While Moscow has been aggressively advancing its interests on the international stage, Russia’s stagnating economy means the country risks gradually falling behind the rest of the world and possibly facing social unrest at home. President Vladimir Putin is well aware of the danger and has launched a $390 billion spending program intended to “transform” the Russian economy, with 12 so-called national projects at its core. While this new supply-side economic model is meant to boost the pace of Russia’s economic growth above the global average, and would build on impressive reforms in the banking and tax sectors, the effort’s success is far from assured. One obvious obstacle is Western sanctions, but potentially far more damaging to Russia’s long-term economic prospects is the crisis of confidence among entrepreneurs and investors. What’s worse, Putin’s national projects, if ever they get off the ground, are likely to “bake in” some of the very problems leading to that lack of confidence—including the state’s heavy hand in the economy.

Monumental Task

Russia’s economy is in bad shape. Its petro-driven growth model exhausted itself well before the Ukraine crisis of 2014 and the West’s subsequent sanctions against Russia. Growth declined steadily from 2010 to 2014, despite $100 oil in all but one of those years; it stayed below 2 percent in 2013-2017—first hitting zero in 2013—and barely inched up to 2.3 in 2018. The first three months of this year saw GDP rise by just 0.8 percent year on year, according to the state statistics agency Rosstat—the lowest figure since late 2017, when growth was 0.3 percent. This was lower than both the Central Bank’s prognosis of 1.5 percent and the lowest forecast in a Bloomberg survey of 14 economists, the median for which was 1.2 percent.

The national projects, which presume some 25.7 trillion rubles in spending over six years and are enshrined in a set of May 2018 presidential decrees, rest on the optimistic assumption that Russia’s annual growth will rise to 3 percent by 2021, and then to about 3.1 percent in 2020-2036, according to the official budget forecast. Meanwhile, in this scenario, global economic growth would fall to 3.2 percent by 2024 and below 3 percent after that, ensuring that Russia’s economic power increases relative to the rest of the world, as it arguably did for much of Putin’s presidency.

This comes in a landscape where, despite the economic growth of the 2000s, Putin has failed to create conditions in which Russia’s businessmen want to invest in their own country—a lack of confidence that puts a significant brake on Russia’s long-term growth. Domestic investment from the private sector is woefully low. In 2018 investment in fixed assets amounted to 20.6 percent of GDP, according to Rosstat, but the vast majority of that was due to a few mega-projects carried out by the state. Putin’s increasingly repressive control, the stagnation in wages and soggy economic growth have shaken confidence among the business class, who are reluctant to invest and grow their businesses. The oligarchs—that is, those who do business with the state using personal connections—are likewise unwilling to invest, preferring to take their profits out of their companies as cash: Russia currently has the highest dividend yields in the world—twice the level of the benchmark MSCI EM average. In nearly three decades Russia has had a net inflow of capital in only two years, 2006 and 2007, at the height of a boom when Russian entrepreneurs brought $131 billion back into the country. When the 2008 crisis struck $133 billion fled again and Russia has seen capital flight every year since.

Far from revitalizing the economy, Putin’s new spending program is more likely to deepen this crisis of confidence by entrenching Russia’s increasingly state-led economic model. The national projects seem designed to increase Russia’s autonomy from the global economy and they contain few provisions for attracting foreign investment. What improvements to the investment climate there are target investors from the Middle East and Asia as sources of capital—regions where state-to-state relations play the predominant role. Nothing in the new program deals with improving the rule of law, bolstering property rights, building institutions to make the government more accountable or any other measures that could improve entrepreneurs’ confidence.

Western sanctions, although ineffective in changing the Kremlin’s foreign policies and having a limited effect on the Russian economy, have fed this crisis of confidence; moreover, they are an impediment to the national projects in that a large share of the investment is supposed to be raised from the private sector. Russia’s foreign direct investment (FDI), excluding reinvestment, fell to a paltry $1.9 billion in 2018; if you subtract profits reinvested by foreign-owned companies already operating in Russia, then effectively Russia is receiving no outside investment at all other than a few mega-deals struck with China. Even when reinvestment is taken into account, FDI in Russia in 2015-2018 averaged 1.5 percent of GDP, according to the Institute of International Finance—the lowest it’s been in 20 years. Former Finance Minister Alexei Kudrin, who unofficially leads the Kremlin’s liberal reform team, said in April that the government’s plan to increase investment to 25 percent of GDP by 2024 would most likely fail.

