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 SIPDIS 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). -------------- Summary -------------- ¶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 -------------- Russia's Current Reserves Policy -------------- ¶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. -------------- Why Russia Has Large Reserves -------------- ¶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 MOSCOW 00000496 002 OF 003 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. -------------- What will Russia do with its Reserves? -------------- ¶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 MOSCOW 00000496 003 OF 003 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. -------------- Comment -------------- ¶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