Russia Defence and Security Report Q3 2009

Russia is in the midst of a very deep macroeconomic crisis, and we now expect the economy in 2009 to contract by 7.1% in real terms, with risks weighted to the downside. This will be a domestic demanddriven recession, but contextualised within a wider global capital shortage. As Russia continues to experience net capital outflows, domestic credit conditions will remain highly constricted through to at least 2010, ensuring a prolonged contraction in gross fixed capital formation and private consumption.

Economic conditions continued to worsen in Russia through Q109, confirming our view that the Q308 financial crisis would have severe consequences for the real economy in 2009. While no official GDP figures for the quarter have been released, Russian Deputy Economy Minister Andrei Klepach stated on April 23 that the economy likely contracted by 9.5% year-on-year (y-o-y). If confirmed, this will mark the largest decline since the post-communist economic transition. On the back of the estimate, we have further revised down our full-year real GDP growth forecast for Russia and now expect a contraction of 7.1% – a worse outturn than experienced during the last major recession in 1998.

While through to the end of 2008, it was the external sector that was predominantly impacted, weighed by the collapse in oil prices through H208, in 2009 we expect the feed through to reach domestic demand.

Ultimately, the underlying problem in the Russian economy is a capital shortage. The sharp drop off in energy export earnings tied to weak commodity prices has slashed the current account surplus to multiyear lows and, by extension, foreign capital available in the economy. This, though, has been accentuated much further by the net capital outflow recorded through investments and external lending.

We have lowered Russia's short-term political risk rating to 62.0 on the back of the spike in unemployment in April. In comments made on May 26, Russian President Dmitry Medvedev cautioned the cabinet on making overly pessimistic statements on the state of the economic outlook. He specifically referred to comments made by Finance Minister Alexei Kudrin who had said that Russia would not experience the same favourable economic conditions (seen in 2002-2007) for over 50 years. Calling the finance minister's statement 'unacceptable', Medvedev also stated that Kudrin may wish to seek employment elsewhere. We have long cautioned that divisions within the senior levels of government in Russia were likely to rise alongside the global recession, and these latest statements reinforce this view.

We maintain that there are high risks of a cabinet shuffle.

We believe that the most significant foreign policy precedent of the war applies mainly to what Russia refers to as its 'near abroad'. By establishing that it is willing to breach national sovereignty, Moscow has sent a clear message to capitals throughout the CIS, Georgia and Ukraine that its core strategic interests should not be ignored.

As a result of the growing internal conflict in the North Caucasus, Russia has decided to place greater operational emphasis on Special Forces. Developments in Chechnya in 1994 and 1999 showed Russia that regular armed forces were not able to deal with the low-level conflict and that, more importantly, conscripts were not able to deal with the rigour of an insurgency. What was needed was a professional force dedicated to dealing with insurgencies. Russia’s State Weapons Programme 2015 underwent refinement in 2006. The main aim is to provide Russia with a modernised nuclear deterrent force and to enhance the army’s poor public image. The armed forces were reduced by 200,000 in 2005 in a bid to professionalise the Russian army.

Russia maintains a massive defence industry that, despite the pain associated with modernisation, restructuring and excess capacity, supports a thriving export industry. Russia is at least challenging, if not surpassing, the US in terms of total defence industry exports. In 2008, Russia exported US$7bn worth of military items, and the government arms-exporting agency Rosoboronexport expects foreign military sales to remain at that level through the next several years.

This quarter, we have introduced a significant new aspect to BMI's defence reports, which is the City Terrorism Rating (CTR). This assesses the risk of a terrorist attack. The CTR takes into account the overall BMI Terrorism Rating for the country in question. It also incorporates the 'prevalence' of terrorism, which recognises the frequency of attacks and whether the city is a target for terrorists. The CTR also recognises the 'threat' of terrorism in terms of the likely numbers of victims and the ability of groups to launch sustained campaigns. In Russia we assess the CTRs for Moscow and St Petersburg. Both cites score lower ratings (62.5 and 55.0, respectively) than the country as a whole. Also both are located towards the lower end of the cities ranked to date. Moscow is ranked at 23 out of the 32 cities rated and St Petersburg even lower at 27th.