Russian Federation - 2007 Article IV Consultation, Preliminary Conclusions of the IMF Mission
May 28, 2007
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
May 28, 2007
1. GDP growth continues to strengthen, while the economy is close to potential. The expansion in domestic demand is running well ahead of output, spilling over into a fast declining current account surplus. The buoyancy of demand reflects favorable external conditions, notably high oil prices and surging inflows into emerging markets, not least into Russia; increased investments; a continued strong nexus between high growth in productivity, real wages and consumption; and a notable fiscal relaxation. With oil prices and capital inflows forecast to stay high, and investor sentiments appearing robust, we expect growth to remain at 7 percent in 2007. Indeed, growth may even be higher, depending on the size of the further fiscal relaxation that appears to be in store.
2. The twin surpluses are set to unwind rapidly, and the ruble to continue to appreciate fast in real terms, in part because the government is spending an increasing share of oil revenues. The general government is expected to run a broadly balanced budget within the next two years—a dramatic drop from a surplus of 8½ percent of GDP last year—and the current account surplus is projected to vanish over the same period—an equally dramatic drop from a surplus of almost 10 percent of GDP last year. Important in this regard, whereas the large terms-of-trade gain associated with high oil prices was mostly saved in the past, it is now being passed-through to the economy, owing to increased spending of oil revenues. We understand that the authorities plan to continue to ratchet up this spending over the next few years. However, doing so at a time when resource constraints are tightening and private demand is increasingly buoyant means that fiscal policy is causing demand to further outpace output, speeding up the rate of real appreciation and the unwinding of the current account surplus.
3. The rapid real appreciation is a source of rising tension between fiscal and monetary policy. With the economy already running close to full throttle, pushing the fiscal accelerator, while simultaneously pressuring the CBR to resist the resulting upward pressure on the ruble, points to an increasing tension in the policy mix. As resource slack in the economy is used up, unsterilized foreign-exchange interventions will rapidly spill over into higher inflation, leaving the CBR merely with the choice of whether to affect the inevitable real appreciation through higher inflation or nominal appreciation. Some real appreciation is indeed desirable as it helps to reduce the large current-account surplus resulting from the exceptionally large terms-of-trade gains from 2004-06, and the mission believes that there is no problem of competitiveness at this time. Nonetheless, the pace of real appreciation appears to be becoming politically unacceptable, and we would suggest that the only effective available instrument is to defer further spending of oil revenues until the economy's absorption capacity has increased, either as a result of stronger potential growth or a cooling of private demand.
4. This suggests that there is a need to rebalance the policy mix. Fiscal policy should be calibrated with a greater view to alleviating cyclical pressures, while monetary policy should be refocused on inflation reduction in the context of a more flexible exchange rate policy. In this regard, the fiscal stance will increasingly need to offset the impact of surging capital inflows on domestic demand. This will be a much more challenging task than that of mobilizing support for saving oil revenues in the stabilization fund, as it entails a reduction in the non-oil deficit.
5. Against this background, the proposed fiscal relaxation is a matter of some concern. The approved annual 2007 and three-year 2008-10 budgets already entail a relaxation of the non-oil deficit of 2½ percent of GDP until 2009, on the heels of a prior expansion of 1.6 percent during 2005-06. The currently considered proposals for the supplementary 2007 budget would imply an additional increase in spending authorizations of 2¼ percent of GDP, to be distributed over the next 4 years. With this, the mission estimates that the planned expansion in the non-oil deficit over 2007-2009 will amount to up to 3 percent of GDP. In view of the buoyant outlook for private demand, the mission believes that this may further exacerbate existing tensions between fiscal and monetary policy.
6. The mission recommends that there should be no further relaxation in the non-oil deficit at this juncture. While the stabilization fund should be allowed to automatically offset any unexpected drop in oil prices, we recommend that there be no further relaxation of the non-oil balance until cyclical pressures have eased. Under the current outlook, this suggests that there should be no supplementary 2007 budget to increase spending limits, and that the 2008 budget should keep the non-oil deficit at the same level, relative to GDP, as expected in the 2007 budget.
7. The Government should also consider whether the proposed spending effectively harnesses Russia's oil wealth and supports long-term growth. We understand that, when calibrating fiscal policy, the government must weigh cyclical considerations against the need to improve infrastructure and spur development. But much of the increase since 2005 has been on recurrent expenditures, which are set to increase by 1.4 percent of GDP in 2007 alone. This will have little impact on long-term growth. In contrast, most of the increase under the proposed supplementary 2007 budget targets investments and other projects that possibly could have such an impact. We are concerned, however, that some of this spending will entail notably higher government intervention in the economy. Moreover, as far as spending that lies within the normal purview of government is concerned, we doubt the effectiveness of a large-scale spending increase at a time when key efficiency-enhancing public sector reforms are delayed. The difficulties in getting support for such reforms is illustrated by the very rapid increase in public-sector employment over the past 4-5 years, in stark contrast with the government's long-standing goal of reducing such employment.
