Public Information Notice No. 02/40

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Russian Federation

April 4, 2002

On March 8, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federation.¹

Background

Despite a weaker external environment, macroeconomic performance was very strong in 2001. Output grew steadily, the federal budget registered a large surplus and the current account surplus, while narrowing significantly, remained large. The strong balance of payments led to a large accumulation of reserves. The net external inflows were partially sterilized which prevented a nominal appreciation of the ruble but led to a rapid growth in monetary aggregates. As a result, inflation exceeded the authorities' target of 14 percent. Structural reforms accelerated with significant progress in a broad range of areas. As a result of the strong macroeconomic performance, improved investment climate, and political stability, Russia's stock market index increased dramatically and spreads on sovereign Eurobonds narrowed sharply as ratings agencies provided a series of upgrades. Russia's first sovereign Eurobond was paid on schedule and negotiations with holders of some Soviet-era claims advanced with restructuring agreements reached with a number of creditors. Non-sovereign borrowers regained access to international capital markets.

Output grew by 5.2 percent, driven by domestic demand as the contribution from net exports and government consumption was negative. Growing real wages and buoyant consumer confidence fostered growth in real private consumption. Investment growth, however, slowed as rising real wages and the real appreciation of the ruble reduced enterprise profitability. Hardening budget constraints produced a decline in barter, and the unemployment rate fell below 8½ percent.

Fiscal policy strengthened further with an overall surplus of about 2½ percent of GDP. Budget revenues increased due to improved tax compliance, strong energy exports, and high VAT collection from robust consumption demand. Expenditure continued to be restrained, with a modest increase in federal noninterest expenditures due to increased transfers to the regions and greater social spending. Balances of the enlarged government, however, deteriorated due to smaller surpluses of extrabudgetary funds as pensions/social benefits were increased to partly offset the real decrease in these payments since the crisis.

The current account surplus narrowed sharply to 11 percent of GDP as the continued real exchange rate appreciation and robust consumption demand led to higher imports. The decline in energy exports was modest as rising export volumes partly offset falling energy prices. Non-oil exports stagnated due to depressed commodity prices and slowing world demand. Net private capital outflows, though still large, slowed, possibly due to an improved investment climate and lower returns in mature and other emerging markets. As a result, there was a healthy accumulation of international reserves which reached US$36.5 billion (5½ months of imports) at year-end.

For much of the year monetary policy attempted to deal with the strong balance of payments without endangering growth prospects, against the backdrop of an uncertain increase in money demand. In this setting, the Central Bank of Russia (CBR) attempted to moderate the pace of the appreciation of the real exchange rate by partially sterilizing external inflows. This process was aided by the strong fiscal performance as well as the sterilization operations conducted by the CBR. Inflation during the year amounted to 18.6 percent, exceeding the authorities' target of 14 percent, due to the above factors as well as increases in administered prices.

Structural reforms focused on strengthening the investment climate through a combination of tax reform, deregulation, enhancing property rights, and developing financial markets and institutions. Tax reforms simplified the tax system, reduced the tax burden, and broadened the tax base. New laws were introduced on business registration, licensing, and inspections; a new Land Code established the general principle of land ownership for urban land; and a new Labor Code liberalized the hiring and firing of workers and clarified employees' rights. Reform strategies for the railways and the electricity sector were approved, aiming to restructure, liberalize, and privatize potentially competitive segments of these markets. A number of measures were introduced to liberalize both current and capital account transactions. Progress was also made with financial sector reform: amendments to banking legislation were approved strengthening the legal framework for banking supervision and restructuring, a pilot scheme was initiated for introduction of International Accounting Standards (IAS) and anti-money laundering legislation was adopted. The CBR and the government also approved a concept paper for the development of the banking system, but concrete proposals are yet to be developed in this area.

Executive Board Assessment

Executive Directors commended the authorities for Russia's impressive macroeconomic performance in 2001, which followed earlier gains in competitiveness and strong energy exports that had boosted growth in the three years since the 1998 crisis. Directors also welcomed the authorities' strong record of fiscal consolidation. The large fiscal and external surpluses have led to a significant buildup in reserves and have positioned the Russian economy to weather the more recent pressures generated by a less favorable external environment. Encouraging progress has also been made in advancing structural reforms in several key areas including tax, pension, land, labor, and judicial reform.

Directors supported the thrust of the policy stance for 2002, and agreed that the authorities' main priorities for the period ahead should be to continue prudent macroeconomic policies while making a determined effort to ensure the timely implementation of key structural reforms. Looking ahead, they also considered that continued vigilance and readiness to adjust the overall policy stance as needed, together with the cushion provided by the strong external reserve position, should allow the authorities to cope with possible adverse developments.

