Public Information Notice: IMF Concludes Article IV Consultation with Russia
August 2, 1999
|Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.|
On July 28, 1999, the Executive Board concluded the Article IV consultation with Russia.1
The severe financial crisis that erupted in mid-1998 was due primarily to failure to tackle underlying fiscal problems, in particular to halt the erosion of federal government revenues, and to advance structural reforms. Because of the persistence of these problems, the stabilization achieved from 1995 onwards under the policy of maintaining the exchange rate within a band was tenuous at best. It proved eventually unsustainable when the external environment deteriorated in 1997-98 and when political turmoil in Russia cast increasing doubt on the resolve to come to grips with the fiscal problems.
The large fiscal deficits of 7-8½ percent of GDP at the federal level had resulted in an explosive increase in the debt burden, particularly at the short end, in 1996-97. In addition, by mid-1998, the external terms of trade had deteriorated by almost 18 percent compared to a year earlier due to a drop in international prices for Russia's main exports. The impact on the capital account of investor withdrawals from emerging markets in the wake of the Asian economic crisis was equally severe; net financing of the federal government deficit by nonresidents in the form of Eurobonds and ruble-denominated debt declined by 1.8 percent of GDP during July 1997-June 1998, compared with the previous 12-month period. From late 1997 onwards, domestic interest rates were increased sharply in response to developments in the balance of payments. While the ruble was successfully maintained within its band until mid-August 1998, in the absence of decisive fiscal adjustment the policy mix resulted in large losses of external reserves.
Faced with a severe cash-flow problem as investors continued to withdraw from the government debt market and as international reserves dropped precipitously, the authorities announced a restructuring of ruble-denominated government debt and a widening of the exchange rate band in August 1998; the ruble was subsequently allowed to float in early September. The servicing of Soviet-era external debt was also halted and the government initiated talks with creditors for a rescheduling of such debt falling due in 1999-2000. The immediate impact of these developments was extremely unfavorable. A large number of banks that had invested heavily in treasury bills and had extensive foreign currency exposure collapsed, the domestic payment system was temporarily impaired, access to international capital markets was severed, and trade financing was severely disrupted. Both output and government revenues contracted sharply. Furthermore, the stance of monetary policy was lax and inflation was on an increasing path.
There has been a turn-around in 1999, however. Industrial output during April-June exceeded the levels of one year earlier by over 5 percent on average. The recovery appears to have been primarily led by import substitution following the depreciation of the ruble. Foreign exchange market pressures have also eased and the ruble has stabilized, while monthly inflation has come down to under 2 percent in June, reflecting a tightening of fiscal and monetary policies. The federal cash deficit fell to 4.7 percent of quarterly GDP during the first quarter of 1999, compared to 5.4 percent during the last quarter of 1998, as revenues recovered by 2 percentage points of GDP during the same period. The improved revenue performance, which has been sustained during the second quarter, reflects the recovery in output, the impact of the ruble depreciation and higher energy prices on the tax base, and an effort to improve tax collections. The overall balance of payments position has also become stronger. Following the recent recovery of energy prices and a sharp compression of imports, the external current account, on a cash basis, has swung from a deficit of $2.7 billion in the first quarter of 1998 to a surplus of $4.8 billion in the first quarter of 1999.
The structural reform agenda suffered a set-back in 1998 as a number of administrative measures in the area of foreign exchange control were introduced in the wake of the August crisis and there was a standstill in other areas of structural reform. Furthermore, limited progress was made in addressing the problems of the insolvent banking sector. More recently, however, the authorities have eliminated some of the foreign exchange measures introduced in 1998, such as the segmentation of the foreign exchange market. A bank restructuring law was adopted in June and licenses of a number of large insolvent banks have recently been withdrawn.
