IMF Executive Board Concludes 2007 Article IV Consultation with the Russian FederationPublic Information Notice (PIN) No. 07/123
October 5, 2007
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 September 12, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federation.1
Russia's economic growth remains robust. High oil prices, a strong catch-up potential, and sound fiscal policy underlie Russia's long spell of robust growth. Several years of double-digit terms-of-trade gains, reinforced by rapidly developing financial markets and much-improved access to foreign borrowing, have underpinned strong investment growth, punctured only by a soft spot in late 2004. Nevertheless, the level of investment has remained low, and capital and labor have accounted for less than half of the increase in GDP since 2003, with the balance due to higher total factor productivity. Robust growth has thus owed much to Russia's still considerable catch-up potential, as resources are reallocated to more dynamic sectors in the economy. The resulting nexus of strong productivity growth, rising real incomes, and higher consumption has been a key source of self-sustaining growth, especially in recent years as capacity constraints have slowed energy exports.
Despite the broad stabilization of oil prices since mid-2006, GDP growth has strengthened, rising from 6.7 percent in 2006 to 7.8 percent for the first half of 2007. Moreover, much of this momentum reflects a pickup in investment, suggesting that growth in Russia is now becoming more evenly balanced. Consumption nonetheless remains the main engine, spurred by real income growth of over 10 percent.
With surging growth, the economy is running increasingly close to capacity. Domestic resource constraints are tightening, not least in the labor market, causing increased leakage of demand into imports and renewed inflationary pressures. From a peak of almost 14 percent (year-on-year) in mid-2005, inflation dropped to 7½ percent in March 2007. However, inflation has since firmed to over 8½ percent as of August, standing above the end-year target of 8 percent. Following six years of robust GDP growth, measures of capacity utilization are at historical highs. The constraints are particularly evident in the oil sector. Having increased by about 10 percent annually through 2003, the increase in oil production slowed sharply in 2004-05, and appears now to have stabilized at about 2-3 percent.
Russia's balance of payments has strengthened. The current account surplus has narrowed as a result of accelerating import growth and slowing energy exports. But this has been more than offset by sharply higher capital inflows—as of early September, reserves increased by a record US$113 billion in the year to date, reaching a total of US$417 billion. With a still-substantial current account surplus, rapidly increasing foreign exchange reserves and declining external debt, Russia's external vulnerability is low, although non-government debt is rising rapidly.
The overall fiscal surplus has continued to increase because of higher oil revenues. However, fiscal policy has since 2005 allowed an increasing share of Russia's oil-revenue windfall to pass through to the economy. This relaxation has been reflected in a continued deterioration in the general government's non-oil balance. Staff projects that the non-oil balance will decline further under the 2007 budget, by 0.9 percent of GDP.
Monetary policy has become more accommodative over the past year, reflecting the resumption by the Central Bank of Russia (CBR) of a more steady exchange rate policy in mid-2006. This represents a reversal of the policy introduced in early 2005, wherein the CBR had allowed some, albeit limited, appreciation. The return to a more stable exchange rate policy has been associated with a surge in capital inflows, record-high interventions, and a sharp acceleration in base-money growth to 40 percent through July (year-on-year). Importantly, in the context of a year-end inflation target of 8 percent, rising inflationary pressures and market expectations of a possible appreciation have exacerbated capital inflows, not least through the banking system. Since June, however, the CBR has allowed for greater exchange-rate flexibility to help stem inflation. Additionally, the worldwide market turmoil of August has eased the pace of capital inflows.
Notwithstanding currently unsettled conditions on world markets, demand pressures are expected to remain strong in 2007. Russia's terms-of-trade are projected to ease slightly in 2007, but the overall environment will still remain broadly supportive. As in 2006, the balance of payments is expected to strengthen further, with capital inflows more than offsetting a lower current account surplus. Overall, staff projects GDP growth of around 7 percent over the near term, driven by robust consumption and investment demand. This outlook also reflects a substantial fiscal impulse in 2007 along with a rapid expansion of consumer credit. In light of recent trends, inflation threatens to exceed the official end-year target of 8 percent.
Executive Board Assessment
Executive Directors commended the strong performance of the Russian economy in recent years, noting that this has been due not only to high oil prices and large capital inflows but also to good macroeconomic management. In particular, the policy of saving the large oil revenue windfall has provided a considerable measure of stability. However, Directors noted that Russia continues to face tensions in the policy mix designed to reduce inflation while preserving exchange rate stability.
Directors noted that demand pressures appear to be intensifying, driven by acceleration in investment and strong growth in private consumption. With output close to potential, upward pressures on prices and the real exchange rate are likely to persist.
Against this background, Directors noted that the planned fiscal relaxation in the next few years would provide an undesirable fiscal stimulus. This would increase pressures for real ruble appreciation and make it more difficult to reduce inflation. It is also likely to exhaust most of the remaining margin of competitiveness, raising the risk of the real exchange rate overshooting its equilibrium level. Directors therefore called on the authorities to avoid increasing the non-oil deficit during the remainder of 2007 and in 2008.
Directors emphasized the need to control public spending, and to pay more attention to the quality and efficiency of expenditures. In this regard, they welcomed the new framework for spending of oil revenues, which is close to best practice for management of natural resource wealth. They cautioned, however, that the back-loading of spending cuts in socially sensitive areas in 2010-11, in the run-up to elections, is risky. Such cuts might not be feasible unless efficiency-enhancing social and public sector reforms are reinvigorated. Most Directors also advised against extending the government's mandate to areas where private sector participation might be more efficient.
Directors noted that the recent rise in inflation stemmed from the return to a less flexible exchange rate policy since mid-2006, a change that led to large unsterilized interventions in the face of surging capital inflows. They stressed that keeping inflation on the targeted path would require returning to a more flexible exchange rate policy. In this regard, Directors welcomed the authorities' willingness to accept appreciation, as was evident from June until August this year. They urged the central bank to stand ready to scale back interventions as needed to keep inflation within target, noting that greater focus on the inflation target while allowing more exchange rate flexibility could help curb one-way bets and reduce speculative capital inflows.
Directors welcomed the rapid development of Russia's financial sector, but cautioned that high rates of credit growth might also increase vulnerabilities. In particular, the rapid increase in consumer lending, corporate-bond issuances, and open foreign-exchange positions should be kept under close review. While Russia has weathered the recent turmoil in financial markets relatively well, the tightening of access to foreign capital markets could increase the vulnerability of a number of banks. Directors welcomed the current Financial Sector Assessment Program update, which provides a timely opportunity for a review of vulnerabilities.
Directors observed that the key long-term challenge will be to improve Russia's investment climate. Although recent investment growth has been impressive, they noted that the level of investment is still relatively low and that Russia still ranks poorly in international comparisons of the business climate. Raising investment levels is particularly important in light of the projected decline in the labor force and the declining prospect for continued high productivity gains over the medium term. In this regard, Directors observed that progress on important reforms in public administration and the civil service has been limited. The challenge facing the new government would be to reinvigorate such reforms.