## The Economy's Adjustment to the Current Recession

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---

### Context and shock absorption
- 45 percent decline in oil prices between 2014 and 2015 and the continued quasi closure of international financial markets to Russian entities depressed economic conditions.
- Policy response that cushioned the shocks included:
  - a flexible exchange rate regime;
  - banking sector capital and liquidity injections;
  - limited fiscal stimulus;
  - regulatory forbearance.
- External deleveraging reduced external private debt by USD 176bn over the past two years.
- Capital outflows declined in 2015 to half their 2014 level.

### Comparative adjustment
- The 30 percent cumulative deterioration in the terms-of-trade was larger than the 2009–10 episodes, yet real GDP contraction in 2015 was milder than in 2009 amid a much more pronounced real exchange rate adjustment (REER).
- Labor and income adjustments:
  - Real wages fell by 9 percent in 2015, compared to a 3 percent decline in 2009.
  - Unemployment remained broadly stable at around 6 percent, versus more than 8 percent in 2009.
  - Real wage decline led to a rebalancing of national income in favor of corporate profits, notably in non-oil basic commodities’ sectors.
- Trade and import substitution:
  - Some non-oil export volumes (chemicals, agricultural products) increased during 2014–15.
  - Domestic sales of goods and services (real terms) fell less than domestic demand, suggesting import substitution; agriculture and food, chemicals, rubber and plastics outperformed among tradable goods.
  - Domestic sales of goods and services outperformed domestic demand in episodes of REER decline since the late 1990s, increasing the share of domestic goods in total demand by 5–6 percentage points, though these gains were reversed when REER rebounded.

### Recent developments (to mid‑2016)
- Oil market:
  - Brent prices reached a low of USD 26 per barrel in January 2016.
  - Oil prices averaged USD 47 per barrel in May 2016.
- Inflation and activity:
  - Inflation reached 7½ percent in April 2016, down from 16½ percent a year before.
  - Industrial production stopped declining sequentially; PMI suggests continued manufacturing weakness; services sector activity gathering strength.
- Banking sector:
  - Reported NPLs reached 9.2 percent of total loans in Q1 2016.
  - Overall capital adequacy ratio resumed declining, driven by low profitability and anemic credit growth; the move to Basel III narrowed eligible capital with an estimated impact of 0.6 percentage point.
  - Deposit flows increased; liquidity in rubles and FX improved; no signs of increased dollarization.
  - CBR continued closing banks, mostly small, for weakness or non-compliance (including AML/CFT).

### Outlook and risks
- Staff central projections:
  - Real GDP expected to decline by 1.2 percent in 2016.
  - CPI inflation expected to be 6.6 percent at end–2016 and 5.2 percent at end–2017.
  - Growth expected to resume in 2017 and reach 1 percent.
  - Potential growth likely to be at around 1½ percent over the medium term absent significant structural reforms.
- Key risks:
  - Further decline in oil prices.
  - Intensification of geopolitical tensions.
  - A weaker banking system persisting longer.
  - Absence of credible medium‑term fiscal consolidation could foster uncertainty and limit investment and growth.
- Buffers and mitigating factors:
  - Floating exchange rate.
  - Large official foreign exchange reserves: International reserves stood at USD368 billion at end‑2015, equivalent to 266 percent of the Fund’s basic reserve adequacy metric; adjusted adequacy metric falls to 199 percent.
  - Positive net international investment position of about 20 percent of GDP.
  - Current account surplus.
  - Low public sector debt and moderate financing needs.
  - National Wealth Fund (NWF) liquid assets worth 5 percent of GDP could be used as an alternative to finance the deficit in a tail event.
  - Balance sheet currency mismatches seem low.

### Authorities’ views
- Ministry of Finance expected a milder contraction in 2016 of 0.2 percent, citing lower fiscal multipliers and stronger domestic demand expectations.
- Authorities and the CBR judged the economy largely adjusted to the shocks and noted improving financial conditions; they highlighted strong performance in specific sectors (agriculture, chemicals).
- Authorities underscored risks from volatile oil prices, the banking system, and incomplete fiscal adjustment, and agreed that lack of structural reform would leave growth prospects dim.

### Fiscal policy: designing and sequencing fiscal consolidation
- 2016 budget and near-term measures:
  - 2016 budget targeted a deficit of 3 percent of GDP based on oil prices averaging USD 50 per barrel.
  - Measures after early‑2016 oil price decline included a 10 percent across‑the‑board cut in non‑defense/non‑social spending and reallocation under an “anti‑crisis package”.
  - The deficit to be financed primarily through a drawdown from the Reserve Fund (RF) and via privatization receipts; net domestic market financing projected at 0.4 percent of GDP; net external financing negligible after USD 1.75bn in Eurobonds already issued.
- Medium‑term objectives:
  - Authorities announced goal of balancing the budget by 2020 and reintroducing the fiscal rule; considering reintroducing a fiscal rule based on a fixed oil price of USD40 or USD50 per barrel.
  - 2017 budget and multi‑year framework to be submitted to Parliament in October.
- Staff estimates and recommendations:
  - Based on an average Urals oil price of USD 42.2 per barrel, staff expects the federal deficit to reach 3.2 percent of GDP.
  - General government deficit expected to worsen from 3.5 percent of GDP in 2015 to 3.7 percent of GDP in 2016.
  - Staff argued a smaller underlying fiscal adjustment of about 0.7 percent of GDP in 2016 would have been appropriate given slack and available fiscal space.
  - Staff recommended anchoring consolidation in a credible medium‑term framework; staff baseline consistent with balancing the budget by 2020 requiring fiscal measures of 4 percent of GDP over 2017–2020.
  - Staff advocated for consolidation of better quality (lower multipliers in the short term), preserving more of the RF, and greater reliance on debt issuance given relatively low public debt and domestic demand for government bonds.
  - Strengthen financial oversight of government‑controlled enterprises and reestablish a three‑year fiscal framework to reduce uncertainty.

