Russia’s Looming Pension Crisis

Julia Tsepliaeva
Chief Economist on Russia & CIS
Merrill Lynch

It seems obvious that the pension system, in its current shape, may become one of the main recipients of budget funds and underlying causes of a budget deficit in the coming years. The draft of the federal budget for 2010-2012 suggests the budget is likely to maintain a considerable deficit of above 4 percent of the GDP for the coming several years. In our view, the deficit will remain at this level at least until 2020 (on a $70 per barrel Urals oil price assumption), which means a significant cutback on government spending and massive borrowing.

According to the government plans, in 2010 average pensions are to be increased by 50 percent to 7,750 rubles on average. This could boost the pension/wage ratio to 38 percent (closer to the 1990 level). An important part of this increase will come from aggressive valorization – which is an increase in the consideration of the Soviet working period in the current pension calculation. This increase is clearly necessary as current pensions are below the subsistence level, but the financing of this measure falls on the federal budget as the corresponding increase in taxation (hike in UST from 26 percent to 34 percent) has been postponed to 2011 as an anti-crisis measure. According to our estimates, this decision will cost the budget 700 billion rubles in 2010, or 1.6 percent of GDP.

Ivan Bokhmat
Macro and Equity Strategy Analyst
Merrill Lynch

Instead of letting the business finance the pension system from taxes, the government plans to spend money from the National Welfare Fund (NWF) and the budget to finance the deficit of the pension system. The valorization of the pensions will cost 500 billion rubles, 561 billion rubles and 609 billion rubles in 2010, 2011 and 2012, respectively – the NWF’s money will be used for that. When the fund is depleted (we see this happening in 2010-11), the federal budget will have to finance valorization directly. The deficit of the Pension Fund will have to be financed from the budget. In 2010, we share the view of the Finance Ministry that the pension fund deficit could increase to1,166 billion rubles, excluding the valorization effect. Together with valorization, in 2010-2012, federal budget transfers to finance pensions could increase to 5.3 percent of GDP in 2010 and 4.4-4.6 percent of GDP in 2011-12. This will fuel the budget deficit in 2010-12 and keep it high in the mid-term.

The heavy pension burden confirms our view that the budget deficit is likely to remain chronic in the coming decade. Although we expect this dramatic increase in pension payments to be a one-off event and economic growth and inflation to reduce the burden on the budget, we believe that high pension obligations will prevent substantial cuts in expenditure. We also believe that the shift in budget focus from the investment and economic growth stimulation typical in 2005-08, toward social expenditure and social patronage represents a step change in policy that is likely to be sustained in the mid-term. We do not believe the government has the financial resources at hand to deliver on its previous ambitious infrastructure investment plans in full.

We do not expect the debt problem to seriously bother the government in the mid-term. The sovereign-debt-to-GDP ratio is tiny, so debt expansion will start from a very low base of 5.7 percent of GDP in 2008. In 2009, we do not expect debt to expand above 8.5 percent of GDP, because a significant part of the budget deficit will be financed by the Reserve Fund. Nevertheless, taking into account the sizable pension transfer of more than 3 percent of GDP fuelling the budget deficit in the mid-term, the sovereign debt-to-GDP ratio may expand to 45 percent of GDP in 2010-20. Debt servicing pressure is very likely to increase from the current 0.4 percent of GDP to 3 or 3.5 percent of GDP. Consequently, up to one-third of federal budget revenues may have to be channeled to finance pensions and service debt.