Russia 110708 Basic Political Developments

National Economic Trends

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Alfa Bank

The government yesterday approved key parameters for the 2012 budget, with the budget deficit at 2.7% of GDP when under $93/bbl for oil prices. The budget draft assumes a budget breakeven of $125/bbl, which did not come as a surprise. The bad news, however, is that this increase in the breakeven happened despite the introduction of a 10% payroll tax on annual salaries above RUB 512,000.

As we mentioned yesterday, the 11% y/y increase in expenditures came as a surprise, as it appears to contradict Medvedev's recent budget address calling for controlled budget risks. Furthermore, we are very surprised by the silent approval of the 10% payroll tax on higher-level salaries, which offsets the positive effect on business that was expected from the reduction of the payroll tax rate from 34% to 30%. While we have discussed this risk previously, we were not expecting that this measure would be approved without discussion. The fact that even after the introduction of this additional payroll tax the breakeven is expected to increase to $125/bbl next year is definitely NEGATIVE.

While the market reacted positively yesterday, we reiterate our cautious view. First, the reaction was due to the significant reversal of the plan for the next three years, which previously implied flat spending in real terms but now assumes around 10% real growth for the period. However, we believe that this is a reflection of 2012 political trends that could return to consideration within the government. Secondly, as 80% of the increase in overall spending will be compensated by the increase in tax revenues, the net impact on the real sector will be relatively modest. Finally, we consider the $125/bbl breakeven too high, which may result in a call for tightening in policy soon.

Natalia Orlova

Pre-election Budget Maneuver

The Russian Government Is Finding It Hard to Trim Deficit Spending in its Pre-election Budget

By Tai Adelaja Russia Profile 07/07/2011

With Russian parliamentary elections on the horizon, the Russian government is opening up its treasury and plans to spend trillions of rubles on pumping up salaries, raising pensions and easing the social tax burdens on businesses. The cabinet on Thursday considered the country’s largely predetermined budget parameters that provide for 3.8 trillion rubles ($135.66 billion) in social spending, by far the largest item in the three-year federal budget. The preliminary budget further puts baseline defense spending at 1.85 trillion rubles ($66 billion) and another 1.69 trillion rubles ($60.2 billion) has been earmarked for security and law enforcement.

Over the next three years, the Russian government plans to spend 293.3 billion rubles ($10.47 billion) to raise public workers' salaries using indexation mechanisms. Another 1.2 trillion rubles ($42.84 billion) will go toward building new roads and upgrading the country’s dilapidated transport infrastructure. State pension funds will continue to get a boost after a surge in commodities prices helped bolster state finances. The government plans to transfer 2.3 trillion rubles to the funds this year and up to 3.1 trillion by 2014. Easing the social tax burden for companies will cost the budget 236.4 billion rubles in 2012 and another 275.6 billion rubles in 2013, according to the budget parameters considered on Thursday.

Despite rising global oil prices, the new spending spree is expected to punch a hole in the budget. The federal budget deficit is expected to make up 2.7 percent of gross domestic product in 2012-2013, which is twice the 1.3 percent calculated for 2011, but should drop to 2.3 percent in 2014, according to the preliminary budget drawn up by the Finance Ministry. Prime Minister Vladimir Putin told the cabinet on Thursday that Russia's federal budget deficit this year may in fact be lower than 2.7 percent of GDP. “The projected budget deficit in 2012 is 1.6 trillion rubles ($57 billion), or 2.7 percent of GDP ... We hope that next year the real deficit will be lower than projected,” RIA Novosti quoted Putin as saying. Putin added that the government should continue to look for ways to achieve a deficit-free budget.

The Cabinet may have to forgo its plans to cut government spending and return to a deficit-free budget in 2015, Vedomosti business daily said Thursday, citing unnamed sources at the Ministry of Finance. The country's 2012 budget is based on an average oil price of $93 per barrel, but Finance Ministry officials have said that the government can only achieve a deficit-free budget if Urals crude, the country's chief oil export blend, is trading at $124 per barrel. The government is hoping to pay for the budget deficit mainly by borrowing about 1.6 trillion rubles ($57 billion) over three years, and tapping into incomes from its privatization program which could yield up to 300 billion rubles ($10.7 billion), Vedomosti reported. That will still leave the country with a national debt equal to 11.2 percent of gross national product in 2012 and 17 percent of GDP in 2014. Putin said Thursday that the budget could receive 10.6 trillion rubles ($378.42 billion) in revenues in 2012, while government spending is expected to reach 12.2 billion rubles ($435 million).

