Markets are in turmoil following yet another oil shock to the Russian economy. But Russia has made enormous progress since the last time oil prices collapsed in 2014 and the Ministry of Finance is sanguine about the outlook for growth and spending this year. bne IntelliNews crunched the numbers to see just how bad a $10 fall or more in oil prices is.
Russia aims to keep the federal budget in surplus and the economy growing over the next three years, despite the recent fall in oil prices.
Oil revenues are expected to slide significantly, but the corresponding fall in the value of the ruble will mitigate that decline to some extent. As the Russian budget calculates spending on the basis of oil revenues denominated in dollars but spends in rubles, the government is actually one of the biggest winners from the devaluation that comes with falling oil prices. Although there are less dollars coming into the budget from oil exports, they buy a lot more rubles and the spending allocations do not change even if those rubles are worth less.
Russia’s decision to free the ruble in 2014 has created a mechanism to cushion the economy from a really nasty oil shock and analysts are almost unanimous that the CBR has learnt its lesson from 2014: it will not burn through its hard currency reserves to defend the ruble in this crisis. In 2014 the ruble fell from circa RUB35 to dollar to a low of RUB80. This time round the ruble immediately dropped like a stone following Russia’s decision to withdraw from the OPEC+ deal on March 6, falling from circa RUB68 to the dollar to RUB75 as the market opened again the following Monday. But since then it has already clawed back some of its losses and was trading at RUB71.4 at the time of writing on the morning of March 12.
Russia has been making a big effort to diversify its revenue base away from oil but in 2019 budget oil revenues still accounted for 40% of the total tax take. According to the three-year budget plan now in place, that figure is supposed to fall to 35% by 2022.
However, the reduction in oil and gas revenues – despite the boost from the FX effect – will not be completely covered by the ongoing rise in non-oil revenues, largely driven by growing agricultural exports. Russia remains vulnerable to the drop in oil prices, but it has been careful to buy some protection in the form of reserve funds.
As part of the budget's makeover since a near-miss financial crisis in 2016, when a RUB2tn ($27bn) hole in the budget could not be filled, has been the hunt for new revenue sources. Deep reforms have been made to the tax service and new sources of income found, chief among them being an increase of 2pp to the VAT rate and a rise in the retirement age.
As a result of fiscal consolidation, federal budget spending in 2018 reached a 10-year low of 16.1% of GDP, while the tax take has grown by 20%, despite only a small increase in the tax burden.
Spending is set to rise over the next three years, according to the new new budget, thanks to the implementation of the 12 national projects. However, this spending hike will not be that dramatic, as much of the spending on the national projects will be financed by reallocating existing spending on other areas and will be supported by private sector spending. All in all, economists estimate the share of spending will rise to around 17% of GDP in the coming years. Already much of the spending on the projects in the first half of this year will be financed by funds allocated last year that were not spent on time.
And even if low oil prices persist, then the Ministry of Finance says it has enough in the National Welfare Fund (NWF) to cover a shortfall for up to 10 years.
The NWF contained $150bn as of the start of March, or circa 9% of GDP, and remains flat at a level of $42 for a barrel of oil. If oil falls below these prices the NWF can be used to fund the difference and if the size of the fund drops below 5% of GDP then spending from the fund is capped at 1% of GDP, or about RUB1tn per year, imposing an automatic austerity response if the fund begins to get too small.
In general, balancing the fund continues to be the priority of budget policy in the next three years, according to experts. At the same time, the question of how to replace the shortfall in oil and gas revenues in the future remains unanswered, according to Ilya Sokolov, an economist writing in the Economic Times.
NWF and non-oil deficit
The problem with the current budget plan is that the assumptions for both the oil prices and ruble exchange rate already look far too optimistic.
Oil prices plummeted from around $55 in February to $32 on March 10, although they had recovered somewhat to $37 for Brent at the time of writing. Analysts and the government are still assuming an average price around $55 for this year.
The value of the ruble also collapsed from RUB68 to RUB75 and is very likely to remain weak for at least the rest of the first half of this year.
Let’s dig into the numbers and see in detail what the budget will look like going forward. The key to the government’s plans to keep its boat afloat is the $150bn it has in reserve in the NWF.
In 2019 the government is expecting to collect a total of RUB20,174.9bn ($272.6bn) in tax revenues, of which RUB11,933.5bn ($161.3bn) is from oil, or 41% of the total. That is also equivalent to 7.6% of GDP, but this share is supposed to shrink steadily over the following years to 6% of GDP by 2022.
The NWF held RUB8,249.6bn ($123bn) as of March 1, which is the equivalent of 7.3% of GDP. The fund is fed by siphoning off excess tax revenues from oil sales from anything earned when oil is over $42.2, but this money is held on account by the Central Bank of Russia (CBR) and the accounts are reconciled periodically.