The authorities' macroeconomic framework for 1999 envisages that the economic contraction will bottom out in 1999, with output for the year as a whole declining by 2 percent. The external position should strengthen, enabling a small increase in foreign reserves. Prudent monetary policy should lay the basis for annual inflation to come down to 50 percent in 1999, compared to over 84 percent in 1998. The government budget is projected to generate a primary surplus of 2 percent of GDP, compared to a deficit of 1.3 percent in 1998.
Executive Board Assessment
Executive Directors found that the proposed program represented an appropriate policy response by the authorities under the current circumstances.
Most Directors were of the view that the economic crisis that erupted in August 1998 had been due mainly to the failure of the authorities to tackle serious longstanding fiscal problems and to implement agreed structural reforms. The deterioration of the external environment as a result of Asia's economic crisis had been only the immediate cause of the crisis. Directors warned that the limited recovery and the measure of stability achieved in recent months would prove unsustainable unless strenuous and determined efforts were made to reduce the fiscal deficit and to accelerate structural reforms.
Directors generally felt that the proposed program was targeted at the root causes of Russia's economic problems. Directors noted, however, that policy implementation under past programs had been disappointing, and that important elements of the new program had been proposed before, but had not been carried out. Moreover, noting that the failure of previous programs reflected at least in part the lack of political support, Directors urged the authorities to make strengthened efforts to promote broader support for, and deeper ownership of, the program. Despite the up-front measures and other recent encouraging signs, Directors cautioned that considerable risks remain. They stressed that Russia's extremely difficult economic and financial situation, amid a sharp cut-back in access to external financing, should lend a new sense of urgency to the need for fundamental and lasting reform.
Directors stressed that fiscal consolidation remains at the heart of the adjustment effort. They considered that the target of a primary surplus for the federal government of 2 percent of GDP in 1999 was warranted in light of the severe debt situation, and that a further increase in the primary surplus would be required in 2000. Directors noted that a main objective of fiscal policy should be to halt and reverse the prolonged decline in federal revenues, which had forced reliance on ad hoc expenditure cuts and caused periodic arrears accumulation. In this regard, several Directors cautioned against any reduction in tax rates at the present time, especially a reduction in the basic value-added tax rate. Such measures should be delayed at least until the measures to strengthen tax compliance have yielded significant results. Directors generally believed that the fiscal program for 1999 struck a good balance between expenditure saving and revenue enhancing measures, although some Directors were concerned that continued heavy reliance on expenditure compression could harm social and economic stability. Some Directors urged Russia and the World Bank to work together on a Public Expenditure Review that would focus on social and poverty alleviation needs as well as steps to help improve accountability.
Directors emphasized that the program's fiscal targets would not be achieved without very strong political support to enforce statutory tax obligations. They noted that Russia's fiscal problems reflected, to an important degree, the fact that many large enterprises were using their political influence to avoid seizure of assets in cases of tax delinquency. As a result, the tax authorities were forced to negotiate tax payments and to accept payments well below statutory obligations. Several Directors noted that the policy of cutting oil pipeline access of tax delinquent oil companies was potentially very effective, and they emphasized that full political support for this measure would be a key test of the government's resolve to tackle the fiscal problems. Enforcing bankruptcy and other laws would also help alleviate these problems.
Pointing to the fact that the authorities had periodically allowed current expenditures to be offset against tax arrears, Directors warned that this practice had undermined tax compliance and distorted expenditure priorities; they urged the authorities to refrain from tax offsets in the future. Several Directors also attached considerable importance to improving the budgetary relations between the federal and other levels of government, with an appropriate legal framework being developed to clarify the division of responsibilities.
Turning to monetary and exchange rate policies, Directors emphasized that Russia was best served by a flexible exchange rate policy at present, and they welcomed the tightening of monetary policy since early 1999. They urged the authorities to resist demands for preferential central bank credits to ailing banks and to specific sectors. Moreover, the government should pay a market-determined interest rate on central bank credits. These policies would avoid burdening the central bank with conflicting objectives, and allow monetary policy to be geared to the pursuit of price stability. Directors expressed concern about pressures to curtail the central bank's independence, and recommended that the government should firmly resist such moves.
