Russia -- Concluding Statement of the 2005 IMF Mission
June 6, 2005
Russia—Concluding Statement of the 2005 IMF Mission
June 6, 2005
Russia has had several years of high GDP growth, partly due to high oil prices, but also good macroeconomic policies, notably that of taxing and saving oil revenues. This policy is now being relaxed, however, as a much larger share of oil revenues is being spent by the government, despite continued buoyancy in other demand and a slowdown in potential growth. This risks exacerbating the slowdown by increasing the already high inflationary pressures and causing the real ruble appreciation to overshoot its long-term path. Moreover, while there is scope for relaxing fiscal policy once inflationary pressures ease, the fact that the increased spending is used overwhelmingly for public sector wages and pensions suggest that the oil wealth is not being harnessed in support of reforms that could raise potential GDP growth. At best, Russia risks missing an opportunity to accelerate growth over the long run; at worst, it may have to undertake a painful and prolonged fiscal tightening if oil prices drop substantially. If it is becoming politically impossible to continue to resist pressures to spend the oil wealth on wages and transfers, it becomes a matter of urgency to raise potential growth by reinvigorating structural reforms, which have lost the momentum that they had a few years back.
Recent developments and the outlook for 2005
GDP growth has slowed. While growth in all the main components of demand accelerated notably in 2004, GDP growth decelerated and the higher demand spilled over entirely into higher imports and increased inflationary pressures. This points to emerging supply constraints in some sectors and in local labor markets, after 6-7 years of robust GDP growth but relatively low levels of investments. The deceleration in GDP growth was pronounced since mid-2004, when oil production weakened notably, due to disruptions associated with the break-up of Yukos and capacity constraints in both extraction and transportation. The Yukos affair appears also to have taken a toll on the investment climate as investment growth began to decelerate from mid-year as well, suggesting that the slowing of GDP growth has reflected an interplay of demand and supply factors. Recent data confirm that GDP has continued to grow more slowly in 2005 and that inflationary pressures have remained high.
GDP growth is likely to remain subdued. The mission estimates that real GDP will grow by about 5½ percent in 2005, close to the government's revised estimate of 5.8 percent, and well below the 7.1 percent recorded in 2004. The main reason for this is the assumption that growth in oil extraction will not regain the fast pace of recent years, but also that investment growth will fail to recover fully as well. Consumption growth, on the other hand, is expected to remain buoyant, and could possibly even accelerate compared to 2004, due to the continued strong growth in real wages, record high oil prices, and a much more expansionary fiscal policy stance. As in 2004, it is expected that a further boost to consumption will elicit only a limited domestic supply response, causing mainly a further sharp rise in imports. Achieving even a modest decline in inflation under these conditions will require a change in monetary and exchange rate policies, as discussed below. The projections are admittedly subject to much uncertainty, especially with regard to the investment climate and the extent of supply constraints in the economy, not least in the energy sector.
The major fiscal relaxation now underway risks increasing inflationary pressures and the pace of real ruble appreciation:
• As to 2005, the fiscal surplus is set to increase due to higher oil prices and an attendant increase in oil sector taxes saved in the stabilization fund, but the share of such taxes that is not being saved is rising. Measured at a constant oil price of $20 per barrel, the balance of the federal government will decline by at least 1.5 percent of GDP in 2005, taking into account the amendment to the budget approved by the government this week. The decline will be higher if there is a second amendment of the budget before the end of 2005, as expected. Including other levels of government, the decline comes to about 2.6 percent of GDP. The approved amendment is mainly being financed through increased transfers from the stabilization fund and the use of back-taxes and fines paid by Yukos.
• As to 2006, plans discussed with the mission entail a further relaxation on a constant oil price basis by, at least, 1.3 percent of GDP. This assumes that the government will be able to maintain expenditure constant as a share of GDP, despite allocations for a new investment fund, additional transfers to the regions, and the need to make a down payment on the President's promise to raise pensions and public wages by 50 percent in real terms over the next three years. The mission estimates that the oil price required to balance the budget at the federal level is set to increase from $23 per barrel in 2004 to $28 per barrel in 2005 and to $31 per barrel in 2006, even if there is no second amendment to the 2005 budget and the government manages to keep to its target for expenditures next year.1
The pace of fiscal relaxation should be reconsidered. With buoyant private sector demand already significantly outpacing potential GDP growth, allowing more of Russia's terms-of-trade gain to translate into even faster demand growth amounts effectively to a relaxation of fiscal policy. This risks further intensifying the already high and rising inflationary pressures, which could damage potential GDP growth by driving up interest rates and causing the real ruble appreciation to overshoot its long-term path. The mission believes that the current policy of taxing and saving oil revenues arising from oil prices above $20 per barrel in the oil stabilization fund should remain largely unchanged. This policy has served Russia well as it has prevented even stronger inflationary pressures and much faster real ruble appreciation. Significantly weakening it would be a notable deterioration in the overall stance of macroeconomic policies.
