Russian Federation -- Concluding Statement of the IMF 2009 Article IV Consultation Mission
June 1, 2009
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.
June 1, 2009
Against the background of a global economy in severe recession and shocks to oil prices and capital flows, the Russian economy is set to contract sharply in 2009 and to begin to recover only slowly in 2010. While the authorities’ policy response to the crisis has generally been timely and well focused, changes are needed in two key areas. First, with rising overdue loans and uncertainty about the state of bank balance sheets, a more determined and proactive approach—including mandatory stress tests and a program for recapitalization—is needed to restore the health of the banking system and reinvigorate credit growth. Second, while a large fiscal stimulus is justified at this juncture, the planned relaxation is excessive considering concerns about its reversibility and effectiveness. Its size should be limited and its composition reoriented toward expenditures that are better-targeted and self-reversing.
The global economy is undergoing its worst recession since the 1930s, with severe implications for the Russian economy
1. Global activity is expected to decline in 2009 for the first time in the post-war era. Advanced economies are experiencing particularly sharp declines, while emerging economies are being hit hard through both trade and financial channels. And while there are tentative signs that the rate of decline in output is moderating, the global economy is still expected to contract by around 1¼ percent in 2009, before a recovery emerges gradually in the course of 2010.
2. The Russian economy has been hard hit by dual shocks, as the two key drivers of its prolonged boom—rapidly rising oil prices and massive capital inflows—have sharply reversed. Going forward, the external environment is likely to remain challenging, as the subdued outlook for global growth implies only a gradual recovery in commodity prices. Moreover, global deleveraging by financial institutions suggests that capital inflows to emerging economies, including Russia, are unlikely to return to their pre-crisis levels any time soon. Against this background, the mission expects GDP to decline by 6½ percent in 2009 and to expand only modestly in 2010, if at all. As in the world at large, Russia’s economic recovery depends critically on restoring the health of its banking sector.
3. The swing in growth is much larger in Russia than in its G-20 peers. This extreme susceptibility to the global business cycle and to the attendant collapse in commodity prices reflects, to some extent, longstanding policy weaknesses. While the oil stabilization fund mechanism—the prudent policy of taxing and saving much of Russia’s oil price windfall—is appropriately absorbing most of the oil price shock transmitted through the external current account, the reversal in capital flows has led to painful adjustments and exposed policy weaknesses. In particular, the pre-crisis policy of controlled ruble appreciation, alongside regulatory and supervisory shortcomings, encouraged excessive foreign currency borrowing at a time when high oil prices increased investor appetite for Russian financial assets. The result was an oil price-related surge in capital inflows and an associated credit boom that left Russia highly vulnerable to shocks through the capital account.
The banking system is under stress amid rising overdue loans and capital shortfalls; credit may remain stifled as banks adjust their balance sheets and build liquidity buffers
4. The policy response to the crisis has been swift and substantial, driven by concerns about vulnerabilities that had built up in the corporate and banking sectors. In this regard, the sharp drop in oil prices and the attendant pressure on the ruble exposed the extent of currency mismatches, as it led to a massive drive to hedge exposures in expectations of ruble depreciation, starting last summer. The CBR initially facilitated this outflow by providing sizeable liquidity injections at low interest rates, while drawing on its large international reserve cushion to prevent the ruble from quickly depreciating to its new equilibrium level. This reflected the CBR’s deep concern that a rapid depreciation would lead to an abrupt loss of confidence in the banking system and a full-scale financial crisis. However, as the reserve loss associated with this policy became increasingly unsustainable, the CBR was forced to tighten monetary policy in January, raising policy rates, alongside a steep ruble devaluation. In this current, second, phase of the crisis in Russia, the banking system is coming under renewed pressure, and longstanding concerns regarding the robustness of the system and the regulatory framework are being tested.
5. The situation in the banking system indeed appears to be deteriorating. Banks are registering mounting overdue loans, despite regulatory forbearance by the CBR and anecdotal evidence suggesting substantial evergreening of loans. Loan delinquencies are increasing, reaching 3.7 percent of total loans at end-March, while banks do not appear to have sufficient loan loss reserves. The mission agrees with the CBR and private sector analysts that overdue loans are likely to increase sharply over the course of the year, and it expects that a significant amount of additional provisions would be needed to bring loan-loss reserves to adequate levels. At this stage, the CBR has not yet undertaken a comprehensive analysis to ascertain the scale and scope of the problem in the banking system, including possible capital shortfalls, in part because of longstanding data and reporting deficiencies. Moreover, while the government has set aside Ruble 500 billion to support bank recapitalization, the modalities and conditions for such support remain to be decided.
6. Absent a more determined policy intervention, there is a risk that banks will struggle to adjust balance sheets for a prolonged period, with credit and counterparty concerns stifling credit expansion and exacerbating banks’ liquidity preference. Uncertainty regarding the state of bank balance sheets, including the extent of bad assets and the potential capital shortfall, could limit the availability of funding for banks for a protracted period, with knock-on effects on their ability and willingness to extend fresh credit. Indeed, banks are already exhibiting strong liquidity preference to help offset declining cash flows from deteriorating loan portfolios and to build up a cushion to deal with emerging problems.
