IN TRANSLATION: Three Budget Traps

Article by Konstantin Gaaze for RBK

The formulation of the budget for 2017 – a pre-election year – is largely complete. The wheel of the budget process this year turned slowly and with the maximum possible theatricality. In the spring, MinFin scared its colleagues in the cabinet by promising doomsday, in the form of the exhaustion of Russia’s reserves, and in the summer, wringing its hands, chopped away at entitlements piece by piece (but not enough to hurt Unite Russia’s electoral chances). Then came the moment of truth: MinFin went on the offensive and made good on all it had planned. Spending will be effectively frozen for three years and the priorities will be cutting the deficit, and gradually replacing reserve funds – used to finance the deficit – with loaned capital.

The key characteristic of economic and fiscal planning this year has been the transformation of the GDP growth rate into a tool for balancing the treasury’s spending and revenue. The rapidity at which growth forecasts were adjusted tells the whole story: according to a table published by Vedomosti, growth projections performed a strange somersault. At first, the three year projection was as follows: .6%, 1.7%, and 2.1%. Then, the projections were dropped to .2%, .9%, and 1.2%. But after a series of frenetic meetings with the president, the outlook became more optimistic again. It’s not entirely clear where the wave of pessimism came from, nor how it was overcome. From the table it’s clear that officials “adjusted” the outlook for real wages and income (which both grew over the month of planning), as well as the outlook for the ruble exchange rate: for some reason, with oil set to remain at $40 for all three years, the exchange rate will drop from 69 to the dollar in 2018 and 71 in 2019.

This manipulation allows us to conclude that growth is not the priority for the president, government, or Bank of Russia. Growth today is just a number in a table that can be changed depending on how the deficit is looking. Why did it turn out this way? Leaving to the side the question of political responsibility for excessive optimism or alarmism of certain officials or ministries (or, for that matter, the lack of an economic “grand strategy”), there are three political problems squeezing the only “uncompromised” growth factor: domestic demand. Officials have admitted that these problems are in a certain sense inevitable, but not that they are critical. But either way, they haven’t left space for the growth of demand. For simplicity’s sake, we’ll call each of these problems a trap, and give each one the name of a politician whose efforts have been ensnared in them, depressing demand.

The Medvedev Trap

Prime Minister Dmitri Medvedev has been a consistent supporter of budget consolidation, and paradoxically, no less an effective one (perhaps even more so) than Alexei Kudrin. Even before the saga of sanctions and declining oil prices, the prime minister and his team were called the culprits of crisis: in 2013, they drafted too austere a budget and “imploded” an unstable growth trajectory. The “Medvedev Cocktail” had and still has the same ingredients: growing defense spending, stagnant social payouts, cut with decreased real spending on education and medicine. On paper, money for state sector wages, pensions, and other social payouts should be trimmed as well. But in reality, due to Putin’s May Decrees [1], the government spends more on wage growth and less on the social side. The same thing, of course, happens in the regions.

The results are as follows. According to data from the Analytical Center under the Government, the number of recipients of financial assistance in the regions quadrupled over the past decade: from 6.6 million to 25.4 million people. The number of support programs about tripled: from 8 to 21. The amount of payouts over this timeframe grew not due to targeting or means testing (fewer large payments) but due to a growth in the number of recipients. In 2013, the government began cutting spending, mobilizing its financial resources for the president’s May Decrees. The regions halted payout growth as well. Teachers and doctors were by no means destitute before the Decrees, and were generally counted among the class, at least in the broad sense of the term. However, aid recipients simply went from poor to destitute [2]. Today, according to data from the Higher School of Economics’ Social Policy Institute, almost 70% of families that call themselves poor or very poor receive only social payouts, pensions, or other assistance. The government, in other words, did not raise the over living standard of Russians, but instead bulldozed the lifestyles of those dependent on payouts. Before the fight against the deficit, May Decrees, and militarization of the budget, these 25 million people were a strategic reserve of consumer demand: the growth of their standard of living, albeit slow, accelerated or at least maintained demand. But now they’ve been driven to destitution, which means different economic behavior and different priorities.

