GOR APPROVES 2010-12 BUDGET PARAMETERS: ARE THEY

C O N F I D E N T I A L MOSCOW 002064 SIPDIS C O R R E C T E D C O P Y (TEXT) STATE FOR EUR/RUS, EEB/IFD TREASURY FOR TORGERSON, WRIGHT DOC FOR 4231/MAC/EUR/JBROUGHER NSC FOR MCFAUL E.O. 12958: DECL: 08/12/2019 TAGS: ECON EFIN RS SUBJECT: GOR APPROVES 2010-12 BUDGET PARAMETERS: ARE THEY SUSTAINABLE? Classified By: CDA: ERUBIN, Reasons 1.4 (b)and(d) Summary -------------- ¶1. (C) The GOR has approved the macroeconomic parameters of the 2010-12 federal budget based on a moderately conservative assessment that the oil price will remain at $55-57/bbl for Urals. Revenues are expected to grow slightly in line with nominal GDP and expenditures are planned at near current levels. The GOR will run a deficit of 7.5% in 2010 - dropping to 3% in 2012 - to be financed initially by the shrinking Reserve Fund and eventually through international borrowing: Eurobond issues, the World Bank and foreign commercial banks. Analysts are concerned that financing the deficit through an injection of ruble liquidity would be inflationary and upset the forex market. Heavy borrowing on the international markets would lead to a surge in sovereign bond yields, thus crowding out the private sector. Moreover, some experts criticize the budget for neglecting much needed infrastructure development at the expense of social spending. Lastly, many doubt the GOR has the political will to cut expenditures, particularly in the social sphere and loss making state sector enterprises. End summary. Outline of the 2010-12 Budget Parameters -------------- ¶2. (SBU) On July 30, the GOR discussed and approved the guidelines and main parameters of the 2010-12 federal budget. Based on a realistic assessment that the oil price will remain at a moderate $55-57 per barrel for Urals, revenues are expected to grow slowly, almost in line with nominal GDP (about 15.7% of GDP in 2010 and 2011 and 18.5% of GDP in 2012, or 9.961 trillion rubles compared with 9.980 trillion rubles this year). This will result in a budget deficit of 3.2 trillion rubles - approximately 101 billion USD - or 7.5% of GDP in 2010; 2 trillion rubles, or 4.3% of GDP in 2011; and 1.6 trillion rubles, or 3% of GDP in 2012. (Note: Russia is currently running a budget deficit of 9.4 percent of GDP, which, in turn, has dropped 10.1 percent in the first six months of this year. Russian officials have revised the deficit forecast upward several times this year. Analysts are divided as to whether Russia has passed the worst part of its recession. End note.) ¶3. (SBU) The 2010 deficit will be financed mostly from the Reserve fund (1.68 trillion rubles) and the National Welfare Fund (682 billion rubles). In 2011, the GOR plans to take 5.6 billion rubles from the Reserve Fund, which will then be practically depleted, and 74 billion rubles from the national Welfare Fund. In 2012, another 712 billion rubles will be drawn from the National Welfare Fund. Foreign borrowing could become the secondary source of deficit financing in 2010 and the main one over the two following years. According to Finance Minister Kudrin, after a 10-year hiatus, Russia will issue Eurobonds worth $17.8 billion (613.6 billion rubles) in 2010; $20.7 billion (764.7 billion rubles) in 2011; and $20 billion (784 billion rubles) in 2012. In addition, Deputy Finance Minister Dmitriy Pankin recently announced that the GOR may borrow from the World Bank and/or foreign commercial banks in 2010 (between $2-4 billion), although there are no plans to borrow from the IMF. Pankin added that if the price of Urals oil holds above the $55-57 per barrel level figured into the 2010 budget, borrowing plans would likely be scaled back. ¶4. (SBU) Given the global macroeconomic uncertainty and the high volatility of the commodity markets, the GOR decided to produce an itemized budget bill covering just 2010, while for the following two years, the GOR approved the budget's revenues and expenditures without breaking those down by agencies. By November 1, all agencies are required to develop programs for optimization of their expenditures. (Note: The final version of the 2009 budget was approved in March, only after - as many believe - the GOR was reasonably confident about the oil price, since oil and gas-related taxes comprise a large part