Who’s Going to Pay for Russia’s Fiscal Adventurism?

February 4, 2014

Putin and Russia seem to have a seemingly endless ability to spend money to support the country’s political aspirations. Whether it’s the mindboggling $50 billion for Putin’s pet project on the Sochi Olympics (up from Putin’s initial estimate of $12 billion, with which he personally used to lobby the IOC in Guatemala), the $2 billion loan to Belarus, the contingent offer of $15 billion to shore up Ukraine’s ludicrously unstable economy, the massive financial demands to support his domestic social policies, or even the supply of advanced weaponry at no or low cost to regional allies, it seems that Russia’s fiscal adventurism is of no consequence to Putin. And all this spending comes in the face of a dramatically weakening economic picture, with Russia’s growth rate diminishing or remaining the same since Putin won his last election to the Presidency in 2012. But the economic realities are becoming too much for even the perpetually economically optimistic Kremlin to ignore and are starting to show signs of realizing that new sources of revenue, beyond commodities (the budget balances around an estimated $120 per barrel of oil, and currently is hovering around $109), are needed.

Despite having low foreign debt, significant reserves and limiting budget deficits, Russia’s economic future is a far cry from the meteoric 7% growth that it experienced for much of the last decade. The situation is so bad that even Russia’s own economic ministry is forecasting growth averaging 2.5% a year until 2030. Even the IMF labeled Russia’s growth model “exhausted,” commenting: “inadequate physical infrastructure, including the transportation and electricity networks; overreliance on commodities; and a weak business climate,” have all contributed to the lower growth predictions.

But beyond the usual criticisms of the Russian economy and Byzantine legal system, Russia continues to face a crisis of money leaving the country, with an estimated $420.6 billion leaving the country since 2008 (according to Russia’s own central bank) along with the Ruble sliding to its weakest point against the Dollar since 2009 when the Central Bank spent $100 billion to support the currency.

So the question remains, how is Russia able to increase revenues to support Putin’s ambitious projects (including his military Modernizatsiia program)?

Well for starters, Putin tried privatizing some of the major nationalized companies, but his demands that they be listed on the Moscow stock exchange, combined with Russia’s notoriously capricious protections for business, led to disappointing results. Even Putin’s grandiose announcements of state spending on infrastructure were not enough to interest foreign investors.

It seems that if Putin is unable to attract foreign investors, he is determined to go out and forcefully draw back in much of the capital and businesses that have fled the country to tax havens, calling it “deoffshorization.” Putin has made the return of capital from abroad a prominent mainstay of his return to the presidency; he has banned state officials from having foreign banks accounts, has put the issue of offshore tax havens on the G20 and G8 agenda, and is attempting to pass new legislation ‘incentivizing’ (forcing) Russian owned companies to either do business inside of Russia or at least pay taxes regardless of their location. “The offshore nature of Russia’s economy has become a household word. Experts call this escaping the jurisdiction. We need a comprehensive system of measures for the deoffshorization of our economy,” he stated.

One of the pillars of his efforts to curb the exodus of capital from the country has been to ban state officials (including the CEO’s of state corporations) from holding foreign bank accounts (but not property, as was originally planned but which has been dropped). The ban was meant to not only ‘renationalize’ the elite but to also undercut one of the most resonating issues of the opposition (and through which opposition figure Alexei Navalny had gained his notoriety, by uncovering foreign assets and instances of corruption among the elite). By forcing the elites to repatriate their assets back to Russia, Putin is seeking to increase his leverage over the elites as an assurance of support. With the elite’s financials back in Russia, the Kremlin can not only keep track of the elite’s financial wealth, but also hold it hostage, under the threat of spurious (or not so spurious) legal charges, in exchange for continued loyalty. Further evidence of this is Russia’s refusal to ratify article 20 of the UN Convention Against Corruption, which states that public officials have to have a reasonable explanation of where their income and assets come from if it exceeds their salaries. The refusal to ratify means that the Kremlin wants to maintain the ability to allow supporters to continue to profit from their positions so long as they continue to remain loyal, and should their loyalty come into question they can then target them for abuse of office or other illegal activities that were heretofore acceptable.

Critical to the plan of “deoffshorization” has been the attempt to clamp down on the rampant exploitation of the tax code by businesses who locate themselves in offshore tax havens and take advantage of advantageous taxation agreements between Russia and many other locations. As The Moscow Times notes: “First, taxes will be levied on Russian-owned companies registered in offshore tax zones according to the Russian Tax Code. Second, companies registered abroad will be barred from receiving support or guarantees from the budget or such state banks as VEB. Third, foreign firms will be forbidden from winning state contracts.” The new measures aim to tackle what is an endemic activity among Russian businesses, to locate themselves in a beneficial tax haven, transfer their profits to that low tax jurisdiction, and then repatriate those profits back tax free into Russia in the form of investment (beyond the evident tax benefits, companies also locate themselves overseas to fall under the jurisdiction of more professional and neutral legal systems). This has led to Ireland, Cyprus, the Netherlands and Luxembourg being the largest sources of investment in Russia in 2012, all of whom have large offshore banking sectors. As Putin stated in his most recent State of the Union Address, “the profits of the companies that are registered in offshore havens but belong to Russian owners and beneficiaries must be taxed under our own tax code, and the tax revenues must be paid to the Russian treasury… We must come up with a system for getting hold of that money.”

And this push couldn’t have come at a better time. In the wake of Cyprus and the worldwide financial meltdown, advanced economies around the globe realized the vast amounts of capital they were losing to offshore financial centers, further legitimizing the Kremlin’s efforts. The issue of offshore tax havens has become a global issue, with the U.S. signing tax information sharing agreements around the globe (Foreign Account Tax Compliance Act, FATCA. Russia is in negotiations to sign the agreement which will provide for the reciprocal exchange of financial information) to Britain declaring that it will create a beneficial ownership registry (who really owns companies) that will be publicly available. The issue of offshore tax havens was the one area of agreement when the G8 leaders met this summer in Ireland, and the issue has been championed by Russia at the G20. Additionally, Russia is debating ratifying an OECD agreement that would significantly expand its financial information sharing agreements among the signatory states and bring an estimated $5-6 billion into the state coffers. The reason this agreement is crucial to “deoffshorization” is because the assistance of foreign governments is crucial, as was noted in the Russian business newspaper Kommersant: “However, these measures, particularly those associated with attempts to track offshore revenues back to their Russian owners, cannot be implemented in practice without reliable information from foreign fiscal services.”

Putin’s deoffshorization efforts have started to gain momentum and have coincided with the interests of the global community. By forcing capital to remain in the country, Putin not only solidifies his hold over the elite but also strikes a chord with the populace by framing his efforts as attempting to remedy the corruption of the privatization years: “We must put an end to the offshore legacy of wild privatization. Otherwise, there can be no talk about any normal [investment] climate in the country or trust in us.” But despite the efforts to force capital to remain in the country, until Russia takes the necessary steps to reform the investment climate, provide stable legal adjudications and protections for businessmen, Russia is going to continue to experience dramatic financial outflows. Unless structural and institutional changes are made, the future might not be so gracious in bankrolling Putin’s policy aspirations.