Turning to structural reforms, Directors noted that there had been little progress since last August, with some reversals in important areas, and they urged the authorities to accelerate reforms. Directors welcomed the close relationship between Russia's agreement with the Fund and its ongoing programs with the World Bank focussed on structural areas. While there was a need to advance across the full range of structural reform, Directors argued that dealing with the pervasive problems of barter and nonpayments and the acceleration of bank restructuring would be key to the sustainability of macroeconomic stabilization and to signaling the strength of the authorities' commitment to the reform effort.
Many Directors were disappointed by the slow progress made in bank restructuring until recently; they therefore welcomed the recent strengthening of the legal framework for bank restructuring, including the establishment of ARCO, and the decision to liquidate six large insolvent banks. The authorities should now forcefully push ahead with bank restructuring, continuing to liquidate insolvent banks or refer them to the bank restructuring agency, and amend the Bank Bankruptcy Act in order to deal properly with insolvent banks. Some Directors stressed the need for the Central Bank of Russia (CBR) to shoulder its responsibilities in encouraging bank restructuring. Directors noted that the political resolve to advance reforms in this crucial area, which would require the authorities to resist what undoubtedly would be fierce opposition from vested interests, would be a key test of the commitment to structural reform in general. Noting that external competition would facilitate the process of financial restructuring, several Directors urged the authorities to create a level playing field for domestic and foreign banks.
Directors noted that the de facto default of GKOs and OFZs was a regrettable setback and that normalization of relations with domestic and external creditors should be a main objective. Russia would be unable to service its external debt in full under current circumstances, and exceptional balance of payments support in the form of rescheduling of a part of payments falling due in 1999 and 2000 would be unavoidable. Directors urged the authorities to seek orderly and cooperative rescheduling agreements with creditors, and welcomed the discussions under the auspices of the Paris and London Clubs. Each of the program reviews under the arrangement with the Fund will include an examination of the program's financing assurances, until such arrears have been eliminated.
Directors welcomed the recent unification of the interbank market for foreign exchange. They also commended the authorities' continued commitment to a liberal trade regime and the intention to push forward with negotiations on accession to the World Trade Organization.
Directors expressed strong disapproval of the finding that the channeling by the CBR of domestic transactions through FIMACO, as well as a fictitious claim on FIMACO, meant that the balance sheet of the CBR had in 1996 given a misleading impression of the true state of the reserves and of monetary and exchange rate policies. Without these indirect transactions and the inaccurate reporting of foreign reserves, several purchases by Russia from the Fund in the past could possibly have been delayed.
Directors felt that these transactions constituted an episode of a fundamental lack of cooperation on the part of the authorities and a serious violation of Russia's obligations to the Fund. Emphasizing that truthful reporting and cooperative relations between the Fund and its members were crucial to the work of the Fund, Directors strongly urged the Russian authorities to take actions to prevent a recurrence of similar problems. Several Directors welcomed the authorities' agreement to the publication of the PricewaterhouseCoopers report, which could signal their willingness to eschew such actions in the future and enhance policy transparency. However, a number of other Directors felt that the corrective actions taken so far fell well short of what was needed. Several of these Directors stressed that the willingness of the Fund to continue to support Russia under the requested Stand-By Arrangement would hinge on the authorities' willingness to take more forceful actions. In this regard, a number of Directors strongly suggested that a commitment by Russia to subscribe to the SDDS, or at least to publish data on reserves that fully meet the SDDS reporting requirements on reserves, would put to rest many of the concerns about reserve management practices in the future. Directors took note of the findings that the July 1998 tranche from the Fund had not been misappropriated.
Beyond strengthening provision of reserves data, Directors urged the authorities, more generally, to enhance the availability of timely and comprehensive economic data.