The threat of new, more severe sanctions has spurred the Kremlin to undertake a slew of initiatives to reduce its exposure to and actively cut ties with Western capital markets and business. Among the more noticeable measures were Russia’s sell-off of two-thirds of its U.S. treasury-bill holdings in 2018, while massively increasing the share of Chinese yuan it holds as a reserve currency, as well as the ongoing stockpiling of gold and import-substitution programs to reduce dependency on foreign-supplied software, food and machinery, among other things.

New Model Needed

Irrespective of the clash with the West, Russia needs a new economic model. The earlier, oil-centric approach has run its course. And if the 1990s became a demand-side success—with the Kremlin hiking wages by 10 percent a year to close the destabilizing gap between the public and private sector and fueling consumption—the new model is more of a supply-side approach, where red tape is cut, the tax burden remains low and the state will invest massively in infrastructure. At the same time, there will be heavy investment in the social sphere, such as health care and education.

Specific goals of the May decrees include: raising productivity growth to 5 percent per year during the next decade (since 2009 it has averaged only 1 percent); increasing the share of small and medium enterprises, or SMEs, in GDP to 40 percent (from the current 20); boosting the number of people employed by SMEs from 19 million to 25 million; and halving the number of people living in poverty (currently 13.2 percent of the population or 20 million people). Many of these goals are supposed to result from spending on the national projects and an extra 2 trillion rubles a year on top of the 16 trillion in federal budget expenditures: Two-thirds of that spending will go to the social sphere and the remaining third will be spent on infrastructure.

This is not the first time the Kremlin has attempted a massive infrastructure investment program. In 2007, when inflation fell into single digits for the first time since the fall of the Soviet Union and Russia was awash with petrodollars, the Kremlin announced $1 trillion in infrastructure investment. But the initiative was quickly dropped when the global financial crisis hit and every spare penny was needed to stave off economic collapse. (A set of 2012 May decrees, aimed at raising living standards and modernizing the economy, is also hard to classify as a success.)

Already there is skepticism about the latest effort. Much of its first year has been lost to internal disputes over the specific menu of projects and their funding sources, according to Bloomberg: A $5 billion rail bridge was crossed off the list after it became clear how underused it would be; a high-speed train to Tatarstan was scrapped as too expensive. Clearly, better assessments are needed, but Putin is pushing for results.

Reforms, Round 1: Taxes and Banks

Russia has implemented a raft of deep, successful reforms in recent years, but they have been limited to the financial and fiscal sectors.

One motivating factor for the tax reforms came in the second half of 2014 when Russia was hit by a double whammy: The collapse of oil prices at the end of the year sharply reduced the government’s main source of tax revenue just as the sanctions regime reduced the government’s ability to raise capital. This led to a near-miss crisis in 2016 when the Finance Ministry was unable to fill a 2-trillion-ruble hole in the budget. Eventually the problem was solved with the “privatization” of a 19.5 percent stake in oil major Rosneft, which later reportedly turned out to be a loan from Russian coffers.

That scare goaded the Finance Ministry to launch wide-reaching reforms to improve efficiency and beef up the enforcement of the tax code. There has been a tightening of regulations and a crackdown on schemes and scams. The tax service also got a revolutionary new IT system and the upshot has been a 30 percent increase in the federal tax take in 2018, despite almost no change to the tax burden.

The best evidence of the effectiveness of these changes is that the oil price needed for a balanced federal budget has fallen from $115 in 2008 to $49 now, according to Renaissance Capital, and is expected to fall further.

Concurrent with tax reforms has been the hunt for new sources of revenue. This has ended up in a makeover of the mineral extraction tax (MET), the mandatory payment of 50 percent of income as dividends for all state-owned enterprises (SOE), a 2-percentage-point increase in the VAT rate and an increase in retirement ages, to name some of the most prominent changes.

