Mission Concluding Statements
Russian Federation and the IMF
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1. Russia's current strong economic performance reflects a mixture of favorable external and domestic developments, including improved economic policies. There are, however, emerging signs of macroeconomic tensions and considerable uncertainty about the durability of the achievements, especially in the event of much lower oil prices. The mission is recommending changes in current and planned policies that it believes are necessary to prevent the huge oil surplus from causing macroeconomic problems in the short-term, and to reduce potential disruptions from much lower oil prices and strengthen the economy's ability to sustain stable growth over the longer term.
Recent economic developments and the outlook
2. The economic situation continues to improve and the short-term outlook is favorable. GDP growth is high, real incomes and employment are rising, and key social indicators are improving. Growth is becoming broader based across sectors and better balanced, with contributions from all main components of demand. The increase in investment outside the oil and gas sectors is particularly encouraging. The strength of growth continues to hinge crucially on the favorable external environment, notably high oil prices, but the rise in investment has also been due to political stability, generally sound macroeconomic policies, and some structural reforms, suggesting that GDP is deriving strength from domestic developments as well. With oil prices likely to remain relatively high and the new government committed to structural reforms, the short-term outlook for GDP is good. The mission believes that real GDP will grow by 7¼ percent in 2004—as in 2003—slowing only marginally to 6½ percent in 2005, mainly owing to somewhat lower oil prices.
3. Macroeconomic tensions have emerged, however, as growth has accelerated. During the past two years, core inflation has become entrenched in the 10-11 percent range, real wages have grown faster than labor productivity, and the ruble has begun to appreciate at a much quicker pace in real terms, by about 10 percent over the last 12 months. These developments indicate that labor markets are tightening and that some sectors are getting closer to capacity limits. This, and the favorable outlook for GDP, raises the question of whether macroeconomic policies adequately reflect the strong cyclical position of the economy. The mission believes that important adjustments are needed to the authorities' plans for fiscal policy, and to the framework for monetary and exchange rate polices.
4. Government plans for 2005 are likely to entail a significant fiscal relaxation. The proposed cut in the unified social tax and partial monetization of currently unfunded benefits will cost the budget around 2 percent of GDP. The draft budget includes expenditure cuts that are expected to largely offset this cost, but the mission has doubts about their feasibility, notably the assumption of a very large reduction in spending by regional and local governments. The assumption that they will cut spending and run a surplus of ¾ percent of GDP at a time when they are assuming increased responsibilities for education and other social spending is unrealistic, especially since the federal government does not have effective instruments to control their spending. Thus, whereas the draft budget envisages a general government surplus of 1¼ percent of GDP at an oil price of $26 a barrel, the mission's assessment is that the current proposals would lead to an outcome of close to balance at the same oil price. This would represent a fiscal loosening of 1-1½ percent of GDP compared with 2004, after allowing for oil price changes.
5. The planned relaxation of fiscal policy will significantly increase inflationary pressures. It could also notably accelerate the pace of real ruble appreciation, a key concern of the Russian authorities. At this favorable point of the economic cycle, fiscal policy should not be a source of additional stimulus. In this regard, the mission disagrees with two arguments that appear to have considerable support:
• First, the tax cuts and expenditure increases underlying the relaxation will not raise potential GDP soon. While the mission supports cutting the high social tax rates and partly monetizing the so-called unfunded benefits, these reforms will increase potential GDP only gradually, and only if accompanied by broad-based and sustained reforms to improve the investment climate. The notion that cutting high tax rates will quickly spur capacity enhancing investments finds little support in international experience.
• Second, the fact that there will still be a fiscal surplus due to high oil taxes will not shield the economy from inflationary pressures associated with a fiscal relaxation. With high poverty and ailing infrastructure, and with oil prices remaining high, the view that the time has come to spend much more of the oil tax windfall on reforms is not surprising. However, even if most observers expect oil prices, for the foreseeable future, to stay well above $20 per barrel—the benchmark currently determining when to save oil revenues—this does not mean that a larger share of oil sector taxes can safely be spent. As long as private sector demand is growing strongly and inflationary pressures persist, fiscal policy must ensure that current oil prices are not reflected in a further increase in demand, private or public. The proposal to spend half of revenues from oil prices above $20 per barrel once the cap on accumulation in the stabilization fund of Ruble 500 billion is reached—which could happen by the middle of next year—would, in the view of the mission, be very ill-advised.
