In December 1979, the Soviet army invaded Afghanistan to uphold a friendly regime that was being challenged by the Taliban. The crude oil price at the time was at a high of US$101 a barrel. The high price, buttressed by growing production of oil in Siberia, gave the Soviet Union unprecedented revenues. Instead of saving this money for times of emergency, the Soviet government financed military campaigns abroad and imports of foreign consumer goods. By 1986, the Brent crude oil price had fallen to around US$30 a barrel. The Soviet economy was by that time suffering from serious structural problems arising from the inefficiencies of central planning. As a result, Mikhail Gorbachev embarked upon the policy of Perestroika (restructuring) and convergence with the West. The high oil price coincided with Soviet military engagement abroad, but as the price fell, the Soviet Union became more democratic and open to the West.
In recent days it has been suggested that Russia and Saudi Arabia might put back their primordial mistrust and engage in a cartel deal to cut back oil production and raise prices. The willingness of both countries, but especially of far heftier Russia, is a testimony to the crucial importance of oil prices for the country, both at home and abroad. The increase in oil prices over 28 – 29 January 2016 from US$31 to US$35.99 per barrel of Brent Crude, sparked by the mere suggestion of a Russian deal with OPEC, has certainly given Russian politicians some breathing space, at least for the coming couple of weeks. Yet this increase would not cut it: Russia needs oil prices of at least US$50 per barrel to balance its budget for 2016, a scenario that seems increasingly unlikely, given investor doubts, Chinese slowdown, and the entry of Iran into international commodity markets.
Even oiled-up machines break down
The correlation between oil price and Soviet international relations was not coincidental: in the uncompetitive Soviet economy, oil and gas revenues accounted for 67% of all exports. The correlation remained strong after the collapse of the Soviet Union and during the transition to a market economy. When Vladimir Putin came to power in 2000, the price of oil was US$25 a barrel. Mr Putin was initially cooperative towards the West and did not object to NATO’s enlargement that incorporated the Baltic States, Bulgaria and Romania, all former Soviet allies, into the organisation. By 2007, the oil price was at US$105 a barrel. In 2008, Russia invaded Georgia, and its relationship with America substantially deteriorated.
As a result of the global financial crisis, however, oil prices fell to US$67 a barrel by 2009, and Russia accepted America’s détente policy for the Caucasus, even though it amounted to little besides the freezing of the conflict and the de facto annexation of South Ossetia and Abkhazia by Russia.
Over the last two years, Russia has once again became quite active in international affairs. The support for separatists in eastern Ukraine and the annexation of Crimea took place when the price of oil was still over US$100 a barrel. But as the oil price fell, the chilly relations between Russia and the West did not ease. Many observers have interpreted the conflict in Ukraine as a populist compensation “paid” to the Russian public for the falling oil prices and lack of economic growth. September 2015 saw Russia conduct its first Middle Eastern intervention in decades, in support of the regime of Syria’s President Bashar Assad. Russia’s presence in the oil-rich region soon led to a deterioration in its already strained international relations, as Turkey shot down one of its fighter jets in late November 2015, for apparent breach of its airspace.
Trouble for the rouble
Russia’s economy had a very difficult 2015. As the oil price fell from its mid-2014 peak of over US$100 a barrel, Russia’s exports and government revenues, heavily dependent on oil and gas, shrank substantially. GDP decreased by nearly 4%; inflation ran close to 13%. Having lost half its value against the dollar in the second half of 2014, the rouble depreciated by a further 20% in 2015.
Recent turbulence in the oil market has postponed premature hopes of a speedy recovery. The IMF predicts that GDP will contract again this year, by 1%. Yet Russia is unlikely to see a repeat of the acute problems experienced in late 2014. Russian businesses have much more robust finances. Their foreign debt has fallen by 30% since 2014. Until May of 2016, firms and banks are due to repay less than they did in December 2014 alone. The second half of the year will be as easy in terms of the debt burden.
The central bank has taken effective measures to recapitalise the banking sector and to allow greater flexibility and resilience against bad loans. The big oil companies, meanwhile, have coped with a weak currency. Their operating expenses are priced in roubles but most of their revenues come in dollars. Progressive oil and gas taxes have also helped: when prices fall, the state budget is the one that bears the brunt. Total oil production grew by 1.4% in 2015 and thus reached new record heights. The profitability of the largest Russian oil conglomerates, Rosneft, Lukoil and Bashneft, is higher than it was in 2014.
The government’s finances, however, appear more troublesome. The budget for 2016 was constructed on the assumption of an average oil price of US$50 a barrel, which would have produced a deficit of only 3% of GDP. However, the state of Russia’s public finances under oil prices between US$30 and US$40, as the current market predicts, is not a cause for optimism. If the trend persists, the budget deficit will rise by roughly 1% of GDP for every US$5 fall in the oil price below the projected price of US$50. At the current price of US$30 a barrel, assuming no intermediate change in public spending or the exchange rate, the deficit would probably reach 7%.
