RUSSIA'S RESERVES: A $500 BILLION QUESTION

C O N F I D E N T I A L SECTION 01 OF 03 MOSCOW 000496

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SIPDIS

DEPT FOR EUR/RUS, DEPT PASS TO FEDERAL RESERVE, NSC FOR
WARLICK

E.O. 12958: DECL: 02/21/2018
TAGS: ECON ENIV ENRG PREL RS ETRD
SUBJECT: RUSSIA'S RESERVES: A $500 BILLION QUESTION


Classified By: Ambassador William J. Burns for reasons 1.4 (b/d).

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Summary
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1. (C) Russian government policy has been to use its windfall
from oil and gas revenues to build large reserves, rather
than to address the country's many domestic needs. The bulk
of Russia's reserves, which are approaching $500 billion, are
held in low-yield government bonds in foreign currencies.
The GOR has publicly maintained that this policy is driven by
concerns over inflation and corruption but government
officials acknowledge privately that psychological factors
also play a role: specifically the GOR sees the reserves as a
hedge against external shocks and as evidence of Russia's
return to great power status.


2. (C) The GOR's current plans are to further increase the
reserves while directing most of the increase into Sovereign
Wealth Funds that will seek investments with a higher rate of
return. However, pressure is reportedly building in Russia's
private sector to begin using the reserves to address the
country's deteriorating infrastructure and to reinforce its
social welfare systems. In the near-term, the main effect of
this policy choice will be felt in Russia and whether to draw
down the reserves to improve infrastructure and social
programs could prove a key issue for Medvedev early in his
presidency. Longer-term, Russia's growing reserves and how
they are used could also pose questions for the global
economy writ large. End Summary

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Russia's Current Reserves Policy
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3. (SBU) James Fallows, a Beijing-based American journalist
wrote an article for the January 2008 edition of the Atlantic
magazine entitled "China's $1.4 trillion question." In the
article, Fallows questions why a relatively poor country like
China would in effect loan a wealthy country like the United
States $1.4 trillion -- the total of China's reserves, most
of which is invested in U.S. Treasury notes. Fallows'
article set us thinking about Russia and its reserves --
Russia's "$500 billion question."


4. (SBU) Like China, Russia has a policy of building up large
reserves. As of February 2008, Russia has $481 billion in
government reserves. In absolute terms, this is the third
largest total after China and Japan. And like China, though
there are rich Russians, Russia as a whole is relatively
speaking still a poor country, ranking around 60th in per
capita income according to most measures.


5. (SBU) Unlike China, Russia's economy is not driven by
manufactured exports. Instead, Russia's reserves have been
largely fueled by the government's share of rising oil and
gas revenues. Russia is the world's largest exporter of
hydrocarbons, and energy prices have increased by nearly 400
percent in the last ten years. The GOR has stockpiled much
of this windfall in government reserves, most of which are
held in low-yield government bonds in a mix of currencies,
including the U.S. dollar.


6. (SBU) The oil and gas revenue has entered the government's
reserves either through the "Stabilization Fund," which is
controlled by the Finance Ministry, or into the Central
Bank's traditional reserves via the budget surplus, 4.8
percent of GDP, in 2007. The Central Bank's reserves are
currently by far the larger of the two components, with more
than $400 billion compared to the $157 billion (as of January
30) that has accumulated in the Stabilization Fund.

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Why Russia Has Large Reserves
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7. (SBU) Publicly, the GOR claims that the reserves are
intended to "sterilize " the economy from the run up in
energy prices and thereby prevent inflation. The argument
advanced by Deputy Prime Minister Kudrin and others is that
had this additional liquidity found its way into the economy,
it would have tipped a growing economy into an overheating
one. The IMF Resrep in Moscow seconded this argument in a

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meeting with us and said the sterilization policy had helped
to reduce inflation in recent years. (N.B. However, he also
said the main cause of renewed Russian inflation, which
reached 12 percent year-on-year in January, was lax monetary
policy and that the government's efforts to control it,
including the build up in reserves as well as price controls,
would not be successful without monetary tightening.)


8. (C) The second argument advanced by the GOR for its large
reserves, again often stated by Kudrin himself, is that the
GOR is concerned that if the windfall from oil and gas
exports were to be spent, official corruption would consume a
large percentage of the funds. At a January meeting of the
Moscow G-7 Economic Minister Counselors, several of the
western diplomats with long experience in the country
supported both the inflation and corruption arguments but
still argued that in economic terms it made little sense for
Russia to maintain large reserves, especially in such
low-yield investments, and particularly, in light of the
country's many needs.


9. (C) Vadim Grishin, Kudrin's aide, acknowledged to us that
economically speaking it made little sense for Russia to
maintain such high reserves. He gave inflation and
corruption relatively short shrift as explanations, instead
arguing that the main cause was psychological. The
government elite needed the security the reserves provided.
The crash of 1998, when the country essentially went broke,
had been a searing experience for Russia's governing elite
and they wanted to maintain a hedge against future shocks,
such as a drop in the price of oil and gas. Grishin said the
government did intend to eventually use the funds to address
the country's deficiencies, he specifically noted the pension
system, but that implementation of these plans was still some
ways off.