- Possible Fiscal Adjustment Measures (Percent of GDP) — staff/Ministry of Finance/WB estimates:
  - Revenue measures: up to 4.2
    - Cut tax expenditures: 2.0
    - Increase excise taxes: 0.7
    - Improve productivity of VAT, duties, excise and social contributions: 1.2
    - Increase PIT base: 0.3
  - Expenditure measures: up to 7.6
    - Reduce subsidies: 1.5
    - Better targeted social transfers: 2.0
    - Increase retirement age: 2.0 - 3.0
    - Reduce early pensions: 0.7
    - Improve capital budgeting: 0.4
  - Total: up to 11.8

### Fiscal consolidation and pension reform
- Staff view: parametric pension reform is essential to balance the budget by 2020.
- Staff pension reform proposals (from the 2015 workshop by IMF experts):
  - (1) increasing and equalizing statutory retirement ages;
  - (2) reducing early retirement benefits;
  - (3) improving coverage and compliance;
  - (4) curtailing (continuing) pension benefits for pensioners below (above) the mandatory retirement age;
  - (5) striving to develop and preserve private pensions to support long-term financing to the economy.
- Additional analysis: increasing retirement age and providing incentives to remain in the labor force would ease demographic pressures on labor supply.
- Authorities agree pension reform is indispensable to reach a balanced budget by 2020 and support encouraging private pensions for long-term capital availability.

### Monetary policy: normalization and recommendations
- Policy rates lowered by 600bps during January-August 2015 to a new level of 11 percent; the CBR paused easing in August.
- CBR committed to reaching its 4 percent inflation target by end–2017.
- Staff recommendation: resume normalization of monetary policy at a prudent pace to support the economy.
- Observed constraints:
  - Headline inflation fell to 7.3 percent in May while nominal policy rates remained unchanged, increasing real policy rates.
  - Negative output gap and slow nominal wage growth support disinflation.
  - Pace of easing should be gradual given strong links between volatile oil prices, exchange rate, and inflation; aggressive easing could prompt capital outflows, deposit withdrawals, and destabilizing dollarization.
  - Uncertainty over the fiscal stance and potential external shocks warrant a cautious approach.

### Macro‑financial sector and banking system vulnerabilities
- Banking system capital needs:
  - After adjustments, NPLs might be higher by 3.5 percentage points resulting in a capital shortfall of about 0.5-1 percent of GDP.
  - Under stress scenarios, the shortfall could reach up to about 4½ percent of GDP.
- Corporate and external exposure:
  - About half of corporate debt is denominated in FX.
  - Corporate net foreign currency denominated debt to the banking system amounts to 4 percent of GDP.
  - Private sector’s short-term external assets exceed its short-term liabilities by about USD 65 bn.
  - Most corporations that borrow externally have natural hedges.
- Sovereign buffers and contingent liabilities:
  - RF expected to fall to about 0.2 percent of GDP in 2017.
  - NWF available at 5 percent of GDP for potential deficit financing if reserves are tapped.
  - Potential support to VEB could reach up to 2 percent of GDP over the next few years.
  - Public debt stood at 18 percent of GDP in 2015, overwhelmingly in local currency with long maturities.
- Policy responses and regulatory measures:
  - Nearly all funds allocated under the 2015 government capital support program assigned, amounting to 25 percent of eligible banks’ capital.
  - Participating private banks required to raise an additional 12.5 percent in capital through retained earnings and/or share issuance.
  - Most regulatory forbearance measures from December 2014 lifted, except continued flexibility in provisioning against loans restructured during December 2014–15.
  - To offset tighter capital definition and new Basel III buffers, CBR lowered the minimum regulatory CAR from 10 percent to 8 percent.
  - Tighter capital definition estimated to lower banking system CAR by 0.6 percent of RWA.
  - New capital buffers: 0.625 percent of RWA for capital conservation and 0.15 percent of RWA for the systemic surcharge in 2016; these will gradually increase to 2.5 percent and 1 percent, respectively, when fully implemented in 2019.
  - The effective minimum CAR is reduced temporarily by 0.775 percent of RWA for all banks but will recover and be higher by 2019.

### Financial sector reform and supervisory recommendations
- Stress testing and asset quality:
  - Recommend enhanced stress testing, including liquidity by currency on a consolidated basis.
  - Asset Quality Reviews (AQR) should be credible, transparently disclosed, and involve independent third-party experts; prepare strategies to address AQR findings including viability assessments, recapitalization plans, and resolution preparations for unviable banks.
- Supervisory improvements:
  - Strengthen CBR’s interactions with the external auditing profession: powers to reject inadequate auditors, ensure rotation, and engage with audit firms on supervised institutions.
  - Improve flow of information: require professional service providers to notify CBR of material information relevant to supervised banks; provide legal protection for service providers where necessary.
- Resolution framework improvements:
  - Expand resolution scope to cover bank-holding companies.
  - Enhance CBR powers to facilitate mergers, recapitalization and business transfers, while ensuring continuity of critical functions.
  - Introduce shareholder and creditor safeguards to reduce legal risks.
  - Consider bail-in tools carefully to reduce reliance on public funds; design to account for financial stability and legal risks.
  - Restrict public funds to systemic banks and provide federal indemnity if CBR funds are used temporarily.
  - Authorities announced intention to introduce statutory bail-in of large corporate depositors in 2017.

### Financial Sector Strategy: legal, operational, and structural priorities
- Legal, supervisory, and operational gaps:
  - Implementation of the concept of economic linkages postponed to January 2017.
  - Regulatory framework does not require that lending to affiliates be on the same terms as offered to the public; CBR lacks authority to impose penalties on directors who benefited from favorable conditions.
  - No enforceable requirements for risk policies, processes and limits for country and transfer risks.
  - Large part of operational risk norms are non-binding recommendations.
- Improvements needed in bank resolution and P&A effectiveness; enhance resolution funding arrangements and consider replacing below-market loans with direct capital injections.
- Structural policies:
  - Deepening and diversifying the financial sector is necessary to support strong and sustainable economic growth.
  - Complementary priorities: reduce administrative burdens on businesses, strengthen contract enforcement and property rights, implement recommendations to strengthen financial oversight of SOEs, increase labor mobility and reduce skills mismatches, and support innovation while directing infrastructure spending to electricity and transport bottlenecks.

