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Russian Federation—Concluding Statement for the 2011 Article IV Consultation Mission
June 14, 2011
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 key challenge facing Russia’s economy is to leverage the ongoing commodity boom to put growth on a sustained higher trajectory. This requires breaking with the procyclical policies of the past and reorienting policies in all key areas. A credible, ambitious, and growth-friendly fiscal consolidation—anchored in a sound fiscal framework—would reduce fiscal vulnerabilities. A more decisive monetary tightening—underpinned by a flexible exchange rate, an improved monetary framework, and better communications—would help to bring down inflation. Stronger oversight of the financial sector would promote stability and thereby underpin faster growth. And better governance and a more welcoming business environment would help to attract productive investment and facilitate economic diversification. The 2020 strategy now being formulated provides an opportunity to put in place the needed reforms to support stronger growth.
Leveraging the oil boom to realize Russia’s growth potential
1. Russia’s recovery is underway, but post-crisis economic performance has been unimpressive. Despite the massive fiscal stimulus and a strong pick-up in commodity prices, growth has been modest and inflation is high. A large stock of nonperforming assets continues to weigh on credit growth, while the poor business climate discourages investment and, combined with political uncertainty, contributes to ongoing net capital outflows. And although good progress has been made in unwinding the crisis-related support to banks, the exit from the fiscal stimulus is being drawn out and monetary policy has been slow in addressing inflation. Under unchanged policies, we project growth at 4.8 percent in 2011 and 4.5 percent in 2012, with inflation staying elevated (8 percent at end-2011 and over 7 percent at end-2012) despite an expected decline in food price inflation.
2. In the absence of bold reforms, the medium-term outlook is subdued. Compared with its emerging market peers, Russia experienced a greater degree of economic instability during the past decade and a larger output loss in the recent crisis, owing to its continued dependence on commodities, poor governance, and procyclical economic policies rooted in weak policy frameworks. Unless these weaknesses are addressed forcefully, growth is likely to be modest—less than 4 percent in the medium term. Moreover, the economy will remain highly vulnerable to external shocks. For example, a sharp drop in the oil price would trigger another recession and reduce medium-term growth further.
3. But Russia can do much better, if it leverages the commodity boom to strengthen policies. The challenge is to overcome the complacency that in the past has set in when oil prices are high. The high oil price affords Russia an opportunity to build buffers and introduce growth-enhancing reforms which could lift medium-term growth to 6 percent or more. The focus should be on further scaling back the anti-crisis measures as the economy recovers, reducing fiscal vulnerabilities, reining in inflation, promoting a stronger and more competitive banking system, and creating a better environment for investment. Improvements to policy frameworks and a reinvigoration of long-stalled structural reforms should be central elements of this strategy, and would send a positive signal to investors and boost Russia’s growth potential. This would also generate positive economic spillovers in the region.
Credible fiscal consolidation for stability and growth
4. Continued high nonoil deficits would amplify fiscal vulnerabilities and undermine economic stability. At 12¾ percent of GDP, the federal government nonoil deficit—which should be the focus of fiscal policy in oil-producing countries, given the volatility of oil prices—is more than 8 percent of GDP above its pre-crisis level. If the economy recovers sooner than expected and fiscal adjustment is delayed, fiscal policy risks becoming procyclical, fueling inflation and real appreciation. This would undermine competitiveness and contribute to another boom-bust cycle. At the same time, the oil Reserve Fund—used to finance Russia’s massive fiscal stimulus during the crisis—has been largely run down, leaving public finances vulnerable to a sudden drop in oil prices.
5. While the government’s fiscal consolidation plan is a step in the right direction, it lacks ambition and could be more growth friendly. The 2011-13 budget plans only a modest retrenchment, and by 2013 would leave the nonoil deficit still high at 10½ percent of GDP. And while the preliminary plans for the 2012-14 budget envisage additional consolidation, the nonoil deficit will remain high. As such, the recently-approved supplemental budget is regrettable, since it further delays consolidation. Meanwhile, the composition of the adjustment—with over half of it stemming from an increase in the payroll tax and cuts to investment—is detrimental to employment and growth.