The fiscal relaxation that is possible over the medium term should be in support of reforms that raise potential GDP growth. Even under conservative forecasts for oil prices and considering the much reduced public sector indebtedness, there is scope for reducing the budget surplus over the medium-term, once inflationary pressures ease. Of concern in this regard is the fact that the higher spending to date is overwhelmingly on wages, pensions and other recurrent expenditures; such expenditures account for all but Ruble 30 billion of the Ruble 348 billion amendment to the 2005 budget. Such an increase in recurrent expenditures will reduce the ability to mobilize budgetary resources for the many costly reforms that still lie ahead, like health, education, housing, and communal services, to mention but a few. As these reforms are all delayed, in many instances stalled, there is little prospect for an effective increase in spending on reform in 2005 and 2006. There would possibly be scope for a measured increase in infrastructure investments, but the ability to increase such investment without significant waste is limited, again partly due to the slowness of reforms, in this case civil and public administration reforms. Spending the oil wealth on wages, pensions and other recurrent expenditures before there is a political resolve to push ahead with reforms will at best be a waste of opportunity to accelerate Russia's economic modernization; at worst, it will require a painful and prolonged fiscal tightening if oil prices were to drop sharply.
The change in fiscal policy will exacerbate tensions between exchange rate and inflation objectives. The CBR has continued to intervene heavily in the foreign exchange market to stem the appreciation of the ruble, at the expense of inflation running well above targets. Developments in recent years have demonstrated that the CBR cannot significantly slow the real ruble appreciation over the medium term; its interventions mostly determine the extent to which the real appreciation occurs through nominal appreciation or higher inflation.
Monetary policy should focus more on bringing down inflation. The task of preventing high oil prices from causing an excessive real appreciation must rest with fiscal policy. The CBR should be unburdened of real exchange rate considerations and refocus monetary policies on achieving a steady reduction in inflation, although the official end-year target of 8.5 percent is now unlikely to be attainable. In the current situation, this means that the CBR should stand ready to scale back interventions and allow for nominal ruble appreciation whenever inflation is running above its targeted path. Making clear to the market that monetary policy will be firmly focused on reducing inflation will increase short-term exchange rate uncertainty, discouraging the large speculative short-term capital inflows that have at times complicated monetary policy.
The process of admitting banks into the deposit insurance scheme appears to have strengthened the banking system. The CBR is confident that weaker banks have been denied access. It is important that admission criteria are not weakened during the final round when the banks not admitted are given a second chance.
There is a need for further strengthening the legal and regulatory framework for bank supervision. Despite recent progress, weaknesses remain in the banking system and the CBR must continue to strengthen supervision and regulatory standards. This is particularly important considering that the sharp rise in credits in recent years might have increased the risks to the banking system from a significant slowdown in economic growth. The authorities have already taken several positive steps in the area of prudential regulations, including the introduction of improved asset classification rules and the move to international accounting standards. However, areas in which Russia is falling short of international best practices include consolidated supervision, fit and proper requirements for bank managers and owners, the financial regulator's powers to intervene preemptively in problems banks, and rules on mergers and acquisitions. The authorities also need to strengthen efforts to reduce related-party lending, banks' large loan exposures, and develop contingency plans for dealing with sudden changes in liquidity needs.
Significant progress has been made in removing exchange restrictions on current transactions. The only remaining restriction relates to fees for capital transactions. It should be eliminated to achieve full compliance with Article VIII of the Fund's Articles of Agreement.
Flagging structural reforms pose a threat to Russia's growth potential and macroeconomic stability. The government's long-term reform agenda is generally well-focused, but progress has been disappointing. Apart from the banking sector, most of the reforms that were made a priority by the government upon coming into office last year are running behind schedule, with some at a stand still. A concern in this regard is that the encountered opposition to the social benefit reforms appears to have reduced the resolve to push ahead with other key reforms in the health and education sectors. To the extent that it is proving increasingly impossible to resist mounting political and social pressures to use oil revenues to raise wages and social transfers, it becomes a matter of urgency to double efforts to advance reforms that will underpin such increases by raising potential growth. While wages and pensions are very low, they can only be increased in a sustainable manner through policies that accelerate growth over the medium term.
Priority should be given to reforms that will strengthen the investment climate.. This has become particularly urgent now that, rightly or wrongly, the Yukos affair has raised the specter of interventionism and increased heavy-handedness by regulatory and law enforcement agencies. The government should move forward vigorously with civil service, administrative, and judiciary reforms and take steps to ensure that laws and regulations are upheld in a fair and even handed manner. Investor confidence would also be helped by reforms of Gasprom and other natural monopolies and, in particular, by an early resolution to the outstanding problems holding up Russia's WTO accession.
In concluding, we would like to thank the authorities for their excellent cooperation and kind hospitality.
1 The staff estimate of the oil price that balances the federal budget takes into account the effect of oil prices on all tax revenue, not just on the two natural resource taxes that accrue to the stabilization fund. Therefore, the oil price that would balance the budget is not necessarily the same as the oil price benchmark for the stabilization fund. In addition, the staff estimate of non-oil revenues is somewhat lower than projected in the proposed 2006 budget, owing to a less optimistic assessment of the impact of the proposed tax reform measures.