### Implementation of past IMF recommendations (selected outcomes)
- Fiscal:
  - Authorities suspended the three-year fiscal framework and plan measures for the 2017 budget.
  - Pension indexation to inflation was partial.
  - Authorities adopted a tight fiscal stance, frontloading fiscal adjustment despite the cyclical downturn.
  - Structural non-oil deficit deteriorated by less than expected (0.2 percent of GDP versus 0.4 percent of GDP).
- Monetary:
  - Policy rates decreased by 600bps to 11 percent in 2015; CBR paused easing in August.
  - CBR curtailed FX allotments, increased costs of FX facilities, eliminated the one-year FX facility and halted the FX purchase program amid ruble volatility.
- Financial sector:
  - Almost all regulatory forbearance measures were lifted and the government’s capital support program was completed.
  - Discussions over bail-in legislation are ongoing.
- External:
  - NIIP at end-September 2015: about 23 percent GDP (up from 6 percent in 2013).
  - Gross assets: 89 percent of GDP.
  - Liabilities: 66 percent of GDP.
  - Total external debt: 37.8 percent of GDP.
  - International reserves stood at USD368 billion at end-2015, equivalent to 266 percent of the Fund’s basic reserve adequacy metric; adjusted adequacy metric falls to 199 percent.

### Risk Assessment Matrix (selected risks and policy responses)
- Persistently lower energy prices (Overall: High; Likelihood: High; Impact: High)
  - Policy response: floating exchange rate; fiscal policy could use buffers within medium-term framework; advance structural reforms.
- Increase in geopolitical tensions (Overall: Medium; Likelihood: Medium; Impact: Medium)
  - Policy response: floating exchange rate; FX intervention in disorderly markets; consider interest rate increase; postpone fiscal tightening.
- Weaker banking system for longer (Overall: Medium; Likelihood: Medium; Impact: Medium)
  - Policy response: require time-bound recapitalization plans; consider precautionary capital injections for weak viable government-related banks.
- Sharper-than-expected global slowdown (Overall: Low/Medium; Likelihood: Low/Medium; Impact: Medium)
  - Policy response: allow exchange rate adjustment; rebuild fiscal buffers; advance structural reforms.
- Continued drop in domestic investment due to inward-looking policies (Overall: Low; Likelihood: Low; Impact: Medium)
  - Policy response: focus on structural and governance reforms; avoid distortive measures; leverage REER depreciation and increase trade openness.

*Source: IMF staff report (chapter titled "The Economy's Adjustment to the Current Recession").*

### 1. The Economy's Adjustment to the Current Recession __________________________________________ 5

### 1. The Economy's Adjustment to the Current Recession __________________________________________ 5

### Context and shock absorption
- The 45 percent decline in oil prices between 2014 and 2015 and the continued quasi closure of international financial markets to Russian entities depressed economic conditions.
- Policy response that cushioned the shocks included:
  - a flexible exchange rate regime;
  - banking sector capital and liquidity injections;
  - limited fiscal stimulus;
  - regulatory forbearance.
- External deleveraging reduced external private debt by USD 176bn over the past two years.
- Capital outflows declined in 2015 to half their 2014 level.

### Comparative adjustment (Box 1)
- The 30 percent cumulative deterioration in the terms-of-trade was larger than the 2009–10 episodes, yet real GDP contraction in 2015 was milder than in 2009 amid a much more pronounced real exchange rate adjustment (REER).
- Labor and income adjustments:
  - Real wages fell by 9 percent in 2015, compared to a 3 percent decline in 2009.
  - Unemployment remained broadly stable at around 6 percent, versus more than 8 percent in 2009.
  - Real wage decline led to a rebalancing of national income in favor of corporate profits, notably in non-oil basic commodities’ sectors.
- Trade and import substitution:
  - Some non-oil export volumes (chemicals, agricultural products) increased during 2014–15.
  - Domestic sales of goods and services (real terms) fell less than domestic demand, suggesting import substitution; agriculture and food, chemicals, rubber and plastics outperformed among tradable goods.
  - Domestic sales of goods and services outperformed domestic demand in episodes of REER decline since the late 1990s, increasing the share of domestic goods in total demand by 5–6 percentage points, though these gains were reversed when REER rebounded.

### Recent developments (to mid‑2016)
- Oil market:
  - Brent prices reached a low of USD 26 per barrel in January 2016.
  - Oil prices averaged USD 47 per barrel in May 2016.
- Inflation and activity:
  - Inflation reached 7½ percent in April 2016, down from 16½ percent a year before.
  - Industrial production stopped declining sequentially, PMI suggests continued manufacturing weakness, services sector activity gathering strength.
- Banking sector:
  - Reported NPLs reached 9.2 percent of total loans in Q1 2016.
  - Overall capital adequacy ratio resumed declining, driven by low profitability and anemic credit growth; the move to Basel III narrowed eligible capital with an estimated impact of 0.6 percentage point.
  - Deposit flows increased; liquidity in rubles and FX improved; no signs of increased dollarization.
  - CBR continued closing banks, mostly small, for weakness or non-compliance (including AML/CFT).