8. Aside from concerns about spending efficiency, the government should also consider whether spending most of Russia's terms-of-trade gains over the next few years is advisable, given that many of the most-important and expensive reforms still lie ahead. A case in point is pension reform. The mission understands that government transfers to the Pension Fund will have to be raised gradually to 3 percent of GDP each year to stabilize the replacement rate at current levels. We would suggest that the pace of spending of Russia's oil wealth should be more closely aligned with the pace of reforms.
9. Further spending increases would reduce the room for maneuver in dealing with a future drop in oil prices. Under the current three-year plan, the 2009 budget would balance at an oil price of about $52 per barrel, according to the authorities. Under the proposed supplementary 2007 budget, the oil price balancing the budget would be $56 per barrel. While a drop in prices below this level does not necessarily imply an immediate need for painful tightening—Russia's substantial reserves and low indebtedness leave considerable scope for deficit financing—the fact that the budget was balanced at an oil price below $30 per barrel only last year illustrates the speed at which margins for maneuver are narrowing. In this regard, the risk of fiscal-induced overshooting of the real exchange rate and current-account balance is also heightened by the virtual stagnation of the oil sector, as discussed below. The sluggish growth in the oil sector means that the relative size of the government's most important revenue base is set to shrink significantly over the medium term. These considerations suggest that total expenditures cannot be increased further without significantly increasing the risk of a pro-cyclical tightening in the event of a future drop in oil prices. This underscores the need for moving ahead with efficiency enhancing reforms to create more spending room for the important structural reforms that still lie ahead.
10. The approved change to the medium-term framework for taxing and spending oil revenues is most welcome, but back-loaded implementation raises concerns about the framework's realism. The plan to transfer all oil and gas revenues to a new intergenerational fund, once the stabilization fund reaches 10 percent of GDP; allow for a fixed annual transfer to the budget; and cap the non-oil deficit at 4.7 percent of GDP, are all in line with international best practice. This will not only strengthen the demand-management aspect of fiscal policy, but will also allow inter-generational considerations to have a stronger role in spending decisions. However, implementation is back loaded—the ceiling on the non-oil deficit becomes effective only in 2011, but in the interim the current three-year budget will push Russia in the opposite direction, implying that the next government is assumed to tighten policy by more than 2 percent of GDP in 2010-11, late in the election cycle. Other aspects of the supplementary budget that give cause for concern are the authorization in 2007 of large expenditures for later years that will not be included under the new limits on the non-oil deficit, along with the increased use of extra-budgetary funds. Both run counter to the important progress Russia has made in expenditure control and budget planning.
Monetary and exchange-rate policies
11. The CBR's renewed focus on the exchange rate threatens to reverse recent gains in reducing inflation. Prior to 2005, a policy of gradual nominal depreciation, in the face of strong oil-related inflows, caused inflation to become entrenched at a relatively high level. Since then, however, increased appreciation as a result of greater exchange-rate flexibility has helped set inflation, and inflationary expectations, on a downward path. Now, in the face of surging capital inflows, the authorities seem to be returning to a more inflationary path. Renewed efforts to halt the pace of appreciation have resulted in unprecedented purchases of foreign exchange, amounting to around $50 billion over March-April. And these, in turn, have resulted in a dramatic surge in base-money growth, by about 23 percent over the same two-month period. Moreover, in the context of a de facto exchange-rate target, attempts to sterilize this added liquidity have been necessarily constrained—we agree with the CBR that, without greater exchange-rate flexibility, any move to raise interbank interest rates above world levels would be largely ineffective, as it would only attract further inflows. In our view, this surge in liquidity will ultimately feed into higher prices—despite strong continued remonetization—jeopardizing the CBR's inflation objectives for 2007-08.
12. The CBR is likely to face an intensified trade-off between avoiding inflation and resisting appreciation. This reflects in part the pressures for real appreciation associated with fiscal relaxation in face of buoyant demand and tightening resource constraints. Moreover, robust growth, rising incomes, and expanding opportunities, suggest that foreign interest in Russian assets will remain high, and we expect that an increasing share of external inflows will come through the capital account, rather than the current account. Unlike oil-related earnings, capital-account inflows are not automatically sterilized via the Oil Stabilization Fund, and this shift will, therefore, further intensify the trade-off facing the CBR. Finally, whereas underlying inflation has been masked by slower increases in administered prices during the past two years, the government's commitment to raise domestic energy prices over 2008-11 suggests that, looking forward, administered prices will add to pressures on headline inflation, making the trade-off still more pronounced
13. In view of these considerations, we would advise the CBR to renew its focus on inflation reduction. This means that the exchange rate should be allowed to appreciate as needed to keep inflation on the targeted path. In this regard, we agree that an inflation objective of 7-8 percent in 2007, and 6-7 percent in 2008, is appropriately ambitious and feasible. Given the added cost of setting inflation on a renewed downward path once inflationary expectations begin to ratchet upward, it is important to avoid an increase in inflation in the coming months, suggesting that this refocusing of monetary policy should not be delayed. Additionally, in terms of Russia's monetary framework, greater exchange-rate flexibility would allow the CBR to exert greater control over domestic interest rates, and would therefore be an important step along the path toward formal inflation targeting.