That is why the size of the fund stepped up so dramatically last summer and nearly doubled in size overnight. Taking this accounting quirk into account, as this year’s excess oil money has still not been formally deposited in the fund, the NWF will be worth about RUB10tn, or $150bn when the accounts are next reconciled.
On the face of it, the Russian economy looks pretty healthy and able to withstand the oil price shock for quite a while, thanks to the huge “rainy day” fund.
However, to better understand the true health of the economy it better to look at the “non-oil deficit.” This is the budget deficit Russia would have if all the oil magically disappeared.
Russia has always used its oil revenues to subsidise its spending and this is one of the reasons the Ministry of Finance has been able to keep income tax at 13% and corporate tax at 21% for the last two decades – amongst the lowest tax rates in Europe. During the boom years while the government ran a headline budget surplus, the non-oil deficit was consistently about -4% of GDP. Even though Russia Inc. was running at a profit, if you took out the de facto subsidy the Russian economy earns from just having oil, then it was running at loss if you look at it as a business.
The oil subsidy has been a huge boon and allowed Russia’s economy to make continuous progress ever since Russian President Vladimir Putin took over in 2000, when oil prices began to rise. It allowed the state to keep taxes low. It allowed wages to be increased by about 10% a year for a decade to bring public wages in line with private sector incomes. It allowed the Kremlin to completely modernise the military since 2012, while still meeting its social sphere and other public expenditure obligations. And it has paid for a total transformation of basic infrastructure to bring it more or less in line with the rest of Europe. Now that subsidy will help fund the RUB27tn ($400bn) spending programme for the national projects, while still meeting the social spending largess that Putin promised during his January 15 state of the nation speech.
During times of crisis the non-deficit blows up as the Kremlin digs into its reserves. During the 2008 crisis the non-oil deficit ballooned to 13% of GDP and spiked again in the 2014 crisis to about 9%. But since then the government has managed to bring it down to 5.7% in 2019 – almost back to normal levels – which is a considerable achievement. It says that Russia Inc. is almost back to “normal” after multiple shocks over the last decade and a half.
Going forward and the current budget sees the non-oil deficit starting to increase again, rising to 6% this year and 6.7% in 2022. With the collapse of oil prices, that is now almost certainly an underestimate.
The Kremlin had intended to ramp up the subsidies to the real economy in an effort to get the national projects into place in the coming years, but even at a level of 7% this is still a fairly modest increase compared to what was spent in previous crises. As always, Russia is trying to be prudent with its reserves.
The collapse of oil prices will screw up all these calculations. According to bne IntelliNews’ calculations, a fall of $10 in oil prices in 2020 will lead to a reduction in the size of Russia’s economy of 1.2%. Tax revenues would shrink by RUB1,445bn, reducing their share in the tax take from 39.1% to 36.9% and increasing the non-oil deficit from 6% to 7.1%. This fall is enough to put the budget into a deficit of RUB586bn, or 0.52% of GDP, from its current surplus.
But none of this is a disaster. A deficit of circa RUB500bn can easily be financed by just issuing more Russian Ministry of Finance ruble-denominated OFZ treasury bills, without tapping the NWF.
Even if the Ministry of Finance had to make up a RUB1.5tn hole in the budget each year, with RUB10,000bn in the NWF, the government can keep this up for seven years. That stands in stark contrast to 2016, when a RUB2tn deficit almost sparked a major financial crisis and forced the government to “privatise” a 19% stake in Rosneft, which later turned out to be a loan from Qatar.
Indeed, last autumn the Ministry of Finance released its scenarios for the next ten years gaming out super low oil prices and found economic growth falls to zero only at $40, and only if it stays there for a decade. Even at sustained oil price rates as low as $25, thanks to the reserves Russia can still happily function for as much as ten years.
The bottom line is that the oil price shock currently underway will be painful for the Russian economy, but the Kremlin has done its homework and is well prepared for the coming storm. The Russian Ministry of Energy predicts that oil prices will recover to $40-45 per barrel in the second half of 2020 and $45-50 per barrel in 2021, Deputy Minister Pavel Sorokin revealed in an interview with Reuters.
Accounts Chamber head Alexei Kudrin says with oil at $35 per barrel and the ruble averaging 72 to the dollar this year, the federal budget will lose approximately RUB3tn and run a deficit of just under 2% of GDP. The economy will experience nearly zero growth, not the 1.9% growth initially predicted by the economy ministry. If oil prices average $40 per barrel this year, the situation will be slightly better, Kudrin predicts, but GDP growth will still fall far short of initial expectations.
The key indicator is the non-oil deficit. Russia’s economy is still in transition and as it has failed to develop domestic institutional investors that provide a foundation of long-term money, its markets and economy remain very vulnerable to these shocks. But the non-oil deficit shows that each one of these shocks does less damage than the last one. Thanks to its huge reserves and the fact that corporate Russia has massively deleveraged since 2014, it is well placed to weather this shock with relatively little damage.