11 min read

Bulls on Parade

Whenever it's a choice between swords or ploughshares, Moscow usually opts for swords.
Bulls on Parade

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Whenever it's a choice between swords or ploughshares, Moscow usually opts for swords. Authorities have reportedly killed the freeze on defense spending and are increasing federal defense expenditures for 2022-2024 by 15% instead of just matching inflation. Over 3 years, that looks like a 730 billion ruble ($10 billion) at the same time that budgets for the security services are rising 28% – an additional 2 trillion rubles in total starting with a roughly 500 billion ruble increase for 2022. The increase in defense spending is notable given the problems restructuring debts last year and earlier this year as well as need to supply contracts to help defense manufacturers transition into civilian production. But it's the security services spending that tells the more important story:

Given that the budget calls for surpluses the next few years and the tax burden is being raised on businesses and households, this is a bit mad. Tax hikes on the mining sector are particularly aggressive at capturing a greater share of resource rents via severance taxes as well as raising the tax rate on profits, but none of that is financing social services or other needs. If the scale of vote falsification and use of electronic voting to 'disguise' manipulation in plain sight is any indication of the regime's confidence in its own party of power, then the decision to increase security spending at this rate is a huge tell about their assumptions. There is no growth breakthrough coming, no new way of reshaping the social contract by providing better living standards. Instead, the reimposition of austerity that will inevitably compress. incomes and weaken growth is paired with a preference to fatten up the state's repressive apparatus. I'll have to go back and adjust those figures for inflation when I have more time, but the trend and implication are unmistakeable. The mobilization state that many talk up when defining how 'Putinism' operates has completely failed to mobilize capital and business thus far. Inflation wasn't defeated, the 'speculators' still run rampant given gross profits are accruing to SOEs and large firms at the same rate as during the oligarchs' heyday, and Putin's meeting in March with business leaders didn't spur any change in the status quo. This is particularly concerning for any growth forecasts through 2024-2025 because of the opportunity costs. Not only is this spending 'misallocated' if the regime wants to produce growt. It's probably going to strengthen the power of individuals and groups at the regional and federal level to apply coercive power to raid assets, scare businesses, and otherwise disrupt any economic and political activity considered to be out of bounds.

What's going on?

In yet more confirmation that Russia's 2-3Q growth did not lay a strong foundation for recovery, net savings held by households are now the lowest they've been since 2009. Russians owe a cumulative 23.56 trillion rubles ($323.24 billion) while holding a combined 25.86 trillion rubles ($354.8 billion) in banks. That may appear to be a decent balance all things considered, but right now households are withdrawing an average of 250 billion rubles out of the bank every month, indebtedness continues to rise, and those savings are skewed towards the top 30% of all earners:

The rate of savings decline for 2020-2021 is quite steep and continuing. The one-off payments would only arrest that decline for about a month given they were still quite small. Microfinanciers have relaxed conditions for clients employed in sectors that have been hardest hit by the pandemic, but recovery to pre-crisis indicators is still a ways off. In effect, the lenders are keeping things afloat while borrowers try to keep their wages and incomes up. Per Iunikom24's survey data, borrowers in sectors hardest hit have seen their incomes fall 10-70%. There's tremendous churn underneath the topline data MinEkonomiki cites contradicting the official narrative on the economy:

MinEkonomiki's 2021 growth forecast at 4.2% might literally bear out, but 3% growth for 2022-2024 would have to be export led based on underlying conditions, supply-side policies, and the likely continued tightening of monetary policy. If real wages and incomes shoot up in the official data from labor market imbalances, we'll see it creep into inflation. That already fits the Central Bank's notes that the natural rate of unemployment may be higher now, a tacit admission that supply/demand fragilities create inflation in a stagnant economy. These figures appear somewhat fantastical – for instance, 4.5% growth for fixed asset investment in 2021 looks a lot worse in monetary terms given the decline in 2020, nor does it seem reasonable to forecast it accelerating significantly without a major fiscal impulse. But the budget's consolidating and taxes are rising faster than spending:

Blue = % GDP Green = blns rubles Clockwise – deficit/surplus, volume of sovereign debt, Dollar exchange rate/Urals oil price, money in the National Welfare Fund

In polite terms, this is all bullshit. Some of these gains and targets may be realized, it just won't be a result of the current policy framework, largely hinges on exporting sectors for now, and will almost certainly come with significant tradeoffs. Moscow has significant room to borrow domestically in the years ahead – sovereign debt is intended to be a safe asset for banks and investors that then lend and invest into the real economy, not simply a weight around the regime's neck. Fiscal interventions for households providing income support along with more expansive infrastructure development plans would make it far easier for privately-owned manufacturers and firms to justify productivity-enhancing investments and expansions of capacity to grow the way MinEkonomiki wants. Instead, they're content to sit on their hands and pretend that lower inflation and "stability" in what is alway a dynamic, unstable system will somehow crowd in private capital and help labor.

