Russian Federation—Concluding Statement for the 2010 Article IV Consultation
June 28, 2010
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.
The authorities responded forcefully to the global financial crisis, taking full advantage of the considerable buffers that had been afforded to them by the prudent policy of taxing and saving much of the oil revenue windfall and by the attendant large increase in reserves. Looking ahead, our main concern is that withdrawing the fiscal stimulus will be exceedingly difficult, not least because the budget has become far less flexible amid significant increases in permanent spending. Failure to do so as cyclical conditions normalize would cause significant upward pressure on the real exchange rate. Moreover, with potential growth set to be lower than before the crisis, room for maneuver will be limited, and a return to a policy of resisting nominal ruble appreciation could send inflation back to double-digit levels. Thus, implementing the public sector reforms needed to achieve lasting expenditure consolidation and focusing monetary policy on inflation control, in the context of a flexible exchange rate policy, are essential to preserving macroeconomic stability. In addition, structural reforms, including in the area of banking regulation and supervision, remain key to boosting long-term growth.
Background: Lessons from the Past
The strengths and weaknesses of economic policies evident over the full cycle impart important lessons for the future.
1. Policy weaknesses had left Russia vulnerable when the global crisis hit. During several years prior to the onset of the crisis, Russia had an inflationary macroeconomic policy mix. Fiscal policy was eased through a steady increase in the spending of oil revenue, while the monetary stance was accommodative as the policy of resisting ruble appreciation caused loss of control over money and credit growth, amid weak bank supervision. Against a backdrop of improving confidence on the part of foreign creditors—rooted in rapidly rising commodity prices and swelling reserves—policy weaknesses also exacerbated external borrowing, as the lack of exchange rate flexibility encouraged one-way bets on appreciation. After several years of annual credit growth of 40-50 percent and near-double digit real appreciation, the crisis revealed a construction bubble and a financial sector that was highly exposed—directly and indirectly—to several hundred billion dollars of unhedged foreign exchange liabilities.
2. The authorities responded forcefully to the crisis. The dual shock of collapsing oil prices and convulsions in foreign capital markets caused an abrupt reversal of capital flows as creditors and debtors alike scrambled to cover unhedged positions. The Central Bank of Russia (CBR) accommodated this by providing massive liquidity injections and easing lending criteria, and above all by selling about $200 billion of reserves at a favorable exchange rate as it allowed only a slow depreciation, before undertaking a large step-devaluation several months into the crisis. This almost certainly prevented severe distress in the banking system. Meanwhile, the prudent past policy of taxing and saving much of the oil windfall left significant scope for fiscal relaxation, despite the easing in the preceding years. The non-oil deficit was increased by nearly 7 percent of GDP in 2009, providing a major countercyclical stimulus. In sum, policymakers boldly used the large room for maneuver afforded by Russia’s huge foreign reserves.
3. Russia is now transitioning from stabilization to a slow rebound. All components of demand are increasing. However, growth is becoming consumption-led, reflecting in part the recent 45 percent increase in pensions. But while the current rebound is still dependent on policy support, a self-sustained recovery is set to gradually take hold, not least because the adjustment of bank balance sheets now appears to have run its course, with banks poised to cautiously expand lending. As a result, GDP growth is projected to reach 4¼ percent in 2010 and inflation is expected to remain relatively subdued, reaching 6 percent at end-year. Still, with limited prospects for further increases in oil prices over the medium term, the nexus of strong growth in investment, productivity, real wages, and consumption that powered the pre-crisis growth is unlikely to materialize any time soon. This, and the absence of more fundamental reforms during the era of high oil prices, suggests that Russia will emerge from the crisis with notably lower potential growth. The extent of the decline will depend on policies.
4. The pre-crisis policy weaknesses point to the risks that lie ahead. With lower potential growth than before the crisis, policymakers will have much less room for maneuver as private sector demand recovers than they did in the past. In this regard, given the pressures to spend more of the oil revenue evident before the crisis, we are concerned that it might prove difficult to reverse the sharp increase in the non-oil deficit that took place during the crisis, as discussed below. Failure to do so could cause rapid real appreciation—possibly again approaching double digits—with the real exchange rate significantly overshooting its equilibrium path. Moreover, a return to a policy of resisting the attendant nominal appreciation could cause renewed loss of control over money growth and a rise in inflation, most likely also to double digits. Absent a further surge in oil prices and an associated investment boom, such an unfavorable macroeconomic policy mix—coupled with continued slow progress on structural reforms, including regulatory reforms—would likely take a larger toll in terms of lower growth and higher inflation than in the past. Our projections suggest medium-term growth below 3½ percent under such an unchanged-policies scenario.