6. Against this background, the mission has the following recommendations regarding fiscal policy:
• As to 2004, pressures to raise spending limits in a supplementary budget should be resisted. Oil revenues from prices above $20 should be fully saved.
• As to 2005, there should be no loosening of the fiscal stance, in the sense that there should be no reduction in the surplus after allowing for the effect of oil price changes. This will require a general government budget surplus of 1½ percent of GDP at an oil price of $26 per barrel, requiring measures amounting to 1¼ percent of GDP more than currently planned.
• This means in effect that planned cuts in social taxes and the monetization of in-kind benefits should be mostly offset by increases in other taxes or expenditure reductions. The mission supports raising oil sector taxation and believes that excise taxes could be increased.
• The oil stabilization fund should be maintained in 2005, with a benchmark oil price of $20 a barrel, and the cap on savings in the fund should be removed. There should be no transfers from the fund other than for prepayment of external debt.
• Assumptions about the ability of the federal authorities to control spending at the sub national level should be conservative. In particular, regional and local governments should not be assumed to run a surplus.
• Budgets should also be based on conservative assumptions about the impact of the reduction in social tax rates on the revenue base. The mission agrees with the 2005 budget assumptions in this regard; calls for more optimistic assumptions are not supported by experience from other countries.
• The planned further reforms of VAT in 2006 should be revenue neutral, with a reduction in the standard rate compensated by elimination of the preferential rate and removal of exemptions.
7. Fiscal policy is facing important challenges over the medium term. Plans for further reductions in the non-oil tax burden beyond 2005 and the need to mobilize additional resources for important reforms, support of the pension system, and improvements in social services, suggest that the pressures on limited public sector resources are set to remain high. Once the cyclical pressures ease, there could be a case for spending more of the oil revenues on carefully elaborated long term structural reforms. However, it will remain a key challenge to maintain a fiscal stance that at no point in the oil price cycle leads to a deficit that would require a pro-cyclical tightening, i.e. one that would exacerbate the negative impact of lower oil prices on GDP growth. The oil stabilization fund remains, in the mission's view, a crucial mechanism for ensuring that fiscal policy does not add to volatility in GDP in what remains an extremely oil dependent economy.
Monetary and exchange rate policies
8. The policy of resisting nominal ruble appreciation is a major reason core inflation has become entrenched. As the balance of payments has improved, interventions in the foreign exchange market have caused a surge in money growth. While there has been some decline in headline inflation, this reflects mostly lower increases in administered prices.
9. Monetary policy should be unburdened of real exchange rate objectives. The CBR cannot resist for long the pressures for real appreciation of the ruble coming from the large current account surplus. In present circumstances, some real ruble appreciation is inevitable over the medium term, and the CBR can only influence the extent to which this occurs through nominal appreciation or through higher inflation. In this regard, the mission disagrees with the view that inflation can be reduced only very slowly, if at all, as long as the balance of payments is strong. The disinflationary pressures from an appreciation of the ruble could facilitate a monetary policy geared towards inflation reduction. The mission, therefore, welcomes President Putin's call for an early reduction of inflation to 3 percent, a target that is desirable and achievable. However, this challenge is not realistic if the CBR remains burdened by the task of controlling the real exchange rate. To the extent that it is desirable to resist real appreciation, this objective can only be achieved by fiscal policy. Calls for the CBR to lower inflation and resist real ruble appreciation at the same time as fiscal policy is being relaxed point to increasing contradictions in the overall policy mix.
10. Monetary policy should be focused on reducing core inflation by about two percentage points in both 2004 and 2005. With a continued strong recovery in money demand, the CBR will be able to undertake some unsterilized interventions while keeping inflation on a steady downward path, but interventions should cease or be scaled back and the ruble allowed to appreciate if they threaten the inflation target. Making clear to the market that monetary policy will be firmly focused on reducing inflation, even if this requires nominal appreciation, will increase short-term exchange rate uncertainty and so discourage speculative capital flows.
11. The mission doubts whether deposit requirements on capital flows will have the desired impact. While appropriate as a transitional measure from the system of permits and controls, the experience of other countries suggests that the main result of such requirements is to raise the cost of capital for small and medium-sized domestic borrowers, who are already disadvantaged. The impact of the deposit requirements on capital inflows is transitory, at best, as markets quickly learn how to evade them. These requirements should therefore be seen only as a temporary measure to stem exceptionally large short-term inflows, and not as a substitute for necessary adjustments to macroeconomic policies, especially the adoption of a more flexible exchange rate policy.
