Russia: FinMin returns to austerity with budget 2025

• Deficit is projected to shrink to 0.6% of GDP in 2025
• Budget forecast is based on assumptions of soft economic landing next year
• Government to rely more on non-oil and gas revenues after tax reform
• Kremlin is ready to sacrifice social spending to keep military expenditures high
• Debt level will rise modestly as domestic borrowing remains primary source of financing

The FinMin submitted the draft budget for 2024-2026 to the Duma on Sep 30, two weeks earlier than last year. While the draft is yet to obtain Parliament's approval and will certainly see some changes, we expect them to be fairly cosmetic, which is the standard budget process in Russia. We would say that the key feature of the new budget is FinMin's goal of returning to a more balanced fiscal policy, with the primary balance staying positive, expenditures-to-GDP ratio shrinking and sovereign fund growing over the next three years. However, as usual, we urge not to pay too much attention to the 2026-2027 projections, as the FinMin really focuses only on the budget for the next year and struggles with accurate projections even at a one-year horizon. Budget revenues will grow because of the tax reform and higher personal and corporate (especially corporate) income tax revenue. Most of the government money is to be spent on national defence as the war drags on, while other expenditure articles will see only a mild increase. The holy cow of Putin's economic policy - social spending - is facing a sudden cut in 2025. Despite the primary balance returning to the positive zone, the headline balance will remain in red, as debt service grows because of tight monetary policy and increased borrowing. The FinMin, however, will continue to rely on domestic borrowing to finance the deficit and will borrow even above the deficit level, as other below-the-line articles will remain negative or marginally above zero.

MACROECONOMIC ASSUMPTIONS

The fiscal framework is based on EconMin's mid-term outlook, which sees GDP growth slowing down next year, but remains traditionally upbeat in its mid-term projections. However, as the Russian economy surpassed expectations due to the fiscal stimulus in recent years, the EconMin's outlook turned out to be the closest to the actual figures on numerous occasions, outperforming the more conservative CBR forecasts and the drastically negative expectations voiced by agencies.

The EconMin expects GDP growth to reach 3.9% in 2024 and to slow down to 2.5% in 2025 on tight monetary and fiscal policies. Lower investments and net exports will also weigh on growth, while consumption will expand at a slightly higher pace than in 2024 - though we struggle to find a good explanation for that. The EconMin is surprisingly optimistic regarding the inflation forecast, seeing CPI inflation dropping to 7.3% in 2024 (which now seems almost certainly not happening this year) and 4.5% in 2025, which we believe is also way too positive. The ministry though is rather conservative regarding oil prices, which are expected to decline and the RUB FX rate, which is expected to depreciate. Real wages, industrial production and retail sales will grow slower next year, but will keep solid growth rates nevertheless. Overall, the EconMin expects a very soft landing next year.

While some of EconMin's assumptions may look overly positive, we would say that this year's outlook looks more realistic than a year ago and the actual economic growth was well above EconMin's projections for this year. The ministry itself said that key risks to its forecast are associated with monetary policy remaining tight for too long and the labour market remaining too tight. It is baffling to understand how the labour market will become less tight as the economy maintains positive growth rate amid zero investment growth. The EconMin probably assumes that the high investments over 2023-2024 will transit into higher labour productivity, but we are yet to see that. With the inflation forecast being too optimistic and some concerns regarding GDP growth, there are certain risks for the budget figures, but under Siluanov's rule the FinMin usually takes a conservative stance regarding budget revenues, so we do not expect a significantly higher deficit next year.

