IMF Executive Board Concludes 2008 Article IV Consultation with the Russian FederationPublic Information Notice (PIN) No. 08/112
August 28, 2008
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 August 1, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federation.1
Russia's economic recovery is gaining strength as investment rises. Returns on investment are high—reflecting the scarcity of capital—and surging oil prices, large capital inflows, and a steady deepening of financial markets are providing investors with the financing and retained earnings needed to take advantage of this. The resulting rise in investment, and the associated reallocation of labor to more productive sectors, are unlocking catch-up gains in productivity. This is providing a further boost to growth in real incomes and consumption, which have already been buoyant for some time, owing to large terms-of-trade gains. Financial deepening is also reinforcing this process, by allowing households to take advantage of low indebtedness to borrow against expected future income gains. Against this background, GDP growth has accelerated to an annual rate of more than 8 percent.
But despite a strong supply response, signs of overheating are emerging. Domestic demand growth has risen to an annual rate of 15 percent in real terms, significantly above estimates of potential growth. Inflation has more than doubled since early 2007, running at 15.1 percent (year-on-year) in June 2008. While the increase was initially spurred by rising food and energy prices, it is now beginning to extend to a broader range of goods and services. Tightening domestic resource constraints are particularly evident in labor markets, where shortages have caused real wage growth to accelerate to about 16 percent annually, well above growth in labor productivity. While the ruble is still undervalued, competitiveness margins are narrowing and the real effective exchange rate is moving close to staff's estimate of its equilibrium.
Procyclical fiscal policy is adding to demand pressures. Primary expenditures by the federal government rose by 15 percent in real terms, and the non-oil deficit—excluding a one-off collection of tax arrears from the Yukos oil company—rose by 0.8 percent of GDP in 2007. The 2008 budget entails a further notable impulse, as the non-oil deficit of the federal government is set to increase for the fourth consecutive year, by 0.9 percent of GDP.
The Russian banking system has proven to be relatively resilient in the face of worldwide turmoil. A number of banks that had relied heavily on external borrowing have had to sharply curtail credit growth and restructure their balance sheets. Overall, banks in Russia remain profitable, non-performing loan ratios are still relatively low, and depositor confidence is robust. Taking note of the high rates of lending growth, a recent Financial System Stability Assessment (FSSA) update by IMF and World Bank experts expressed concern about credit risk, recommending a further strengthening of provisioning standards and implementation of consolidated supervision.
The fixed exchange rate is also fueling demand pressures. In defense of the de facto peg, the very strong balance of payments position has required large unsterilized interventions in the foreign-exchange market, which have in turn translated into excess liquidity in the banking system. While the turmoil in global financial markets resulted in a significant drop in foreign inflows in the second half of 2007, this had little net impact on credit growth as large external borrowing prior to the onset of the turmoil had left the banking system highly liquid. In addition, the Central Bank of Russia (CBR) quickly stepped up its repo operations and broadened its list of eligible collateral for liquidity support when money market rates began to rise. More recently, capital inflows have recovered strongly, and the CBR's repo operations have been scaled back sharply. In fact, the CBR has raised interest rates four times in 2008, for a combined increase of 100 bps, and has increased reserve requirements twice. Additionally, the bank has allowed greater exchange rate volatility against the euro-dollar basket since June—the basket has appreciated by 0.9 percent over June-July, 2008. Nonetheless, the central bank is still intervening heavily in the foreign exchange market and Russia's banking system is still comfortably liquid with overnight interbank rates at the lower end of the usual trading range.
The near-term economic outlook is favorable, although inflationary pressures are likely to remain high. GDP growth will continue to be underpinned by strong domestic demand growth, reflecting further fiscal relaxation, additional large terms-of-trade gains, and the renewed recovery in capital inflows. However, with growth already running well above estimated potential, and with a further significant real exchange rate appreciation in the offing, leakage through the balance of payments is likely to increase. In view of this, IMF staff project GDP growth to ease slightly in 2008 to 7¾ percent. With continued robust growth and little remaining spare capacity, inflation is set to exceed the revised end-year target of 10.5 percent by a notable margin. The unwinding of the surplus in the current account is expected to resume in 2009 in the absence of further large terms of trade gains.