Total public debt is expected to grow to about 10 trillion rubles ($356 billion) from 6.6 trillion rubles ($235 billion) over three years, Vedomosti reported. The country recorded its lowest debt level in 2008 when it barely hit 6.5 percent of GDP. Despite expanding pre-election spending, the Finance Ministry appeared determined to protect Russia's two sovereign wealth funds, the Reserve Fund and the National Welfare Fund. The Reserve Fund is expected to grow from 1.4 trillion rubles ($50 billion) in 2012 to 1.6 trillion ($57 billion) in 2014. However, further transfer to the fund is expected to stop in 2014 as the government expects revenues from oil and gas to dip to 7.7 percent of GDP in 2014 from a high of 8.2 percent in 2013, the Finance Ministry said. That means that Russia's "safety cushion," the country’s sovereign wealth funds, will flatten out over three years, going down slightly from 2.56 trillion rubles ($91 billion) in 2012 to 2.53 trillion rubles ($90 billion) in 2014.

The government hopes to use a combination of tax increases and spending cuts to spread the burden of bringing down the country's budget deficits over the next three years. An increase in the tax burden on the gas sector is expected to boost budget revenues by 504.2 billion rubles ($18 billion) while keeping the present level of contract soldiers could save the budget an additional 371.1 billion rubles ($13.2 billion). The government also hopes to save 179.7 billion rubles ($6.4 billion) by withholding its contribution to the country's mortgage fund and an additional 54.3 billion rubles ($1.9 billion) is expected from reducing the number of army servicemen.

However, the budget also reflects government determination to keep its controversial procurement system intact while it considers proposals to cut back on its budget by 300 billion rubles ($10.7 billion) over the next three years. The government is also planning to go ahead with all its investment and other federally targeted programs. As a way of patching the budget hole, regional and municipal authorities will be required, starting next year, to channel into the federal budget about two-thirds of all revenues from excise taxes on alcohol and hydrolysis spirits as well as a stamp duty on motor vehicle registration and penalties for traffic violations.

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Renaissance Capital
July 8, 2011

In our view the new medium-term fiscal framework for 2012-2014 raises serious concerns about government's previous intentions to balance the budget by 2015. The Russian Ministry of Finance (MinFin) yesterday (6 June) announced its medium-term fiscal framework for 2012-2014 and the key macroeconomic assumptions underpinning those projections (Figure 1). The most salient feature of the new budget framework is that the headline deficit is estimated at 2.3% of GDP in 2014, thus jeopardising previous claims targeting a balanced budget by 2015. While the federal deficits remain broadly unchanged, relative to the previous framework as a share of GDP, we think this masks the fact that these are achieved at much higher forecast oil price levels, suggesting a substantial increase in expenditure. This naturally implies heightened vulnerability to oil price fluctuations.

The macroeconomic assumptions on GDP, inflation and oil prices seem realistic. The underlying macroeconomic assumptions on output growth and inflation are broadly in line with our own view on the medium-term prospects of the Russian economy. We have argued that in a post-crisis environment, characterised by subdued G-10 growth and with less scope for multi-year oil price increases, Russia's potential growth is about 4.5-5%. The government assumes 3.5%, 4.2% and 4.6% GDP growth for 2012, 2013 and 2014, respectively. With regard to inflation, it is expected to decelerate gradually from 7.5% in 2011 to 5.0% in 2014. This implies average annual nominal GDP growth of about 10% which, in our view, accurately reflects the current macroeconomic environment. At the same time, in contrast to the earlier practice of making fairly conservative assumptions on oil prices, the fiscal framework now anticipates an average oil price of $95/bbl over the next three years.

However, the significant non-discretionary increase in public spending on the eve of elections is a key driver of the deteriorating fiscal position. 2012 expenditures are increased by RUB947bn ($33.8bn) while 2013 outlays are raised by RUB1,242bn ($44.4bn) relative to the previous budget framework which ran until 2013. The key areas that will see increases in spending are pensions, public sector salaries and military personnel. In addition, a planned reduction of the social security tax from 34% to 30% will also be compensated for by increased allocation of budget funds. Overall, we see the nature of the planned increases in government expenditure as conveying the message that these are conveniently done to match the upcoming political cycle. After two consecutive years of nominal expenditure growing lower or in line with inflation (5% in 2010 and 9% in 2011), subsequent spending growth is set to accelerate to levels above those of projected inflation (11% in 2012 and 10% in 2013). We believe this has thrown to the winds earlier intentions to maintain slightly negative real expenditure growth to reverse the massive pre-crisis expansions of real spending (Figure 2).

