades to be cleared in the Euroclear system (as has long been the case for Brazilian local currency bonds and many other EM peers). A further reform planned for next year would allow trading in local bonds to take place “over the counter”. These changes will significantly broaden the potential range of global institutions that would be able in practice to invest in ruble-denominated bonds.

3. Privatization

The chronic and unpredictable deficit financing requirement will strengthen the government’s incentive to implement its new privatization programme. This programme was expanded and made more radical in August 2011: the number of major companies included grew from 10 to 21; and in several cases (including major companies like Rosneft and RusHydro) the goal has changed from divesting minority stakes to outright privatization in the sense of reducing the government’s shareholding below the 50 per cent control level.

Non-recurrent privatization revenues are not a sustainable way to finance recurrent budget deficits. In addition, given the wider benefits of privatization (reduced state presence in the economy and greater competition leading to higher investment and productivity gains), maximizing sale proceeds for the budget should not be the sole or even the top priority. At the same time, the attractions of privatization as a deficit financing expedient are obvious and will be strong. Moreover, the annual privatization revenues of Rb 300 billion (US$10 billion) forecast for 2012-14 look conservative. That target could be exceeded by a single placement of a minority shareholding in one or two of the major companies on the list. The greater danger – especially given the orthodox assumption that privatization revenues should be used to finance specific projects rather than general deficits – is that above-budgeted privatization proceeds are diverted into pet projects rather than used towards deficit reduction.

INVESTMENT CONCLUSION

Our forecast is that Putin will choose not to hedge against the macroeconomic and political risk stemming from the effect on the public finances of a deep and long-lasting oil price correction (a scenario which, as discussed in the previous section, would require the price to fall by at least 40 per cent and not recover for more than a year). In other words, he will not go for an up-front fiscal adjustment after being elected president once again in March 2012. Incidentally, we would have taken the same view even if Kudrin had remained at the helm in the Finance Ministry.

Putin’s acceptance of higher fiscal risk is plainly evident from the most recent public discussions in which he has been involved. Kudrin’s warning in his September 2011 Reuters conference speech about the danger of not being able to fulfil spending commitments and the need to manage that risk by raising taxes elicited a public riposte from Putin (at the annual autumn investment forum in Sochi) to the effect that what was needed was not higher taxes but more efficient public spending. In subsequent remarks, Putin put forward an argument heard from political leaders all round the world that fiscal problems would be resolved thanks to faster growth. He added in his election campaign launch speech on 24 September that the military procurement programme – which, as we have seen, is one of the two main causes of heightened fiscal risk – would itself be an important growth driver.

Two conclusions, one positive and the other negative, can be drawn from this:

• The structural deficit will persist and this creates negative risks not only for overall stability and growth but specifically for portfolio equity investors. In normal circumstances, these risks will play out over the medium term; but they could also materialize abruptly and brutally in the event of a shock.

• The requirement to finance this deficit has the potential to deliver what, relative to the present consensus, would be some positive surprises for investors.

Tax hike overhang

We saw in the “Context” section above how this year’s hike in payroll dues to the pension and social funds damaged firms’ propensity to invest and compromised potential wage growth. This episode illustrates the general fragility of Russia’s investment climate and the particular sensitivity of domestic business to tax instability. That sensitivity would be all the more acute in the face of the more radical tax increases that would be imposed if the government chose to tighten fiscal policy or was forced by some shock into a fiscal retrenchment, which, as in the present Eurozone crisis, would be pro-cyclical.

This negative factor would seem less ominous if it depended on a dramatic oil price correction – which, though all too plausible, may still be unlikely on balance. The unfortunate reality, however, is that the spectacle of continued deficits, even if they continue to be smoothly financed from year to year, will still fuel expectations of tax hikes further down the road. This overhang will to some extent weigh against investment decisions both in general and in those sectors that are perceived to be relatively exposed to the risk of a rising tax burden. Besides likely extensions of already planned hikes in the mineral extraction tax for gas as well as in tobacco and alcohol duties, higher tax projects are known to include a new unified property levy tied to the market value of real estate.

But the main sector at risk is mining, which until now has enjoyed a much lighter tax burden than other extractive industries. Meanwhile, sectors oriented to consumer demand are less exposed since tax hike options feeding directly through to inflation would likely remain low down the government’s priority list.

How deficit funding strategies will benefit the ruble and equities

We have already noted how the expansion of the domestic bond market to meet deficit financing requirements could have positive fundamental side-effects for monetary stability and investment-led growth. From a specific and more immediate investment perspective, the most interesting angle here is the prospect of substantial new foreign funds flowing into this local Russian debt market.

