Russian Federation: Concluding Statement for the 2014 Article IV Consultation Mission
April 30, 2014
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The Russian economy, already slowing because of pre-existing structural bottlenecks, has been further affected by geopolitical uncertainties arising from conflict between Russia and Ukraine. Growth is expected to ease to 0.2 percent in 2014, with considerable downside risks. To safeguard against risks, the current macro framework should be further strengthened to provide a credible policy anchor. Monetary policy should focus on reducing inflation, and more exchange rate flexibility should provide a buffer against external shocks. Adherence to the fiscal rule should continue, with additional consolidation in the outer years. Revitalizing the government’s structural reform agenda is essential to provide the needed catalyst to growth.
Geopolitical tensions and structural bottlenecks take a toll on growth
1. GDP growth is slowing down significantly. In 2014, Russia’s growth is expected to continue its slowing trend to 0.2 percent, from 1.3 percent in 2013. Investment will further contract due to the uncertainty around the geopolitical situation. Capital outflows increased significantly in Q1 2014 to US$ 51 billion. While still strong, the pace of consumption growth—supported by wage and credit growth—has begun to slow. Net exports are expected to support growth, as imports are weakening, with the current account surplus projected to increase to around 3 percent of GDP. A slight recovery in growth to 1 percent is projected in 2015, on the back of stronger exports and an uptick in investment. However, unaddressed structural bottlenecks and stagnant investment are reducing potential output over the medium term.
2. Short-term risks are squarely on the downside. Current projections are contingent upon a gradual resolution of the geopolitical tensions; continued conflict could lead to additional sanctions and worse outcomes. Even in the absence of further intensification, continued uncertainty and the resulting deterioration of confidence may reduce investment and consumption further. In addition, Russia’s economy and public finances remain very sensitive to oil prices. The impact of these risks on external sustainability is mitigated by sizeable buffers, including large international reserves, low headline budget deficits, and low net public debt. However, their materialization would imply a substantial setback to the growth outlook.
3. Faced with exceptional circumstances, policies should aim in the near-term at preserving macroeconomic stability. In recent years, Russia has considerably improved its macroeconomic framework with the adoption of a fiscal rule, the preparation for inflation targeting, and the implementation of increased exchange rate flexibility. A commitment to continuing this reform agenda would provide an important policy anchor at this juncture.
4. A new growth model needs to emerge with an economy integrated with the world. After almost 15 years of growth based on rising oil prices, successful macroeconomic stabilization policies, and increasing use of spare resources, this growth framework has reached its limits. A new growth model needs to emerge to realize the full potential of the economy. More integration with the world economy should help close the productivity gap with other countries, foster investment and diversification, and enhance growth. On the other hand, less integration with the world economy would slow this process, missing out on available opportunities for technological transfers and the exploitation of comparative advantages. Decisive adoption of long-overdue structural reforms would improve market confidence.
Monetary and financial policies appropriately focused on anchoring inflation expectations and preserving financial stability
5. A tighter monetary stance is required over the next year to attain the 2015 inflation target. Due to the increase in food prices and the depreciation of the ruble, inflation reached 7.2 percent at the end of April and is expected to remain over 6 percent at year end. The recent cumulative increase of 2 percentage points of the policy rates signaled a strong commitment of the Central Bank of Russia (CBR) to contain recent inflationary pressures. Nonetheless, this monetary tightening will likely not suffice to bring inflation to the CBR’s target of 5 percent, given the size of the ruble depreciation year-to-date and the lag in the impact of monetary policy. The CBR should stand ready to raise further its policy rates over the next year to meet its 4.5 percent inflation target in 2015 and anchor inflation expectations in the transition to a full-fledged inflation targeting framework. Higher rates would also help reduce capital outflows that have emerged amid tightening of global liquidity and rate hikes by major emerging markets’ central banks.
6. The CBR should resume its policy towards greater exchange rate flexibility as soon as the current uncertainties subside. Enhancing exchange rate flexibility and using interest rates as the main policy instrument would ensure a successful transition to inflation targeting. Exchange rate flexibility provides an important buffer against external shocks—in particular if the shocks and the associated currency stress are prolonged. As soon as the situation permits, the CBR should gradually simplify and eliminate its intervention bands, lower the size of cumulative interventions required to move the exchange rate corridor, and increase the size of the corridor shifts.
