Enough Money to Keep the War Going

As a result of the Kremlin simultaneously overestimating the capabilities of the Russian army and underestimating the Ukrainian’s will to defend their freedom, what was supposed to be a quick military operation has turned into a protracted war, claiming tens of thousands of military and civilian lives. Although Ukraine has experienced the heaviest material losses, Russia has also had to face serious challenges in 2022, including a worsening economic situation and escalating budgetary issues. 

Many experts believed and continue to believe that the Western sanctions imposed on Russia will cripple economic activity, and reduce export opportunities and budget revenues, thus limiting the Kremlin’s ability to conduct its war of aggression. However, the data indicates that these estimates do not reflect the real state of affairs: the Russian budget will not experience problems of a serious enough magnitude to force the Kremlin to change its policy, this year or the next.

The price of sanctions and counter-sanctions

Economic sanctions imposed by Western countries have led to a recession; according to the estimates published by the Russian government and Central Bank, Russia’s GDP is set to fall by about 3% in 2022, and the economy’s decline in the fourth quarter of this year will be about 7% when compared to the fourth quarter of 2021. Sanctions and counter-sanctions (namely restrictions on Russian gas supplies to Europe) have affected Russia’s fiscal revenues in two ways: through the changes to macroeconomic parameters and the volatility of prices and volumes in foreign trade.

Due to both the contraction in the economy and falling demand, as well as restrictions on the export of certain goods due to sanctions and the refusal of many Western companies to work both in Russia or with Russian companies, imports in the second and third quarters of 2022 dropped by 23% and 14.5% respectively. This, in turn, led to a decline in import-related budget revenues (VAT, import excise tax and duty), which accounted for 19% of fiscal revenues in 2021. Over the course of 10 months in 2022, this share of the budget’s revenues fell by 20% compared to the same period last year.

The economy also faced a sharp increase in inflation between February and April; according to data from Rosstat, during the eight weeks immediately following the beginning of the war (from February 26 to April 22), consumer prices increased by 9.9% in annual terms. According to the same agency, the GDP deflator was 23.4% and 17% in the first two quarters of this year (compared to the same period in 2021). Although the increase in consumer prices plateaued in May, the government was forced to urgently increase pensions and make one-off social benefit payments in order to maintain the living standards of the most vulnerable social groups. To add to this, the budget also included additional investment costs to account for the increasing price of metals and building materials. 

The Russian economy is highly dependent on the oil and gas sector. According to the Central Bank, hydrocarbon exports amounted to 49.5% of its total merchandise exports in 2021. More than 35% of the federal budget’s revenues come from companies that produce and export hydrocarbons. As early as April, the European Union began to discuss the idea of imposing restrictions on the import of Russian oil and petroleum products. In response, Russian companies scrambled to look for new customers and agreed to significantly discount the price of their products. According to the Ministry of Finance, between April and October of this year, Russian oil was sold at a 25% discount relative to the price of Brent. However, due to high global oil prices, the price of Russian oil was actually higher this year than in 2021, even when factoring in the price of this discount. 

Since August 2021, the largest Russian gas producer has been steadily reducing sales in its most important market — the EU. For 11 months (from January to mid-November), gas exports from Russia to Europe (including Turkey) decreased by almost 45%, and Gazprom’s gas production fell by almost 20%. Surprisingly, Gazprom and the budget have actually benefited from this situation, as a steep increase in prices across the European market (460% compared to 2021) increased the company’s income by such large margins that the government introduced a temporary, three month tax on Gazprom’s revenue. Due to the 1.25 trillion ruble surplus in earnings, the annual budget was boosted by 5%. 

