One of the reasons why the economic crisis triggered by the war and Western sanctions has not caused bigger problems in Russia is that so far both the population and elites could afford to believe that throwing more resources on the war in the short run will allow them to avoid costly, permanent, long-term readjustments. But this will change.
Russian political decision-making has long been struggling with a tension between authoritarian short-sightedness and the desire to ensure the long-term sustainability of the political system either through grand development projects or by enhancing governance to an extent that it can be put on autopilot. Short-termism arguably was likely one of the reasons why the project of the war in Ukraine trumped grand development projects that were unlikely to show sufficient results before 2024.
Short-termism characterized Russia’s answer to international sanctions as well. Russia’s economy is facing a slow-motion crash with cascading effects between various sectors, which will also affect its fiscal balance as early as this year. The Central Bank’s adroit maneuvers have so far saved the financial system from collapsing and, what is probably even more important, created a semblance of stability. Otherwise federal fiscal responses have been fairly small relative to the size of the challenge ahead: under 2 trillion rubles in additional social aid, transfers and debt relief for regions (total federal expenses were planned over 25 trillion rubles for 2022). Budgetary expenses, mostly on research, development and transportation, are going to be cut by 1.6 trillion rubles over three years, seemingly without any strategic perspective. To cover a growing deficit, the National Wealth Fund, with around 7 trillion rubles of liquid assets, will be able to buy government bonds – a fairly inefficient and risky way to spend the funds; rather a characteristically hasty and short-term fix.
As regards individual industries facing drastic decline, the federal response has been even more muted. The automotive industry, which was one of the early casualties of the self-induced economic crisis with 90 percent of automotive plants shutting down entirely or partially, will receive 20.7 billion rubles and new gas stations to “stimulate demand” and will get a new development strategy sometime in the autumn. Failing technology-intensive development projects are expected to take off once the government increases political control over them: each were assigned a deputy prime minister to look over. It is almost certain that efficiency gains can be made here and there with better management, yet again, this rather looks like an attempt to outsource the responsibility for the management of a portfolio without addressing its root causes.
According to Meduza, as of July 2022, Putin’s “economic Politburo” is doing mostly firefighting, not strategic planning. Crucially, Prime Minister Mikhail Mishustin, whose main role since his appointment in 2020 has been to build a government apparatus able to plan and execute strategic projects, is not in it and has kept a low profile throughout the past five months.
A state of limbo
It’s unclear whether members of the government, most of whom had no idea about the February invasion beforehand, think that the challenges Russia is facing are short-term. But political decision-making seems to be in a state of limbo where everyone accepts, for the moment, that it is not them who sets priorities (as Sam Greene presciently noted on February 24, the logic of war took precedence over the logic of politics). The baseless hope that the situation could change meaningfully before the autumn, is still pretty much present even in policy-focused discussions. Those who have sounded the alarm bells – e.g. Rostec chief Sergey Chemezov, VTB chair Andrey Kostin, Sber CEO Herman Gref, Severstal chair Alexey Mordashov) have done so in a manner suggesting that they were crying out for help and trying to scare decision-makers. They were not analyzing a situation that they have accepted as a new baseline. As regards the oil and especially the gas sector, it does not seem as if industry leaders or the government has accepted a permanent loss of EU markets. Rosneft chief Igor Sechin is still a firm believer in his company’s Vostok Oil project, which he called an economic “Noah’s Ark”, even though it is geared towards European markets and its future is all but uncertain after the exit of Trafigura from the project. Russia’s energy blackmail of EU economies could suggest that Gazprom has accepted that its reputation in Europe as a reliable supplier is gone forever and thus by turning off turbines it only incurs short-term costs (or not even those). Or it could suggest that Russia expects to be able to go back to business as usual in the foreseeable future. The visit of Hungarian foreign minister Peter Szijjarto in Moscow where Szijjarto asked for more gas did not only score a PR win for Russia, but also signaled that the government thinks that is has a future on the EU’s energy market.
Five months into the February invasion, both the Russian population and the elite seem to be in wait-and-see mode. While falling volumes of retail and wholesale trade suggest worsening consumer outlooks, this has so far been mainly driven by falling consumption in cities, not the countryside. Industrial decline has not translated into growing unemployment, and the state likely has the power to delay this by putting pressure on employers. Bank runs have been avoided. The ruble is strong, even though this is to a large extent a consequence of a collapse of imports. Most importantly, most people can afford not to think of the war, as there has been no overt mobilization. Meanwhile, economic actors from big business to government decision makers, instead of spending resources on a deep contingency planning, are forced to take a potentially expensive bet on the game Putin is playing, and put these plans off for a later time or trust that they will not be needed.
But at some point, in the near future – we’re talking weeks to months – this will have to change. The question is not when Russia runs out of money but how long it can put off key investments into maintaining its fiscal stability, by betting on the success of an increasingly costly war.
If uncertainty about the time frame or the outcome of the war persists, then in order to ensure the continued flow of money into federal and regional budgets, the government and large businesses will have to make radical adjustments. For this they will have to switch from a short-term to a long-term perspective, which they have been unable or unwilling to do so far. After all, a massive, forced reorientation of the oil and gas export infrastructure to the Asian (mostly Chinese) market would lead to Russia losing the very flexibility that it has been seeking after 2014 when it started ramping up its trade with Asian markets.
