Public Information Notice No. 05/130

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Russian Federation

September 21, 2005

On September 7, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federation.¹

Background

Russia is in its seventh year of robust economic growth. This strong performance was ignited by the sharp depreciation in the wake of the 1998 crisis, and subsequently sustained by large terms-of-trade gains, in combination with increased political and macroeconomic stability. Higher output and investment in the oil sector have been key conduits of the broad based recovery, which is still running its course.

While still vibrant, the economy has softened notably since mid-2004, despite record high oil prices. Yearly GDP growth decelerated from 7½ percent in the first half of 2004 to 5½ percent in the same period this year, mainly owing to lower growth in oil production and investments. Consumption has remained buoyant and has been the main source of domestic demand growth, fueled by continued rapid increases in real wages.

The softening mainly reflects a confluence of policy induced supply disruptions and jolts to the investment climate. The Yukos affair has triggered serious concerns about state interventionism and the government's commitment to reinvigorate flagging structural reforms. The sharp rise in oil taxation since the middle of last year might also have taken a toll on oil output and investments, although profitability in the oil sector has remained high amid rising oil prices.

The softening is also likely to have been due to the gradual tightening of resource constraints that has been evident for a number of years, not least in the oil sector and in labor markets in high-growth areas. Reflecting such resource constraints, the acceleration in domestic demand growth in 2004 as a whole spilled over into much higher imports, but left GDP growth unchanged compared to 2003.

Fiscal policy has offset much of the stimulus arising from the large terms of trade shock. The headline surplus of the general government has increased every year since 2001 as the government has taxed and saved much of the rapidly increasing oil revenues. Under the current oil price outlook, staff projects that the budget will entail an overall surplus of 7½ percent of GDP in 2005, up from 5 percent of GDP in 2004, and 6½ percent of GDP in 2006.

However, the underlying fiscal stance is being relaxed, until recently gradually, and now more rapidly. The fiscal surplus on a constant oil price basis has been declining, except in 2004, as the government has gradually increased spending of oil revenues. This relaxation has taken place at a time of tightening resource constraints and buoyant overall demand and has therefore contributed to inflationary pressures and a faster pace of real ruble appreciation. Still, the relaxation was measured until recently, but is set to quicken significantly following the amendment of the 2005 budget. Preliminary plans for 2006 entail a further relaxation. The relaxation has required an increase in the benchmark price below which oil revenues are not saved in the stabilization fund from US$20 per barrel to US$27 per barrel.

Monetary policy remains relatively lax. While reserve money growth has slowed somewhat since mid-2004, mainly because of an accelerated build-up of government deposits with the Central Bank of Russia, it remains high, as do the increases in broader aggregates. Rising inflation, declining interest rates, and large capital outflows point to a continued accommodative stance.

The economy is expected to continue to grow robustly, although not at the pace seen before last year's slowdown. Staff projects GDP growth of 5½ percent in 2005, fuelled by consumption. Both exports and investment are expected to remain subdued compared to previous years, high oil prices notwithstanding, as concerns about the investment climate linger and supply constraints in the oil sector are unlikely to ease in the near future. Inflation, which was already running at an annual rate of 7¾ percent in the first half of 2005, is likely to exceed the official target again this year. External vulnerability has been greatly reduced since the 1998 crisis owing to a very favorable balance of payments position and large foreign reserves of more than 3½ times short term debt.

Executive Board Assessment

Directors commended the strong performance of the Russian economy in recent years, which has been due not only to high oil prices, but also to a generally prudent fiscal policy stance. Under the current outlook for oil prices, Directors expected economic growth to remain robust and external vulnerabilities low over the near term. Directors saw the strong fundamentals as creating a window of opportunity to propel forward the structural reform agenda, which is lagging behind in key areas.