The real estate market continues to hum along despite mounting red flags across the economy elsewhere. Moscow set an absolute record for mortgage deals for Jan.-Aug. this year – 82,600. That's a 44% increase over the same period in 2020 and a 64% increase over the same period in 2019. A comparison of deals by month shows a slowdown in August vs. July, but not one that saps the momentum out of sales in Moscow yet:

Apparently cost inflation for construction materials is finally slowing down in the Volga region. That's not seen evenly across the regions and the price crunch is encouraging another policy response to control costs – strengthening punishments for sales of uncertified construction materials that are considered "falsified industrial production." About 1/4 of the nation's used construction materials are reportedly falsified according to a report from MinStroi. Worth reminding everyone that construction material costs have more than doubled since the pandemic began. The rate of dealmaking in Moscow suggests that rich(er) Russians and families with savings are still looking to buy, both for quality of life and as a store of value. That's where Evergrande and other Chinese property developers' emerging defaults or near-defaults is worth following since Beijing's policy response will bear heavily on future commodity prices, demand, and inflation across the input basket for construction on top of steel production curbs that have led to commodity deflation. Iron prices are less than half of where they were in May above $230 a ton, now below $100. Note the relationship between bids on Evergrande's March 2022 maturity debt and iron ore to boot:

Ironically, Russian policy attempts to insulate domestic price levels from global ones could mute the potential impacts of these sharp declines in input prices. China has been the 'motor' behind commodity price levels and demand for several decades now. If Chinese authorities really want to cool down the property market and short-circuit a set of domino defaults, then they either have to accept slower growth or increase infrastructure investment to offset the loss of GDP from housing. The latter doesn't follow from policy choices so far, nor do markets seem to be expecting such a surge to happen. If China grows closer to 3-4% annually in the next few years ahead, that means much weaker underlying commodity demand and an easing of that inflationary bottleneck. However, price increases in Russia on the labor side will stick, as will price increases if there's an attempt to rely more on domestic production to meet all demand and cheaper imports aren't allowed in. Russia's a top-1o country in terms of relative increases in the price of housing during the COVID crisis. At least there seems to be evidence pricing pressures are easing at the national level headed into 2022.

Russia's domestic power market is in for more bartering over regulatory changes intended to rationalize revenues and support modernization efforts. The Market Council is proposing to differentiate payments for power generation in relation to how intensively the equipment at a plant is used. The more intensive the use, the more money it should receive. The proposal hasn't yet officially reached MinEnergo, but when asked for comment, the official cited said they support the initiative to improve the efficiency of the power system. It's a warning shot – excess capacity or unused capacity will have a harder time muddling through financially if such a system is adopted. There isn't yet a clear proposed mechanism to make this work, so it's early days. Policymakers are trying to solve a problem that dogs them as a result of how power is priced. Consumers pay a single price after operators bid on capacity (with some price controls in place), but generating capacity isn't used equally. Capacity that's more often held in reserve earns the same amount as capacity used constantly regardless of differential costs for maintenance. The easiest fix is to apply some sort of coefficient to the bid cost of power depending on the source. However, the proposal hides a bit of a problem: renewables won't match the same utilization levels or necessarily carry the same kinds of maintenance needs as fossil fuel plants. In other words, a policy that's quite logical as a means of supporting the modernization of existing plants would be less effective at supporting a broader decarbonization of the power system in the absence of hydropower or expanded nuclear power generating capacity. Everyone's rightly concerned that renewable capacity can drive down prices and risk the loss of sufficient backup capacity.