### Outlook and risks
- Staff central projections:
  - Real GDP expected to decline by 1.2 percent in 2016.
  - CPI inflation expected to be 6.6 percent at end–2016 and 5.2 percent at end–2017.
  - Growth expected to resume in 2017 and reach 1 percent.
  - Potential growth likely to be at around 1½ percent over the medium term absent significant structural reforms.
- Key risks:
  - Further decline in oil prices.
  - Intensification of geopolitical tensions.
  - A weaker banking system persisting longer.
  - Absence of credible medium‑term fiscal consolidation could foster uncertainty and limit investment and growth.
- Buffers and mitigating factors:
  - Floating exchange rate.
  - Large official foreign exchange reserves: International reserves stood at USD368 billion at end‑2015, equivalent to 266 percent of the Fund’s basic reserve adequacy metric; adjusted adequacy metric falls to 199 percent.
  - Positive net international investment position of about 20 percent of GDP.
  - Current account surplus.
  - Low public sector debt and moderate financing needs.
  - National Wealth Fund (NWF) liquid assets worth 5 percent of GDP could be used as an alternative to finance the deficit in a tail event.
  - Balance sheet currency mismatches seem low.

### Authorities’ views
- The Ministry of Finance expected a milder contraction in 2016 of 0.2 percent, citing lower fiscal multipliers and stronger domestic demand expectations.
- Authorities and the CBR judged the economy largely adjusted to the shocks and noted improving financial conditions; they highlighted strong performance in specific sectors (agriculture, chemicals).
- They underscored risks from volatile oil prices, the banking system, and incomplete fiscal adjustment, and agreed that lack of structural reform would leave growth prospects dim.

### Fiscal policy: designing and sequencing fiscal consolidation
- 2016 budget and near-term measures:
  - 2016 budget targeted a deficit of 3 percent of GDP based on oil prices averaging USD 50 per barrel.
  - Measures after early‑2016 oil price decline included a 10 percent across‑the‑board cut in non‑defense/non‑social spending and reallocation under an “anti‑crisis package”.
  - The deficit to be financed primarily through a drawdown from the Reserve Fund (RF) and via privatization receipts; net domestic market financing projected at 0.4 percent of GDP; net external financing negligible after USD 1.75bn in Eurobonds already issued.
- Medium‑term objectives:
  - Authorities announced goal of balancing the budget by 2020 and reintroducing the fiscal rule; considering reintroducing a fiscal rule based on a fixed oil price of USD40 or USD50 per barrel.
  - 2017 budget and multi‑year framework to be submitted to Parliament in October.
- Staff estimates and recommendations:
  - Based on an average Urals oil price of USD 42.2 per barrel, staff expects the federal deficit to reach 3.2 percent of GDP.
  - General government deficit expected to worsen from 3.5 percent of GDP in 2015 to 3.7 percent of GDP in 2016.
  - Staff argued a smaller underlying fiscal adjustment of about 0.7 percent of GDP in 2016 would have been appropriate given slack and available fiscal space.
  - Staff recommended anchoring consolidation in a credible medium‑term framework; staff baseline consistent with balancing the budget by 2020 requiring fiscal measures of 4 percent of GDP over 2017–2020.
  - Staff advocated for consolidation of better quality (lower multipliers in the short term), preserving more of the RF, and greater reliance on debt issuance given relatively low public debt and domestic demand for government bonds.
  - Strengthen financial oversight of government‑controlled enterprises and reestablish a three‑year fiscal framework to reduce uncertainty.

- Possible Fiscal Adjustment Measures (Percent of GDP) — staff/Ministry of Finance/WB estimates (as presented)
  - Revenue measures: up to 4.2
    - Cut tax expenditures: 2.0
    - Increase excise taxes: 0.7
    - Improve productivity of VAT, duties, excise and social contributions: 1.2
    - Increase PIT base: 0.3
  - Expenditure measures: up to 7.6
    - Reduce subsidies: 1.5
    - Better targeted social transfers: 2.0
    - Increase retirement age: 2.0 - 3.0
    - Reduce early pensions: 0.7
    - Improve capital budgeting: 0.4
  - Total: up to 11.8

*Source: IMF staff report (chapter titled "The Economy's Adjustment to the Current Recession").*

### 15.      Staff noted that parametric pension reform is essential to balance the budget by 2020.

### _cr16229 - 15.      Staff noted that parametric pension reform is essential to balance the budget by 2020.

### Fiscal consolidation and pension reform
- Staff view: parametric pension reform is essential to balance the budget by 2020.
- Staff pension reform proposals (from the 2015 workshop by IMF experts):
  - (1) increasing and equalizing statutory retirement ages;
  - (2) reducing early retirement benefits;
  - (3) improving coverage and compliance;
  - (4) curtailing (continuing) pension benefits for pensioners below (above) the mandatory retirement age;
  - (5) striving to develop and preserve private pensions to support long-term financing to the economy.
- Additional analysis: increasing retirement age and providing incentives to remain in the labor force would ease demographic pressures on labor supply.

### Fiscal rules and medium-term sustainability
- Staff recommendation: adopt a credible fiscal rule to support medium-term fiscal sustainability.
- Staff view on rule design:
  - A more flexible oil-price rule that sets an oil benchmark incorporating future oil prices could be preferable (example cited: Mexico).
  - Such a rule would help avoid suspending the rule during spending pressures in an oil price boom or when market pressures constrain financing in an oil price downturn.
- Intergenerational equity: staff noted that an additional fiscal adjustment of at least one percent of GDP would be required by 2021.

### Revisions to fiscal anchor estimate (real annuity and oil-price outlook)
- Updated analysis uses the “real annuity” concept: a constant real transfer over a fixed period of time (50 years) after which resource wealth is exhausted.
- Comparison with 2015 Article IV:
  - 2015 Article IV: a real annuity starting in 2021 amounting to 4.6 percent of GDP was consistent with Russia’s estimated oil wealth.
  - Updated (lower oil-price) analysis: real annuity reduced to 4.1 percent of GDP.
  - Implication: implies a need for an overall stronger fiscal effort of about 0.5 percent of GDP by 2021 relative to the original 2015 baseline.

