KUDRIN ON RUSSIA'S RISING DEFENSE BUDGET AND

C O N F I D E N T I A L MOSCOW 002865

SIPDIS

STATE FOR EUR/RUS, EEB/IFD
TREASURY FOR TORGERSON
DOC FOR 4231/MAC/EUR/JBROUGHER
NSC FOR ELLISON

E.O. 12958: DECL: 09/25/2018
TAGS: EFIN ECON ETRD PREL PINR RS
SUBJECT: KUDRIN ON RUSSIA'S RISING DEFENSE BUDGET AND
CONTINUING FINANCIAL CRISIS

REF: A. MOSCOW 2800

B. MOSCOW 2804

Classified By: Ambassador John Beyrle, Reasons 1.4 (b/d).

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Summary
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1. (C) During a September 23 meeting with the Ambassador,
Finance Minister Aleksey Kudrin said defense spending in 2009
would increase only slightly. He acknowledged that there was
pressure for greater increases because of the current
tensions, but said Russia did not want and could not win a
new arms race; higher defense spending would destabilize the
Russian economy. In a candid discussion of Russia's
financial crisis, Kudrin explained that the increased
liquidity the GOR had provided in recent weeks would not
remedy the economy's main weaknesses: oil dependence and an
underdeveloped financial system. He predicted that the
banking sector would be hit hard by the crisis and said the
GOR would not bail out every bank that was in trouble.
Kudrin added that he valued consultations he had with senior
Treasury officials this year as well as Secretary Paulson's
frank assessment of the U.S. market's current distress. He
said he was looking forward to seeing Paulson in Washington
in October at the World Bank/IMF meetings. End Summary.

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Higher Defense Spending but Not Too High
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2. (C) In response to the Ambassador's question about
whether the budget would be affected by defense or
agriculture spending increases, Kudrin responded that federal
expenditures would change very little from the planning
reflected in the 2009-2011 budget that the GOR had approved
and submitted to the Duma in late August (Ref A).
Expenditures would remain steady as a percentage of GDP. He
conceded, however, that defense spending would increase in
the 2009 budget but said the increase would be "symbolic" and
similar to the increase in the 2008 budget.


3. (C) Kudrin indicated, however, that there was
considerable pressure within the GOR to devote even more
resources to defense spending. This was a consequence of the
increased tensions with the U.S. over the Georgian conflict
as well as disagreements over NATO expansion and missile
defense. Russia did not want and could not win another arms
race. Moreover, the Russian military would have difficulty
absorbing a large increase in its budget and using the funds
effectively, and a big increase in its budget would be seen
by Russia's neighbors as a threat. Kudrin admitted that
higher defense spending could also have a destabilizing
effect on the Russian economy. He expressed hope that
U.S.-Russia tensions would subside, and thus pressure to
raise defense spending would subside as well.


4. (C) Describing his comments as his "personal opinions"
(but similar to what we've heard from other senior GOR
officials),Kudrin said that expanding NATO to include
Ukraine was both hasty and short-sighted. He suggested that
MAP for Ukraine took no account of the historical ties
between the two countries or the intricate web of personal,
familial and professional relationships between Russians and
Ukrainians that would be damaged. Kudrin accepted the
Ambassador's statement that neither NATO nor NATO expansion
posed a threat to Russia's security, but he maintained that
Russian citizens would not see membership for Ukraine that
way and neither would many Ukrainian citizens.

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Russia's Financial Woes: More on the Way
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5. (C) In a candid assessment of Russia's financial crisis,
Kudrin said GOR action to increase available liquidity during
the last month had done little more than temporarily provide
breathing room for banks to meet their short-term
obligations. The main underlying problems were the country's
dependence on oil and an underdeveloped financial system,
both of which raised the risks in the Russian markets. He
compared Russia to other emerging markets but said softening
oil prices and the flight to quality had shown Russia to be

more sensitive than China or India to global trends. The
banking sector's poor financial intermediation had also made
the economy increasingly dependent on net capital inflows,
and those in-flows were now declining.


6. (C) Kudrin said the effect of the crisis on Russia's
banking sector would likely be severe. Banks have relied
heavily on foreign capital for medium and long-term financing
and declining access to that capital would put them under
pressure. In addition, he pointed to the distress that had
befallen KIT Finance and Svyaz Bank. Both banks had used
their holdings of shares in Russian firms as collateral on
the interbank loan market, and when share prices plummeted,
both had defaulted on their obligations.


7. (C) As part of its efforts to keep the situation under
control, Kudrin said that the GOR had orchestrated Leader
Asset Management's takeover of KIT Finance (Ref B) and had
also taken steps for state bank Vneshekonombank (VEB) to
absorb Svyaz Bank. However, the GOR would not be able to
facilitate the rescue of every distressed financial
institution; those decisions would be made on a case-by-case
basis. He speculated that many banks were having
difficulties meeting their obligations and that the crisis
would quicken the pace of the banking sector's consolidation
as many small and medium-sized banks were closed or taken
over by larger banks.

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Good Relationship with Treasury
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8. (C) Kudrin said that he valued the opportunities that he
had had, particularly in the last few months, to consult with
Secretary Paulson and senior Treasury officials on the
evolving financial crisis. He also expressed gratitude for
the helpful discussions with Treasury on the margins of G8,
G20, and APEC meetings and he expressed appreciation for the
recent exchanges with Treasury about Russia's holdings of
Fannie Mae and Freddie Mac bonds as well as Secretary
Paulson's views on the turmoil currently affecting U.S.
markets. He hoped that he and Secretary Paulson would have
time to meet at the upcoming World Bank/IMF meetings and that
there would be the usual G8 meeting among Finance Ministers
to discuss anti-money laundering, counter-terrorist
financing, and assistance issues.


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Comment
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9. (C) Kudrin was extremely candid, in line with his stated
interest in keeping the lines to Treasury open as Russia
wrestles with a financial crisis that he clearly worries is
not yet under control. His reassurances that as Finance
Minister he opposes large increases in defense spending --
and for that matter any increased spending in this time of
economic uncertainty -- were consistent with his advocacy of
budgetary discipline above all. However, nationalist
pressures to increase military spending will test his ability
to win the final argument on this. End Comment.
BEYRLE