Russia: Mission Concluding Statement of the 2008 Article IV Consultation
June 9, 2008
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.
Soaring oil prices, large capital inflows, and high credit growth are providing the impetus for a virtuous circle of robust growth in investment, productivity, real incomes and consumption. Meanwhile, there have so far been no significant negative spillovers from the global financial market turmoil. However, despite a strong supply response, surging domestic demand has been associated with signs of overheating. This reflects in part that a procyclical fiscal policy is stimulating demand, while the fixed exchange rate policy in the face of rising oil prices and large capital inflows is leading to very high money and credit growth. Looking forward, the reduction in inflation projected by the authorities relies in the view of the mission mainly on the expectation of lower growth in global food prices, not on policy changes, and domestically generated inflationary pressures are set to remain high, if not increase. Plans for a further fiscal relaxation should be revisited and monetary policy should be tightened and refocused on controlling inflation in the context of a flexible exchange rate policy. The possibility that rising inflation will eventually force a significant monetary tightening and a period of below-potential GDP growth is the main risk to the outlook at this stage. As to the financial sector, the regulatory framework has improved but additional changes are needed, not least to manage risks arising from rapid credit growth.
Rising investment is increasing and solidifying economic growth
1. Higher investments are helping Russia to realize its catch-up potential. Returns on investment are high—reflecting the scarcity of capital—and surging oil prices, large capital inflows following the liberalization of capital controls, and a steady deepening of financial markets are providing investors with the financing and retained earnings needed to take advantage of this. The resulting rise in investment, and the associated reallocation of labor to more productive sectors, are unlocking catch-up gains in productivity. This is providing a further boost to growth in real incomes and consumption, which have already been buoyant for some time, owing to large terms-of-trade gains. Financial deepening is also reinforcing this process, by allowing households to take advantage of low indebtedness to borrow against expected future income gains.
2. Prudent management of oil revenues has so far prevented excessive real appreciation. The ruble has appreciated steadily in real terms, but this is unavoidable, indeed desirable, in view of the large terms-of-trade and productivity gains. In line with this appreciation, growth is led by non-tradable sectors, like construction and services, but there are no strong signs so far that the pace of appreciation has exceeded the tradable sectors' ability to stay competitive—manufacturing output is rising at a robust pace. Crucial in this regard has been the policy of saving most of the oil revenue windfall in the stabilization fund, which has prevented excessive real appreciation. This policy has also been key in building the improved investor confidence—at home and abroad—that is underlying the recovery.
The risk of overheating is a threat to growth prospects
3. Signs of over-heating are emerging. Inflation has almost doubled during the past year and now extends well beyond food and energy price increases. Domestic demand is increasing at an annual rate of 15 percent in real terms, while GDP is growing at 8 percent, which is somewhat above the level that can be maintained without causing accelerating inflation, according to estimates by both Russian and IMF experts. Resource constraints are particularly evident in labor markets, where shortages are causing real wage increases of about 16 percent annually, well above growth in labor productivity. As a result, unit labor costs are now rising. Domestic resource constraints are also evident in the rise in import volume growth to almost 30 percent annually.
4. Demand pressures are being exacerbated by procyclical fiscal policy. Primary expenditures by the federal government rose by 15 percent in real terms, and the non-oil deficit—excluding a one-off collection of tax arrears from Yukos—rose by 0.8 percent of GDP in 2007. A further relaxation is underway this year. While the relaxation might be limited compared to the large share of taxes on the oil and gas sector that is still being saved, it provides an unhelpful pro-cyclical fiscal stimulus at a time when buoyant private demand and rapidly raising food and energy prices are already causing fast rising inflation.
5. Meanwhile monetary policy remains hampered by the focus on stabilizing the ruble in terms of the euro-dollar basket. Money and credit grew by about 50 percent last year as sharply rising oil prices and capital inflows—attracted by the booming economy and expectations of future appreciation—resulted in surging unsterilized foreign exchange market interventions. More recently, money and credit growth has slowed somewhat as a result of the global financial turmoil, but this relief will likely be only temporary as Russian banks and non-financial enterprises are now returning to the Eurobond market in force. While the global repricing of risk entails somewhat higher interest rate spreads, the impact on rates have been limited, owing to the decline in foreign rates resulting from an easing of monetary policy abroad. This "import" of the monetary policy stance of the euro area and the US is clearly inappropriate, as Russia is overheating while these economies are cooling.