This dynamic is playing out now in the UK, Germany, and other European power markets. Most of them lack the same price regulating system and effective subsidies for natural gas consumption, however. That's why hydrogen – and German energy policy with the incoming coalition government – matter so much for any solution to Russia's decarbonization and modernization challenge. Investments are continually delayed to avoid short-term inflation and a shift towards setting potential revenues on the basis of the intensity of use of existing plants will likely hurt variable green energy more than other sources in most contexts (not, say, solar panels on businesses' or households' roofs). Assuming this initiative moves ahead – 2025-2026 seems to be a tentative timeframe to introduce a new system – then hydrogen becomes a more rational domestic investment since it can mirror natural gas and use natural gas infrastructure. If it becomes a significant part of the energy mix in the EU, there's room for deeper commercial and political cooperation and partnerships even with the Baltics decoupling from Russian power grids.

Russian Railways' 2022-2025 investment plans appear to have finally be negotiated and the outcome suggests a series of compromises that are probably net negative for economic development in the South and suggest more debt issuances. The net spend looks likely to increase by 800 billion rubles ($11 billion), 150 billion of which will go into the Northern Latitudinal Railway in Yamalo-Nenets. A combined trillion rubles will go to aid upgrades and modernization works, much of which is behind schedule, but not without costs. The high-speed line between Moscow and St. Petersburg is losing over half its funding – FM Anton Siluanov is confident that borrowing can cover the 130+ billion ruble gap – and the 350 billion rubles assigned to the "southern cluster" has been raided completely and the proposed rail bypass linking Sochi and Krivenkovskaya (a bit inland from Tuapse) has been spiked. My best guess is the latter was relatively superfluous and overpriced – I recall exorbitant sums thrown at the coastal highway in particular amid a series of infrastructure plans that were cut or interrupted by the 2014-2015 oil and sanctions shock. Either way, that's a big pullback given Krasnodar Krai is the center of Russia's agricultural resurgence and could, in theory, provide new economic clusters with easy access to Black Sea import-export infrastructure as well as quicker airtravel access to place like Istanbul, Cyprus, Israel, or the Gulf States than Moscow. It's the Northern Latitudinal Railway that's gotten the most attention from Putin based on the reporting. What's up with that?

As of now, the NLR doesn't have a clear financing structure. Putin seems confident regional governments can borrow to pay for it, others have proposed using the National Welfare Fund, but overall, it's a project that can be afforded. Trouble is that it only serves the narrow constituency of interests operating on the Yamal Peninsula and offers limited development upside, as much as it's helpful for residents and businesses in the region to be able to travel east-west via rail. Of course, once you build it the costs of maintenance and repair works will outstrip those in southern Russia considerably which will then create additional future cost drags for RZhD. It's the 1 trillion ruble rush to throw money at repair and modernization overall that's most impactful, but the decision to cut resources from the south – admittedly they probably weren't being used particularly effectively – to focus on Yamal speaks to a slowly expanding problem for state investment and delivery on development promises. These compromises require regional governments or RZhD to borrow more, transferring the financial risk from the sovereign to subnational/corporate bodies dependent on the sovereign for their credit rating and access to credit. Individual tradeoffs may make sense. Financing more of the HSR spending for Moscow-Petersburg by borrowing makes a fair amount of sense given it's a high-traffic route linking the nation's two largest economic centers. That logic doesn't work in Krasnodar Krai or other contexts where demand is not certain, but the positive externalities of having better rail access and links are fairly evident. We'll have to wait and see if the cash infusion despite fiscal consolidation helps things or if inflation and incompetence swallow it up.

COVID Status Report

Like clockwork, cases are back up and deaths broke the psychological barrier of 800 used by the OperShtab. 19,706 new cases and 817 deaths were reported today. The week-on-week case rate change saw a 5.8% rise, which tracks with past episodes coming off a trough before a surge:

According to Anna Popova of Rospotrebnadzor, cases are rising in 36 regions at the moment. Based on the official data, the R rate is around 1.04 at the moment. That's not terrible. However, the last time it hit 1.04 last year, it setup the massive case surge in June:

What's more, the case fatality rate kept climbing pre-election, probably due to conscious undercounting of cases and testing gaps, and is now at about 4.35%. Russian tour companies trying to scrape out business amid weaker demand and foreign disruptions are apparently starting to offer vaccine trip packages to Serbia and Germany. There are also some interesting dynamics in response to COVID revealed through demand trends – demand for medical masks is down 19%, but demand for antiseptic handwash and related products is up 53%. Clearly people are worried, they just don't want the inconvenience of masking despite it being a low cost, low-to-medium impact move. As of now, it seems that the 4th wave is under way though the 3rd wave never really ended. I'm going to watch the death figures closely and check for independent assessments of daily mortality and excess mortality. Things seem primed to get a lot worse for October.

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