### Authorities’ views on fiscal policy and pensions
- Authorities agree on the need for medium-term fiscal consolidation under a credible fiscal rule and that the decline in oil prices is mainly permanent, requiring permanent fiscal adjustment.
- Divergence from staff: authorities believe fiscal consolidation is unlikely to adversely impact short-term activity, assuming low fiscal multipliers (reflecting a lower output gap estimate and tight monetary conditions).
- Authorities’ consolidation measures under consideration: means testing of social benefits, streamlining inefficient health care spending, and a comprehensive expenditure review.
- Authorities agree pension reform is indispensable to reach a balanced budget by 2020 and support encouraging private pensions for long-term capital availability.
- On fiscal rule design: authorities favor a rule based on a fixed oil price for simplicity, transparency, and ease of communication.
- On financing and market conditions:
  - Reliance on the RF to finance the deficit reflects the still-high cost of domestic borrowing.
  - Authorities note complexities in issuing externally and believe moral suasion by US and EU authorities could increase uncertainty and risk premia.
  - Considering legislative budgetary changes to allow greater flexibility in debt issuance to exploit better market conditions.

### Monetary policy: normalization and recommendations
- Context and recent actions:
  - Policy rates remained constant since August 2015 due to inflation risks.
  - Policy rate was lowered by 600bps during January-August to a new level of 11 percent; the CBR paused easing in August.
  - CBR committed to reaching its 4 percent inflation target by end–2017.
- Staff recommendation: resume normalization of monetary policy at a prudent pace to support the economy.
- Observed developments and constraints:
  - Headline inflation fell to 7.3 percent in May while nominal policy rates remained unchanged, increasing real policy rates.
  - Negative output gap and slow nominal wage growth (public sector salary freeze for a second year and partial pension benefit indexation) support disinflation.
  - Exchange rate broadly in line with fundamentals (Annex II), limiting further depreciation pressures.
  - Pace of easing should be gradual given strong historical links between volatile oil prices, exchange rate, and inflation; aggressive easing could prompt capital outflows, deposit withdrawals, and destabilizing dollarization.
  - Uncertainty over the fiscal stance for the next year and potential external shocks (US policy tightening, capital flow volatility related to China) warrant a cautious approach.

### Macro-financial sector and banking system vulnerabilities
- Banking system capital needs:
  - After adjustments, NPLs might be higher by 3.5 percentage points resulting in a capital shortfall of about 0.5-1 percent of GDP.
  - Under stress scenarios, the shortfall could reach up to about 4½ percent of GDP.
- Corporate and external exposure:
  - About half of corporate debt is denominated in FX.
  - Corporate net foreign currency denominated debt to the banking system amounts to 4 percent of GDP.
  - Private sector’s short-term external assets exceed its short-term liabilities by about USD 65 bn.
  - Most corporations that borrow externally have natural hedges.
- Sovereign buffers and contingent liabilities:
  - RF expected to fall to about 0.2 percent of GDP in 2017.
  - NWF available at 5 percent of GDP for potential deficit financing if reserves are tapped.
  - Potential support to VEB could reach up to 2 percent of GDP over the next few years.
  - Public debt stood at 18 percent of GDP in 2015, overwhelmingly in local currency with long maturities.
- Policy responses and regulatory measures:
  - Nearly all funds allocated under the 2015 government capital support program assigned, amounting to 25 percent of eligible banks’ capital.
  - Participating private banks required to raise an additional 12.5 percent in capital through retained earnings and/or share issuance.
  - Most regulatory forbearance measures from December 2014 lifted, except continued flexibility in provisioning against loans restructured during December 2014–15.
  - To offset tighter capital definition and new Basel III buffers, CBR lowered the minimum regulatory CAR from 10 percent to 8 percent.
  - Tighter capital definition estimated to lower banking system CAR by 0.6 percent of RWA.
  - New capital buffers: 0.625 percent of RWA for capital conservation and 0.15 percent of RWA for the systemic surcharge in 2016; these will gradually increase to 2.5 percent and 1 percent, respectively, when fully implemented in 2019.
  - The effective minimum CAR is reduced temporarily by 0.775 percent of RWA for all banks but will recover and be higher by 2019.

### Financial sector reform and supervisory recommendations
- Stress testing and asset quality:
  - Recommend enhanced stress testing, including liquidity by currency on a consolidated basis to capture downstreaming of problematic assets and currency-specific liquidity shortages.
  - Asset Quality Reviews (AQR) should be credible, transparently disclosed, and involve independent third-party experts; authorities should prepare strategies to address AQR findings, including viability assessments, recapitalization plans, and resolution preparations for unviable banks.
- Supervision improvements identified by FSAP:
  - Strengthen CBR’s interactions with the external auditing profession: powers to reject inadequate auditors, ensure rotation, and engage with audit firms on supervised institutions.
  - Improve flow of information: require professional service providers to notify CBR of material information relevant to supervised banks; legal protection for service providers where necessary.

*Source: _cr16229 - 15.      Staff noted that parametric pension reform is essential to balance the budget by 2020.*

### Box 5. Financial Sector Strategy (Concluded)

### Box 5. Financial Sector Strategy (Concluded)

### Legal, supervisory, and operational gaps
- Related parties and connectedness:
  - Concept of economic linkages introduced in law in 2014; implementation postponed twice, latest to January 2017.
  - Regulatory framework does not require that lending to affiliates be on same terms and conditions as those generally offered to the public.
  - CBR lacks authority to impose penalties on directors who benefited from favorable conditions.
- Management of country and transfer risks:
  - No enforceable requirements for risk policies, processes and limits.
  - CBR’s approval is not required for major acquisition of domestic nonbank institutions.
- Oversight of operational risk:
  - A large part of norms that govern operational risk is in the form of non-binding recommendations.

### Improvements needed in the bank resolution framework
- FSAP-identified priorities:
  - Expand the scope of resolution to cover bank-holding companies.
  - Enhance CBR powers to facilitate mergers, recapitalization and business transfers, while ensuring continuity of critical functions.
  - Introduce shareholder and creditor safeguards to reduce legal risks.
- Enhancing Purchase and Assumption (P&A) effectiveness:
  - Remove financing constraints.
  - Increase flexibility in determining the scope of liabilities to be transferred.
  - Use fair valuation of assets.
- Bail-in tool:
  - Introducing bail-in could reduce reliance on public funds, but framework must be carefully designed to account for implications on financial stability and legal risks.
- Resolution funding:
  - Public funds should be restricted to systemic banks and provided with federal funds or, if temporarily with CBR funds, with an indemnity.
  - Consider replacing below-market rate loans with direct capital injection to facilitate a swift return of healthy resolved banks to the market.
- Authorities announced intention to introduce statutory bail-in of large corporate depositors in 2017.

