2016 - Russia’s Year of the Financial Reserves

Even as expectations for the Russian economy in 2016 continue to plummet, commentators seem unanimous that Russia will weather the fall because it has low debt and sufficient reserves to cushion a large and growing government revenue shortfall.  However, weathering the fall looks decidedly uncertain.

The economic data are unremittingly bad.  The government’s preliminary estimate for GDP in 2015 is that it fell -3.7%.  Underlying economic indicators fell further.  Retail sales fell -10% in 2015 and capital investment fell -8.4%.  With inflation peaking at about +16%, real wages fell by -9%.  The fall in retail sales is particularly troublesome because, after oil and gas sales, Russia’s growth has been based on domestic consumption.  The government reported that the economy shrank -2.5% in January, which is less than in December but a rate of decline still far greater than the official projection for the year as a whole.  The economy will have to strengthen significantly to meet official projections after such a poor start.

At the moment, government spending is all that fuels the economy; particularly manufacturing, where the government has placed its hopes for survival; I’m sorry, "revival".  However, government spending is falling, with the government already seeking another -10% budget cut this year.  Pensions, public sector salaries and social payments are being trimmed and eroded by inflation.  Military spending has been protected from cuts and helps to bolster the manufacturing sector, but military spending is not a solution.  Apart from overseas sales, domestic military sales is the government paying itself in depreciating rubles.  There is no economic value added.  Nor will the trumpeted few green shoots of import substitution help, because they are small and starved for capital, expertise and demand in the face of falling consumption.

Growing unemployment and underemployment will drag the numbers lower and GDP will catch up with the fall in consumption and investment.  In fact, it would not surprise to see the preliminary number for 2015 GDP revised downward.  First quarter 2016 will look little better.  Growth expectations for 2016 have been falling steadily and, since the beginning of the year, have taken a steep dive.  In December expectations were still only slightly negative at -0.6%, reflecting a general view that Russia had put the worst of the economic crisis behind it--a view famously expressed by Putin himself.  In January though general expectations fell to -1 to -2%. Russia’s new credit rating agency, for example, expects the economy to decline by -1.7% in 2016 ([TASS Business and Economy).

With the economy still plummeting, Russia is running out of options.  Allowing the ruble to devalue averted a deeper crisis in 2015 but cannot be repeated without undermining the economy entirely.  A lower ruble would increase inflation and push the cost of basic needs far above what many Russians can afford.  Already 2 million more Russians fell into poverty in 2015 and many who did not, saw their purchasing power decline significantly due to inflation.  In 2000, when Putin came to power, there were over 42 million Russians below the poverty line. Today there are only about 16 million.  A huge improvement.  But in 2000 things were looking up with growing oil revenue.  In 2016 things are looking bad and getting worse.  An estimated 40% of Russians are financially stressed, only able to afford their most basic daily needs (wsws.org).  That's 57m Russians.  Before the current economic crisis, Russians’ expectations were much higher and losing ground is not what they were promised.  Having tasted an improved lifestyle for a generation now, not to mention the benefits such as higher pensions, the Russian people are not prepared to see that evaporate with a return to a Soviet era standard of living.  They want not just a stronger, more respected Russia but also the material rewards.

Technical analysis may suggest a bottom for the Russian economy in 2016 because most economic models track the price of oil as a key independent variable, which has to stop falling sometime.

However, the health of the Russian economy, and therefore confidence in its ability to weather the crisis, is now dependent on the Emergency Reserve Fund and the National Wealth Fund.  With investment, consumption and government spending falling, Russia’s reserves are supporting the government budget and business investment.  These reserves are Russia’s last defense against economic collapse.  Finance Minister Siluanov is quoted as saying, “We lose stability without reserves.”

The key variable to watch in 2016 will be the rate at which Russia’s Emergency Reserve Fund is depleted to cover the public sector shortfall.  The National Wealth Fund is based on loans and is substantially committed.  Russia is pulling other strings to mange its shortfall, such as budget cuts, but Minister Siluanov thinks Russia’s Emergency Reserve Fund could be exhausted by the end of 2016 (RT Russian Reserves).  The Emergency Reserve Fund stood at about US$50 billion on January 1, but it has been shrinking by US$6 to 9 billion a month.  It was down US$9.4 billion in December.  At that rate the Fund will not last the year.  The exhaustion of the Emergency Reserve Fund would be a cataclysmic signal of diminishing economic health.   The point at which the fund may be exhausted is perilously close.

Russia also has other financial resources it might draw on by various means to avert an actual liquidity problem if the Emergency Reserve Fund were exhausted, such as its currency reserves held by the Russian central bank (Central Bank).  But that introduces a larger problem.  If Russia were to use its currency reserves at the same rate as it is currently using the Emergency Reserve Fund, currency reserves would fall and the primary pillar of Russia’s financial credibility would wobble dangerously.   It was the plunge in currency reserves in 2014 that nearly caused a financial panic.  Now, the currency reserves--which include the Emergency and National Wealth Funds--are smaller.  Drawing down its currency reserves would be the ultimate signal that Russia’s economy is in fatal decline.

Since confidence is key to a turnaround, a Russian economy with nothing to sustain it but plummeting reserves, held in whatever account, will implode long before the last ruble is spent, because without reserves the last wheel will have come off the Russian economy, and that is a wreck that anyone can see coming a long way off.  Late in the year, perhaps long before the Emergency Reserve Fund is exhausted, confidence in the management of the economy could evaporate and panic may drive the economy off the cliff, as Minister Siluanov fears.

Dirk Mattheisen is a writer and blogger on political economy with a focus on European affairs.  He is also an independent consultant on institutional governance of international economic and financial institutions.  Dirk Mattheisen is a former Assistant Corporate Secretary of The World Bank Group.