5. A more positive growth outlook requires policies that decisively break from the past. The priority is for early action on structural reforms to underpin the exit from fiscal stimulus, improve the investment climate, and boost potential output growth. Monetary policy should focus firmly on inflation control in the context of a more flexible exchange rate. Action is also needed to fully return the banking system to health and lay the basis for a sustained resumption of credit expansion. These policies have been the main focus of our discussions.
The dramatic rise in permanent spending suggests that withdrawing the stimulus will not be possible without reinvigorating long-delayed public sector reforms.
6. There is no firm strategy yet for withdrawing the huge fiscal stimulus. The authorities previously expected to start doing so this year, and to gradually lower the non-oil deficit to 9½ percent of GDP by 2012, from 13¾ percent of GDP in 2009. However, with the recent supplementary budget, there is instead a small further expansion in 2010, and the authorities also appear to be revisiting the planned pace of consolidation over the medium term.
7. Withdrawal of stimulus should start now, gathering significant pace in 2011-12. With cyclical conditions set to gradually normalize—and with lower potential growth—the authorities should plan on fully reversing the large increase in the non-oil deficit in the coming years. Given the scale of the needed reversal, we believe that striking an appropriate balance between short-term cyclical considerations and medium-term consolidation would require the withdrawal of stimulus to have begun already this year. The expansion of the federal government’s non-oil balance implied by the 2010 supplementary budget is, therefore, regrettable, and the prospect of another supplement in the fall is worrisome. Moreover, the previously planned target of reducing the non-oil deficit to 9½ percent of GDP by 2012 remains, in our view, broadly consistent with the current outlook for economic activity. Looking further into the future, the target of a non-oil deficit of 4.7 percent of GDP implied by the authorities’ long-term fiscal framework should remain the fiscal anchor.
8. Achieving the necessary fiscal consolidation will be a formidable task. The budget has become increasingly inflexible—of the 8½ percent of GDP increase in the underlying non-oil deficit compared to its pre-crisis level, three-quarters reflects higher permanent measures, with some 4½ percent accounted for by higher pensions alone. As a result, non-statutory spending is now only 9 percent of GDP—equal to the size of the consolidation needed to achieve the government’s own long-term target for the non-oil deficit of 4.7 percent of GDP by 2015. Without deep public sector reforms, there is little prospect for achieving the needed consolidation.
9. Reinvigorating long-stalled public sector reforms is thus a matter of urgency. Cross-country comparisons suggest that significant savings can be achieved in health and social protection without compromising the quality of service delivery. Moreover, the pension system is not financially viable without comprehensive reforms, including a gradual but major increase in the retirement age. While reforms in these areas have been on the agenda for several years, they appear still to have insufficient political support, and progress remains slow. Advancing such reforms is becoming essential to economic stability over the medium term.
10. The fiscal framework needs to be strengthened. Supplementary budgets have been adopted every year since the 1998 crisis—in some years there have been several such budgets. With the exception of the recent crisis, the changes implied by supplementary budgets have, since 2004, invariably run counter to what would have been required from a cyclical perspective. Moreover, the recent shift in focus of fiscal policy to the overall balance, rather than the non-oil balance, is in effect also increasing the pro-cyclicality of fiscal policy. In this regard, it is regrettable that the 2010 budget is—for the first time in many years—based on an oil-price assumption that is above the futures price. To ensure an effective counter-cyclical fiscal stance, strengthening the medium-term budget framework should be a matter of priority, starting by eschewing the use of supplementary budgets and firmly focusing on the non-oil deficit.
Preventing a renewed increase in inflation is bound increasingly to test the commitment to exchange rate flexibility.
11. Monetary policy should be focused on inflation control, in the context of a flexible exchange rate policy. The increased flexibility of the exchange rate during the past year is, therefore, much welcome. This, alongside cuts in policy interest rates, has helped deter speculative capital inflows. However, with weak cyclical conditions and low capital inflows, the commitment to a flexible exchange rate policy still remains to be tested in an environment that involves a sharper trade-off between inflation and the nominal exchange rate. Indeed, risks in this regard would increase significantly absent decisive action to reduce public expenditures. Finally, we continue to support an eventual move to formal inflation targeting. Recent enhancements in the CBR’s public communications are helping to prepare the public for such a move.