### FSAP recommendations, stress tests, and asset quality review (AQR)
- Stress tests and AQR:
  - Stress tests, including on liquidity by currency, should be performed on a consolidated basis.
  - A granular and comprehensive review of banks’ asset portfolios (AQR) needed to gauge capitalization needs, reduce uncertainty on valuations, and bolster confidence after forbearance.
  - AQR will be helpful to ascertain the identified capital shortfall in the baseline scenario of 0.5-1 percent of GDP.
  - If confirmed, authorities should devise necessary plans (see bank resolution recommendations) to keep the banking system on a sound footing.
- Supervisory improvements:
  - Authorities should prepare an action plan to address deficiencies in supervision.
  - Vigilant implementation and monitoring needed for recent changes supporting CBR’s Risk Based Approach in supervision.
- Liquidity framework improvements:
  - Reduce fragmentation of the money market.
  - CBR’s collateral framework could: eliminate early pre-payment and extendibility options to repo pledged instruments; set additional controls for non-marketable collaterals; make the legal basis for realizing them more robust.
  - CBR should formalize an appropriate safety net to meet emergency liquidity needs of individual institutions.

### Authorities’ actions and views
- CBR actions:
  - Approved a work program to improve supervision and asset valuation.
  - Will establish a new department to assess risk in all banks, using new reports and IT platform, with loan-by-loan data for legal entities.
  - Do not plan comprehensive AQRs; instead plan off-site asset quality analysis and stress tests by loan products, expected to provide analytical support and a comprehensive view of banks’ capital needs by end-2017.
  - Systemic banks to submit results from their Internal Capital Adequacy Assessment Process (ICAAP) in 2017; all other banks in 2018.
  - Legal amendments under preparation to require lending to related parties on market terms.
  - Several bills drafted in Parliament to improve CBR interaction with external auditors, require CBR approval for major acquisition of financial companies, and increase powers for CBR to assess collateral values.
  - Argued that extraordinary economic circumstances and urgent need to remove weak banks justified extensive use of CBR funds in resolution.
- Views on VEB:
  - Authorities agreed VEB should have better underwriting and supervisory standards; recent change in management noted as a first step.
  - Mission recommended bringing VEB into a prudential supervisory framework to support risk, capital and liquidity management, and corporate governance.
- Broader authority stance:
  - Authorities broadly agreed with FSAP findings and have already taken steps to address some key recommendations.
  - Committed to avoid further delays in extending the definition of related parties to cover economic relations (now planned for January 2017).

### Banking system policy recommendations and priorities
- Strengthen banking system to support growth:
  - Continue implementing privatization plans as economic conditions permit.
  - Close weak banks.
  - Refrain from using state-owned financial institutions to bail out struggling commercial banks.
  - Encourage private sector involvement in bank resolution.
  - Proceed with privatization of state-owned banks as conditions permit.
- Asset quality assessment enhancements suggested by staff:
  - Add a strong on-site component, with file reviews and evaluation of collateral valuation and enforceability.
  - Establish a panel of external experts to advise on scope and methodologies, draft terms of reference, and oversee conduct.
  - Complement bail-in plans with plans to remove legal and operational impediments in P&A transactions to focus on rescuing essential functions rather than entire failed banks.

### Structural policies and links to financial sector strategy
- Role of structural reforms:
  - Deepening and diversifying the financial sector is necessary to support strong and sustainable economic growth.
  - Structural reforms are indispensable to leverage a more competitive exchange rate and reallocate resources to the non-energy tradable sector.
- Complementary structural priorities (high level):
  - Accelerate reforms to reduce unwarranted administrative pressures on businesses, strengthen contract enforcement and protection of property rights, and implement recommendations to strengthen financial oversight of SOEs.
  - Increase labor mobility and reduce skills mismatches by improving vocational training, coordinating employers and training institutes, and consider parametric pension reform such as increasing the statutory retirement age to increase labor supply.
  - Support innovation and protect infrastructure spending while directing it to bottlenecks in electricity and transport.

*Source: Box 5. Financial Sector Strategy (Concluded), _cr16229 - Box 5. Financial Sector Strategy (Concluded).*

### 39.      It is proposed that the next Article IV consultation be held on the standard 12-month

### _cr16229 - 39.      It is proposed that the next Article IV consultation be held on the standard 12-month

### Timing of next Article IV consultation
- It is proposed that the next Article IV consultation be held on the standard 12-month cycle.

### Jurisdiction and document identifier
- RUSSIAN FEDERATION
- INTERNATIONAL MONETARY FUND 25

*RUSSIAN FEDERATION — INTERNATIONAL MONETARY FUND 25*

### Box 6. Reform Priorities

### Box 6. Reform Priorities

### Methodology for identifying reform priorities
- Reform priorities are set by benchmarking to the EU. First, competitiveness gaps are identified by benchmarking Russia to the average EU country, and on an income-adjusted basis, along a wide set of indicators.1
- Then, these gaps are ranked according to their importance for growth using cross-country growth regressions.
- Finally, reform priorities are identified by interacting the size of the reform gaps with the growth regression coefficients.
- Footnote: 1 The methodology is based on the Regional Economic Issues, Special Report, March 2015. Competitiveness is defined as the set of institutions, policies, and factors that determine the level of productivity of a country. Data is sourced from the World Economic Forum’s Global Competitiveness Report.