14. The CBR has expressed a concern that added appreciation will encourage speculative capital inflows. We agree that the slow-but-steady pace of appreciation during 2005-2006 presented investors with a predictable exchange-rate path, effectively encouraging currency speculators to make one-way bets. However, the present policy of resisting appreciation will, in our view, only encourage such bets—increased intervention associated with this policy typically results in accelerating money growth, which may in turn bring into starker contrast the rising tension between the CBR's inflation- and exchange-rate goals, reinforcing markets' perception that the exchange rate target will eventually have to give way, in order to keep inflation under control. Rather than fuel added speculation, therefore, we believe that faster appreciation might instead discourage speculative inflows, by ensuring that market expectations about the future course of the exchange rate are more balanced.
15. In the view of the mission, higher reserve requirements are not an effective substitute for a more fundamental realignment of fiscal and exchange-rate policy. The recent increase in reserve requirements, effective July 1, is intended to slow money growth, and the mission understands that the CBR stands ready to raise requirements even further to maintain control over such growth. While higher reserve requirements may have a direct impact on monetary conditions, undue reliance on this tool may entail significant longer-term costs, as it raises the cost of bank intermediation and distorts the development of the financial system in favor of non-bank institutions. Ideally, therefore, this instrument, or other prudential-style administrative measures, are best reserved for financial-stability purposes.
16. The rapid development of the financial sector is most welcome. The deepening of financial markets and the expansion of credit, not least the growing market for consumer credit and mortgages, and the rise of the corporate bond market, combined with a reduction in borrowing costs, have done much to spur growth. Still, the sector is far from offering the full range of modern instruments needed to support a dynamic corporate sector. Further development could be facilitated by eliminating inconsistencies among different laws and codes, and clarifying responsibilities among the various agencies charged with overseeing the sector.
17. Increased regulatory vigilance is needed as the explosive increase in credits, reinforced by surging capital flows, is increasing vulnerabilities. While market participants and regulators are confident that banks have generally updated their risk-management procedures to keep pace with the expansion of credit, they are concerned that a number of banks have engaged in excessively risky lending practices, particularly in the market for consumer loans. Potentially significant vulnerabilities also arise from the rapid increase in open positions, as banks have increasingly funded their ruble lending through foreign-currency borrowing, as well as from the large increase in banks' holdings of ruble-denominated corporate bonds. These vulnerabilities are heightened by the lack of access of many banks to either the interbank market or foreign funding, and by weaknesses in Russia's prudential framework and regulatory practices. While there appears to be no major systemic risk, an in-depth review of vulnerabilities should be a priority. The Financial Sector Assessment Program update by a joint Fund-World Bank team of experts is now well underway, and should provide an early opportunity for such a review.
18. The energy sector is now weighing on the long-term outlook. The oil sector is not expected to recover over the medium-term from the precipitous decline that took place in 2004-2005. Thus, having previously contributed significantly to economic growth, it is now becoming a drag on growth in the sense that it is projected to expand at only half the pace of the economy at large. This also means a sharp decline in the relative importance of a sector that has been the main source of revenue to the budget and of foreign exchange inflows in the past, which in turn significantly increases the risk of the external current account and the real exchange rate overshooting their long-term equilibrium if the fiscal relaxation of the non-oil deficit continues in the coming years, as discussed above. In this regard, the poor performance of the oil sector as the state has assumed greater control in recent years and the equally disappointing performance of the state controlled gas sector over a much longer period stand in stark contrast to the strong growth of the privately controlled energy sector until recently, suggesting that the state may not be the best steward of this important sector. While the long-term goal should clearly be to diversify the economy away from dependence on the natural resource sector, this sector provides Russia with a strong comparative advantage and its resources could help spur growth and economic transformation if harnessed through the right policies.
19. Otherwise, the long-run growth potential remains favorable. Analysis suggests that the strong output growth of recent years has owed less to higher employment and investment than to increased total factor productivity, a measure of the efficiency gains achieved by reallocating existing resources from less-productive to more-productive sectors. Such catch-up gains are typical of the early stages of transition, and Russia appears to still have considerable unrealized potential in this regard as many of the important structural reforms that still lie ahead promise to further improve the allocation of existing resources. A case in point is the likely impact of housing- and communal-services reforms on inter-regional labor mobility. Still, as Russia progresses towards a market economy, the scope for high catch-up gains will eventually begin to wane, at which point long-term growth prospects will become increasingly dependent on raising the still-low level of investment. Such an increase is particularly important in the case of Russia, as adverse demographic factors suggest that the labor force will soon begin to contract. This points to the need to reinvigorate reforms that promise to improve the investment climate. While the implementation of such reforms in recent year has generally fallen short of the timetable that the government has set for itself—except for electricity reforms—progress has been made in advancing technical work and improving the legal and institutional framework necessary for implementation in important areas. The challenge facing the new government will be to take advantage of this progress to reinvigorate implementation of reforms, not least civil-service and administrative reforms, as well as reforms of the natural monopolies and of the health and education sectors.