It is also a question of money. Grand investment projects – e.g. Northern megaprojects like Vostok oil and LNG projects targeting the European market – will have to be drawn up or reconfigured. But due to companies losing access to financial and export markets, the Ministry of Economy already expects capital investment to fall by 19.4% in 2022 (from an already low level), and there are even worse predictions. Capital outflows are expected to reach a record level this year at $243 billion – almost $100 billion more than in 2014. Therefore, public funds will increasingly have to be used – which the Russian government is already doing – and this money will have to be reallocated from other headings. The state is already moving into some key energy projects, notably the Sakhalin-1 and Sakhalin-2 LNG plants, although this is only partly driven by a desire to ensure their long-term viability. The effective nationalization of the Sakhalin-2 plant caused anxiety in Japan, to which the plant sells approximately 60 percent of its liquefied natural gas. This is likely the kind of anxiety that Far East Minister Alexey Chekunov was expecting when he said in an interview that he expected Japan and South Korea to come around on the issue of selling technology to Russia as they needed Russian LNG shipments.
Tighter budgets
Meanwhile, a stubbornly strong ruble means that fiscal receipts, while still higher than planned in the budget, are now falling behind the Ministry of Finance’s expectations. The Duma approving a windfall tax on Gazprom’s revenues earlier this month, days after the gas company put off paying dividends, suggested that the government is trying to grab as much money as it can, expecting leaner times ahead.
And leaner times are indeed ahead as Russia’s fiscal space is shrinking. It is true that the money accumulated in the National Wealth Fund – the liquid part of which is over 7 trillion rubles – and expected extra oil & gas related revenues of at least 1 trillion rubles will provide a cushion. The Russian government currently expects a federal fiscal deficit of roughly 6 trillion rubles over 2022-25. But there are too many moving parts. In real terms, receipts in June were already significantly below their 2021 levels and the recession is only now starting. Falling oil and gas production – by 17 and 5 percent respectively in 2022, according to an April estimate seen by Reuters – will be a drag on other industries too. Some, e.g. metallurgy, are already experiencing falling revenues even as they have to pay higher taxes.
At the same time, fiscal expenses are growing. Due to the classification of budgetary data, it is difficult to assess what exactly the extra money is spent on. But military spending in April was 630 billion rubles, up from 275 billion in April 2021. Social and sectoral aid and extra transfers to regions have so far made up a relatively small amount, likely because the assumption was – and perhaps still is – that drastically higher military expenses will allow Russia to win the war on its own terms and thus avoid having to make bigger adjustments. With every week that goes by, with every factory closing down, with every step that the EU takes towards closing Russia out of its energy market, this gamble will be increasingly difficult to maintain.
And this is only the federal budget. Regional budgets, even after transfers from the federal budget, are expecting deficits in the coming years and perhaps even this year. As of April, only 27 regions (of 83 and the occupied Crimea and Sevastopol) were still growing. A slow but steady industrial breakdown will affect regions’ own revenues – more than half of which comes from profit and personal income taxes – and municipal revenues, which regional budgets have to subsidize. In July, the government expected a consolidated deficit of 132.5 billion rubles in 2023 and 78.5 billion in 2024, even considering federal transfers. It is unclear whether this fairly conservative estimate already includes reconstruction expenses on the occupied districts of Ukraine, over which 27 regions had to take up “shefstvo”, the increasingly high cost of social aid, the costs incurred by domestic labor migrants who will return from bigger cities, the rapidly deflating construction industry etc.
So far, the federal government’s focus is on problematic regions: those experiencing large-scale industrial decline and/or those that face regional elections in September this year: the Samara Region, Buryatia, Udmurtia, the Maritime Territory, etc. In these regions the injection of relatively small amounts of money – a couple of billions of rubles here and there to finance construction, roadworks or renovations – may make the desired impact. But starting already this year, the federal budget will need to fill the gaps in the budgets of most regions in one way or another, since they cannot afford (and are strongly discouraged) to take out loans on the market. Even without additional transfers or correcting for inflation, which will be very likely necessary, this commits the federal government to spend more than 3.5 trillion rubles of spending a year as a baseline, which is difficult to cut. (Alternatively, regional governors will try to pass part of the costs on to local businesses, as they did during the COVID-19 pandemic, but for obvious reasons this is not easy on a large scale.) Alexey Teksler, the governor of the Chelyabinsk Region, warned of sharply falling revenues for regional budgets in the second half of the year – that is before regions usually submit their requests for additional transfers to balance their budgets, and before the Duma starts discussing fiscal plans for the next three years.
Don’t look up
In short, we are likely weeks or months away from a moment when Russia’s political decision makers and its business elite can no longer play wait-and-see: as companies running out of spare parts and stockpiles accelerate industrial decline, as (and if) the government’s energy blackmail in Europe – which the whole gamble increasingly relies on – does not work, as the government needs to make decisions on major readjustments and back these up with a fiscal plan, they will either have to accept irreversible, long-term changes, or resist.
The Istanbul Agreement on grain exports was a good example of how long-term interests can still influence Russian decision making: Russia’s willingness to negotiate was likely both driven by its strategic interests in the Middle East and Africa, and the interests of its politically connected big agricultural holdings, which have mostly grown by expansion and not by modernization or efficiency gains, and thus cannot afford to be cut off of global markets. The fact that days after the agreement was signed, Russia conducted a strike against the port of Odesa showed how often long-term thinking is upset by short-term impulses and decision-making focused on the interests of a personalist autocrat.
One of them will eventually have to give.