A comprehensive plan to address the looming overhang of bad assets and associated capital shortfalls is urgently needed to lay the foundation for a resumption of credit growth
7. Following mandatory, rigorous stress tests, viable banks should be quickly recapitalized. Absent a systematic analysis of individual banks, it is unclear whether the budgetary appropriation for recapitalization will be sufficient.
• Detailed reviews and mandatory stress tests should be undertaken for large- and medium-sized banks to obtain better estimates of viability and capital needs. While different options would need to be considered for recapitalizing viable banks—including the scope for burden sharing between the private and public sector—it is critical that the authorities move quickly and convincingly. The CBR will require additional resources to ensure adequate manpower to undertake labor-intensive stress tests and to intensify monitoring of systemically important banks.
• Regulatory guidance should be developed to provide banks with a roadmap regarding the supervisory actions that the CBR intends to implement as banks’ capital deteriorates and the level of problem loans increases. This would enable banks to plan early to either increase capital from private sources or to attempt to find a buyer.
• In dealing with foreign-owned banks, the authorities should work to strengthen cross-border coordination, especially by working closely with home-country supervisors. This might help to avoid an abrupt unwinding of foreign exposures in Russia.
• The goal of banking-sector support should be the healthy resumption of market-based lending—public support should not be accompanied by the imposition of lending or interest-rate targets that could risk causing further balance sheet deterioration.
8. A strengthening of the CBR’s supervisory authority, along with the development of contingency plans and regulatory guidance, would bolster the authorities’ ability to proactively address potential future problems in the banking system. The establishment of more transparent financial accounting rules and clear supervisory expectations on remedial actions and prompt resolution of problem banks would increase market efficiency and reduce circumstances where the presence of non-viable banks distorts funding and lending rates.
• The CBR should be granted broader consolidated supervision authority. Absent this, its ability to monitor transactions between affiliates is severely hampered, increasing risks that losses are hidden through affiliate operations or off-balance sheet transfers.
• In light of the potential for a significant increase in bank resolutions, the DIA should develop plans for the orderly disposition of large volumes of assets from liquidated banks or from DIA-assisted mergers, as well as a possible rise in deposit payouts.
• The CBR should begin to formulate plans for rolling back regulatory forbearance. A communication strategy should be developed to explain how the rollback would be implemented and the procedures that the CBR would adopt for determining compliance with capital requirements after the rollback.
Countercyclical fiscal relaxation is appropriate, but the planned expansion should be scaled back and its composition improved given the need to balance short-term cyclical considerations with medium-term fiscal concerns
9. A significant countercyclical fiscal relaxation is underway. The general government balance is set to decline by 10½ percent of GDP in 2009. Half of this decline reflects the loss of oil revenues, while the remainder represents a discretionary relaxation, most of which still lies ahead. The key challenge is to balance what is undoubtedly a strong cyclical rationale for providing a significant fiscal stimulus against medium-term fiscal objectives.
10. The mission is concerned that the current cyclical position and associated support for the large fiscal stimulus are allowing an expenditure and tax structure to emerge that will be difficult to reverse once the economy recovers, implying an eventual return to a highly procyclical fiscal stance with upward pressures on prices and the real exchange rate.
• Despite persistent underexecution, fiscal policy had become increasingly pro-cyclical in the years preceding the crisis. While the medium-term fiscal framework was based on a relatively conservative and prudent target for the non-oil deficit (4.7 percent of GDP), the target had little operational impact as the non-oil deficit was allowed to expand steadily in the pre-crisis years. This reflected growing political pressures to spend more of the oil wealth on investments and other priority projects, as well as a failure to curb other spending because of lack of public sector reforms, not least health, education and civil service reforms.
• Given the 2009 budget, bringing the non-oil deficit back to the 4.7 percent of GDP medium-term target would require an adjustment in expenditure or non-oil revenues of some 8 percent of GDP over the next four years. Taking into account budgetary financing of critical reforms to the pension system (estimated at some 3 percent of GDP annually), as well as costs associated with support to the banking sector, the required adjustment could reach 11-13 percent of GDP. With an already high tax burden, and with non-statutory spending at the federal level amounting to only 7¼ percent of GDP, fiscal adjustment on this draconian scale would only be possible with unprecedented political support for deep and comprehensive public sector reforms.