These efforts have transformed Russia’s public finances and the government marked its first budget surplus in years at the end of 2018, with 2.7 percent of GDP. The official forecast this year is for another record-large surplus of 1.9 trillion rubles, or at least 1.8 percent of GDP.

The most obvious and highly successful of all these reforms has been the clean-up of the banking system that began in 2013 when Elvira Nabiullina took over the Central Bank of Russia, or CBR. Nabiullina has been closing six or seven banks a month on average since her appointment. At the same time the CBR has been checking banks and uncovering innumerable scams, with directors being jailed for stealing depositors’ money. In the summer of 2017 the clean-up went into a new phase when the CBR closed several leading commercial banks—the so-called Garden Ring banks—that had been pumping up their balance sheets using pension funds under their control. The shock to the system—the sector lost a cumulative 322 billion rubles in a single month—almost caused a meltdown. However, since then the banking sector has recovered and made more profits in the first quarter of this year than any time in the last five years.

Reforms, Round 2: Spend, Spend, Waste?

The reforms so far have vastly improved the state’s financial standing and created a much more efficient banking sector, but these in and of themselves won’t produce more growth or prosperity. It is not clear that the next round of change, focused on the 12 national projects, will either, although all the spending it envisions—on housing, healthcare, childcare, poverty, business promotion and more—is designed to have a visible impact on people’s lives.

Two-thirds of the spending is aimed at the social sphere and implementation will be in the hands of “the Kudrin team,” most of whose key members have worked for Kudrin at some point, including Nabiullina and the well-regarded Minister of Health and Social Development Tatiana Golikova, who previously headed the Audit Chamber, now run by Kudrin. Golikova will directly oversee the largest part of the social spending.

The other third will be directed at mega-infrastructure projects similar to the Kerch bridge in Crimea and the Power of Siberia gas pipeline to China. In an effort to prevent corruption the state has placed this spending under the oversight of the state-owned bank VEB (formerly Vnesheconombank), which is run by Putin confidante and former First Deputy Prime Minister Igor Shuvalov.

While Russia’s record on the impact of infrastructure spending isn’t bad, the latest plans may prove too inefficient and state-centric to engender confidence within the business community as a whole. In recent years Putin has gradually withdrawn from hands-on involvement with running the real economy, which is increasingly being left to the liberal team; however, he personally oversees the big set-piece infrastructure projects, like the Kerch bridge, and controls them by awarding contracts to his inner circle of “stoligarchs,” or state-sponsored oligarchs, making them billionaires in the process. Last month, Shuvalov started talks to buy up the construction companies of the oligarchs close to Putin that have been doing much of the large-scale infrastructure work so far, which suggests the Kremlin is trying to institutionalize what has thus far been an informal control system run by Putin personally. VEB looks increasingly like a “Ministry of Infrastructure” cast from a Soviet mold. If VEB’s deals go ahead, the bank will directly control both the capital and the construction companies that will carry out the infrastructure investment. And that means corruption and waste.

Russia’s Fiscal Fortress

The biggest impact the West’s punitive measures have had on the Kremlin has been forcing it to build a fiscal fortress. In doing so, Putin has largely sanction-proofed the Russian economy, but he has also prioritized safety over growth, refusing to leverage Russia’s economic potential and loosen the purse strings to promote more growth. For an emerging market having wide buffers is a good idea, but the Kremlin has carried this to an extreme.

The war mentality that predominates at the CBR has led to the accumulation of gross international reserves that topped $490 billion at the end of April—just shy of Nabiullina’s informal target of $500 billion—or some 13 months of future export cover, when three months is considered adequate by economists. At the same time the government has been paying down external debt, which dropped to $468 billion at the end of the first quarter, or about 15 percent of GDP. Not only does Russia have by far the lowest external debt of any major economy in the world—which universally runs north of 50 percent of GDP—it can also cover its entire external debt dollar for dollar in cash.That leaves little traction for new sanctions. Thanks to Finance Minister Anton Siluanov’s fiscal reforms, “Russia Inc.” is back in the black, currently running a large triple surplus of trade, currency account and budget. The rent Russia earns from raw material exports makes it very hard to pressure. Sanctioning Russia’s oil exports won’t work as Russia is one of the biggest exporters in the world and shutting this down would cause chaos on the commodity markets. That point was amply demonstrated when sanctions were imposed on oligarch Oleg Deripaska’s aluminium producer Rusal, one of the world’s major suppliers: Prices for the metal skyrocketed and the pain of the sanctions threatened to boomerang back at U.S. consumers.