Counter-consensus prospect of ruble strength on foreign buying of OFZs

The implementation of the announced market liberalization measures, in the sense of practical reforms to facilitate access for international institutional investors, deserves close attention at the start of 2012. As argued in our latest EM asset allocation research, weak growth and the related fiscal troubles in much of the developed world will increase the attraction of the returns on offer from EM sovereign debt, especially in local currency. Were this potential to be realized to any meaningful degree in the Russian OFZ market, the resulting capital inflows would put upward pressure on the ruble exchange rate. We highlight this prospect not only as inherently plausible (albeit subject to regulatory uncertainty) but, above all, because it runs contrary to the existing consensus of persistent ruble weakness in 2012 on the back of the expected narrowing current account.

That consensus on a weaker ruble in 2012 includes the latest Ministry of Economic Development forecast, but it is worth noting that the CBR’s draft 2012 monetary programme forecasts the US$36 billion net private capital outflow of 2011 reversing into a net inflow of US$0-10 billion in 2012 in the base case forecast. The possibility of much stronger foreign fund flows into the local bond market must be part of the CBR’s thinking.

Privatization potential is likely to be realized

The other major deficit funding strategy – privatization – is directly relevant to equity investing in Russia and a strong positive driver for the market. Many commentators have remarked on the mechanism at work here – namely, that the fiscal incentive to raise privatization revenues will translate into an incentive to make the slated companies more attractive by improving corporate governance, enhancing dividend policies, accelerating structural reform of the capital market and so forth. That leaves us to consider one risk factor, and one specific kind of privatization opportunity.

Shelving risk is low

The risk is the postponement of most, if not all, of the major privatizations (at least, those planned in the form of public market offerings) on the grounds that acceptable valuations cannot be obtained in a weak and volatile equity market environment. This may make sense during the present global market turmoil – not least given that the main planned privatization offering in H2/11 is a 7.58 per cent stake in Sberbank, whose share price has been hammered by the contagion of the European banking crisis. But the argument that privatizations should be delayed for the sake of notionally higher future proceeds is all too often trotted out as a pretext by officials (and the managements of the SOEs concerned) whose real goal is to stop privatization from happening at all.

We see three reasons for rating this risk as a low one:

• The high-level political commitment to privatization is strong and broadly – that is, not just fiscally – motivated. While Putin may well be less enthusiastic than Medvedev about the outright privatization of prize assets like Rosneft, we believe this hypothetical tension will remain moot during the three to four years which, in practice, the government would need to sell its present 75 per cent shareholding in that company down to 50 per cent – with the budget netting billions of dollars of extra annual revenue all the while.

• Unless markets are in effect closed, the relief from the fiscal headache provided by any possibility of capturing such additional revenue without having to raise a single tax will be overwhelmingly attractive.

• Privatization is a painless way to burnish reformist credentials. It has always been our view that if Putin decided to return to the presidency (as is now confirmed), he will go out of his way to counter expectations of stagnation. The departure of Kudrin could reinforce this effect specifically as regards fiscal policy and performance. Kudrin is widely credited with preventing the fiscal loosening from going even further than it has done. At the same time, his long tenure as a Finance Minister with a highly credible track record bred a certain complacency that the increasing fiscal risks would somehow be contained in the end. It follows that his departure not only damages the Russian government’s fiscal credibility but will also banish complacency. So the need to rebuild credibility will now be combined with a stronger focus on achieving this result. A steady stream of substantial privatization revenues is an effective and relatively easy answer.

General fiscal incentive reinforced by sector specific incentives – as in the power grids

Finally, the general boost to the investment case for Russian equities stemming from fiscally-motivated privatizations will be supplemented by some specific sector opportunities. Companies from one sector in particular are being added to the list of major planned privatizations not only to help increase the overall prospective budget revenues but also to transfer to the private sector a heavy prospective capex burden that would otherwise end up (one way or the other) being yet another call on the already strained federal budget. The sector in question is electricity distribution – that is, MRSK Holding and its regional subsidiaries, which own and operate the low-voltage grids.

Just as the ambitious privatization plans give the government an incentive to pursue general market-friendly reform, so it will be motivated to take the regulatory steps required to enhance the sector-specific investment case for electricity distribution. Regulatory developments in 2011 have been negative, particularly on tariff compression (the allowed returns on the newly defined regulatory asset base). The appearance of MRSK Holding on the expanded list of major privatization candidates (as submitted to the Kremlin by the government in August) points to a positive turnaround in the regulatory trend, which is the main driver of share prices in this sector.

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