BUDGET REVENUES

Based on the EconMin's assumptions, the FinMin expects budget revenues to grow by 11.6% y/y next year to RUB 40.3tn or 18.8% of projected GDP. In particular, the FinMin expects oil and gas revenues to decline by 3.5% and non-oil and gas revenues to grow by a solid 18.5%. The oil and gas revenues will decline on lower oil prices and extraction, but will be supported by a weaker RUB. Non-oil and gas revenues will grow on higher GDP (turnover taxes are projected to increase by 15.9%) and because of the tax reform (revenue taxes are projected to grow by 113% next year). The FinMin also expects a higher tax collection rate, which is probably the weakest point of the new budget. While the ministry certainly improves tax administration every year, assuming a considerably higher tax collection is always a gamble to some extent. Last year the FinMin also gambled forecasting one-off budget revenues at RUB 2.5tn, while now it expects them at only RUB 1.8tn. At least in this budget law the FinMin does not forecast any significant income from one-off revenues. Overall, we see the budget growing less dependent on oil&gas revenues and relying more on non-oil and gas revenues after the tax reform, which is a good thing for long-term fiscal stability. At the same time, the oil rent becomes smaller for Russia because of the sanctions, but FinMin's appetite remains big, meaning a higher tax burden for the economy in the future.

BUDGET EXPENDITURE

Analyzing fiscal expenditures is difficult: while the FinMin raised the expenditure forecast for 2024 to RUB 36.7tn, it did not provide an updated breakdown. We think it is safe to assume that most of the additional expenditures are spread between military expenditures and debt service, as the key rate and cost of debt clearly deviate from last year's projections. The growth rates for these two articles of expenditures will be bloated, but regarding other articles we expect them to be adequate.

Expenditures are projected to grow by 13.1% y/y to RUB 41.5tn or 19.3% of GDP. The highest spikes are surprisingly observed not for debt service and military expenditure, but for the utilities sector (+100% y/y) and environmental expenses (+80% y/y). However, even combined the spending on these two articles will equal only 1.2% of GDP. We link the growth in spending on utilities to the development of domestic gas infrastructure as Gazprom now needs a more developed domestic market to offset lower external demand. Spending on the environment grows as Russia remains surprisingly strongly committed to reaching the goals of the Paris Agreement. The military and debt service expenditures are projected to grow by 25% y/y and 39.1% y/y, but once again, these growth rates are bloated. The only cut in nominal terms is expected for social spending and a significant one (-15.6% y/y). That is also a surprising move from the budget, as high social expenditures were the main pillar of last year's budget and generally align with Kremlin's economic policy. Social spending helps Putin gain political support and provides for lower poverty levels and less inequality in incomes. Potentially the government expects to spend less on social support as the poverty level has been declining in recent years on high wage growth.

Regarding expenditures relative to GDP, it is again difficult to compare the actual changes, as we do not know the breakdown of expenditures for this year. We would say that it is safe to assume that debt service, environmental and utilities expenditures will have a bigger share in GDP, while this is not so obvious for military expenditures, which can surge this year. Other expenditures will probably have a lower share in GDP, despite nominal growth.

DEFICIT AND FINANCING

With its new goal of returning to austerity, the government forecasts fiscal deficit of RUB 1.2tn or 0.6% of GDP next year. The FinMin expects to finance the deficit through new borrowing, with debt expected to grow by RUB 3.3tn next year and continue to grow at the same pace through the forecasting period. Apart from that regional budgets' debt to the FinMin should contract by RUB 0.1tn. Privatization proceeds are as usual forecasted at near-zero level. The FinMin expects to increase lending to other countries by RUB 0.3tn, which most likely includes loans to Belarus and various investment projects abroad (Rosatom's nuclear power plant construction projects are usually financed through FinMin's sovereign loans). The National Wealth Fund is projected to grow by RUB 1.8tn next year on additional oil and gas revenues.

With the government relying exclusively on new borrowing to finance the deficit and additional below-the-line spending, public debt is projected to grow to RUB 35.4tn or 16.5% of GDP in 2025 and to RUB 44.9tn or 18.1% of GDP by 2027. Surprisingly, the government still expects some growth (RUB 0.1tn) in FinMin's external debt in 2025. We recall that since the beginning of the war with Ukraine the government regularly reserves the possibility of USD 1bn borrowing from external sources, but have not yet done this. Regarding the rest of the debt, the government plans to rely on domestic sources, so we can expect OFZ issuance to remain high next year. While Russia can still boast one of the lowest debt-to-GDP ratios in the world, the growing cost of debt service is becoming more and more important for the budget.