Mission Concluding Statement 

May 21, 2015

The Russian economy is in a recession due to lower oil prices and sanctions. In addition, long-term growth remains low given structural bottlenecks. The authorities’ macroeconomic policies have helped stabilize the situation, but there remain significant uncertainties regarding oil prices and geopolitical risks. Given these risks, the macroeconomic policy stance must be prudent. Thus, monetary policy normalization should continue at a pace commensurate with the decline in underlying inflation and inflation expectations. Fiscal policy rightly allows for a limited stimulus in 2015, but a medium-term consolidation program is necessary to adjust to permanently lower oil prices. The banking system recapitalization program should be better tailored and targeted to ensure public funds are used efficiently. Finally, re-invigorating the structural reform agenda and avoiding de-integration from the world economy remain crucial to lift potential growth.

A recession is expected in 2015 followed by a mild recovery in 2016. GDP is expected to decline by 3.4 percent in 2015 driven by a contraction in domestic demand weighed down by falling real wages, higher cost of capital, and weakened confidence. The ruble depreciation compared to 2014 will boost net exports, with the current account surplus increasing to around 4 percent of GDP, although it will not be enough to avert a contraction in output. The external position will remain challenging due to deleveraging in the face of limited market access. Inflation is expected to fall to 12.5 percent by year end. Due to the authorities’ policy response and higher oil prices, growth should resume in 2016 while inflation is expected to decline further to single digits. However, the recovery is unlikely to be strong as the limiting factors behind decelerating potential growth will take time to be addressed, leading to medium-term growth of 1.5 percent per year.

There are significant risks mitigated by large buffers. Persistently low oil prices or an increase in geopolitical tensions could further weaken the economic outlook and increase balance of payment pressures. However, in the near-term, sizeable buffers, including high international reserves, low public debt, and a positive net international investment position should help safeguard external sustainability.

Given high uncertainties, the authorities should continue with their prudent policies. Policy responses to the balance of payment pressures in the fourth quarter of 2014—inter alia, adoption of a fully flexible exchange rate, tightening of monetary policy, announcement of a bank recapitalization program, and introduction of foreign exchange (FX) facilities—were broadly appropriate to stabilize confidence. In view of the still-elevated external uncertainties, policies should continue to be prudent and aim at a careful use of the existing buffers to maintain macroeconomic stability. In particular: 

• Monetary policy normalization should continue at a pace commensurate with the decline in underlying inflation and inflation expectations. The acceleration in inflation up to March reflected the one-off impact of ruble depreciation and countersanctions. The economic slowdown, recent ruble appreciation, and the partial wage indexation in the 2015 budget will support disinflation. However, the pace of easing needs to be balanced against uncertainties over the external outlook, the potential for second-round effects, and the central bank’s need to build credibility under the recently introduced inflation targeting regime.

• The re-pricing of the FX liquidity facilities was adequate. The central bank could consider limiting further the FX allotments to ensure that the facilities remain sufficient for emergency purposes. The announced program of FX purchases to build precautionary buffers is welcome. The strategy could be strengthened by indicating the time-frame the central bank expects to be conducting these operations, thereby avoiding an open-ended policy that may be misconstrued as targeting an exchange rate level.

• The fiscal stance for 2015 is appropriate. The general government non-oil deficit is expected to deteriorate to about 13 percent of GDP in 2015. This is justifiable given cyclical considerations and available fiscal space. However, the use of off-budget measures—investment by the National Wealth Fund and issuance of guarantees—should be coordinated to avoid an overly stimulative fiscal stance.

• Fiscal consolidation over the medium-term is necessary to adjust to lower oil prices and rebuild buffers. Although the projected non-oil deficits are expected to improve over time, they will remain relatively large, considerably depleting the Reserve Fund. Moreover, fiscal consolidation efforts could be undermined by the implementation of the current fiscal rule and full indexation of pension benefits, especially in 2016. The needed fiscal adjusment should safeguard productive spending, such as public investment and education, and be anchored by revisiting the fiscal rule. In addition, it should be accompanied by permanent fiscal measures which could include (i) pension reform, (ii) reducing energy subsidies, and (iii) better targeting social transfers.

• The authorities’ use of regulatory forbearance and public support has been successful in stabilizing the banking system. The forbearance strategy was appropriately combined with intensified supervision, but should be strengthened by increasing transparency with regards to asset quality to further improve market confidence. The total amount of funds allocated to the recapitalization program appears to be sufficiently large to support the 27 banks that were already identified. Finally, the plan to lift forbearance along with the implementation of the recapitalization program is welcome.

• The parameters of the recapitalization program should be adjusted to strengthen incentives. The current context could justify the use of public funds, but only banks identified ex ante as systemically important should be eligible. The cost of the capital support should be increased to strengthen the banks’ incentive to seek private sector capital. Banks receiving public support should not be forced to increase lending given the risks for credit quality, future losses, and potential inefficient credit allocation. Finally, when requiring private shareholders to co-finance the capital injection, the authorities should aim to achieve a level playing field between private and state-controlled banks.

The medium term growth outlook is mediocre due to low potential growth. Boosting growth requires re-invigorating the reform agenda. In that context, avoiding de-integration from the world economy, coupled with less regulation and a reduction of the government’s role in the economy remain crucial to foster efficiency, confidence and investment. Specific reforms could include (i) improving protection of property rights, (ii) enhancing customs administration and reducing trade barriers, and (iii) empowering the Federal Antimonopoly Service (FAS) to eliminate entry barriers to several sectors/markets. In addition, to improve labor force dynamics in the face of negative demographic trends, pension reform should be a priority. Finally, reducing banking sector fragmentation by continuing the ongoing intensification of supervision, tightening capital standards through the implementation of Basel III, and further strengthening the role of credit bureaus and collateral registries, would help improve capital allocation, thereby enhancing potential growth.