Russia's budget deficit has increased significantly in recent months and is likely to remain under pressure due to lower oil prices and higher military spending, Capital Economics said in a note on February 22.

Although the government is not expected to face severe fiscal strains this year, the country's public finances are on a downward trajectory, and wider budget deficits may lead to further interest rate hikes that could potentially crowd out the private sector.

The latest data shows that oil and gas tax revenues slumped by 46% year on year in January to $6bn. Part of the fall was due to changes in the timing of tax collections, which will be resolved over time. However, lower crude and natural gas prices are taking their toll. Meanwhile, government spending unexpectedly surged by 55% y/y in the three months to January, its highest rate since 2007.

All of this has resulted in a 2.5% increase in the budget deficit as a percentage of GDP in the last three months. The deficit currently stands at 3.4% of GDP on a 12-month basis, which is only slightly smaller than during the pandemic. (chart)

Banks appear to have become less willing to buy new debt. The Finance Ministry issued a record amount of ruble debt in the fourth quarter of 2022, with a large share of it being floating rate bonds, tied in some way to interbank rates, with more than 90% being purchased by large local banks. However, the Central Bank reported that the share of auctions bought by large banks in January dropped to 60%, as the majority of placements were fixed-rate bonds that carry more interest rate risk for banks.

“Large bond issuance alongside a reluctance by banks to hold debt have pushed up bond yields and caused a marked steepening of the yield curve – the benchmark 10-year local currency government bond yield is now 11.0%, its highest rate in the past 20 years or so outside of major periods of stress in Russia’s financial markets (2008/09 financial crisis, 2014/15 ruble crisis and 2022 sanctions). The 350bp spread over the short-term policy rate (7.50%) is the largest since 2009,” says Liam Peach, an emerging market economist with Capital Economics.

The Russian government is now issuing a substantial amount of bonds to finance its budget deficit, and the price at which it is selling those bonds has risen significantly since the start of the war.

Despite concerns over Russia's economic stability, the country's risk of experiencing acute fiscal strains remains low. There are various ways in which the government can address the deficit, according to a recent report by Oxford Economics. In addition, Russia's ability to finance its budget deficit domestically offers further reassurance.

One way the government can plug the deficit is by raising taxes on the energy sector, which has already been implemented. The Finance Ministry is considering linking oil taxes to Brent crude oil, rather than Urals, which currently trades at a $30 per barrel discount. This could lead to a significant reduction in the government's financing needs, but would come at the expense of energy firms' profits. Finance Minister Siluanov has also indicated that the government intends to stick to its deficit plan of 2% of GDP this year, and is expecting to receive RUB300 trillion (0.3% of GDP) from a "voluntary" tax on business profits.

Russia can also finance its budget deficit domestically. First, the government can run down assets in the National Wealth Fund, which amount to $150bn. This can realistically be drawn down for two more years before being exhausted, but the Finance Ministry is likely to avoid this. Secondly, the Finance Ministry can continue to issue bonds on the domestic market and exert more influence on financial institutions, especially the large state-owned banks, to hold more debt.

Finally, the government can issue new bonds and pay higher interest rates, which is not a significant concern for Russia. The government's debt-to-GDP ratio is only 16%, and its debt interest costs are low compared to other countries, with Russia spending just 2% of its revenue on interest costs per year. Even if Russia issues all of its debt at an interest rate above 10%, there would be a gradual decline in the government's debt service capacity over time. Although some major banks may reduce their bond purchases, Russia's financial system is large enough that many financial institutions would step in.

“The deficit will remain wide for the foreseeable future. Energy tax revenues are likely to be 2% of GDP lower this year than in 2022 and military spending will probably increase as stocks of military equipment are drawn down. We expect a budget deficit of 2.5% of GDP this year,” says Peach.

The CBR is concerned about the inflationary impact of government spending and is likely to raise interest rates before long, says Peach. There’s also a crowding out effect in the bond market: the rise in bond yields will push interest rates higher across the economy and banks may cut back on lending to the private sector if they continue to add bonds on their balance sheets. But on balance Russia’s economy will likely cope.

“The upshot is that severe fiscal strains are unlikely to emerge in Russia. But a large budget deficit will still have an impact on the economy. Non-defence spending and public investment are likely to be areas that lose out if budget pressures intensify and the war drags on,” says Peach.