12. There is a need for further strengthening of the enforcement of prudential standards. Important indicators suggest that the banking system has become stronger. However, banks have benefited substantially from the good macroeconomic environment, which could be masking continuing structural weaknesses. In particular, rapid credit growth, against a background of the high dependence of the economy on oil prices and the non-transparent business environment, raises questions about the impact of a large drop in such prices on balance sheets. The review process currently underway for participation in the deposit insurance scheme provides an important opportunity to strengthen supervision in a non-crisis environment. The CBR must continue to resist pressure from weak banks to relax standards for participation, and it is crucial that all levels of government are fully supportive of it in this regard. The recent uncertainty in markets caused by the closure of a bank for violating anti-money laundering laws points to the importance of the CBR's actions being transparent and well understood by the public.
13. Acceleration of banking reforms is needed to strengthen supervision and promote competition in the banking sector. Foremost is the need to improve the bank bankruptcy law to speed up the resolution of problem banks. Other priorities include moving to risk-based supervision, improving governance and the transparency of bank ownership, and adopting International Financial Reporting Standards. These priorities are all reflected in the authorities' medium-term action plan. However, the mission believes that the plan should give a higher priority to the development of a strategy for the future of state-owned banks. Generally, the mission believes that there is a need to accelerate the pace of banking sector reforms. The liberalization of the capital account now underway gives added urgency to this task, because of vulnerabilities associated with the intermediation of external capital flows through a weak banking system.
14. Priority should, in the mission's view, be given to improving the investment climate and reducing the dependence on oil. Faced with pressing needs in many areas, the government should focus on reforms that will help speed up the diversification of the economy away from its heavy dependence on oil by spurring investments outside the energy-sector. Promoting small and medium-sized enterprises is particularly important. Without such a focus, a decline in oil prices from the highs of recent years is likely to see a notable weakening in GDP growth, to well below what is needed to meet President Putin's call for a doubling of GDP in ten years.
15. The government's reform plans are generally well focused. While details and timetables still need to be elaborated in many areas, the mission believes that the broad objectives are consistent with giving priority to improving the investment climate:
• Plans for reforms of government—focusing on expenditure reforms now that the main tax reforms are nearing completion—are particularly welcome, as the public sector's large claim on resources and its still pervasive interference in the economy, not least at local and regional levels, remain a serious obstacle to investment. Public sector structures contain large vestiges from central planning that are unsuited to a market oriented economy, and plans for administrative reforms and deregulation, and supporting reforms of the health and education sectors, will entail far-reaching changes in these structures when fully implemented
• Plans for housing reforms, including development of the mortgage market, are particularly important for labor mobility, the lack of which produces large regional income inequality and limits potential GDP growth by causing regional labor shortages.
• Reforms of the banking sector—as discussed above—are key to improving what, despite recent improvements, is still a relatively low level of financial intermediation, to the detriment of small and medium sized enterprises.
• The drive for early WTO accession will catalyze key reforms, promote competition and reduce rent-seeking. A challenge in this regard is to resist opposition from sectors seeking to maintain protective barriers by unduly prolonging transition periods before being exposed to foreign competition.
16. Slower increases in administered prices should not be used to restrain inflation. Administered price increases have been delayed because of concerns about the one-time impact on inflation, and the mission disagrees with this policy. It agrees, however, that soft budget constraints and wasteful spending in natural monopolies mean that changes in their prices must go hand-in-hand with reforms to strengthen governance. In this regard, the mission is concerned about the continued lack of a comprehensive reform plan for Gazprom.
17. While the plans for reforms are appropriate, implementation is uncertain. A key challenge will be to build momentum behind reforms in the current favorable environment. Following a burst of reforms in 2000-2001, the momentum slowed significantly. In this regard, most of the government's priorities are not new in that they pertain to reforms that have stalled in recent years because of fierce resistance from vested interests, or high social costs. Looking forward, this raises the question whether there is sufficient political resolve behind the commitment to accelerate reforms—in particular, whether high oil prices risk causing complacency. Administrative reforms and reforms of the social sectors and natural monopolies will test the government's ability to more forcefully resist vested interests, and to mobilize consensus for socially difficult changes. While the mission is aware of reservations about the ability and determination to push ahead more strongly than in recent years, it is encouraged by the fact that all its main interlocutors within the government recognize that the strong growth owes much to high oil prices and can be sustained, once these prices decline from current highs, only if reforms are accelerated now.
IMF EXTERNAL RELATIONS DEPARTMENT