6. Inflation is likely to continue to increase unless policies are modified. With oil prices remaining high and no serious impact of the global financial turmoil, private demand is set to grow with largely undiminished strength in 2008-09. We expect GDP growth to remain above potential, growing at 7¾ percent in 2008. In this context, the current mix of procyclical fiscal and accommodative monetary policies will drive inflation up further, unless the global increase in food prices abates. Indeed, the authorities' projected reduction in the rate of inflation hinges mostly on the expectation of such favorable external developments, not on a fundamental policy change. While lower food-price increases might indeed bring some relief in terms of lower head-line inflation, this will do little to reduce the domestically generated pressures that are pushing up underlying inflation. Absent policy changes, we expect inflation to be running at about 14 percent by end-2008, with the risks on the upside.
7. Rising inflation is a threat to GDP growth. There are already signs that increasing inflation is slowing the remonetization of the economy, and concerns are rising among banks that a lack of long-term financial ruble assets will increasingly hamper the ability to provide the long-term credits needed to sustain rising investments and boost potential growth. In this regard, as inflation goes unchecked, the risk is rising that the CBR might eventually have to apply monetary breaks with such a force that GDP growth will drop below potential. If inflation expectations are allowed to get entrenched, the period of below-potential growth could be prolonged. In the mission's view, it is this risk, not the impact of a possible drop in oil prices, that is the main threat to growth in the coming years.
Policy corrections are needed
8. Monetary policy should be tightened by allowing greater exchange rate flexibility. The recent increases in policy rates and reserve requirements will not entail significant tightening. While we welcome the commitment on the part of the CBR to move to formal inflation targeting, once it believes the conditions for such a framework are in place, this does not argue against an immediate refocusing of monetary policy on inflation reduction. We have discussed a number of alternative frameworks for the day-to-day conduct of monetary policy that would achieve such a refocusing, all of which require the CBR to scale back interventions and allow the ruble to appreciate if needed to keep inflation on a downward path. Whatever framework the CBR chooses, a tightening of monetary policy—resulting in reduced credit growth and higher real interest rates—is unavoidable at this time.
9. External factors can not be relied upon to automatically bring about the necessary monetary tightening. We would strongly caution against delaying a tightening on the assumption that a rapid unwinding of the current account surplus will soon ease pressures for ruble appreciation and, therefore, reduce liquidity injections through exchange market interventions: upward pressures on the ruble will remain high, even as the current account swings into a deficit, as long as buoyant private demand and an expansionary fiscal policy maintain GDP growth above potential. Meanwhile, as mentioned, there are no signs that the global financial market turmoil is having a substantial impact on Russia. More generally, with Russia's cyclical position now strengthening significantly relative to that of the Euro area and the US, adopting an independent monetary policy, calibrated with a view to cyclical conditions in Russia, is more important than ever.
10. Conflicting policy objectives are exacerbating capital inflows. Market participants are aware of the increasing inconsistency between the authorities' inflation and exchange rate targets, and are increasing foreign borrowing in the expectation that the latter will eventually give way to the former. While the increased day-to-day exchange rate volatility engineered by the CBR lately might discourage short-term inflows, most inflows are of medium-term maturity and will not be deterred by higher short-run volatility around a fixed rate.
11. The key to discouraging speculative capital inflows is to keep inflation on the targeted path, thereby eliminating expectations of future monetary tightening. This points to the need for a clearly communicated and consistently implemented commitment to inflation reduction on the part of the CBR, but the credibility of such a commitment will to a large extent hinge on support from countercyclical fiscal policy. Such support is particularly important because monetary policy is bound to be circumscribed by large capital inflows over the medium term, even if speculative inflows subside.
12. Further fiscal relaxation should be avoided. The supplement to the budget proposed by the government last week, equivalent to 0.3 percent of GDP, entails a small but unwelcome addition to the fiscal stimulus already implied by the 0.6 percent increase in the non-oil deficit contained in the original 2008 budget. This will further add to inflationary pressures. The mission believes that this proposal should be reconsidered, that any revenues above budgeted amounts should be saved, and that the 2008 budget should be under executed to the extent possible, as in previous years. As to 2009, fiscal policy should ideally be withdrawing stimulus. As a second best, however, the further increase in the non-oil deficit of 0.7 percent implied in the approved medium-term budget should be avoided.1
Important reforms are likely to increase the demand on public sector resources
13. Increased budgetary resources will be needed for investment in infrastructure, social spending and pension reform. Severe infrastructure bottlenecks are an obstacle to long-term growth prospects, and the proposal to boost spending in this area, in part through public-private partnerships, is appropriate. Improving the quality of public health service is another understandable priority, and the reforms under consideration will also require additional resources. Reforms of the public pension system are particularly pressing. The replacement rate of 24 percent—which is already far below the lowest rate among OECD countries—is projected to decline to 17 percent by 2027 under current policies. According to the mission's calculations, just maintaining the rate at its current level would require additional annual transfers to the pension fund averaging 1½ percent of GDP.2
14. Proposals for changes in the VAT should be reconsidered. The mission disagrees that this tax is distortionary. Reducing VAT rates would go against international trends, and replacing the VAT with a sales tax would be a step backwards. The distortions arising from the VAT are due to administration problems, especially the long delays in making refunds. This is particularly a burden on exporters and companies with large investment. Instead of the proposed changes, it should be an issue of priority to ensure that the tax administration takes immediate steps to overcome this long standing problem. To the extent that there is a desire to reform the VAT, the focus should be on a revenue-neutral streamlining, entailing a unification of the general and specific rates and the elimination of exemptions. Calculations by IMF experts suggest that unification at a tax rate of 16 percent would be broadly revenue neutral. However, VAT reform should not be a priority as this is the least distortionary tax in Russia. From this perspective, the focus should be on the unified social tax and the profit tax.