Directors noted that the recent strength in Russia's fiscal and external positions has created room for a prudent relaxation of the underlying fiscal stance over the medium term without jeopardizing fiscal or external sustainability. The proposed relaxation of fiscal policy in 2002 should serve to support growth in the face of an external environment that is likely to be weaker than in recent years. The envisaged fiscal easing will allow a partial unwinding of the expenditure compression that occurred in the aftermath of the crisis and, in the context of the expected weakening of the external position, this easing should not place undue sterilization demands on the CBR that could crowd out the private sector. Directors welcomed the various provisions included in the budget that would ensure that it remains financed, including through automatic expenditure adjustments, in the event of unanticipated declines in oil revenues.

Directors noted that fiscal developments remain subject to risks emanating from lower than anticipated growth, lower energy prices, and difficulties in achieving expenditure reduction at subnational levels, which will require careful monitoring. In particular, if economic activity turns out weaker than anticipated, it will be important to take timely action against any weakening of tax compliance or resurgence of nonpayment/barter practices. Directors cautioned that the room for fiscal relaxation should be used prudently, as many of the remaining structural reforms will have significant fiscal implications. A number of Directors also stressed the need for wage moderation in the public sector. Noting the importance of sound local government finances for achieving the budgetary objectives, Directors welcomed the authorities' intention to strengthen the federal Treasury's monitoring of local government finances, and they looked forward to the completion of the extension of the federal Treasury to regions with weak financial positions. They also supported the authorities' intention to introduce a three-year fiscal plan.

Directors were of the view that monetary policy should target a lasting reduction in inflation. They noted that the conduct of monetary policy is now less likely to be complicated by the large current account surpluses and the upward pressures on the ruble that could have jeopardized output recovery in previous years. Directors urged the CBR to hold firm on containing inflation, including through sterilization if the balance of payments were to turn out stronger than anticipated. In the latter case, the government should support monetary policy by saving higher fiscal surpluses, as it has done in the past. Directors also cautioned against delaying justified increases in administered prices to suppress inflation.

Directors considered that, over time, the real value of the ruble should be expected to appreciate in line with productivity gains. In light of the significant impact of volatile energy prices, most Directors recognized that the authorities' policy of limiting the pace of real appreciation of the ruble remains appropriate, given the need to protect growth prospects in the nonenergy tradable sector, which is vital for fostering medium-term growth.

Directors welcomed the recent impetus to structural reforms, but noted that the remaining agenda is vast, and sustained implementation of reforms remains a key challenge. They endorsed the authorities' focus on reforms directed at enhancing long-term growth prospects and economic diversification through improvements in the investment climate that would help to attract greater foreign direct investment and encourage the development of small- and medium-sized enterprises. Directors singled out financial sector reform and strengthening property rights through judicial and land reform as being particularly important. More broadly, the authorities should continue to make progress on improving public sector administration and corporate governance, including through reporting according to International Accounting Standards. They also noted that reform of the natural monopolies, in particular of the energy and railway sectors, and of housing and communal services, will be essential components of a successful restructuring of the economy. Directors were encouraged by the priority that the Russian authorities attach to joining the World Trade Organization.

Directors welcomed the government-CBR concept paper on financial sector reform, and encouraged the articulation of this statement of broad policies into a clear, operational strategy to be implemented consistently. They highlighted, in particular, the importance of broad-based measures to stimulate competition within the banking system, including the development of a clear strategy for the future of the state banks. Directors cautioned against the premature introduction of deposit insurance in the absence of a significant strengthening of regulatory and supervisory capacities. They welcomed the authorities' decision to participate in a broad-based Financial Sector Assessment Program, whose forward-looking approach should lay the groundwork for future reforms in the financial sector.

Directors stressed that initiatives to amend the Central Bank Law should not undermine the CBR's independence in conducting monetary policy nor burden the CBR with potentially conflicting objectives. Any amendment should ensure that the task of achieving low inflation remains the primary objective of the CBR, and that the CBR has sufficient autonomy in the conduct of monetary policy to achieve this objective. Several Directors urged the CBR to enhance the transparency of its operations and to divest its holdings in commercial banks. A few Directors suggested that, over time and when the necessary institutional framework is in place, the adoption of an inflation-targeting framework could greatly enhance the transparency and effectiveness of monetary policy.

Directors welcomed Russia's efforts to fight money laundering and combat the financing of terrorism. With new money laundering legislation—which strengthens the legislative base and institutional infrastructure—now in place, Directors urged the authorities to ensure the full implementation of the newly enacted measures, and to take the steps needed to freeze terrorist assets.

Directors welcomed the steps taken by Russia to liberalize exchange restrictions in 2001, and encouraged the authorities to develop a time-bound plan for the removal of the remaining exchange restrictions. They commended the authorities' progress in regularizing relations with external creditors and looked forward to continuing good performance in this area.

Directors also encouraged the authorities to take additional steps to strengthen data collection and transparency, particularly with regard to the national accounts.