VOX: The cost of reform and Putin’s spending promises - part 1

VOX: The cost of reform and Putin’s spending promises - part 1
Russian market in Saratov / Wikicommons
By Ben Aris in Berlin March 26, 2018

bnePeople Russia Vladimir Tikhomirov chief economist at BCS GM 200pxlRussian President Vladimir Putin has made a lot of big spending promises, and while the economy has clearly emerged from an eight-year recession, economists are sceptical that any of the targets Putin set in his latest state of the nation speech can be hit.

But maybe that was not the point. Putin was setting ambitious goals for the government, fully aware that they cannot be reached. The high bar is supposed to be something for phlegmatic bureaucrats to strive towards, and those that get close to the target will be lionised. It's a very Soviet way of organising things that smacks of the Soviet-era five-year plans, BSC Global Markets chief economist Vladimir Tikhomirov tells bne IntelliNews in the latest podcast "The cost of chance and Putin’s spending promises".

Cutting defence

On the other hand, the thrust of the economic first half of Putin’s speech was a clear change of direction: the military modernisation phase that started in about 2012 has come to an end and the president has refocused on restoring the prosperity that was sacrificed in the last six years to beefing up Russia’s military muscle. Now the emphasis is on social spending and investing into Russia’s human capital. How will the Kremlin pay for all this? To start with, defence spending has already been cut by so much that it is affecting industrial production.

“Defence was cut last year as part of the manoeuvre to balance the budget. If you remember, oil prices have recovered from $40, but last year the government was concerned over the oil prices’ stability. At the same time they wanted to cut the deficit, and were looking at the budget expenditure. However, cutting public [sector] salaries is difficult for any government and given the political cycle it is not possible,” Tikhomirov says.

“Defence is a big part of budget spending so they have decided to postpone some defence projects… to push them back to later years and cut the spending in the current year,” he adds.

It is not at all clear how much Russia actually spends on defence as a large part of that spending is secret — especially the parts that pertain to procurement of new weapons. However, even the public part of the spending, which includes spending on police and the costs of maintaining a standing army, are significant.

Tikhomirov estimates the total security spending in the budget, including on police and law enforcement, was about RUB15 trillion ($265bn), which is approximately 15%-17% of GDP. Security accounts for about 30% of total public spending. Of this, actual defence spending is about RUB5 trillion or 3.5%-4% of GDP, according to Tikhomirov.

“But that also includes the spending on the standing forces and not the new procurement of arms — that is the secret part of the budget. I’d say that part could account for somewhere around 1.5%-2% of GDP more — about RUB2 trillion,” Tikhomirov says, adding that the amount is in line with the earlier spending plan announcements at the start of the military revamp.

The programme to renovate the Russian army was announced in 2010 and was supposed to run for 10 years. The total amount publicly announced was RUB20 trillion, which on average comes to about RUB2 trillion a year. “So it all fits,” says Tikhomirov.

Russia’s economy has always been semi-militarised with the military-industrial complex being an important factor in the country’s output. That is still true today, but the military play second fiddle to raw material production.

“[Military spending] is important to certain parts of the economy, especially if you look at manufacturing. In total the share of the defence industry in Russia’s economy in GDP terms is actually fairly low — about 6-8%, perhaps 10% maximum. Much more significant is the resources industry — oil, gas and metals,” says Tikhomirov. “But for manufacturing [defence] is significant. And that is one of the explanations why we have seen this fairly significant slowdown in manufacturing output towards the end of last year, which was driven quite significantly by cuts in defence spending.”

Bold growth targets

Russia’s Rosbank totted up the cost of all Putin’s social spending promises and came to the number of RUB20.5 trillion over six years, which is about half as much again as the Russian government spends each year. Clearly the state is going to struggle to find an extra RUB3.5 trillion a year when it is still running a deficit now, albeit a much reduced deficit. Here too, Putin made big demands, calling for an increase in the size of the economy by 50% over six years.

“It is not very realistic,” says Tikhomirov. “There are various ways to look at this and one way — how Putin probably sees it — is trying to put very ambitious goals in front of the government, demanding more from them, and if they eventually come up with a slightly lower output then that could create more impetus for the economy, rather than setting a more realistic goal and failing.

