Twelve years ago, Russia defaulted after failing to solve fiscal problems much like the ones now confronting leaders in the Euro area. Today, Russian policy makers are again facing choices that will determine the country’s chances of avoiding another fiscal disaster. In order to keep the deficit unchanged, they must cut expenditures. With public debt at a relatively low level, however, the deficit is a smaller concern than is stagnation—or even recession. The government should not accelerate spending cuts until the economy has recovered.

Default and Deficit Management

The 1998 default charged Russian authorities with the difficult task of eliminating the fiscal deficit without any chance of turning to financial markets for credit. Though the Bank of Russia provided a small amount of financing through mid-1999, the government had largely managed to eliminate the deficit by that time, due to a number of factors:

  • The default and re-structuring of the public debt led to a sharp reduction in the debt service costs.
  • The ruble devalued four-fold, sharply increasing the profits of and tax revenues from raw materials exporters.
  • Annual inflation, which increased from about 7 percent to 30 percent, also increased tax revenues in nominal terms.
  • The government followed a rigid spending policy, refusing to index public wages and pensions at that time.

Since 2000, the steady increase in world oil prices has helped government revenues outpace expenses. By 2003, profits from the oil and gas sector (through export duties and the mineral resource tax) had grown so large that the government used excess revenues to establish the Stabilization Fund—which has since been split into the Reserve Fund and National Welfare Fund.

In addition to oil and gas profits, however, a shift in policy makers’ budget paradigm also proved essential to the radical fiscal improvement: the 1998 crisis created such political turbulence that nearly all political forces agreed that a federal budget deficit was unacceptable. To prevent another crisis, authorities substantially improved the administration of taxes1 and exhibited extreme restraint in spending from 1999 to 2001. They kept federal expenditures at a nearly stable, low level despite growing revenues.

Spending as a Political Tool

The situation started to change, as often happens, with the approach of an election. Though President Putin’s second-term victory in 2002 was widely anticipated, authorities working to build an absolute majority for United Russia, the ruling party, in the State Duma campaigned on promises of increased government spending. Federal expenditures rose to 18 percent of GDP in 2002–2003, up from 14 percent of GDP in 1999–2001, and did not fall following the election.

In 2008, the same pattern recurred as authorities aimed not only to build a constitutional majority for United Russia, but also to ensure a smooth transition of power from Putin to Medvedev. This time, politicians singled out pensioners, who are more active than other groups in elections,  as the primary recipients of additional funds. Between 2007 and 2010, the average level of expenditures reached 21 percent of GDP.2

By 2009, however, the budgetary situation had changed drastically amid the economic crisis and rapidly declining oil prices:

  • Revenues from the oil and gas sector decreased from 11 percent of GDP in the second half of 2008 to 5.9 percent of GDP in the first quarter of 2009 and 7.6 percent of GDP in 2009 overall.
  • Non-oil-and-gas revenues fell from 13.6 percent of GDP in 2008 to 11.2 percent of GDP in 2009.
  • At the same time, the government radically increased federal spending,3 resulting in a deficit of 5.9 percent of GDP in 2009—the first deficit in ten years.

Fiscal Prospects

Does this mean the fiscal situation in Russia is bad? Not at the moment.

The budgetary situation has improved this year. In the first quarter of 2010, oil and gas sector revenues rose to 10 percent of GDP as oil prices increased to $75-$80/barrel, and non-oil-and-gas revenues returned to their pre-crisis levels as a percentage of GDP; as a result, the deficit fell to 3.2 percent of GDP. Higher-than-expected oil prices will likely keep the overall 2010 deficit below its projected level (6.8 percent of GDP, which was based on assumptions of 3.1 percent GDP growth and oil prices of $58/barrel), but a stronger ruble and additional pension increases may not let it fall below 5 percent of GDP.