10. (C) Another "psychological" explanation for Russia's
large reserves is that it buttresses the GOR's claims to have
returned to great power status. The German Economic Minister
Counselor said that he saw this as a key part of the
explanation. Russia uses its large reserves as visible
evidence of its economic success and to support its claims to
more influence in international economics. Grishin
acknowledged that this was also part of the explanation,
noting that "political realties" had yet to adapt to the new
"economic realties" internationally. For instance, he
complained that in Tokyo earlier this month, the discussion
on financial markets had been by the G-7 rather than the G-8.
Given Russia's increasing weight in international economics,
including its large reserves, it should have a greater voice,
including within the World Bank and the IMF.

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What will Russia do with its Reserves?
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11. (C) There is reportedly pressure building among some
Russian elites for the government to begin spending the
reserves. Igor Yurgens, the senior Russian partner at
Renaissance Capital, recently told us that all of the young
entrepreneurs and economists that he knows were
overwhelmingly supportive of investing the reserves now, in
particular in upgrading Russia's infrastructure. Yurgens
noted that former Minister of Trade and Economic Development
German Gref, who had supported the current policy while in
government, had now publicly called for spending the
reserves. And Yurgens predicted that Kudrin would also
change his point of view if and when he left government.


12. (C) Roland Nash, one of Renaissance's senior analysts,
said driving this view is a sense that Russia's growth will
begin to slow if infrastructure bottlenecks are not addressed
and if Russia's human capital is not renewed. He told us
that much of the wealth generated in Russia over the last ten
years could be thought of in accounting terms as
depreciation. Russia has invested very little in maintaining
the infrastructure it inherited from the Soviet Union. Among
the results are crumbling roads, an overstretched electrical
grid, and deteriorating ports and airports. According to
Nash, the country needs to invest upwards of a trillion
dollars in infrastructure alone and still more in its social
welfare systems.


13. (C) Yurgens said the GOR may also begin to face public

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pressure to spend the reserves. He noted that the National
Priority Projects in health, education, agriculture, and
housing, which have been headed by President Putin's
designated heir, Dmitriy Medvedev, were intended in part to
provide political cover for the government's overall economic
policies. However, Yurgens, who has been part of a small
commission advising Medvedev on the projects, said that to
date few funds have been spent and the focus has been on
relatively small "pilot projects" that have had little effect
on society at large. As president, Medvedev may face
increasing calls to make good on his past NPP promises.


14. (C) Despite this pressure, the GOR is unlikely to begin
spending down the reserves any time soon. In fact, a large
increase in the reserves is more likely to occur, as Russia
is about to change both the way it accumulates reserves and
how it invests them. Russia's 2008-2010 budget calls for the
Stabilization Fund to be divided into two parts: a Reserve
Fund and a National Welfare Fund, both of which but
especially the latter appear to be Sovereign Wealth Funds.
The Reserve Fund will henceforth accumulate all oil and gas
revenues up to 10 percent of GDP (which would have been
roughly $125 billion or so in 2007). All remaining revenue
from oil and gas over and above the 10 percent figure will
accumulate in the National Welfare Fund. The government
budget, though deprived of oil and gas revenue, will be kept
in balance through transfers from the Reserve Fund as needed
through at least 2010.


15. (C) If the GOR sticks to its current plans and energy
prices remain high, the two SWFs, the Reserve Fund and the
National Welfare Fund, could double in a year, and in just a
few years, will dwarf Russia's sizeable traditional reserves.
The Reserve Fund, along with the Central Bank's reserves, is
to continue to be held in low-risk, low-yield, government
bonds as well as bank deposits. However, the National
Welfare Fund is supposed to undertake riskier investments
with potentially greater returns. Grishin told us that for
the time being the National Welfare Fund would also be
invested very conservatively. It would not yet, for
instance, be invested in corporate bonds, let alone any
direct investments in enterprises. Grishin added that the
mix of currencies in which Russia put its reserves, dollars,
euros, and pounds sterling might be altered to include yen
and that the weight would also likely change if the dollar
continued to lose value.

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Comment
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16. Russia's $500 billion dollar question, soon to be a much
larger question, is whether the GOR will use its reserves to
jump start a process of renewing its physical infrastructure
and its social welfare systems. Medvedev may have to decide
whether to draw down the reserves to achieve some of the
economic modernization and social improvements he has already
outlined in public statements. As of now, however, the signs
are that the GOR is not planning to do so any time soon. The
effects of this policy decision are likely to be felt
initially primarily within Russia, where the decision to
further build up the government's reserves could prove
unpopular with many Russians, who may begin questioning the
government's priorities. Longer term, if Russia follows
through on plans to invest its increasing reserves more
aggressively, it could have consequences for the global
economy.
BURNS