ANALYSIS - Reliance on oil could lure Russia into budget trap

MOSCOW (Reuters) - Russia's reliance on oil to ride its way out of recession could set it up for a fall, potentially alienating investors who snapped up its Eurobond just three months ago, unless it acts now to cut spending and hike taxes.

The deepest recession in 15 years pushed the Russian budget into the red by nearly 3 trillion roubles ($100 billion), or 5.9 percent of GDP, in 2009. The gap is expected to ease to 5 percent this year and the government has set itself an ambitious target of returning to the black by 2015.

To achieve this, Russia would need to cut budget spending -- currently at a historic high of nearly 23 percent of GDP -- by around 2 percent a year in real terms over the next five years, estimates Neil Shearing from Capital Economics.

Instead, the government has actually raised spending plans for this year by 3 percent, reflecting an expected increase in precarious oil price revenues.

"For now you cannot say that the bottom has fallen out but it is a very worrying signal ... In order to balance the budget we need oil at $95 a barrel. I do not see any other way for Russia than reducing this breakeven oil price to a more acceptable level. And that means cutting spending," said Evgeny Gavrilenkov, chief economist at Troika Dialog.

"If we do not succeed in restraining spending, there will be higher inflation and all the old problems that brings: real appreciation of the rouble, falling competitiveness."

But -- with parliamentary elections expected next year, followed by a presidential vote in 2012 -- the necessary measures are already proving a hard political pill to swallow.

Already, plans to increase excises on alcohol and tobacco look to have been shelved, while pensions have been increased, putting further pressure on public finances.

The lobbying power of big firms also makes tax hikes hard.

"If I were the finance minister and the economy minister, I would return to the issue of increasing domestic gas tariffs ... I would raise taxes for Gazprom to the level of the oil sector, which would bring in around 1 trillion roubles," said Julia Tsepliaeva, chief economist for Russia at BNP Paribas.

"But the lobbying potential of (state gas export monopoly) Gazprom is so big that politically it may be hard to get money from there."

BUDGET TRAP

Another reason to cut spending and increase revenues is that the budget for the next three years is based on Urals oil averaging $75 a barrel or more -- a forecast some analysts consider too optimistic.

"It will not take much in terms of a reduction in oil prices to produce a much more tenuous fiscal position," Tim Ash, head of CEEMEA research at RBS in London, said in a research note.

If oil falls to $60, "which does not appear an unreasonable threat", the deficit could reach 7-8 percent, significantly increasing the need for borrowing, he added.

Investors snapped up $5.5 billion of Russia's first sovereign Eurobond issue in over a decade this April, but their appetite is also largely fuelled by high oil prices -- meaning it could wane just when Russia needs cash the most.

"It is unlikely that investors will be always ready to lend at 5 percent," said BNP's Tsepliaeva. "The interest rates at which we borrow may prove an unpleasant surprise ... especially if the central bank moves towards tightening monetary policy."

Higher state borrowing to fund the deficit -- be it at home or abroad -- will likely toughen market conditions for would-be corporate issuers, exacerbating the problems with refinancing that Fitch Ratings already expects in 2011-12.

Instead of ratings upgrades forecast by Finance Minister Alexei Kudrin, Russia could face downgrades. Standard & Poor's has said it could lower its "BBB" investment-grade rating "if the authorities fail to implement tight expenditure control over the next budgetary cycle", although it currently has a "stable" outlook.

Fiscal prudence is also seen as a key challenge by the World Bank, which is concerned that high levels of social spending may become entrenched and inflation may surge.

With the economy growing 4 percent a year and a budget deficit of 3 percent, Russia's sovereign debt would reach 25 percent of GDP in 10 years' time and 40 percent in 20 years, a study by the Development Centre of the Higher School of Economics shows.

"The Russian economy is in a state of euphoria from the resumption of growth, and has not noticed how it has fallen into the budget trap," the Development Centre said in a report.