The one place where Russia remains vulnerable to sanctions is on the ruble-denominated OFZ treasury bills market—the Finance Ministry’s work horse bond, which it uses to finance its operations. Since Russia was hooked up to the Clearstream international payments and settlement system in 2012, the share of foreign investors holding these bonds has soared and reached a peak in April 2018 of 34 percent of the total outstanding bonds. Now budgeted borrowing using OFZs is slated to double from the 1 trillion rubles the ministry usually issues to more than 2 trillion each year over the next three years.

U.S. officials have proposed including OFZs in the next round of sanctions, but the practicality of such a move is questionable. Anxious bond holders sold off their holdings in the second half of last year, reducing their share to 25 percent, but the market rebounded strongly in the first quarter of 2019 as fears faded. And, as with the Rusal sanctions, banning investors from owning OFZs will almost certainly cause chaos on international capital markets. Russia’s rock-solid macroeconomic fundamentals and the 8-plus-percent OFZ yield have made the bond highly attractive and it is widely held by international institutions, including U.S. pension and insurance funds. Sanctioning OFZs would cause billions of dollars of losses for all their investors. Alternative buyers of the bonds in Asia do not have the liquidity to absorb the supply of bonds that would suddenly become available. Indeed, such sanctions would probably be more painful for the investors than the Russian government, which would no longer have to service or redeem this debt if it claimed a force majeure event had occurred.

Sanctioning Russia’s sovereign debt would be seen as an act of economic war by the Kremlin. Following the May 2014 annexation of Crimea the first round of sanctions was largely symbolic, targeting individuals with visa bans and asset freezes. But as time has passed the sanctions have escalated, culminating in the April 6 measures against Deripaska, which didn't just ban investors from owning any new bonds or stocks Rusal may issue but from doing any business at all with him or his companies. Targeting sovereign bonds would be going up to the next level.

Looking Ahead

It is the threat of more painful sanctions, rather than existing sanctions, that has driven much of Russia’s policy decisions in recent years. As mentioned above, the CBR has already decoupled Russia’s reserves from the international capital market by selling off its U.S. T-bill holdings and stockpiling gold. Afraid that it might be cut off from the SWIFT payment system, Russia in 2014 set up the MIR payment system, which is now up and running. Massive investment into agriculture over the last four years has made Russia largely self-sufficient in most produce (it used to import large amounts of chicken from the U.S., but is a net exporter now). And most recently, on May 1, Putin signed into law measures that mean Russia can cut itself off from the global internet—although no one is sure what will actually happen if it tries.

The national projects, with their heavy investment program to transform the domestic economy, can now begin because the Kremlin feels it has frozen the conflicts in Syria and Ukraine and strengthened its fiscal fortress enough to withstand any sanctions the West can throw at it.

If Putin’s efforts at an economic reboot succeed, Russia may feel even more assertive in defending its interests on the world stage; if they fail, Moscow may instead become more accommodating. This could mean Russia will be driven deeper into China’s arms or forge closer ties with Europe, which remains Russia’s biggest trade partner as a bloc (for now), or Moscow might even do more to mend fences with the U.S. But the success or failure of the spending program will take years to determine, so whatever changes the efforts might usher in will take years to see.

Correction: An earlier version of this article said Europe "remains Russia’s biggest investor and trade partner after China," but, according to the IMF, EU trade with Russia in 2018 totaled $294.2 billion versus China's $108.3 billion. That said, Russian-Chinese trade increased by 22 percent in 2013-2018, while Russia's trade with the EU fell by 30 percent.

Photo by Alexander Bozhkov distributed via Wikimedia Commons under a CC Attribution-Share Alike 4.0 International license.

The opinions expressed in this commentary are solely those of the author.