IMF Executive Board Concludes 2006 Article IV Consultation with the Russian FederationPublic Information Notice (PIN) No. 06/128
November 6, 2006
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 October 18, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federation.1
Propelled by large terms-of-trade gains, GDP has regained momentum. Growth has recovered from a yearly rate of about 5 percent in early 2005 to about 7 percent at present, broadly the same pace as before the 2004 slowdown. The renewed momentum reflects a recovery in investments, as a confluence of negative factors that depressed capital spending in the second half of 2004 has waned against the backdrop of continued terms-of-trade gains. Consumption remains, however, the main source of growth, supported by strong real wage growth and a fiscal relaxation that began in early 2005.
GDP growth is running increasingly close to potential. Domestic resource constraints are tightening, causing increased leakage through the balance of payments and accelerated ruble appreciation. Following six years with robust GDP growth, but relatively low investments, measures of capacity utilization are at historical highs. Constraints are particularly evident in the oil sector. Having increased by about 10 percent annually through 2003, the increase in crude oil production has slowed sharply, and appears now to have stabilized at 2-3 percent. Labor markets are also tightening, reflected in very low unemployment rates in key regions and strong real wage growth.
Adding to the demand pressures is a notable fiscal relaxation. In 2004 fiscal policy had been saving most of the oil windfall to mitigate the pressures arising from the large terms-of-trade gains, but the non-oil primary deficit is set to rise by almost 3 percent of GDP in 2005-06, as oil revenues are being used to reduce taxes and increase expenditures. The draft 2007 budget entails a significant further easing.
Despite some tightening, monetary policy has remained accommodative. The Central Bank of Russia (CBR) has allowed somewhat more nominal exchange rate flexibility, and this has helped to reduce inflation from a yearly rate of 13½ percent in May 2005 to 9 percent in June this year. However, while inflation has eased, unsterilized foreign exchange interventions have remained high, leading to an acceleration in the growth of monetary aggregates. Recently, there has been a renewed pick up in inflation.
Progress with structural reforms outside the banking sector has been generally somewhat slow. This includes reforms of the health and education sectors, the civil service and public administration, and the natural monopolies.
Demand pressures are expected to remain strong in 2006-07 and possibly intensify. Staff projects GDP growth of 6½ percent in both years. Growth in consumption and investment is expected to remain robust, partly on the strength of high oil prices. The strong demand also reflects the substantial impulse that is still coming from the cumulative terms-of-trade gains of 11 percent of GDP during 2003-05, as spending plans are adjusting only gradually to these gains, not least in the oil sector. Inflation, which was already 7 percent in the first eight months of this year, is likely to exceed the official end-year target of 8½ percent once again. A large current account surplus, rapidly increasing foreign exchange reserves and declining external debt point to low external vulnerability.
Executive Board Assessment
Directors commended the strong performance of the Russian economy in recent years, reflected in robust real GDP growth, strong external and fiscal positions, and growth in productivity and consumption. They attributed this not only to high oil prices, but also to significant supply responses from the private sector in the context of generally prudent macroeconomic policies, not least the policy of taxing and saving the large oil windfall.
Directors expected robust growth to continue in 2006 and 2007 under the current outlook for oil prices, but-with the economy running close to potential-saw a more challenging macroeconomic environment going forward. In these circumstances, Directors noted the importance of refraining from further fiscal relaxation in the near term considering the buoyancy of demand and still strong inflationary pressures and of increasing the focus of monetary policy on inflation control, supported by more exchange rate flexibility.
Directors stressed that long-term growth prospects depend on accelerating the implementation of structural reforms and strengthening the investment climate. They noted that the rise in investment and employment levels has been limited and the strong growth performance so far has been mainly based on increases in total factor productivity, reflecting still significant scope for efficiency gains through equipment upgrade and resource reallocation. Directors cautioned that this catch-up potential will inevitably start to diminish, leaving growth increasingly dependent on raising investment and instituting reforms over the medium term.
Against this background, most Directors were concerned that the pace of economic reforms has remained slow. A reinvigoration of reforms in the inefficient and undercapitalized natural monopolies as well as the public administration is particularly urgent. Directors observed that these reforms should be carefully sequenced with other reforms, including reforms of the communal services, judiciary, health, and education sectors. Recognizing that these are socially sensitive areas, they encouraged the authorities to advance reforms now while favorable energy prices and large productivity gains are boosting growth and real incomes.
Directors emphasized the importance of the oil and gas sectors for growth prospects. In this connection, they welcomed the recent changes to the tax regime designed to stimulate investment in these sectors. They expressed concern, however, that the increased state ownership in the oil sector might negatively impinge on the future dynamism in this sector. The disappointing performance of the state-controlled gas sector during recent years, despite record high energy prices, was seen as a sobering reminder in this regard.
Directors were encouraged by the strengthening of the banking sector, but expressed concerns about regulatory vigilance. They noted that profitability is high and direct exposure to market risk low, and welcomed the gradual emergence of a better supervisory framework. However, they observed that risk management by commercial banks needs to be improved. Directors congratulated the CBR for its steadfast determination in recalling licenses of banks that have violated anti-money laundering provisions. Nevertheless, they expressed concern that the limited number of deposit-taking institutions barred from deposit insurance might reflect insufficient regulatory vigilance. In light of this, Directors cautioned that the favorable macroeconomic environment could be masking vulnerabilities that might become evident in the event of a major drop in oil prices. Greater attention should also be paid to the implications of the de-dollarization process that is currently under way. Directors welcomed the planned FSAP update as providing a good opportunity for a further analysis of banking sector vulnerabilities and the measures needed to bolster the regulatory framework.
Directors noted that the policy of taxing and saving oil revenues in the face of surging oil prices has served Russia well, preventing overheating amid strong demand pressures from the large terms-of-trade gains. They were concerned, therefore, about a premature relaxation of this policy, and urged the authorities not to weaken the non-oil balance further at this juncture.
While acknowledging that there is considerable scope for additional, growth-oriented expenditures in the medium term, Directors were concerned that the rapid loosening since early 2005 has mainly supported higher wages, recurrent expenditures, and tax cuts that are unlikely to boost potential growth. They cautioned that such spending, together with sluggish structural reforms, could cause the exchange rate to overshoot its long-term equilibrium and lead to the emergence of an unsustainable non-oil deficit and spending structure. They stressed that harnessing Russia's oil wealth in support of policies that will strengthen long-term growth would require reforms to be reinvigorated. The authorities were encouraged to move toward a medium-term budgetary framework with clear rules, including an explicit role for the non-oil balance.
As to monetary and exchange rate policies, Directors welcomed the decline in inflation in the first half of 2006, but most cautioned that more exchange rate flexibility would be needed for the progress to be consolidated. The renewed increase in inflation pressures in recent months was a timely reminder of the risks in this regard. Directors urged the CBR to give clear priority to its inflation target, standing ready to scale back interventions and allow ruble appreciation if inflation exceeds the targeted path.
Directors welcomed the elimination of all capital account restrictions and the concurrent elimination of the one outstanding restriction on current account transactions, arising from regulations accompanying the 2004 Federal Law on Foreign Exchange Regulation and Foreign Exchange Control.
Directors noted the Russian authorities' assurances that a number of restrictions on imports from neighboring countries had been imposed for sanitary reasons. The authorities were encouraged to seek a rapid and transparent resolution of these issues.
Directors were disappointed that Russia's accession to the WTO has again been delayed. They looked toward a swift resolution of outstanding issues holding up bilateral agreements. Directors urged the authorities to resist calls for prolonged transition agreements, noting that WTO accession would promote structural reform and boost trade and investment.