10 August 2015

Russian Regions Are Running Out of Money

August 7, 2015

The potential for regional instability will grow as Russia's economic crisis drags on.
Many of Russia's regional governments will default unless the Kremlin steps in.
Russia's focus will shift inward as its economy worsens, limiting its bandwidth to act abroad. Analysis

Russia has entered its second recession in six years. The effects of the country's economic downturn have begun to trickle down from the federal level, spreading to Russia's regions, cities and people. The federal government has long relied on the regional and municipal governments to carry their own burdens, and many are teetering on the verge of bankruptcy or collapse as Moscow siphons off a growing share of their funds. The Russian people are also beginning to feel the economic pressure more acutely as an increasing number of citizens fall under the poverty line and watch their savings dry up.

The Kremlin can do little to alleviate the worsening crises, since its own resources are finite, and the road to economic recovery is long. Instead, it has responded with political and security measures aimed at preventing or cracking down on dissent among the regions and people. But these steps will do little to address the Russian economy's deep structural flaws. Unless oil prices rebound or the Kremlin steps in and drains its coffers, the economic and financial pressure weighing on Russia will only grow over the next few years. The Kremlin, in turn, could tighten its control to prevent mass protests and keep regional governments from destabilizing.

Russia's Regions Carry Heavy Debt Burdens

Russia's massive landmass is split into 83 regions of varying shapes and sizes. Historically, the Kremlin has granted regional leaders the power to run their own territories, provided they remain loyal to the federal government. Crackdowns, of the kind seen during the 1998 financial crisis, and wars, such as the conflicts in Chechnya and Dagestan, have repeatedly tested that loyalty throughout Russia's history. As a result, the stability of the regions - and by extent, the country - remains a persistent concern for the Kremlin. At the same time, the Kremlin can use threats of instability to justify its expansion of power within the regions in an effort to keep them loyal.

The severe economic crisis plaguing Russia is ratcheting up the potential for instability within the regions. Russia's regional governments have long carried a large share of the country's financial burden. Though the country's total debt is only around $300 billion - a relatively small figure for a country whose gross domestic product is nearly $2 trillion - about one-third of that debt is concentrated among regional governments, which do not have as many resources as the federal government. Since the 2008-2009 financial crisis, regional debt has climbed from $35 billion in 2010 to an estimated $103 billion in 2015. Meanwhile, according to Moody's Investors Services, regional debt repayments and borrowing are down 53 percent and up 25 percent, respectively, this year. The regions' budget deficits have risen by 42 percent since 2014, and of the 83 regional governments, 63 are believed to be near bankruptcy or default, according to Russia's Economy Ministry. Moscow's Higher School of Economics found that 20 regions are technically already in default.

Sources of Debt

There are three primary factors underpinning the regions' mounting debts: federal obligations and edicts, economic stagnation and limited credit access.

All of Russia's regions must meet a series of burdensome obligations to the Kremlin and social spending. Of the income each region generates, only 37 percent stays in the region itself; the rest goes to the federal government. The Kremlin returns a small portion of that in the form of subsidies, though no more than 20 percent of the original payment. Since 2011, the federal government has raised regional taxes by 12 percent.In 2012, Russian President Vladimir Putin issued a series of decrees that required the regions to raise salaries by 10 percent and spend money on dilapidated housing. The salary edict has cost the regions $56 billion since 2014 alone, while the social spending requirement has cost some $42 billion since its enactment in 2012. Regional leaders and the Russian media have called Putin's orders "unfunded mandates," since the federal government has not contributed to the projects.

In addition, the economic stagnation affecting the country as a whole is beginning to reach the regions and cities. For the first time since 2010, the Kremlin is running a budget deficit. Russia's Ministry of Economic Development has predicted that the economy will contract 3.2 percent this year, followed by nominal growth of 0.7 percent in 2016. The estimate is largely based on low oil prices and the federal government's heavy reliance on energy revenues, which make up nearly 50 percent of the Kremlin's budget and 25 percent of GDP. But the Russian economy had begun to slow even before oil prices sank in 2014; the country's GDP grew by only 1.3 percent in 2013, compared with 7-8 percent growth in the mid-2000s.

Federal aid to the regions has also fallen sharply in recent years, from $56 billion in 2012 to $28 billion in 2014. Federal budget cuts have slashed regional funding by another 15 percent in 2015. The tightened purse strings have not affected all regions equally; politically sensitive and unsecure regions, such as Crimea, Chechnya and Dagestan, all receive high levels of funding from the Kremlin. Just last week, the Russian government announced plans for 30 anchor investment projects in Chechnya and Dagestan over the next year. Still, nearly all of the other regions have seen their financial support dwindle.

European and U.S. sanctions have only added to Russia's economic woes. Foreign direct investment into Russia fell by more than 50 percent over the past year. At the same time, capital flight reached $151 billion in 2014 and is following a similar trajectory this year. Regional governments are finding it increasingly difficult to refinance their debt because of the West's unwillingness to invest in Russia, and they are being forced to borrow at nearly twice the going rate. The region of Belgorod, for example, placed 5.3 billion rubles' (around $82 million) worth of five-year notes at a rate of 12.65 percent, compared with its 8.3 percent rate in 2013.

Moscow's Attention Turns Toward Stability

In response to their mounting financial burdens, Russia's regional governments have already begun to slash their spending. According to the Higher School of Economics, 26 regions have cut funding for education, 21 have reduced spending on health care and 16 have slashed social security spending in the first half of 2015. For months, minor strikes have taken place across Moscow after 28 hospitals shut down and 7,000 medical employees were laid off. Teachers in Novosibirsk have protested repeatedly in 2015 in response to a 20 percent cut to their salaries.

As pressure continues to build at the regional level, Russia's cities and citizens will increasingly feel the effects of economic deterioration. So far, the country has not seen large-scale protests emerge, in part because Russians tend to weather economic hardship better than most. But public sentiment can turn quickly, just as it did in the 1998 financial crisis. The Kremlin is preparing a series of financial, political and security measures to ensure that the regions remain stable in the years to come. Next, Stratfor will look at other sources of pressure in the Russian economy and how the Kremlin will respond.

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