6. Reducing fiscal vulnerabilities requires a larger and faster fiscal adjustment. The authorities’ long-term nonoil deficit target of 4.7 percent of GDP, suspended during the crisis, remains consistent with fiscal sustainability and equitable intergenerational use of the oil wealth. Concrete plans—grounded in growth-friendly measures, including a reversal of the payroll tax increase, reductions in subsidies and tax exemptions, and better targeting of social transfers—should be laid out to reach this target by 2015. Durable adjustment will require fundamental reforms, including to pensions, social protection, and healthcare. Front-loading the consolidation (with two-thirds of it carried out during 2011-13) would enhance the credibility of adjustment and help to realize sooner the growth benefits from more vibrant investment and stronger consumption on the back of lower long-term real interest rates. These actions would also help to rebuild buffers in the oil funds, in line with the authorities’ stated goal. As fiscal deficits decline and move into surplus, the government could continue with modest borrowing (for example, 1 percent of GDP annually in net terms) to facilitate the development of domestic capital markets.
7. Reinstating the nonoil deficit as a fiscal anchor would support the consolidation effort. International experience suggests that a fiscal rule, backed by strong political support, can help to anchor fiscal policy and achieve balanced economic growth. The government is considering whether to reinstate the long-term nonoil deficit target or to replace it with an oil-price rule, where revenue above a certain oil price is saved in the oil funds. We continue to see the long-term nonoil deficit target as the best anchor for fiscal policy in Russia. An oil-price rule can seem appealing because it is easy to communicate and could help to delink government expenditure and the economy from oil price volatility. However, it would still be a second-best alternative to the nonoil deficit rule since it does not necessarily preserve the wealth from oil for future generations (as a nonoil balance target does). Moreover, to be an effective fiscal anchor, the oil-price rule must be supplemented with a ceiling on expenditure to avoid procyclical fiscal policy.
8. A stronger fiscal framework would further enhance the credibility of fiscal policy and improve its effectiveness. Key elements would include: refraining from supplementary budgets to avoid procyclical increases in spending; creating an independent fiscal agency tasked with conducting impartial and transparent fiscal analysis and assessment of fiscal policy implementation; and improving public procurement to increase the efficiency of government spending. The planned comprehensive accounting of tax exemptions is welcome, since it would help in prioritizing the use of budget resources and increase transparency. In addition, better management of fiscal risks—including from state-owned enterprises and the deposit insurance scheme—would further reduce vulnerabilities.
Stronger monetary policy to rein in inflation
9. A continued tightening of monetary policy is needed to rein in inflation. The CBR has appropriately, if belatedly, started a tightening cycle, but the use of multiple instruments has sent confusing policy signals, while remaining excess liquidity of banks continues to render key CBR policy rates nonbinding. Meanwhile, core inflation is high and our projections suggest that without further tightening inflation will remain well outside the CBR’s target range of 6-7 percent for 2011. Continued policy tightening—through further rate increases and withdrawal of excess liquidity—will be needed this year to help reduce inflation to 6 percent by 2012 and to 3-5 percent over the medium term—a target range which we consider appropriate for Russia. This tightening should be supported by a consistent communications policy, the transparency of which could be increased by publishing information on inflation expectations and medium-term inflation forecasts, including by adding a forward-looking section in the CBR’s Inflation Report.
10. Further improvements to the monetary framework would enhance the effectiveness of the policy tightening. The CBR has recently made a welcome start by narrowing the overly-wide policy interest rate corridor, but additional improvements to the operational framework are needed to facilitate policy implementation. These include a further narrowing of the policy interest rate corridor, streamlining the set of policy instruments, draining excess bank liquidity, and creating a binding policy interest rate at the center of the corridor. A time-bound path for these changes—spanning no more than 12-18 months—needs to be decided on and communicated clearly to market participants.
