For much of late 2008 and early 2009, market attention was on Russia’s FX reserves as the CBR spent freely to control the descent of the ruble. Thus far, my prediction that the ruble would hold its basket level of 41 is proving true, although I would concede that ultimately the jury is still out. I believe the recent market rally is a false dawn, and so all asset classes are likely to be pressured again in the coming months.
But, for now, with oil around the $50/bbl mark, the ruble is close to fair value, where the current account will roughly balance. Now, with a massive economic downturn underway, attention will shift to government finances.

Chart 1: Reserve Fund ($ bln)
Spending To Cover Budget Deficit

Data released this week confirm that the Reserve Fund has now transferred one trillion rubles to Finance Ministry to support the state budget; Kudrin has launched a process of marketing Russia to raise capital on the international market on 2010; and now taxes have started show signs of inching up at the margin. (Unified Social Tax looks like rising back over 30%.) How serious is the situation, and how well can the government cope?

Not A Pretty Picture
There should be no doubt that the fiscal situation is very tight in Russia. Prime Minister Putin has correctly finger pointed western nations for triggering the global downturn, but it was his strategies that led to Russia’s over-reliance on resource revenues. Any student of history could tell you clearly how sustainable rising oil prices were, and Russia’s dependence on oil and gas income led to gross inefficiencies and economic failures.
At the same time, Russia persistently developed the worst investment reputation among its peer group. To be certain, the challenge of emerging from the Soviet Union was enormous, but Russia pursued what it deemed self interest so aggressively that Russian stocks now trade with a fully justifiable discount. Returns are necessarily high in Russia, as the incumbent administration has developed a reputation for changing position, disregarding laws and reversing contracts.

Silver Lining
The greatest achievement of the Putin presidency was unquestionably the reduction of debt, both nominally and as a percentage of GDP. Oil and gas revenues caused structural economic failings, but also led to a capitalisation of assets and a fundamental restoration of Russia as a sovereign state.
Importantly, at the same time as destroying its nascent reputation as an attractive and welcoming place for foreign investors, Russia met in full and more its fiduciary responsibilities. Russia’s risk profile created high debt yields, and it honoured them. This fact underscores the notion that debt investments have performed better than equities portfolios over the long-term.

Fast Forward
Looking ahead to 2010, Russia is likely to run out of state revenues. If the state continues to spend a full kilt – which it most likely will, because Russia’s notion of democracy is keeping the balance of people economically content – then, absent a powerful recovery in oil prices, the Reserve Fund will dry up next year. As things stand, the Fund will lose a total of almost $100 bln this year and currently has $107 bln left.
Before that happens, the Russian government will go to the global capital market to raise money. It is likely to prove successful. Its credit rating remains investment grade, its willingness to pay is an arguable point, the ratings agencies are rightly nervous about it, noting a close correlation between complicity and oil prices, but Russia will likely strike a constructive tone.
The Finance Ministry is approaching the challenge with a respectable sense of responsibility. Initiating marketing efforts a full year ahead, it clearly understands the difficulty of presenting itself as a reliable counterparty.
Meanwhile, Kazakhstan (which has admittedly been far less aggressive toward foreign investors) serves as an example of how well commodities resources can attract lending at the sovereign level.

Strategic Implications
It may be hard work then, but Russia is thankfully unlikely to face a cash crunch during this recession (a fact which has led me to label this as a “normal” economic cycle for Russia).
With cash flow needs met, the bigger issue is perhaps the strategic implications. After amassing such large reserves, Russians should be disappointed that their nation has to borrow again so soon. The costs of running “Russia Incorporated” are excessive in the extreme.
In a sense then, disappointing as the news of higher possible taxation is from a commercial perspective, it is reassuring from a macro standpoint. (It is worth remembering that Russia is officially a low tax nation, but official metrics belie the true costs of doing business.)
Crises are part danger part opportunity, and so it is for Russia. Clearly the heady days of $100+ oil are not coming back soon. But, the government now has a chance to begin cleaning out the system. Raising taxes is a peripheral effort. If we get a line-by-line overhaul of the federal budget, and a genuine campaign against corruption, then Russia has every chance of improving its image as an investment destination at this time.
Such objectives will meet staunch resistance, but accurately match Medvedev’s stated intentions. The economic crisis could provide the ideal backdrop for him to pursue his goals. The challenge is great, but so is the opportunity. Failure to change now would push up the cost of borrowing and damage the cost of living and development for the whole country.