In the first two weeks after Russia began its aggression against Ukraine, the ruble devalued from 75/$ to 120/$, which exacerbated inflation expectations and provoked panic among the population. In response, the Russian authorities imposed severe financial and currency restrictions on both existing and capital transactions, limiting the convertibility of the ruble. As a result of this, the current account balance of payments increased sharply, which led to a strengthening of the ruble to 50/$, or, in other words, a value of more than twice that of its record low. The ruble exchange rate subsequently stabilised at around 60/$. Since fiscal revenue related to the extraction and export of hydrocarbons is calculated in dollars, the rapid strengthening of the ruble led to its devaluation.

Overall, in the first 10 months of 2022, all of the aforementioned factors led to Russia’s budget revenues from the production and export of hydrocarbons increasing by 34% compared to 2021.

The cost of war and its implications for the 2022 budget

Due to its protracted military action, Russia’s military spending has increased sharply, and in mid-September, the Ministry of Finance announced that, by the end of the year, it would increase by 1.45 trillion rubles (45%) to the level established by law. In June, the government discussed an increase in the amount it would spend on the purchase and repair of weapons by 600-700 billion rubles. As a result, roughly the same amount could be directed to the Ministry of Defence’s current expenses.

In addition to this, the Ministry of Finance announced an extraordinary increase (by 50%) in spending under the category of ‘National Government Issues’ in 2022. In the draft budget for next year, spending on this issue remains high, although 25% lower than the level of 2022. If we assume that excess spending under this heading (past the uniform growth between 2021 and 2023) is related to the military, then its volume will be in the region of 850 billion rubles (0.7% of GDP). The announcement of mobilisation in September, which resulted in an additional 318 thousand people being drafted into the army, will require an additional increase in military spending to the tune of approximately 0.3% of GDP. As a result, Russia's military spending in 2022 could reach 5% of its GDP, which will be a record high for Russia’s post-Soviet period.

To add to this, since defence expenditures within the Russian budget are classified, it is impossible to determine exactly how the budget funds were distributed and whether the budget covered all of the government’s obligations, including payments to mobilised citizens and to the families of dead and wounded military personnel (these benefits are paid by the Pension Fund, which receives its own subsidies from the federal budget). Therefore, it would come as no surprise if, after some time has passed, we were to discover that the total spent on the aggression against Ukraine is much higher than previously thought.

Since the deep financial crisis of 1998, Russian authorities have actively pursued an extremely restrained fiscal policy. 2022 does not appear to be any different: this year, spending was 17.7% more than originally intended, while revenues, according to the Ministry of Finance, are expected to be just 10.7% higher than planned, this will lead to a deficit of about 1.3 trillion rubles (or approximately 0.8% of GDP). Given that Russia is no longer able to raise debt funding in external markets and the chances of raising money domestically are extremely limited, the resulting deficit will be largely financed by accumulated reserves (the original budgetary plan projected a surplus). On November 1st, the liquid assets of the government's fiscal reserve (National Wealth Fund, NWF) amounted to 7.9 trillion rubles. If we assume that this entire budget deficit for 2022 will be financed by the NWF, then the sum of liquid reserves at the beginning of 2023 will be 6.9 trillion rubles (this is equal to 23.7% of next year’s planned budget expenditures).

The 2023 budget: the price of uncertainty

When planning the budget for 2023, the Russian government faced a high level of uncertainty and serious political constraints.

The main question that remains unanswered concerns the terms and conditions for ending the war in Ukraine. In the draft budget, the government has put indexation of military spending at 6.5%, which is slightly above the forecasted rate of inflation (5.5%). At the same time, the draft budget accommodates an increase in expenditures under the heading of ‘National Security and Law Enforcement’ by almost 60% compared to the level of 2022, as well as a significant increase in the Pension Fund’s expenditures (by almost 2 trillion rubles, or 19%). This goes far beyond the current trend and, undoubtedly, can be traced to the war in Ukraine.