Executive Board Assessment
Executive Directors welcomed the continued strong performance of the Russian economy, manifested in higher and more broad-based economic growth and supported by robust investment and productivity increases. Directors considered that sound economic management and high oil prices have both contributed to this performance. They commended the authorities on the prudent management of oil revenues so far—in particular, the policy of saving most of the oil-price windfall in the stabilization fund.
Directors expressed concern about the threat to Russia's growth prospects from rising inflationary pressures. Price rises now extend well beyond what can be explained by worldwide increases in food and energy prices, and are likely to exceed the authorities' objective by a substantial margin. Directors considered that the current macroeconomic policy mix is contributing to the overheating of the economy. In particular, a procyclical fiscal stance in the 2008 and 2009 budgets and the policy of resisting exchange rate appreciation through unsterilized interventions are exacerbating demand pressures.
Directors accordingly suggested a careful reconsideration of the authorities' policy stance, so that price developments are not shaped primarily by uncertain external developments that remain beyond the authorities' control—in particular, an eventual deceleration of food prices and a further unwinding of the current account. Directors generally cautioned that upward pressures on the ruble will likely remain high as long as buoyant private demand and a procyclical fiscal policy maintain GDP growth above potential.
Against this background, Directors encouraged the authorities to tighten monetary policy, while noting that the peg of the ruble to a dollar-euro basket could become increasingly inflationary as Russia's cyclical position strengthens relative to that of the U.S. and euro area economies. They also observed that the growing tension between inflation and exchange rate objectives is fuelling capital inflows, and further complicating monetary management. While welcoming the authorities' commitment to fight inflation and the recent increases in interest rates and the steps to introduce more flexibility in the exchange rate, most Directors called for a further refocusing of monetary policy towards inflation reduction accompanied by greater exchange rate flexibility—an approach that would also pave the way for an eventual move to inflation targeting. They suggested that at this juncture competitiveness concerns should not stand in the way of further exchange rate appreciation given the productivity gains that have accompanied recent real exchange rate appreciation. While generally seeing merit in greater exchange rate flexibility, some Directors were not convinced of the need for early adjustment of the nominal exchange rate, pointing, in particular, to the risk that faster appreciation might exacerbate speculative capital inflows.
Directors expressed concern about the increasing procyclicality of fiscal policy. In the near term, this will further burden monetary policy and increase inflationary pressures. In the medium-term, a continued procyclical policy might cause the real exchange rate to overshoot its equilibrium level. Directors accordingly called upon the authorities to adhere to their medium-term fiscal strategy—which calls for a reduction in the non-oil deficit—and to reinvigorate the pace of structural reform. A number of Directors also encouraged the authorities to reconsider the pending supplementary budget in 2008, and to avoid any further fiscal stimulus until demand pressures ease.
Directors noted that Russia's financial sector has weathered the recent global financial turmoil well, and is generally well positioned to withstand further turmoil. They noted that this assessment is in line with the findings of the recent Financial Sector Assessment Program (FSAP) update, which concluded that the financial system has strengthened significantly since 2003. At the same time, Directors pointed to the risk that, after years of negative real interest rates and rapid lending growth, a significant policy-induced increase in real interest rates might have an adverse impact on the banking system. Directors encouraged the authorities to further improve the regulatory and prudential framework, in line with the recommendations of the FSAP update. Directors also welcomed the authorities' commitment to follow generally accepted principles and best practices as guidelines for Russia's sovereign wealth funds.
Directors welcomed the government's focus on improving Russia's investment climate. This will require the elimination of infrastructure bottlenecks and the promotion of a more favorable business environment. Directors were encouraged by the new government's development strategy and priorities, in particular its focus on strengthening the judiciary and tackling corruption. Plans to reinvigorate the reform of the civil service and the public administration will also be important. Directors saw the economy's strong growth and gains from high oil prices as providing a valuable opportunity for the authorities to press ahead with their earlier plans for reform. The authorities' plans to join the World Trade Organization should also serve as a catalyst to strengthen the reform momentum.