Most worrying to us, the non-oil structural deficit remains in double digits as a share of GDP until the end of the forecast period. The headline deficit numbers do not look excessive, but it presents a somewhat misleading picture of the health of public finances, since in commodity-exporting economies, one has to adjust for volatile natural resource revenues in order to get a better sense of the underlying fiscal stance. We therefore compute the structural non-oil deficit, which adjusts the headline budget number for the state of the economic cycle. The new fiscal framework brings an adjustment of only 1.7% of GDP of the non-oil deficit from 2011-2014 (from -11.5% in 2011 to -9.7% in 2014). This also leaves the non-oil structural deficit at about twice the level consistent with preserving the country's oil wealth constant over time (-4.7% of GDP). The latter was also the government's own recommended target which was enshrined in the budget code, but removed in late 2008 to allow for accelerated anti-crisis spending.

The $125/bbl oil price which balances the budget suggests heightened sensitivity to external shocks. The rise in the break-even oil price over the past couple of years has been nothing short of exceptional and suggests the increasing vulnerability of the budget to adverse shocks in commodity prices. This process has of course been driven by the steady expansion of government spending pre- and post-crisis. While the severity of the 2008 crisis correctly led to an aggressive counter-cyclical fiscal policy, the economic recovery has also argued for a reversal of fiscal spending and a consolidation of fiscal policy. Unfortunately, the pressures arising from the upcoming parliamentary and presidential elections have dented previously espoused ambitions to rein in spending, necessitating very high oil prices to balance the budget, in our view.

The budget framework does not bode well for inflation and raises the chances of an earlier rate hike. We previously maintained the view that government's avowed intention to pursue negative real expenditure growth was commendable as it demonstrated a desire to bring the non-oil deficit back to more normal levels. We also argued that, although not ambitious enough, this policy is at least consistent in flavour with its genuine expenditure-consolidating mood. However, the latest medium-term framework delivers a serious blow to our beliefs as it suggests a much weaker ambition to steer fiscal policy on the right track. Given the tight historical correlation between government spending and inflation, our more benign inflation view will also come under threat. Consequently, interest rates may need to be raised earlier than the end of the year, as we previously argued. Overall, we believe the new fiscal framework is sending the wrong message at a time when consolidation should have been the overriding policy objective.

Consumers feeling better

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UralSib
July 8, 2011

Consumers more confident... Based on a Rosstat survey, consumer confidence recovered and grew from -13% in 1Q11 to -9% in 2Q11. The index of expected changes in the economic situation in the near future grew 4.8 ppt QoQ to -0.2%, indicating that more people are expecting the economic situation to improve over the next 12 months. The index of changes that have occurred in the economy rose 5 ppt QoQ to -7%, meaning that the number of people valuing past economic changes as negative has de- creased. The index of expected changes in individuals' material standing grew 5 ppt QoQ to -3%. The index of past changes in individuals' material position also rose 4 ppt QoQ to -10%. The number of respondents who consider their material position has deteriorated, declined to 30% from 35% in 1Q11. The index of favorable conditions for large purchases grew 5 ppt QoQ to - 23% and the savings index improved 4 ppt QoQ to -39%. Consumer confidence improved among all age groups, but, positively, the main improvement was recorded among the younger population aged 16-29 years.

... thanks to improvement in their financial position. Consumer confidence rebounded after a sudden drop in 1Q11, due to a hike in the social tax at the beginning of the year. The latest economic statistics show that the economy has improved after a weak start to the year and unemployment has declined close to the pre-crisis level. However, real incomes are still falling, despite growth in real salaries and higher retail sales, indicating that domestic demand is still quite strong, which is also confirmed by im- ports growing at a faster pace than exports. We believe that real incomes are negative due to a decline in entrepreneurial income as it has partly moved into the gray economy after the tax increase at the beginning of the year. Consumer confidence improved on a QoQ basis in the larger European economies, such as Germany, France and Britain, but declined in PIIGS countries, due to the latest spike in the sovereign debt crisis. We forecast further improvement in consumer confidence as we expect GDP growth to accelerate to 4.5% YoY in 2H11, which will support consumer spending.

Alexei Devyatov