The second problem the government faces is the uncertainty of the economic situation. The Russian economy shrank much less in 2022 than many experts had predicted in the spring, giving the Kremlin a reason for optimism. President Putin has stated several times that the economy has gotten through its most difficult period and is approaching a phase of growth. Consequently, the government could not include a further recession in its forecast budget; instead, the Russian economy is expected to begin growing in the first quarter of next year. As a result, the budget’s tax revenues (those which are not related to hydrocarbons) are predicted to increase by almost 13%, which seems overly optimistic.

The government's optimism is not shared by many experts, including those of the Central Bank, who have spoken of the possibility that sanctions may continue to negatively impact the economy next year. The official forecast of the Central Bank assumes that the Russian economy will resume its growth in the second half of 2023, but Elvira Nabiullina, the Chairman of the Central Bank, has stated several times that the situation may turn out to be more difficult than forecast and the economic downturn may last longer.

The third problem concerns the assessment of possible pressure put on the Russian oil industry by sanctions. The EU embargo on the purchase of Russian oil came into effect on December 5th, and the embargo on the purchase of Russian oil products will begin on the 5th of February. In addition to this, the G7’s price cap on Russian oil, set at $60 per barrel, or 10% lower than the actual export price of Russian oil in November 2022, was implemented on December 5th. In response, the Ministry of Finance has proposed abandoning the statutory rules for calculating the extraction and export revenues of hydrocarbons and setting in the budget the nominal amount of such revenues, which will amount to 34% of total revenues. Thus, if the budget previously used the ‘cut-off price’ to determine the excess revenues that were sent to the NWF, now 9 trillion rubles will be directed to the financing of current expenses, after which the budget’s revenues will be sent to the fiscal reserve. 

In absolute terms, this fixed amount of income is almost the same as the level of income in 2021, which, at first glance, casts doubt on its viability. It is unlikely that next year, under pressure from sanctions, Russia will be able to increase its oil production or exports. The average actual export price of Russian oil in 2021 was $69/barrel, which is in line with the level of September/October 2022. The current exchange rate of the ruble against the dollar is 15% higher than the average for 2021, and the government does not see a high likelihood that the ruble will significantly weaken over the coming year. These factors may reduce the budget’s revenues from the extraction and export of hydrocarbons by 15–20% of 2021 levels.

To compensate for its possible losses, the government has initiated the legislation to increase the tax on mineral extraction for hydrocarbons companies, and to increase income tax for companies exporting liquefied natural gas. The proposed law also reduces budget payments for oil refining companies, which were established within the framework of a mechanism aimed at regulating domestic prices for petroleum products. The government estimates that this tax increase will offset at least half of the previously mentioned potential revenue. Another 20-25% of the potential decline in income should be offset by higher taxes not related to the extraction and export of hydrocarbons, such as coal, metals, and fertilisers. Thus, according to my estimates, there is still a risk of a revenue deficit in 2023, but this will likely be limited to 5-6% of the total budget revenues.

Enough money for the war

The approved budget for 2023 assumes there will be a deficit of just under 2% of GDP. This can be fully financed by fiscal reserves the government already holds.

Although the budget was planned during a time of deep uncertainty, it is not exactly unsustainable. Under certain conditions, income may turn out to be higher or lower than predicted, but the deviation, according to my estimates, is unlikely to exceed 1% of GDP either way. Therefore, taking into account the pessimistic (from the government’s point of view) scenario of low revenue, the budget deficit will likely be no more than 3% of GDP, and it will still be possible to finance this from reserves. In addition, during previous recessions (2008-2009, 2014-2015, 2020), the Ministry of Finance managed to convince President Putin of the need to carry out a budget sequestration, which might have been relatively insignificant but worked to discourage anyone from demanding additional budget allocations. At the same time, I see no opportunity or desire for Western countries to increase their pressure on Russia via extra sanctions in a way that would force the Russian budget to face insurmountable challenges.

While the 2023 budget includes a significant increase in spending as a result of Russia’s military operations in Ukraine, I do not foresee any financial constraint on the Kremlin that could force it to change its aggressive policy.