The Siluanov Trap

MinFin is fighting for a balanced budget, meaning a budget with an equilibrium point between Russia’s reserves, defense spending, and entitlements. Over the years, budgets have become more and more virtual: on paper there’s enough money for everything, albeit with difficulty, but in reality there is increasingly little left to go around. Moreover, MinFin has stuck to an old budget codex, something drafted in different conditions if not a different country outright. What is going on? Municipalities across Russia lack the funds for infrastructure and social facilities. Worse, the budget rules do not allow them to solve their problems together: they could, for instance, construct schools or renovate hospitals that could serve several towns, or pool for roads and boiler rooms. The situation is at times simply absurd: municipalities that border one another and have long formed administrative agglomerations are prevented from, say, constructing an incinerator together. The construction of such a facility by a single village does not make economic sense, but several towns together could make the project work. This, however, remains impossible: blind territorial planning, implemented in Moscow, turns the country into a selection of isolated units that lack the right to local cooperation. In order for there to be such a right, a new budget codex would need to be written, yet MinFin does not seem up to it.

The same is true of projects whose life cycles stretch beyond a single calendar year. It’s senseless to request money for a road that will need two or three years to be built; the project must be split into year-long portions. Understandably, no planning is possible: the three year budget has meaning in Moscow, but not in places where people live from January 1st to December 31st. This is one of the reasons for the lamentable condition of municipal infrastructure, which is not just due to a lack of finances and corruption. The rules squeeze any initiative and reduce room for maneuver. Local authorities are similar to, say, fathers who do small renovations at home under the logic that they’ll redo them later. This ‘later,’ of course, never comes. At the same time, tax incentives and exemptions are generously showered on competent federal lobbyists, which municipalities lack. If their initiative was not constrained, these municipalities would become a significant driver of internal demand. But MinFin has no time or desire to deal with them.

The Nabiullina Trap

The Bank of Russia is out to battle inflation, and analysts say the target – 4%– may be reached as soon as next year. But an unexpected stumbling block has emerged: the dramatic shrinking of the Russian middle class, which one hand is sensitive to changes in interest rates and on the other, thanks to its weight in the economy, makes businesses consider its consumer preferences. Central bank economists write that the smaller the middle class shrinks, the harder it is to impact inflation with tweaks to interest rates. Asking “where did the middle class go?” is senseless, but another question is worth asking: “what did the Bank of Russia do to support it?” At minimum, nothing. At most, a lot to make the middle class evaporate further. Beginning in 2013, CBR began to combat the “overheating” of the consumer lending market, despite comments by bankers that there was no such “overheating” and would not be for some time, and that many other developing countries had a per capita credit burden that was much higher than in Russia. The middle class was only “middle” through a cash advance (in the form of credit): relative in terms of consumption to other groups in Russian society, but not when compared developed countries. The squeeze on credit, and following inflation fight, which further lifted interest rates, destroyed this advance. The middle class rapidly grew poorer, and lacking a safety net in the form of bank credit, began to create its own: savings first in dollars and then in rubles. In this way, consumer demand was undermined twice: first in 2013, and again in 2015.

Now these savings have become a problem themselves: CBR says that the main risk for 2017 is a structural liquidity surplus, which has appeared due to the unwillingness of citizens and business to spend and invest. The surplus may lead to decreased interest on credit (for citizens most of all) and re-accelerate inflation. Banks have too much capital, and MinFin and the Central Bank through concerted action will move to absorb this excess. Inflation may fall to 4%, but without credit there will not be any consumer demand. The reduction of inflation is of course an achievement, but if it doesn’t reboot demand, it won’t provide much inertia for the economy. Investment is held bank not only (perhaps not so much) due to high inflation, but to uncertainty over the economic situation, due in part to squeezed consumer demand. Is it worth it to stick to a target of 4% inflation and maintain an artificially raised interest rate, if a stable reduction in inflation is blocked not only by excess liquidity, but also growing inequality that is in part a consequence of CBR policy?

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