“But the whole practice of setting targets for six years is a very Soviet way of doing things,” he adds. 

The official forecast for growth is currently about 1.8% this year, and going forward economists agree that Russian growth is limited to around 2% a year unless there are some deep structural changes. But what does that actually mean?

“When people talk about structural change in Russia, and it has been a very fashionable topic for years, there are difficult ways to look at it and there are multiple problems to be resolved,” says Tikhomirov. “You are right to say bureaucracy is one of them — maybe not so much at the federal level where there have been significant changes including in the quality of the people, but if you go down to regional and local government you would find significant over-employment, very low levels of education, very low levels of efficiency, and a lot of corruption that goes with that.”

“From a broader perspective there are two particular areas that need to be reformed in Russia. One is labour: Russia faces a significant demographic problem because of the ageing population. And the second is that the labour force is already shrinking — not dramatically, but it will be shrinking fairly dramatically in the years to come. So something needs to be done about that too.”

Tikhomirov says that more incentives for people to work for a longer period of time need to be introduced, including raising the retirement age. The other one is to improve the quality of labour — creating a situation where the efficiency of the economy would allow it to continue to grow rather than stagnate or fall. And to his credit Putin has talked about both these points, specifically referring to investing into education in his speech.

“Putin put an accent on the quality of labour through education, healthcare, etc. in his speech and that is an idea that has been more profoundly expounded by [former finance minister and co-head of the presidential council Alexei] Kudrin and his centre for reforms over the last couple of years. And Putin has taken these ideas on board,” says Tikhomirov.

How big is the state?

However, that is only half the problem. In addition to making workers work better and longer, the state has to make changes to their workplaces as well. And here observers are a lot less confident the government can make a change.

“The other issue where I and the market are more sceptical is that Putin said he wants to see a lower share of the state in the economy,” says Tikhomirov. “He didn't specify how that could happen. One way is via privatisation but that needs to happen. The role of the state in the economy if anything has expanded over the last few years. The fact is the state now controls a significant part of the economy.”

Last year there was a debate over just how big a role the state plays in the Russian economy. A study by the Federal Antimonopoly Services (FAS) put the number at a whopping 70%, but other studies came to a much more modest number. Part of the issue is what status you assign to companies where the state owns some but not all of their shares.

“Technically some of the larger companies like Sberbank, Gazprom and VTB are traded, so the state happens to be the largest shareholder … but there is a significant amount of private capital in these companies and so they are not 100% state-owned,” says Tikhomirov.

“If one looks only at 100% state-owned companies the share is much smaller: in the range of 30%-40% max. If you add in the largest companies that are effectively controlled by the state and fulfil state orders, then the share of the state is 50% for sure. 70% is a bit too much,” says Tikhomirov.

Whatever the precise figure, clearly a large proportion of the Russian population is dependant on the budget — either directly or indirectly — for their income.

“Russia has 42mn pensioners, all receiving funding from the state and that is one-third of the Russian population. That is before you count people employed by state-owned enterprises (SOEs). If you kick in the largest state-owned companies, which are also the biggest employers, then of course the number is more than 50%.”

State companies are inefficient and if the Russian economy is to increase in size by half then productivity needs to be boosted — a point that Putin has made repeatedly (and another one of Kudrin’s ideas). However, the radical way to making this change would be to sack millions of people from their SOE jobs and force them to move to the private sector. The main objection to this reform is there are simply not enough private sector jobs available to employ everyone. And there is little motivation for the government to push this sort of change. In a capitalist market the top priority for companies is to strive for maximum profit, but in Russia the SOEs’ top priority is simply to survive and pay at least a modest wage, as mass unemployment would be politically destabilising.

“The reason why I and the market are sceptical is that if these large companies are transferred to the private sector then they would not be inclined to carry out political orders, and these are crucial to the survival of the state,” says Tikhomirov. “In many instances they do play a crucial role and often a wider geopolitical role. So it is highly unlikely that the Kremlin will give away its control over these companies.”

This is the first of two parts. Watch out for the second podcast and follow-up article coming soon. Listen to the full interview in the podcast here. Sign up to receive bne podcasts as they are released by email by registering here