15. Pressures to increase spending limits appear to be rising. The mission agrees with the Ministry of Finance that adhering to targets in the approved medium-term budget, which lowers the non-oil deficit through a reduction in primary spending relative to GDP from 2010 onwards, should be a priority. Admittedly, this reduction in the spending envelope will be a challenge considering the cost of social reforms and infrastructure projects. In this regard, a growing number of policymakers seem willing to push spending beyond the limits set in the medium-term budget. Given domestic resource constraints, a deficit-financed increase in the public sector's claim on resources could result in crowding out of private investment. The authorities would have to carefully weigh the cost and benefits of such an outcome, taking into account that the impact on potential GDP growth of the envisaged reforms and infrastructure projects will be limited and slow in coming. To the extent that there is a social consensus to shift fiscal policy more towards achieving longer-term goals, it must be accepted that this shift will put more of the burden of demand management on monetary policy, and that it will therefore imply faster real and nominal ruble appreciation.
16. The risk of fiscally induced overshooting of the exchange rate over the medium term cannot be discounted. Absent a slowdown in domestic demand growth, upward pressures on the real effective exchange rate will persist and import growth will remain high. This points to the risk that the exchange rate could overshoot sustainable levels. In particular, a further steady increase in the non-oil fiscal deficit to levels that cannot be sustained with oil prices at their long-run trend could lead to a policy-induced overshooting, requiring a pro-cyclical fiscal tightening if oil prices dropped. This would be particularly painful to the extent that higher deficits reflect increases in recurrent expenditure and permanent tax cuts.
Maintaining the stability of a dynamic financial sector
17. The financial system has weathered the recent global financial turmoil well. With no significant sub-prime exposure, the key impact of the turmoil appears to have centered on a number of midsized banks that relied on international funds to finance consumer lending--as foreign inflows weakened, these banks were forced to rein in their credit activity, but were also able to draw on their strong cash flow position to meet maturing liabilities. Moreover, concerns about a possible liquidity squeeze in the Russian interbank market were addressed decisively by rapid official measures to support local liquidity, as well as additional efforts to broaden the range of tools available for future liquidity support. Overall, therefore, the net effect of the turmoil has been relatively insignificant. Most banks were able to maintain access to international markets, although reduced global demand and higher borrowing costs have encouraged a general shift from the Eurobond market to shorter-term syndicated loans. In addition, the turmoil has encouraged a reassessment by banks of their funding and lending strategies, and has prompted a gradual adjustment to a new higher-cost environment. For the corporate sector, higher foreign borrowing costs and reduced liquidity in the local ruble bond market has resulted in a shift to alternative sources of funding, mainly from banks. More recently, access to foreign capital markets seems to have normalized, as discussed above.
18. A recent update of the Financial System Stability Assessment found that the financial system has strengthened. This reflects favorable economic conditions and the improvement of the legal and regulatory framework. Nonetheless, the update concluded that the system still faces notable risks. The main challenges in the near term are credit risk on account of rapid credit growth—although non-performing loans ratios are still low, the overall level of these loans is rising. Given the fragmented interbank market, liquidity risks are also a potential problem. To further strengthen the regulatory and supervisory framework, loan classification and provisioning standards should be tightened and brought in compliance with Basel Core Principles. The update also found that the bank resolution framework has been effective in dealing with smaller banks, but may face difficulties resolving problems in larger ones. It should be strengthened by giving the CBR the authority to intervene at an early stage so as to minimize the cost of resolution and the disruption to creditors, including depositors. Finally, legal amendments are needed to allow effective consolidated supervision.
1 These estimates are based on lower growth in non-oil revenue in 2009 than projected by the authorities, and on the IMF Staff classification of non-oil revenue.
2 Average for 2007-2050. The transfer would gradually increase from zero in 2007 to 2.9 percent of GDP in 2027, and decline thereafter.