### Key findings on competitiveness gaps
- Russia significantly lags the EU on most competitiveness indicators.
- The largest gaps are in:
  - institutions (property rights and corruption indicators);
  - goods market efficiency (tax and tariff rates);
  - financial market development (legal rights);
  - business sophistication (local supply quality and production process sophistication);
  - innovation (availability of scientists and engineers).
- Some gaps are large even compared to countries with a similar income level.
- Relative to peers, Russia ranks high on innovation, infrastructure, health and education.
- However, gaps are large in institutions and goods and market efficiency — the pre-requisites for innovation and education to deliver substantial growth dividends.

### Priority reform areas for long‑term growth
- Russia’s reform gaps are particularly large in areas found to be most critical for long-term growth.
- The priority areas that need further improvements are:
  - institutions,
  - infrastructure,
  - goods market efficiency,
  - business sophistication,
  - innovation.
- Note from the source figure: Structural Reform Gaps in Russia, 2015; *** denote reform priorities identified by combining gaps with their estimated growth impact.

*Source: _cr16229 - Box 6. Reform Priorities (IMF staff text provided).*

### Annex I. Implementation of Past IMF Recommendations

### Annex I. Implementation of Past IMF Recommendations

### Overview
- During the 2015 Article IV consultation, Directors commended the authorities’ policy actions to stabilize the economy amid lower oil prices and sanctions, and noted pre-existing structural weaknesses. Continued prudent policies and reforms were judged necessary to ensure macroeconomic stability and boost potential growth.

### Fiscal Policy — Key recommendations and implementation
- Recommendation: Medium-term fiscal consolidation to adjust to lower oil prices and rebuild buffers; detailed fiscal measures to help credibility.
  - Implemented policies:
    - The authorities suspended the three-year fiscal framework and are devising measures to be announced in the 2017 budget to adjust to lower oil prices.
- Recommendation: The application of the fiscal rule will lead to a slow consolidation while pension indexation would make it difficult to achieve the necessary fiscal adjustment.
  - Implemented policies:
    - The authorities suspended the fiscal rule, as it was providing too little fiscal adjustment, and are planning on reinstating it when the balanced budget is achieved.
    - Pension indexation to inflation was partial.
- Recommendation: A limited fiscal adjustment could begin in 2016 with the pace of fiscal consolidation adjusted to provide support to the economy.
  - Implemented policies:
    - The authorities have adopted a tight fiscal stance, frontloading the fiscal adjustment despite the cyclical downturn.
- Recommendation: The use of quasi-fiscal operations should be limited and coordinated to avoid an overly stimulative fiscal stance.
  - Implemented outcome:
    - The structural non-oil deficit deteriorated by less than expected (0.2 percent of GDP versus 0.4 percent of GDP) as the fiscal stimulus was limited.

### Monetary Policy — Key recommendations and implementation
- Recommendation: Continue the normalization of policy rates at a gradual pace commensurate with the decline in underlying inflation and inflation expectations.
  - Implemented policies:
    - Policy rates were decreased throughout 2015 by a cumulative 600bps, to 11 percent. The CBR paused its easing cycle in August to assess the impact of lower oil prices and ruble depreciation on underlying inflation and inflation expectations.
- Recommendation: Repricing and rationalizing the FX facilities while indicating a time-frame for conducting FX purchases.
  - Implemented policies:
    - The CBR curtailed FX allotments, increased the costs of its FX facilities and eliminated the one-year FX facility. It also halted the FX purchase program as ruble volatility increased in the second half of 2015 following the decline in oil prices.

### Financial Sector Policy — Key recommendations and implementation
- Recommendation: Eliminate regulatory forbearance promptly along with the implementation of the bank capital support program.
  - Implemented policies:
    - Almost all regulatory forbearance measures were lifted and the government’s capital support program was completed.
- Recommendation: Tailor the capital support program to specific needs of individual banks and introduce tighter eligibility criteria, higher cost of capital, while eliminating credit growth targets.
  - Implemented outcome:
    - The capital support program has been implemented as originally designed.
- Recommendation: Introduce legislation to provide a number of resolution tools including powers to use a bridge bank and to bail-in all unsecured uninsured liabilities.
  - Implemented outcome:
    - The authorities’ supervisory agenda focused on implementing Basel III requirements; discussions over bail-in legislation are ongoing.

### Structural Policies — Key recommendations and implementation
- Recommendation: Improve governance and protection of property rights, increase competition in domestic markets, increase output in the non-energy tradable sector, and attract investment.
  - Implemented policies/outcomes:
    - Import-substitution policies have been the focus, supporting local production in sectors with export potential.
    - Part of the government anti-crisis package aims at supporting SMEs by reducing financial and administrative costs.
    - The privatization agenda remained stalled given adverse market conditions.

### External position and external sector assessment — Key findings
- Net international investment position (NIIP) and external debt:
  - NIIP at end-September 2015: about 23 percent GDP (up from 6 percent in 2013).
  - Gross assets: 89 percent of GDP.
  - Liabilities: 66 percent of GDP.
  - Total external debt: 37.8 percent of GDP.
- Assessment:
  - Projected current account surpluses suggest Russia will continue to maintain a positive IIP.
  - Assets should increase further as accumulation of fiscal savings in the oil funds resumes in the medium-term.
  - External deleveraging since 2014 reduces risks further.
- Overall Assessment:
  - The external position in 2015 was broadly consistent with medium-term fundamentals and desirable policy settings.
- Real Effective Exchange Rate (REER):
  - Background and movements:
    - The REER depreciated 18 percent between 2014 and 2015.
    - The REER at end-January 2016 reached new lows; the REER weakened 3 percent through April 2016 compared to its 2015 average.
  - Assessment:
    - Based on the CA gap, staff assesses the REER was not far from medium-term fundamentals in 2015 with a REER gap of about -7 to +7.
    - Staff notes the REER equilibrium could be lower should the oil price shock become permanent.
- Current account (CA):
  - Background:
    - From 2000 to 2013, the CA surplus fell from 18 to 2 percent of GDP.
    - The CA improved to 2.9 percent in 2014 and 5 percent in 2015.
    - Reduced oil export revenues were approximately 7 percent of GDP.
  - Assessment:
    - Staff assesses the 2015 CA gap was between -2 to 2 percent of GDP.
    - In the medium term, fiscal policy should be tightened to rebuild buffers and save more of the oil wealth for future generations.
- Capital and financial accounts:
  - Background and assessment:
    - Net private capital outflows continued in 2015 though the pace slowed relative to 2014.
    - External deleveraging continued amid limited access to international capital markets.
    - Large international reserves and the floating exchange rate regime reduce vulnerability to shocks.
- FX intervention and reserves:
  - Background:
    - Since adopting a free floating exchange rate regime, FX interventions have been limited. In May 2015, the CBR started rebuilding reserves for a few months.
  - Assessment:
    - International reserves stood at USD368 billion at end-2015, equivalent to 266 percent of the Fund’s basic reserve adequacy metric (exceeding the adequacy minimum of 150 percent).
    - Taking into account vulnerability to commodity shocks, the adjusted adequacy metric falls to 199 percent of the metric, remaining above the minimum adequacy threshold.
    - A policy of small regular reserve purchases to replenish reserves could be justified given heightened uncertainty; large FX interventions should be limited to episodes of market distress.