of the government's revenues. End note.) Analysts Wary of Spending Priorities... -------------- ¶5. (C) Some analysts view a 7.5 GDP deficit next year as a major threat to macroeconomic stability. Troika's chief economist Yevgeniy Gavrilenkov argued in his monthly economic report that given the Russian economy's low level of monetization (M2/GDP is just 31%),running a 7.5 % of GDP deficit implied that around 25% of the current level of M2 would be injected as ruble liquidity, which would undermine the forex market and spur inflation. He contended that eventually the GOR would be forced to start further cutting expenditures. Thus far, he reported, spending on such items as health care, education, culture as well as on some investment and federal target programs (excluding preparations for the 2012 APEC Summit and the 2014 Winter Olympics) had been slightly trimmed, but spending on defense and national security remained untouchable. ¶6. (C) CEO of BNP Paribas Russia Laurent Couraudon, among others, was critical of the government's budget for neglecting much-needed infrastructure development. The trend seemed to be, he told us, that social spending was increasing, so as to keep underperforming companies running, while infrastructure was actually being cut. Chief Economist of HSBC Aleksander Morozov voiced the same opinion, adding that anti-crisis money was going for banks, for transfers to the regions, and for direct subsidies, but not going to the big infrastructure projects. "The efficiency of the stimulus package is doubtful", he concluded, "and it doesn't contribute to sustained growth in the future." ¶7. (C) Many of our interlocutors commented that another sign of the GOR's turning away from fiscal prudence was its decision to postpone increasing its pension tax until 2011. To address the growing pension deficit, the GOR had decided to increase the top rate of income tax from 26% to 35%. The decision to delay this increase until 2011 (and some believe it will be further delayed) will lead to a greater increase in the pension deficit. ... And Cast Some Doubt On Revenue Figures -------------- ¶8. (C) While the government used a modest oil price as the basis for its budget, there is some doubt about its projections. HSBC Bank's Morozov said that if the GOR's estimate of $55-57/barrel was correct, the deficit will in fact be larger. But if oil hits $70/barrel, as some predict, the deficit will be less. The numbers for 2011 and 2012, he added, were unrealistic in that they assumed no growth in nominal spending. ¶9. (C) Another important consideration shared by most analysts is that Russia is not likely to be able (and willing) to borrow internationally on a large scale (i.e.,$20 billion a year). Even if the situation in the global debt markets continues to improve, an attempt to raise this much would lead to a surge in sovereign bond yields, thus crowding out the private sector. (Russia's EMBI-plus sovereign bond index has already widened in recent days relative to Russia's peers' indices). Troika's Gavrilenkov notes that it will also be hard and harmful to borrow domestically as the government will simply oust private borrowers from the relatively small financial system - total ruble money supply being equivalent to only about $400 billion). Comment: -------------- ¶10. (C) We share the skepticism of the analysts that the government's budget scenario is realistic and sustainable. While the GOR has projected relatively conservative parameters for economic growth and budget revenues, there is no indication that it intends to make major cuts in expenditures, particularly social spending. Massive government spending - much of it slated to sustain employment in loss making state owned companies - is inflationary and will not spur economic growth. On the other hand, the populist economic approach is perceived as a means to sustain the high approval ratings of the president and prime minister. ¶11. (C) Putin's strong words to governors assembled on August 10 in Kislovodsk that they should not count on federal authorities to meet regional budget shortfalls reinforces the sense that a share of the tough decisions on belt-tightening - and the political consequences - will need to be made not only in Moscow, but in the regions as well. End Comment. RUBIN