Russian Regions' Recent Lackluster Performances Leave Government Facing Need To Take Action

Primary Credit Analyst: Karen Vartapetov, Moscow (7) 495-783-4018; karen.vartapetov@standardandpoors.com Secondary Contacts: Alexandra Balod, Moscow (7) 495-783-4096; alexandra.balod@standardandpoors.com Ekaterina Ermolenko, Moscow (7) 495-783-4133; ekaterina.ermolenko@standardandpoors.com Boris Kopeykin, Moscow (7) 495-783-4062; boris.kopeykin@standardandpoors.com

Table Of Contents
Regional Revenues Are Under Severe Pressure State Support Could Again Prove Positive There's Still Time To Act Related Criteria And Research

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Russian Regions' Recent Lackluster Performances Leave Government Facing Need To Take Action
Russian regions' coffers are dwindling and exposing weaknesses in the country's institutional framework, leaving the central government with three choices--keep up spending pressure, increase funding, or revise budgetary targets. Standard & Poor's Ratings Services believes the Russian government will have to act now to try to balance regional budgets and preserve--or potentially boost--local and regional governments' (LRGs) credit quality. The latest spending mandates, imposed before and after the presidential election in 2012, are increasing regional governments' spending obligations. The consequent rapidly diminishing spending flexibility has caused the structural gap between the regions' revenues and spending obligations to widen. Overview Russian regions' falling revenues are exposing weaknesses in the Russian institutional framework. We believe the central government will have to act now to balance the regions' budgets. Failure to act would, in our view, render the regions' finances unsustainable and constrain their credit quality.

Regional Revenues Are Under Severe Pressure

Regional governments' revenues fell significantly in the first six months of 2013, according to the Russian Federal Treasury, and we believe the overall revenue dynamics are poor. Corporate profit tax, which makes up on average one quarter of regional revenues, dropped 26% compared with the same period in 2012. Federal government grants, which account for another 20% of revenues, fell by 16% over the same period. Only a solid 11% increase in personal income tax prevented a sharper decline in total revenues, which fell 5%. So far this year the regions have managed to limit spending increases to just 3%, mainly through cuts in capital expenditure, compared with the first half of 2012, which supported their fiscal balances. However, we believe this level of spending might be difficult to sustain. In 2011-2012, the federal government imposed a number of spending proposals on the regions, mostly related to public sector pay, which upset the local revenue and spending balance. These proposals also constrained the regions' spending flexibility by increasing the share of sensitive social spending and leaving salaries accounting for more than 50% of operating expenditures on average. Long-term spending cuts or redistribution will therefore be challenging, in our view, especially for the weaker regions. At the same time, prospects for countywide economic expansion are constrained--according to recent data the Russian economy, posted growth of only 1.4% in the first half of 2013. Even if growth accelerates in the second half of the year, rising costs and significant tax returns due to asset depreciation reported in the first half of 2013 would most likely hinder the restoration of corporate profits.

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Russian Regions' Recent Lackluster Performances Leave Government Facing Need To Take Action

The evidence suggests that due to the widening gap between revenue sources and spending functions there is a high likelihood that financial results in 2013 will be a lot weaker that in 2012.

State Support Could Again Prove Positive

So far, our view of the federal government's willingness to allocate aid to the regions has been positive because of its solid track record of providing extraordinary support to regions under financial stress in 2008-2009. At that time, the government eased the liquidity crisis by giving crisis-ridden regions grants and loans and preventing regional defaults. All things being equal, similar action under the current stress scenario could lead us to revise our assessment of Russia's institutional framework up by one notch to "consolidating but uneven" from "developing and unbalanced." That would likely prompt us to raise our ratings on most Russian LRGs by one or two notches (see "Most Russian Regions' Creditworthiness Is Below Investment Grade Due To A Weak Intergovernmental System, Economy, And Management," published April 16, 2013, on RatingsDirect). However, the situation has changed since 2008-2009 because the government now has now to deal with a systemwide fiscal imbalance in addition to selected regional refinancing risks. We believe there are a number of possible scenarios for the second half of 2013 and early 2014. Under the first one, the federal government could continue to pressure the regions to increase spending regardless of revenue dynamics. This could cause fiscal imbalances to increase, which would cause regional investment programmes to suffer and regional credit quality to deteriorate, in our view. Alternatively, the government might narrow the revenue/expenditure gap by providing additional support to the regions. This scenario would require a strong political will to tackle federal spending lobbies. By our estimates, under existing revenue dynamics the federal government would have to transfer an additional 0.9%-1.0% of Russia's GDP in 2013, and 2.1% of GDP in 2014 to enable the regions to meet the mandated spending hikes. The existing grants budget for 2.3% of GDP in 2013 and 2.2% in 2014. Government reserves are currently 8% of GDP, so accommodating such large increases would likely prove difficult. Under the third possible scenario the government might revise its spending targets by lowering the rate and delaying the timing of expenditure hikes. It has already changed some regional spending targets--it extended the deadline for demolishing dilapidated housing from 2015 to 2017. The government could also delay other mandates, such as salary increases, to ease pressure on the regions. However, we believe this could have serious political consequences. Only keeping up the pressure to increase spending would be likely to have a clearly negative impact on the regional government sector and put the regions' credit quality on a downward trend. The other scenarios, or a combination of them, might narrow the existing revenue/spending imbalance and bring regional financials back to our base-case trajectory. If the government also continued to support the regions' liquidity to relax the refinancing pressure on them, and was more transparent with regard to its support, we might consider an upward assessment of our view of the institutional framework.

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Russian Regions' Recent Lackluster Performances Leave Government Facing Need To Take Action

There's Still Time To Act

We note that the government has so far been reluctant to allocate regional grants in 2013. Their amounts in the first half did not allow the regions to meet federal mandates in full and lagged behind legal provisions. However, in our view, there is still room and time to reverse the existing negative fiscal trend. We believe that it will be difficult to avoid tough decisions as to how to balance regional government finances in the longer run. However, without these decisions, the public finance system in Russia will continue to remain a key credit constraint. And the strongest regions' credit ratings will likely continue to stagnate on the edge of investment grade, while the credit quality of weaker entities will most likely deteriorate.

Related Criteria And Research

Most Russian Regions' Creditworthiness Is Below Investment Grade Due To A Weak Intergovernmental System, Economy, And Management, April 16, 2013 Russian System for Regional Governments Is Developing And Unbalanced, Nov. 12, 2012
Additional Contact: International Public Finance Ratings Europe; PublicFinanceEurope@standardandpoors.com

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