### Technical notes and model estimates (selected)
- Unfavorable valuation changes and “disguised” capital outflows contribute to discrepancies between accumulated CA surpluses and reported NIIP.
- EBA and staff current account and REER model estimates:
  - EBA-estimated 2015 CA norm: 6.2 percent of GDP; cyclically adjusted CA: 7.3 percent of GDP.
  - EBA Level REER model suggests an undervaluation of 21 percent; EBA Index REER regression model suggests an undervaluation of 22 percent.
  - Staff notes commodity terms of trade impacts in these models may understate the recent large oil price shock’s effect on the REER gap.

### Risk Assessment Matrix — Key risks and recommended policy responses
- Persistently lower energy prices (High overall concern; Relative likelihood: High; Expected impact: High)
  - Recommended policy response:
    - Floating exchange rate to cushion the shock.
    - Fiscal policy could temporarily use existing buffers within a medium-term framework that ensures consolidation.
    - Advance structural reforms to improve economic efficiency and enhance diversification.
- Increase in geopolitical tensions (Overall concern: Medium; Relative likelihood: Medium; Expected impact: Medium)
  - Recommended policy response:
    - Floating exchange rate to cushion the shock.
    - Use FX intervention to counter disorderly market conditions; consider an interest rate increase.
    - Fiscal policy tightening could be postponed.
- Weaker banking system for longer (Overall concern: Medium; Relative likelihood: Medium; Expected impact: Medium)
  - Recommended policy response:
    - Require weak banks to submit time-bound recapitalization plans and bring capitalization closer to regulatory minima under an adverse stress scenario.
    - For weak viable government-related banks, consider precautionary capital injections.
- Sharper-than-expected global growth slowdown (e.g., significant China slowdown) (Overall concern: Low/Medium; Relative likelihood: Low/Medium; Expected impact: Medium)
  - Recommended policy response:
    - Allow the exchange rate to adjust; use FX intervention in disorderly conditions.
    - Rebuild fiscal buffers and oil savings by tightening the fiscal rule if prices are lower.
    - Advance structural reforms to enhance economic efficiency and diversification.
- Continued drop in domestic investment due to inward-looking policies and lack of structural reform (Overall concern: Low; Relative likelihood: Low; Expected impact: Medium)
  - Recommended policy response:
    - Focus on structural and governance reforms to improve the investment climate.
    - Avoid distortive measures; leverage real exchange rate depreciation and increase trade openness.

*Source: Annex I. Implementation of Past IMF Recommendations (excerpt).*

### Annex IV. Key FSAP Recommendations

### Annex IV. Key FSAP Recommendations

### Banking Stability
- Conduct an asset quality review (AQR) to ensure adequate bank capitalization (CBR). ST/MT
- Enhance stress testing practices (CBR). MT

### Liquidity Management
- Enhance framework to encourage banks to self insure and manage their risks in the market (CBR). ST
- Review FX repo framework, and formalize lender of last resort (CBR). ST
- Re-establish t-bill program and coordinate sterilization of excess liquidity (MoF, CBR). ST
- Ensure adequate realized capital through legal amendments as needed (CBR). MT

### Financial Sector Oversight and Regulation
- Require prior approval for banks’ domestic investments in nonbank institutions (CBR). ST
- Issue specific requirements for management of banks’ country and transfer risks (CBR). ST
- Upgrade framework for relations with and use of banks’ external auditors (CBR). ST
- Strengthen further the legal framework applicable to related parties (CBR). ST
- Upgrade framework for prudential oversight of banks’ operational risk (CBR). ST
- Bring securities and insurance regulation and supervision into line with international standards (CBR). MT
- Ensure the effective implementation of the AML/CFT framework (CBR, MoF). ST

### Macroprudential Policy
- Adopt legal changes to provide a comprehensive policy toolkit (CBR, MoF). ST/MT

### Crisis Management and Resolution
- Review the framework for the use of public funds to finance the DIA for resolution purposes, to be provided by the federal government. If it is necessary to use CBR funds, the federal government should provide an indemnity (CBR, MoF). MT
- Establish a funding mechanism for recovery of the costs of providing temporary public financing through levies on the financial industry (CBR, MoF). MT
- Introduce the full range of resolution powers and safeguards recommended by the FSB Key Attributes, including by implementing legal and operational changes needed to make purchase and assumption (P&A) an effective resolution tool (CBR, MoF). ST

### Banking Sector Development
- Promote legal reforms to increase state-owned commercial banks (SOB’s) Board effectiveness (MoF, CBR). MT
- Continue gradual privatization of SOBs (MoF, CBR). MT

- “ST–short term” is within one year; “MT-medium term” is one–three years.

*Annex IV. Key FSAP Recommendations*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16229.pdf_