12. The authorities should aim for a reduction in inflation from current levels. Inflation should be targeted at 5-6 percent by end-2010, with a further reduction next year. Moreover, we agree with the CBR that the monetary easing cycle should now be paused, and are of the view that the next move is likely to involve initiating a tightening cycle. At the same time, monetization of still-large fiscal deficits—by drawing down the government’s oil funds—poses additional challenges to monetary policy in that the CBR will need to sterilize these liquidity injections.
Financial Sector Policies
Improved provisioning standards and expanded authority for the central bank are needed to reduce risks in the banking sector.
13. It is difficult to assess the health of the banking system. Despite improvements in recent years, weaknesses in the regulatory and supervisory framework remain. These shortcomings make it difficult to gauge the extent of systemic risks, the severity of the deterioration of the loan portfolio, and the adequacy of capital. In particular, given the overhang of non-performing and restructured loans, banks may not have sufficient buffers to deal with unexpected shocks. Indeed, the stock of bad assets is likely to dent profitability going forward, making banks vulnerable to an increase in interest rates or a deterioration in economic conditions. While the CBR’s unwinding of regulatory forbearance for new loans is appropriate and welcome, most bad loans will remain under forbearance for some time, hampering assessment of bank balance sheets.
14. Improved provisioning standards would reduce risks to bank balance sheets. Strengthening the loan classification and provisioning system is essential to gaining a full understanding of banks’ capital adequacy. In particular, loan risk assessment should be improved and provisioning should be made more forward-looking. This would ensure that banks establish buffers against unexpected losses associated with a deterioration in loan quality. Doing so may reduce reported capital adequacy—undercapitalized financial institutions should be recapitalized, restructured, merged, or closed. To the extent that better provisioning leads to healthier loan portfolios over time, the risk that increases in interest rates will damage bank balance sheets will be reduced. Loans remaining under regulatory forbearance will require close monitoring and an eventual return to stricter standards.
15. The CBR should be afforded greater supervisory powers. The CBR’s authority to conduct consolidated supervision—including over connected lending—should be enhanced. Strengthening regulations on connected lending is critical to compel appropriate disclosure, ensure that suitable (market) terms are applied to such loans, and enable the imposition of sanctions. Relevant legislation has been drafted or is under preparation in these areas, which is welcome.
16. While financial stability is not under immediate threat, lack of decisive action jeopardizes growth prospects. The CBR’s forceful response to the global crisis suggests that it will act quickly and forcefully should financial stability be threatened. The large stock of international reserves continues to afford it ample room for maneuver to do so. Our main concern is that failure to decisively deal with the overhang of non-performing and restructured loans will hamper banks’ ability to expand credit on a sustained basis and will encourage them to direct available resources to struggling clients, away from dynamic enterprises seeking to boost investments. Thus, ensuring a sound banking system is yet another prerequisite for strong and balanced economic growth.
The overarching priority is to reinvigorate reforms stalled during the years of high oil prices and easy growth.
17. Potential growth will remain low absent structural reforms. Russia’s labor force is shrinking and demographic trends are not favorable. Moreover, the unfavorable investment climate—confirmed by Russia’s low ranking on international comparisons in this area—suggests that investment is likely to remain far more subdued than in the pre-crisis years, when high commodity prices powered strong investment growth. Finally, the scope for further catch-up gains in productivity will inevitably decline over time. As a result, post-crisis potential output growth is likely to be lower than pre-crisis levels. This points to the need for rapid and decisive action to advance structural reforms, with a focus on improving the investment climate and boosting the potential for productivity gains.
18. The key structural reform priority is to improve the investment climate. Civil service and public administration reforms are needed to curtail the pervasive influence of government on economic decision making. Reform of the judiciary would help assure investors that property rights will be protected and that the playing field for investing is level. Moreover, moving ahead with the recently announced privatization program would be a useful step toward rolling back the increased state dominance of the past few years. Finally, WTO accession holds the promise of making the investment environment more predictable and rules-based, while reducing dependence on primary commodity sectors. Such reforms are essential to achieve the modernization, innovation, and diversification called for by President Medvedev.