11. In view of these considerations, the mission believes that the discretionary fiscal stimulus should be kept to 2-3 percent of GDP in 2009, limiting the change in the headline general government balance to 7-8 percent of GDP. A better targeted, yet smaller, stimulus could have a similar impact on economic activity, given the larger fiscal multipliers, while avoiding a permanent change in the tax and expenditure structure. In particular, the mission recommends reorienting the stimulus toward a temporary increase in social transfers targeted on credit-constrained households and frontloading “shovel ready” infrastructure projects alongside a strengthening of procurement procedures. This improvement in the composition of fiscal spending would also facilitate the withdrawal of stimulus once private demand recovers, as many of the measures are self-reversing. In this regard, plans for frontloading the pension reform are appropriate, as long as the additional outlays are accommodated by reducing other, less efficient, spending.
12. Looking to 2010, if a smaller discretionary stimulus is targeted in 2009, there would be scope to maintain the fiscal stimulus next year. The desirability of maintaining, rather than withdrawing, the stimulus in 2010 depends critically on the growth outlook, which is highly uncertain. Under the current outlook, and assuming the 2009 stimulus is scaled back and reoriented as described above, maintaining the stimulus next year would provide important support to domestic demand. However, if the growth outlook improves substantially, some withdrawal of stimulus (of around 1 percent of GDP) would be appropriate in 2010.
13. To facilitate the large fiscal adjustment needed over the medium term, reinvigoration of public-sector reforms is a matter of priority. IMF research suggests that Russia has scope to achieve significant budgetary savings by improving expenditure efficiency, without compromising the quality of services. Such savings could be particularly large in healthcare and social protection, but public sector reforms in other areas, including civil service, military, and education, would also be instrumental in creating the much-needed fiscal space. On another medium-term fiscal issue, given that sustainable consumption of Russia’s oil wealth requires ensuring sufficient oil revenue take by the government while creating strong incentives to invest in exploration and production, the mission would support gradually replacing the current revenue-based oil taxation regime with a profit-based system that better adjusts to differences in costs over time and across fields. However, a necessary precondition for such a system would be the introduction of transfer pricing legislation consistent with OECD guidelines and a strengthening of enforcement capacity.
There is scope for a more accommodative monetary policy stance
14. The mission agrees that there is room to cut policy interest rates in the context of a widening output gap and declining inflation. However, it would caution that the direct impact of lower interest rates on domestic demand will likely be somewhat limited at first. Banks facing mounting overdue loans and rising credit risk are likely to scale back the supply of credit as they attempt to build liquidity cushions and strengthen balance sheets, while general uncertainty about the economic situation is reducing the demand for credit. Nonetheless, lower interest rates should help reduce bank funding costs and support the financial system.
15. Given the substantial injection of liquidity arising from monetization of the fiscal deficit, the challenge for monetary policy going forward will be to strike the right balance between domestic and external stability. The fiscal deficit represents a potential liquidity injection of around 70 percent of base money during the remainder of 2009. Although the CBR expects a large portion of this to be sterilized, in part through the repayment of the uncollateralized loan stock, staff still projects a net liquidity injection of around 35 percent of base money. This is a significant injection into a banking system that is already liquid, with attendant risks to external stability. As the fiscal stimulus comes on line, the ruble may come under pressure as lower ruble interest rates induce banks to switch their funds into foreign exchange. This suggest that the CBR should move cautiously in reducing interest rates.
16. The increased exchange-rate flexibility is much welcome. In this regard, the resumption of short-term capital inflows—most notably the carry trade—underscores the importance of not exacerbating such inflows by limiting ruble flexibility. Of course, an abrupt and dramatic shift in exchange rate expectations and a reversal of capital inflows—perhaps associated with a rapid decline in oil prices—could be cushioned by drawing on Russia’ substantial international reserves, but ultimately the authorities should stand ready to let the exchange rate move in line with changing fundamentals.
17. Looking farther ahead, monetary policy should be squarely aimed at bringing down stubbornly high inflation. The crisis has laid bare the cost of orienting monetary policy toward nominal exchange rate stability, as it has allowed high inflation to remain entrenched, well above the levels of Russia’s G-20 peers. The consequences of this policy may be severe in the environment of more limited external financing which is likely to prevail in the years to come. More specifically, entrenched high inflation has constrained the availability of long-term ruble financing. Thus, the ability of Russia’s domestic financial system to mobilize savings to fund much-needed investment is likely to remain limited while inflation stays high, preventing an expansion of the country’s long-term productive capacity. For these reasons, and given that much of the technical preparatory work is now in place, the mission supports the authorities’ plans for an early move to inflation targeting.
The mission is concerned that support for WTO accession is losing momentum
18. As the scope for catch-up gains in productivity begins to diminish, long-term growth will become increasingly dependent on boosting investment, including by improving Russia’s still relatively poor investment climate. In this regard, the mission is concerned that the drive to gain accession to the WTO appears to be losing momentum—enhancing competition and reducing rent seeking through early WTO membership remains key to a strengthening of the investment climate. More generally, while many reforms aimed at improving the investment climate and bolstering institutions—including with respect to civil service, administrative, and judicial reforms—are technically well-advanced, implementation appears to have stalled. The urgency of advancing reforms is heightened by adverse demographic factors, which are leading to a contraction in the labor supply.