Oh, not 1989 again…
Mr Putin has repeatedly expressed his administration’s determination not to let the deficit exceed 3%. In response, the finance ministry has called for a decrease of 10% in public spending, with defense and social spending largely exempt from cuts, since they constitute the regime’s main source of popularity and democratic mandate. There have also been suggestions of selling state assets to the private sector. All of these measure are, however, unlikely to fill the deficit gap. Issuing government bonds to cover the difference is a very expensive option since yields on Russian government bonds have been consistently high due to investors selling them en masse.
The government can always use its foreign currency reserves to help balance public spending, but it currently holds only US$50 billion, down from US$90 billion a year ago. If the budget deficit reaches 6% of GDP, the foreign reserves fund will be exhausted by the end of 2016, according to Nomura, an investment bank. A second foreign exchange fund, which is kept aside to finance pensions and other social payments, holds a further US$70 billion, but mainly in illiquid assets that would be hard to turn into money should a pressing need arise.
A Liquid Solution
If the government runs out of liquidity, it may be tempted to print new money to finance its positions. Such a solution would be unwise, since it will boost inflation and accelerate the rouble’s depreciation. This would further decrease the purchasing power of Russian families and businesses with respect to imported goods, but it may stimulate demand for cheaper, local produce. Deep, unplanned cuts to government spending, on the other hand, could also stand in the way of growth recovery, as the Russian economy critically relies on government spending to boost production and demand in the absence of oil stimuli.
Real wages in the country fell by 9% in 2015 and 4% in 2014, the first such decrease since Mr Putin came to power in 2000. GDP per person (controlling for purchasing power parity) is down from a post-Soviet peak of close to US$15,000 in 2013 to around US$7,000 this year. More than 2 million people slipped below the poverty line in 2015. Pensions normally change with inflation, but in 2016 they will rise by just 4%, with inflation far outpacing them at 10 to 15%. All of this means that lives for ordinary Russians have become conspicuously more difficult over the past two years; the purchasing power of most Russian families has been reduced, and making ends meet on a daily basis is proving increasingly challenging as inflation and real wage growth are going in opposite directions.
A good indicator of quality of life for ordinary Russians, consumer spending, once the engine of Russia’s economy, has substantially decreased. Retail sales dropped by 13%, year on year, in November. Foreign travel during the summer holiday season fell by 30% compared with a year ago, meaning that people are finding it increasingly hard to spare money for a summer holiday abroad, as inflation has eroded the purchasing power of the rouble abroad.
The Bear and the World
As far as economic theory goes, the 25% fall in the inflation-adjusted exchange rate in the past year provides an opportunity to diversify the economy away from oil. For a foreign investor, labour is now cheaper in Russia than in China. This would normally mean that investor would crowd to invest in Russia and make use of cheap labour. However, foreign investment has been decreasing, due to lack of trust in the Russian economy and a judiciary internationally perceived as corrupt and dependent on the executive. Foreign direct investment inflows fell from a quarterly high of US$40 billion in early 2013 to US$3 billion in the second quarter of 2015. As a consequence, manufacturing production was down by 5% year on year in the first half of 2015; agricultural output has stagnated or at best only grown slowly. All of this means further depreciation of the rouble, as investors that have hitherto put their trust in Russia are not selling off their assets and moving their money abroad, flooding the markets with roubles and driving their prices further down. For the global economy, this does not bode well. The end of the BRICS (Brazil, Russia, India, China and South Africa) as the primary engine of world growth seems to be very close, as all of those countries, except for India, have been struggling economically recently. The troubles of Russia are not helping. Domestic problems in Russia are also not good politically, as increased poverty is likely to destabilise the country and lead to increased military adventurism abroad.
Saving the Day
The acutest problems facing the Russian economy and society nowadays are not coming from the outside, but from the inside: overreliance on hydrocarbons and a socioeconomic climate that seems to be discouraging investor trust. Despite the many difficulties, the current low-oil price environment is ideal for solving both of those problems. The government should make bold reforms aiming to scale back bureaucracy, reduce rent-seeking, and promote competition in all markets. Education and an entrepreneurial environment relying on educated young Russians as the main engine of demand and growth should be stimulated. Instead of advertising itself as a place of cheap labour and a plenitude of natural resources, Russia should stress its traditions in manufacturing, aerospace and engineering, as well as its educated workforce, which has been fueling the development of other tech meccas through continued emigration. When asked what makes a country great, Russians have named two qualities in recent polls: wealth and military strength. Both of those are, however, dependent on healthy, consumer-led, competitive, commodity-independent economic growth.