Looking at the fundamental problems in the Russian economy

The Cabinet has almost finalized its federal budget planning for 2006-08. Thus, it is now possible to make an assessment of state finances during Vladimir Putin’s two terms as president. The balance sheet doesn’t promise any political profits for Putin.

The Cabinet has almost finalized its federal budget planning for 2006-08. Thus, it is now possible to make an assessment of state finances during Vladimir Putin’s two terms as president. If we use the simple book-keeping technique of comparing the debit (revenues) and credit (spending) columns, the balance sheet doesn’t promise any political profits for Putin.


In autumn 1999, at a meeting of the coordinating council of Russian manufacturers, left-wing economist Sergei Glaziev corrected the recently-appointed Prime Minister Vladimir Putin as follows: “The economic growth that began a year ago under Yevgeny Primakov’s government has ceased since Primakov’s dismissal.” The then-inexperienced Putin was at a loss for a reply. After leafing through a report prepared for him by the Cabinet staff, all he could do was admit: “It says here that we have recorded 14 consecutive months of growth for the first time this decade.” Glaziev didn’t bother demolishing Putin any further, and the growth rate discussion died away. But the topic didn’t lose its relevance.

Vladimir Putin may be described as fortune’s favorite in terms of the federal budget. He came to power at just the right moment: oil prices started rising sharply, while the fourfold devaluation of the ruble led Russian producers to take their spare capacity out of the mothballs. Under the circumstances, it wasn’t all that hard to record budget surpluses, with extra revenue to pay off foreign debts and cover social spending.

Nevertheless, presidential economic adviser Andrei Illarionov has stated repeatedly that “the governments of the 1990s were the best” in terms of their economic policies. While noting that Putin was one of the prime ministers in those years, Illarionov prefers not to specify the best prime minister – but he actually means Primakov. Illarionov uses two main criteria: growth rates and the reduction of state spending as a percentage of GDP. Indeed, the Primakov government was the best according to these indicators; but that was mainly due to the crisis of August 1998, after which the government was forced to reduce its budget deficit, while the economy had nowhere to go but up – and the Primakov Cabinet did not obstruct that growth.

After Putin took office, state spending started to rise. This refers to what is known as “non-interest spending” – that is, spending on items other than servicing foreign debt. At first, in 2000-01, non-interest spending remained at around 12% of GDP, which is considered very good from the standpoint of liberal budget policy. The first sharp increase came in 2002: 16% of GDP. This was due to the parliamentary elections coming up in December 2003; politicians decided to take out some extra insurance by raising state-sector wages and pensions ahead of time.

All the same, Putin’s budgets in the early 2000s featured a whole range of favorable macroeconomic indicators: surpluses rising, foreign debt payments falling with every year, GDP growth, and lower inflation (over 20% inflation in 1999, down to 12% in 2003). The budget policy of Putin’s team could also be applauded for setting up the Stabilization Fund: since the start of 2004, all extra petroleum revenues have gone into this Fund – oil production taxes and export duties levied as long as oil prices remain above $20 a barrel ($27 a barrel from 2006).


The break came in the second half of 2003. That’s when all the oil-related advantages of federal budget policy started turning into disadvantages. The Russian economy came down with the “Dutch disease.” GDP growth rates, still a point of pride for the authorities (7.3% in 2003), started falling – even though oil prices continued to rise. Inflation, on the contrary, did not fall. After dropping to 12% in 2003, it hasn’t fallen further. According to presidential economic adviser Illarionov, inflation for May 2005 was 13% compared to May 2004. And this is despite all the government’s efforts to direct money into the Stabilization Fund and try to restrict the tariffs of natural monopolies.

Oil prices are still rising, but the effect of devaluation has long since been exhausted; thus, the ruble is growing stronger in real terms. Under these circumstances, GDP growth is slowing, while inflation is accelerating. Essentially, the government faces a choice. First option: aim to double GDP by 2010, as President Putin demanded back in 2003. This would require drastic cuts in all non-interest spending, especially social spending (in order to reduce inflation and stimulate growth). Second option: abandon economic policy principles for the sake of populist election campaign goals. Predictably, the government is trying to sit on the fence. It has to follow the Kremlin’s social policy instructions (for example, doubling state-sector wages in nominal terms within three years) while attempting to double GDP at the same time.

Meanwhile, the continued rise in oil prices has long since ceased to have the anticipated effects. What’s more, the problem of sterilizing excess money supply is becoming more urgent. The Stabilization Fund obviously can’t cope with this task. In other words, the Russian economy cleary experienced an upswing in the early 2000s, but now the problems of slower growth and high inflation are weakening the federal budget. This creates a paradox: officially, there is plenty of money coming in – but in fact, allocated budget spending is insufficient for social needs. This year, for example, according to the Finance Ministry, funding to cover the monetization of social benefits fell short by 400 billion rubles. An extra 11 billion rubles has been allocated to raise pensions for war veterans. This naturally raises the question of whether all pensions should be doubled by 2008. However, while the need to double state-sector wages in nominal terms is not being disputed as yet, the government has stopped talking about doubling pensions. Neither does this year’s presidential address mention such an objective.

To all appearances, social policy is following the old bureaucratic principle of cutting costs at the expense of the most vulnerable. Nevertheless, the results for 2005 are expected to show a significant rise in state spending: up to 15% of GDP, according to the budget. This issue was the cause of a dramatic argument between Andrei Illarionov, who pointed out the danger of this trend at a Cabinet meeting on April 21, and Prime Minister Mikhail Fradkov, who accused Illarionov of using incorrect data.

All of Putin’s budgets, including the plans for the next three years, are characterized by the growth of military and social spending – inevitably drawing approval from patriotic and left-wing voters. And the consequences of this, oddly enough, are apparent in the text of this year’s presidential address. It includes the objective of raising state-sector wages by 50%, in real terms, over the next three years. The Kremlin has already calculated (and the Finance Ministry has agreed) that this entails doubling nominal state-sector wages. Futher on in the presidential address, compound interest calculations are cited as showing that average annual inflation over the next three years will be 10%. The Finance Ministry forecasts that consumer prices will rise by around 10% in 2005, slowing to 6% by 2008. Of course, inflation figures might have been rounded off in the case of state-sector wages, but it’s still a curious admission to make. If we recall that the federal budget’s initial inflation forecast for 2005 was only 8.5%, then it appears the president has essentially acknowledged that the government and the Central Bank have lost the battle against inflation.

In other words, Putin’s last budget (for 2006-08) is pro-inflationary. And that doesn’t bode anything good for state-sector workers or pensioners, or the economy as a whole. Unless inflation can be controlled (and the authorities have virtually admitted that it can’t be controlled), economic growth will continue to slow. This has already happened in March 2005: official statistics show that industrial output essentially stopped growing that month.

The conclusion is discouraging. Although he drew a lucky card in 2000 – the Russian economy’s entry pass to the zone of growth and unprecedentedly favorable export conditions – Putin has failed to take full advantage of this. Over the past five years, the economy still hasn’t undergone the restructuring required to offer some hope of a cure for the “Dutch disease” – that is, expanding the foundations of economic growth beyond oil export revenues. Hence, even the budget achievements of 2000-02 could end up being negated. And the presidential election of 2008 might take place against a very different economic backdrop from the elections of 2000 and 2004.