An approaching storm

For a few months this year, government officials in Moscow experienced a certain feeling of euphoria. Oil prices had not only stopped falling, but had even moderately increased. Exports had increased somewhat, while inflation had fallen. People were talking about reaching the trough of the crisis once again. Amid this chorus of loud ostentatious optimism, lonely warnings about the imminent further fall in oil prices went unheeded.

The latter came, as always, unexpectedly. Negative messages quoting indicators of global markets appeared side by side with even more alarming data about the number of oil rigs in the US. Technological progress and improvements in technology had once again played a cruel joke on Vladimir Putin and Co. Rather than die and go broke under the weight of relatively low oil prices, the US shale business chose to improve its efficiency and has reduced the production costs once again, to a level where even 25 dollars a barrel is not a critically low price anymore. The number of rigs drilling for oil in the US is growing again, and by the end of the year, it will be almost as high as it was before the price slump began. Even those not holding important offices in the relevant Russian ministries will not find it difficult to guess how this will affect the market where excess supply of hydrocarbons is not only failing to fall, but continues to grow.

The continuing decline in oil prices and, most importantly, gloomy economic prospects have caused the financial department of the Russian government to sound the alarm. The reduction of budget expenditures by 15 percent was canceled because of the State Duma elections scheduled for September. However, it is already clear that figures and volumes written into the budget law are simply unrealistic. Increasingly, people talk about reducing spending by 27 to 32 percent.

It would not matter that much, if not for the fact that there is no space left for cuts. Healthcare, utilities, and education have reached the limits of endurance, and any new cuts would see the system simply collapse. On the other hand, the growth of the budget deficit over the past six months is likely to bring about the exhaustion of the Reserve Fund by the end of the year or next spring.

Deputy Finance Minister Tatyana Nesterenko said just that at the “Territory of the Meanings” forum. “But if nothing changes, by the end of next year we will have neither reserves nor money left to pay salaries. Our economy’s current size does not allow for our obligations which we have run up and have to fulfill... Thus, politicians must evaluate and chose the decisions that will allow us to make a manageable escape from this situation, hard as they may be.”

According to the Russian Ministry of Finance, as of July 1, 2016, the Reserve Fund amounted to 38.22 billion dollars, or about 2.5 trillion rubles, and the National Wealth Fund stood at 72.76 billion dollars, or 4.7 trillion rubles. At the same time, the federal budget deficit reached 1.5 trillion rubles in the first half of 2016, while the annual limit was set at 2.4 trillion rubles. That is, the second half deficit should not exceed 0.9 trillion rubles. The revenue fell by 12 percent over six months year-on-year, while the share of oil and gas revenues decreased to 36 percent. Driven by these developments, the budget deficit will clearly overshoot target figures.

Of course, one can always start to live within one’s means. It would mean stopping the Syrian adventure, withdrawing Russian troops from Ukraine and cutting off support for the Donbas separatists. Also, it would involve a significant reduction in the defense budget, hitting not only long-term projects, but operating expenses as well. This would have, firstly, significantly reduced the deficit and secondly, allowed the state to reallocate funds to the civilian sectors, without which normal life is impossible.

The Russian defense industry is running at maximum capacity, as shown by the case of Kalibr missiles. As reported by Nezavisimaya Gazeta in Moscow, chief of the Russian Armed Forces’ Chief Directorate for Armaments Lieutenant-General Anatoly Gulyaev said in the course of the single day of military acceptance that 47 Kalibr ship-borne missiles had been accepted by the Russian Navy. The paper compares the known facts. Missile-armed ships of the Caspian Flotilla struck 11 targets in Syria with 26 Kalibr missiles. Back in November, 18 rockets struck 7 targets. It comes to 44 missiles used in total. Thus, the industry has only made up for the spent missiles. It is probably enough for an hour of combat, but what if tomorrow’s war will be fought against a real opponent, as opposed to Syrian terrorists? The likely answer is obvious. By the way, the report caused outrage among military officials. Interestingly, their rebuttal does not discuss the number of missiles used, but only the cost of the missiles.

Budget cuts do not decrease the appetite of the defense-industrial complex (DIC) in the slightest. This became clear at a recent meeting which was presided over by Prime Minister Dmitry Medvedev. State corporations which are involved in military production demanded additional funding. This time, they had to be content with spending increases for “priority measures” only. According to Deputy Defense Minister Dmitry Bulgakov, the latter mean the completion of construction of 450 new ammunition storage facilities. Defense industry and military were firmly told that the main objective of war preparations was to strengthen the economy and to widen its basis, not to increase indefinitely the production of armaments.

At the same time, the current military expenditures have not been reduced. As many as 4,000 military exercises are to be held this year, and units are receiving new military equipment, albeit ordered in more prosperous times. Till the end of the first half of 2018, little will have changed in this respect. As they say, the Kremlin will part with its last remaining ruble to build the Crimean bridge and fund military expenditures.

The Russian authorities still have some leverage allowing them to regulate the situation.

Firstly, they may opt for money creation. It will lead to a further weakening of the ruble against the major currencies, but it will allow to technically reduce the budget deficit. It will be followed by inflation, but the latter will take some time to emerge.

Secondly, as noted by former Russian presidential adviser Andrei Illarionov, Russia’s international reserves stood at almost 400 billion dollars on June 17. In the case of the budget deficit going to five percent of GDP, it can be funded from this source. However, the example of Venezuela shows that gold sales on the international market provide only very short-term respite.

Its outward calm notwithstanding, the Russian economy is approaching the center of the storm. Nesterenko has warned about it. The prime minister’s offer to the masses is to “hang in there.” In particular, teachers should earn some extra money on side. He did not specify, though, how exactly they should do it. The options are quite limited.