11. Ongoing steps by the CBR toward greater exchange-rate flexibility are welcome. The continued widening of the operational band for the ruble and smaller, less frequent foreign exchange interventions are creating room for monetary policy to focus more squarely on inflation. Going forward, it is important that this trend toward a more flexible ruble continues. In this regard, if large capital inflows were to resume and considering that the ruble is somewhat undervalued in relation to medium-term fundamentals, it would be appropriate to allow exchange-rate appreciation. In addition, the recommended fiscal retrenchment should further reduce any overheating pressures. Capital flow management measures (especially capital controls, such as reserve requirements differentiated by residency) should not be seen as a substitute for these macroeconomic policy measures.
A stronger financial sector to underpin growth
12. The financial system is stable, but concerns remain about asset quality and competition. The authorities succeeded to a large extent in shielding the financial sector from the impact of the recent crisis. The system is now recovering and the performance of financial institutions started to improve already in 2010. Stress tests conducted during the recent Financial Sector Assessment Program (FSAP) mission suggest that the banking system is resilient to a variety of shocks. However, the use of off-balance sheet vehicles for distressed assets and possible overvaluation of on-balance sheet foreclosed assets and restructured loans means that banks’ asset quality may be overstated; and while non-performing loans are declining, the level of provisions appears still on the low side. Moreover, the emergency crisis measures and post-crisis consolidation benefited primarily systemically important banks, including state-owned banks, thereby increasing moral hazard and undermining competition. Although the non-bank sector is small, increased vigilance is required in insurance, where there are signs of distress in several companies.
13. A stronger supervisory framework is a key safeguard of a sound financial system. While Russia’s large reserves provide a buffer against risks, financial sector supervision needs to be brought up to international standards in a number of areas.
• In the banking sector, key improvements would include greater supervisory authority for the CBR, including by adopting without delay the pending legislation on connected lending and consolidated supervision; greater discretion to use “professional judgment” in applying laws and regulations to individual banks, which would facilitate the reduction of the reporting and regulatory burden; and putting in place a clearer and more coherent framework for prompt remedial action. Moreover, the CBR should ensure the adequacy of provisions in the system and more intensive oversight of systemically important banks.
• In the nonbank sector, the recent merger of securities and insurance supervision will give supervisors a comprehensive view of the market, expand the perimeter of oversight, harmonize supervisory approaches and requirements, and realize economies of scale. But for these benefits to materialize, the framework for the new Federal Service for Financial Markets must provide the agency with the power to issue secondary regulation and industry-wide binding norms, independence, and adequate resources. In this regard, the government’s plans appear broadly appropriate, and need to be followed by full and effective implementation.
• Given the concentration in the financial sector, effective systemic risk monitoring is imperative. In this regard, the recent establishment of an interagency working group under the Presidential Council and the department at the CBR in charge of macroprudential analysis is welcome.
Structural reforms to improve the investment climate
14. Russia’s poor business environment and weak governance need to be addressed to achieve economic diversification and vibrant growth. Adverse demographic trends suggest that investment and productivity gains will have to become the primary sources of long-term growth in Russia. This underscores the need for a stronger business climate and better governance—dimensions along which Russia compares poorly to other BRICS and emerging European countries.
15. The recently-announced 10-point plan to improve the investment climate is therefore welcome and should be implemented expeditiously, although some aspects of the plan would need to be carefully managed. In particular, the lost revenue from the proposed reversal of the payroll tax increase should be fully replaced, for example by reducing subsidies to connected enterprises, and eventually, by rationalizing early retirement schemes, increasing the retirement age, and means-testing basic pensions. Similarly, the creation of a private equity fund could encourage foreign investment by reducing operational uncertainties, but its political independence should be ensured and the risks to the sovereign balance sheet from contingent liabilities would need to be contained.
16. More generally, broader governance reforms are needed. These reforms include the strengthening of property rights and the rule of law, and the reform of the judiciary system and civil service. Accession to the WTO would also improve the business climate through increased predictability of the government’s trade policy. Furthermore, decisive implementation of the planned privatization—including in the banking sector—should help to curtail state dominance, improve competition, and reduce moral hazard.
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