Currently, the government plans to reduce the deficit to 4 percent of GDP in 2011 and 3 percent of GDP in 2012. The increase in cumulative payroll taxes—which will rise from 26 percent to 34 percent starting in January 2011—should help, though some experts worry that it may increase tax evasion among small businesses. In addition, the Ministry of Finance has proposed cutting nominal expenditures by 5 percent (y/y) in 2011 and freezing wages in 2011–2012. However, such plans would lead real expenditures to be lower in 2011 than they were in 2008.

With elections coming up again in 2012, the government will likely enact new pension increases and continue indexing state employees’ salaries.

Moreover, it is impossible to imagine Vladimir Putin refraining from wage and pension indexation in an election year. In 2008–2009, policy makers seriously restructured the budget by increasing pensions and some social payments to households. As a result, the share of total payments to households (including salaries, pensions, and transfers) in overall budget spending reached 58 percent, up from only 47 percent in 2006–2007. With the election cycle coming up again in 2011–2012, the government will likely enact new pension increases and continue indexing state employees’ salaries, further raising the share of payments to households. Of course, 75 percent of GDP—the level in Greece—is still a long way off, but, as any politician knows, while increasing spending may be very easy, reducing it in nominal terms is virtually impossible in non-crisis times. If wage indexation occurs but the deficit target remains unchanged, all other budget spending (except of payments to households) will be reduced by 30 percent in real terms, according to the Minister of Economics, Elvira Nabiullina.

Choices Ahead

This leaves policy makers with a not-so-simple choice on the expenditures side, compounded by the unstable nature of revenues and their increased dependence on oil prices. If the government chooses to continue increasing payments to households, it will have to either increase the deficit or, in order to keep the deficit unchanged, reduce other expenditures.

Either choice will be difficult. If the Ministry of Finance accepts a higher deficit than originally planned, pressure to further increase spending (and the deficit) may well lead to financial instability. If, on the other hand, the Ministry effectively defends the budget balance, the government will have to cut purchases of goods and services, repairs, and investments, which stimulate economic growth much more than do pension or wage increases. This will reduce domestic demand, slow economic growth, and lead the budget to deteriorate. The decision the government makes for the 2011 and 2012 budgets will determine Russia’s chances of avoiding a budgetary crisis in the medium-term.

The government should not accelerate expenditure cutting until the economy has recovered.

The government should not accelerate expenditure cutting until the economy has recovered. Currently, the deficit is a smaller concern (as public debt does not exceed 15 percent of GDP) than is stagnation—if not recession—of the economy.

Recent changes in budgetary legislation show the government’s apprehension to make this decision. The deadline for submitting the budget to Parliament has been extended to the beginning of October from the end of August, leaving no more than 5 weeks for public discussion. In addition, the government has decided to allow the Ministry of Finance to not publish data on the state of the Reserve Fund and the National Welfare Fund. If the Ministry chooses to use this option, rumors about inappropriate use of the funds will erupt.
Nonetheless, the decision must be made. It will be a tough one—but a very important one for the future.

Sergei Aleksashenko, former deputy minister of finance of the Russian Federation and former deputy governor of the Russian central bank, is a scholar-in-residence in the Carnegie Moscow Center’s Economic Policy Program.

1. The government used the YUKOS case to demonstrate its disapproval of aggressive tax evasion by big companies.

2. Certainly, the financial crisis—or, more accurately, the government’s anti-crisis measures—influenced expenditures in 2009. But this factor should not be exaggerated. The original 2009 federal budget, passed in November 2008, allocated 9.025 billion rubles for expenditures. In developing the anti-recessionary measures, the government decided to finance it not by raising the general level of spending, but rather by reducing a number of the previously approved allocations. As a result, total federal expenditures in 2009 amounted to 9.692 billion rubles—only 7.4 percent higher than the planned level.

3. Spending rose from 18.3 percent of GDP in 2008 to 23.1 percent in 2009 before the fiscal stimulus was adopted, and 24.7 percent including the fiscal stimulus.