Wednesday, 26 August 2015

Economic crisis looms in the North Caucasus

Published in Analytical Articles

By Natalia Konarzewska (19/08/2015 issue of the CACI Analyst)

The North Caucasus is the Russian Federation’s most economically impoverished region, as well as the most dependent on government revenues. Due to Russia’s dwindling financial situation, federal subsidies for the region are shrinking, which negatively affects welfare and social service expenditures as well as investment projects. Since last year, many state-owned regional companies have gone bankrupt. Fluctuations in government revenues will pressure local governments to increase borrowing from external sources, loans that they will have a hard time paying back. The North Caucasus therefore risks seeing a series of financial defaults. 

BACKGROUND: In August, Russia’s Federal Statistics Service announced that the country’s economic output shrank by 4.6 percent in the second quarter of 2015, against a 2.2 percent decline in the first quarter of the year. The pace of decline surpassed the predictions of the Ministry of Economy, which anticipated that GDP will fall by 4.4 percent. The renewed decline in the oil price, which in August reached US$ 40 per barrel for the first time in over six years and the subsequent depreciation of the ruble will contribute to further economic downfall in the Russian market. Moreover, in late June the European Union extended its sanctions on Russia for another 6 months, which will additionally weaken the Russian economy. In response, Moscow decided to maintain a ban on food products imports from the EU as long the sanctions are in force.

The deteriorating financial situation is already evident in Russia’s regions. In 2015, state funding for the federal subjects was decreased by 9 percent (174 billion rubles – $3.1 billion) in comparison with last year. Local governments, which have borrowed heavily in the past to sustain their lavish spending, can face problems paying their creditors. The northwestern federal subject Novgorod Oblast was the first Russian region to default on its debts in February this year. Novgorod’s default raised fears among heavily indebted regional governments across the country. In June, Standard and Poor’s rating agency calculated that in late 2014, Russian regions accumulated more than 2 billion rubles (US$ 36 million) of debt. According to the agency, the debt burden of 10 regions is close to 100 percent of their revenue and they may soon be unable to meet their financial obligations. The situation is predicted to deteriorate further as in the next three years, the regions’ average debt burden will rise from 33 to 55 percent of their income while regional budget revenues will decrease. This will inevitably lead to a payment crisis in some of the most economically vulnerable regions.

Heavily dependent on federal support, the North Caucasus is the region most vulnerable to the economic crisis. Each of the seven republics in the region – Adygea, Karachaevo-Cherkessia, Kabardino-Balkaria, North Ossetia, Ingushetia, Chechnya and Dagestan draw more than 50 percent of their budget revenues from Moscow. The most volatile republics – Dagestan, Ingushetia and Chechnya – tend to be even more dependent on central government funds, which account for more than 80 percent of their budget. According to the latest RIA Rating Agency socio-economic survey, the North Caucasus has the lowest scores in almost every category in comparison with other federal regions. Almost all federal subjects in the North Caucasus have poor economic indicators such as per capita production of goods and services, dependency on central government revenues, high levels of unemployment, low levels of tax collection and low salaries. In the past few years, Moscow generously invested in the regional economies within the framework of programs aimed at developing tourism, medical and educational facilities, industry and agriculture. However these programs are hardly effective. Despite ensuring a certain level of social services, government programs did not stimulate growth of the local economies and ensure good governance. Almost all North Caucasus local governments are spending the major chunk of their budgets on social welfare (in some cases almost 70 percent of the budget) and neglect investment projects which could stimulate their faltering economies in times of crisis. Poor governance and corruption contribute to the waste and embezzlement of the funds. Furthermore, the conflict-prone region is hardly able to attract private investors since projects, for example in the tourist industry, are not commercially feasible.

IMPLICATIONS: In the coming years Moscow plans to downsize and reallocate funding for the North Caucasus.  The government justifies these changes by the country’s uncertain economic situation and the necessity to cut back on spending commitments.   In late July, Prime Minister Dmitry Medvedev announced that the second stage of funding for one of the federal programs in the North Caucasus – Development of the North Caucasus Federal District until 2025 – aiming to stimulate the local economies, will be decreased by 8.5 percent in 2016-2020. Furthermore, Moscow is changing its strategy for subsidizing the region and plans to establish a new project development fund as an investment mechanism in the North Caucasus. As opposed to the current government investment program in the region, the Federal Target Program South of Russia, the newly proposed fund will allocate funds directly to projects, bypassing local governments, and will finance only selected projects such as ski resorts in Karachaevo-Cherkessia and Kabardino-Balkaria, a medical facility in Stavropol Kray and several projects in Dagestan. The new fund is expected to function between 2017 and 2025 and comprise 170 billion rubles (US$ 2.6 billion). The fact that the fund has a similar level of financing and time-frame as the South of Russia Program suggests that Moscow might plan to terminate the latter. It seems that in the coming years, the new investment strategy in the North Caucasus will severely restrict the role of local governments in redistributing funds and will effectively decrease the number of investments in the social sphere, which were dominating in the previous stages of financing, in favor of a limited number of development projects.

Furthermore, Moscow wants its federal subjects in the North Caucasus to get rid of most tax incentives and downsize their bloated administrations. Nonetheless, local governments are already running out of money and are under pressure to cut their expenditures for welfare, social services and administration. In 2014 and 2015, Dagestan and Stavropol Kray decided to freeze the indexation of social benefits and cut administration salaries. Chechnya had to decrease its budgetary spending in 2015 by 20 percent, but decided to cut the expenditures of government-controlled companies instead of social benefits. Kabardino-Balkaria and Adygea decided to slash their budgets by 10 percent and decided to keep their social welfare expenditures intact. Another dangerous tendency is the level of credit commitments compared to budget revenues. North Ossetia’s debt liabilities account for around 90 percent of the budget and the republic may face a payment crisis at the end of the year.

Another feature of the economic crisis in the North Caucasus is the large number of companies (a majority of them being state-owned) which are going through bankruptcy. In Chechnya, which has been hit especially hard by the wave of bankruptcies, several state-owned enterprises such as an electricity company and companies in the agricultural and construction industry are becoming insolvent. Large enterprises Dagestan’s and Karachaevo-Cherkessia’s agricultural sector are going bankrupt, as are several public utilities companies in Vladikavkaz (North Ossetia). The bankruptcy of such large state-owned enterprises, especially those with large numbers of employees, will sharply increase unemployment in the region, which heavily relies on government jobs.

CONCLUSIONS: Due to shrinking budgetary revenues, Moscow faces problems continuing its policy in the North Caucasus, aimed at buying stability and loyalty of local elites by generous financial help. Austerity measures can have several possible negative implications in the foreseeable future. Although Moscow ensures that social welfare expenditures will be kept intact, downsizing the bloated administration will increase the already high unemployment in the region. Currently, local governments have few options to augment their income and fluctuations in state funding will inevitably pressure them to increase borrowing from external sources, which can lead to a payment crisis. A shrinking number of investment projects decreases the possibilities to stimulate the faltering economy and will make the crisis harder to overcome. Finally, the sudden cut in federal support might aggravate the already tense situation in the North Caucasus and can cause popular unrest. There is a serious risk that social protest could be channeled by the Islamic State, which has recently taken root in the region with an agenda promoting social welfare, justice and equality.

AUTHOR’S BIO: Natalia Konarzewska is a graduate of University of Warsaw and is a freelance expert and analyst with a focus on political and economic developments in the post-Soviet space.

Image Attribution: Wikimedia Commons 

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