Directors considered that the policy of gradually escalating the taxation and saving of oil revenues as oil prices have surged has served Russia well, by preventing over-heating in the face of limited productive capacities in the non-tradable sectors. At the same time, a number of Directors recognized the growing pressures to relax the fiscal stance against the background of the country's social and infrastructure development needs and large oil revenue inflows. Nevertheless, noting emerging capacity constraints in some sectors, Directors were generally concerned that the recent significant and pro-cyclical relaxation of fiscal policy, with amendments to the 2005 budget and plans for 2006 that would weaken the non-oil fiscal balance, would exacerbate already-rising inflationary pressures and quicken the pace of real ruble appreciation.

Directors therefore strongly advised that fiscal policy not be loosened further. To that end, the benchmark price above which oil revenues are saved in the Oil Stabilization Fund (OSF) should not be increased again; the use of the OSF should continue to be limited to the prepayment of debt; and additional higher-than-budgeted revenues from oil should be saved. Directors also pointed to the risks associated with increasing spending while key reforms are lagging. While they acknowledged the need to raise public sector wages and pensions, bolster infrastructure investment, and strengthen poverty-alleviating public services, they were concerned that the necessary reforms to modernize and rationalize related social and public administration infrastructure to ensure spending efficiency in these areas were not yet in place. Directors also cautioned that steadily increasing recurrent expenditures that do not raise potential growth rates could worsen the risk of having to undertake a sharp pro-cyclical fiscal tightening in the event of a large drop in oil prices.

Directors recognized that, over the medium term, and once cyclical pressures ease, there will be scope for fiscal relaxation, even over and above the expected budgetary cost of the needed structural reforms. They observed that Russia's oil wealth, if utilized to underpin reforms that raise potential growth rates, including tax reforms, can lay the basis for accelerating the modernization of the economy. More broadly, Directors encouraged the authorities to develop an integrated medium-term fiscal and structural reform plan for utilizing Russia's oil resources.

Regarding monetary and exchange rate policies, most Directors considered the practice of targeting both inflation and the exchange rate to be unsustainable, and called on the Central Bank of Russia to clearly signal to markets that the inflation target takes precedence over other objectives. They urged the CBR to allow the ruble to appreciate if inflation runs above the targeted path. In that vein, most Directors expressed concern that continuing to let real exchange rate concerns bear on monetary policy, even as fiscal policy is being relaxed, will impart an inflationary bias into the macroeconomic policy mix.

Directors were encouraged by the progress made in banking sector reforms. Systemic risks are low and appear manageable, and the process of determining the eligibility of banks for the new deposit insurance scheme appears to have strengthened prudential standards. However, many Directors were concerned with the consequences of continuing regulatory forbearance; in this regard, they noted that in some cases, the standards for admitting banks to the insurance scheme may have been interpreted too leniently. Directors cautioned that, without supervisory vigilance, the rapid increase in banks' balance sheets could raise systemic risks, particularly in the event of a major drop in oil prices.

Directors were concerned that, with ample oil revenues, complacency has set in and key structural reforms have come to a virtual halt. They saw the recent weakening in investments and slowdown in economic growth even as oil prices have surged as a sign that high growth may be difficult to sustain over the medium term without a more determined effort to accelerate reforms. In this regard, priority should be given to reforms that could bolster the investment climate, nurture new private enterprises, and promote economic diversification, especially civil service and public administration reforms.

Directors observed that the Yukos affair had given rise to concerns about state intervention and heavy-handedness on the part of regulatory and law enforcement agencies. They welcomed attempts by senior officials to reassure investors, but noted that concerns in this regard are likely to linger as long as reforms lag.

Directors welcomed the removal of the exchange restrictions and multiple currency practices on current transactions that had been identified previously. However, they urged the authorities to remove quickly the new restrictions that have resulted from implementing regulations accompanying the new Federal Law on Foreign Exchange Regulation and Foreign Exchange Control.

Directors welcomed Russia's subscription to the Special Data Dissemination Standard in January 2005. They noted that Russia's economic and financial statistics are broadly adequate for surveillance purposes, but expressed some concern about data accuracy and the frequency of data revisions.

Directors welcomed the prepayment of all of Russia's outstanding financial obligations to the Fund, and its participation in the Fund's financial transactions plan.