ECONOMIC HEALTH CHECK
Russia: Fragile Recovery from Crisis
August 2, 2010
- Economy recovering from contraction of nearly 8 percent in 2009
- Strong response to crisis but growth still fragile
- Need to reverse fiscal stimulus and boost potential growth
The IMF expects Russia’s economy to resume growth in 2010, by 4¼ percent, after a contraction of 7.9 percent in 2009.
Inflation has fallen rapidly, the current and capital accounts have both rebounded from sharp deteriorations, and the ruble has strengthened. But the IMF says the banking system is still under strain and financial markets remain vulnerable. The key policy challenges are to reverse the large fiscal stimulus and implement structural reforms to boost potential growth.
The IMF’s Russia team recently conducted its annual checkup of Russia’s economy, known as the Article IV consultation. IMF Survey Online spoke with Poul Thomsen, who is now moving on after having been mission chief for Russia since 2004, about how the government has been managing Russia’s economy and what more needs to be done.
IMF Survey Online: The authorities responded strongly to the crisis. What allowed them to do so?
Poul Thomsen: Above all, the authorities’ precrisis policy of taxing and saving much of the oil revenue windfall gave them ample room for maneuver in responding to the crisis. They were running large headline budget surpluses in the precrisis years. And in the process, they accumulated large reserves—almost $600 billion—as a result of sizable current account surpluses and substantial capital inflows.
So when oil prices declined and the crisis hit, the oil stabilization fund mechanism meant the authorities had significant scope for a vigorous policy response. There was room for a dramatic turnaround in the fiscal position from a large surplus to a large deficit—this turnaround amounted to almost 10 percent of GDP. And the authorities could, at the same time, have an accommodating monetary policy— essentially financing the deficit by drawing down on their oil funds held at the central bank, which is equivalent to printing money. This was on top of their earlier massive support to the banking system and to private entities that had large, unhedged foreign exchange exposures.
IMF Survey Online: Despite the forceful response, Russia was hit hard by the crisis. Why do you think this happened?
Thomsen: Even though the authorities did save much of the oil windfall, they gradually began to spend more and more of it in the years preceding the crisis.
At the same time, private sector activity was very buoyant, so the economy began to overheat. Then, when the crisis hit, the economy was in overdrive, and output dropped by more than in many other countries.
Another problem was that the relatively fixed exchange rate policy before the crisis fueled expectations of ruble appreciation as oil prices increased steadily. This policy essentially encouraged investors and borrowers to take one-way bets on the ruble, which led to very large capital inflows. This was especially pervasive among Russian banks and corporates. Indeed, the private sector built up external liabilities of almost half a trillion dollars, while the government built up reserves of roughly the same amount. This left Russia vulnerable to the reversal of capital flows that took place during the crisis.
IMF Survey Online: What do you see as the main challenges facing Russia in the future?
Thomsen: Our main concern is on the fiscal side. Russia has undertaken an enormous fiscal stimulus—almost 10 percent of GDP—to help mitigate the impact of the crisis. It will now have to reverse this fiscal stimulus as cyclical conditions in the economy normalize and private sector demand picks up. Some three-quarters of the stimulus reflects permanent measures, mostly in the form of higher pension outlays, which means expenditure cuts will have to happen in other areas. Discretionary spending, as opposed to statutory spending, accounts for only 9 percent of GDP. This means that Russia will not be able to withdraw the fiscal stimulus unless it undertakes significant public sector reforms in order to allow savings in socially sensitive areas such as health care, education, and pensions. Obviously, these social sector reforms have to be done in a way that protects the most vulnerable. But without such structural changes, it will be difficult for Russia to complete the necessary unwinding of the fiscal stimulus.
IMF Survey Online: Russia has made progress in strengthening banking supervision. What more is needed to increase confidence in the Russian banking system and to facilitate credit extension?
Thomsen: Much has indeed been done to improve banking supervision in recent years. The central bank has stepped up its monitoring and analysis of risks to the banking system. Clear progress has also been made on day-to-day supervision over institutions, including recently through stress testing. And the central bank now has a wide range of tools that can be used to provide emergency liquidity.
But there are still some weak spots. Perhaps one of the most important ones is the ongoing pervasiveness of connected lending in the Russian banking system, with banks lending to owners and their related enterprises, which is a potential source of serious instability if there is a shock to the system. This is why we have called for the central bank to be granted greater supervisory powers over banks and their affiliates.
Another area of concern in the banking sector is the loan classification and provisioning system, which is still not up to international standards. For instance, it is not clear how many current loans were actually restructured during the crisis, so greater transparency is needed in this area. And loan provisioning needs to be made more forward looking, so that banks are preparing for expected future losses and not just those that have already taken place.
We do believe the authorities are well-positioned to continue to deal with threats to financial stability. First, the banking system is still relatively small compared to the size of the economy. Second, the authorities have shown that they have the room for maneuver to deal with problems and that they are prepared to act forcefully.
IMF Survey Online: Given the shrinking labor force, the aging population, and the limited potential for increased productivity in Russia, it seems likely that potential growth is going to be less in the future. What steps can the authorities take to lessen the effects of these developments?
Thomsen: The overarching challenge facing Russian policymakers is to boost potential growth by improving the investment climate. There is a need for fundamental reforms, not least in the public sector, to curtail interference of the public sector on all levels of economic decision making. Russia needs public administration reform, civil service reform, and judicial reforms to ensure a level playing field for all investors. This is the key to achieving modernization and diversification of the economy. President Medvedev’s calls for progress in this area are very much welcome.