7. Recent financial turbulence requires heightened scrutiny of financial stability. Current geopolitical tensions are negatively affecting access to external financing. Even though many corporations benefit from foreign exchange receipts and appear to have enough buffers to deal with the current negative sentiment, close monitoring of systemic risks remains warranted. The banking system appears sound, with a large net foreign asset position, sufficient provisioning for non-performing loans and adequate capitalization. Nonetheless, the uncertain geopolitical environment combined with a slowdown in growth could have an adverse impact on banks’ profitability and asset quality. The CBR should continue to monitor any systemic risk build-up via its regular stress testing exercises and increased oversight.
8. Continued strengthening of banking supervision is welcome. The recent intensification of banking licenses withdrawals from mostly very small banks has signaled a strong commitment by the CBR to deal with weak banks and violators of money-laundering laws. This increased supervision will strengthen the stability of the banking system and support the necessary consolidation of the sector. The CBR should continue to communicate widely and effectively its intended goals in order to maintain depositors’ confidence.
9. Systemic risk from unsecured retail lending appears limited but continued oversight is still warranted. The prudential measures taken by the authorities, including tightening risk weights and raising provisioning, have reduced growth of unsecured consumer lending from its peak of 60 percent reached in mid-2012 to 30 percent at end-2013. Enacted legislation to tighten regulation over predatory lending rate practices will contribute to further reducing unsecured retail credit growth. Continued oversight remains warranted to ensure the effectiveness of the recently enacted legislation and prudential measures.
Fiscal policy appropriate in the near term; consolidation warranted in outer years
10. The fiscal stance remains appropriate for 2014. The non-oil balance is expected to improve by 0.7 percent of GDP this year, following a reduction in VAT refunds related to the completion of large infrastructure projects and the implementation of the fiscal rule. This modest fiscal tightening, despite the economic slowdown, appears justified as output remains close to potential. In addition, adhering to the fiscal rule is essential to support its credibility given the current uncertain environment and the needed medium-term fiscal consolidation. However, in view of the limited size of automatic stabilizers, temporary and targeted discretionary fiscal policy measures could be considered in the event of a more severe and prolonged economic downturn.
11. Mounting spending pressures should be resisted in order to preserve fiscal space for investment. Promises to further increase military and wage spending, increased fiscal commitments deriving from geopolitical tensions, and incomplete pension reform could weigh negatively on future budgets. This recurrent spending could crowd out necessary public investment and slow fiscal consolidation. Local governments are particularly sensitive to budgetary loosening to fulfill the 2012 electoral promises given weak tax revenues.
12. Additional fiscal consolidation in the outer years is needed to rebuild buffers. The current non-oil deficit remains very high and the overall deficit is low only due to high oil prices. While the fiscal rule continues to be an important policy anchor, it does not generate enough savings in the long run to meet the stated Reserve Fund target of 7 percent of GDP. Raising savings to a more appropriate level would require more conservative assumptions during the budget process. Even more fiscal consolidation would be required for intergenerational equity considerations and to offset Dutch disease effects.
13. Further pension reform is necessary. Despite the recent reform, the generosity of the system is expected to decline over time and may become too low to be socially and politically acceptable, leading to fiscal pressure. Additional measures to ensure the viability of the system while keeping its generosity at an acceptable level may be needed, including increases in the retirement age, legal employment, and contribution compliance.
Structural reforms crucial to ensuring higher and sustained medium-term growth
14. Structural reforms remain essential to enhance Russia’s growth potential. Continued efforts at global integration—fostering competition across sectors and regions, improving governance, and lifting heavy regulations—are necessary to attract high-quality investment and boost potential growth. Reforms discussed in the context of the stalled OECD accession negotiations should continue, as skill mismatches in the labor market, large tax burdens, especially for SMEs, and administrative barriers and corruption remain key obstacles. Pushing ahead with the announced privatization plans should enhance economic efficiency. These reforms would be invaluable in channeling domestic savings into domestic investment, as well as attracting foreign investment, permitting development of a diversified economic base for attaining higher and sustainable growth over the medium term.