In early September 1998, the Russian economy was in a dire situation. The exchange rate peg that had been the linchpin of the stabilization effort had been abandoned, with the exchange rate promptly falling from Rub 6.2 per U.S. dollar on August 1 to Rub 20.8 per U.S. dollar on September 9, and inflation soaring to 38 percent for the month of September. The banking system was in disarray—the capital of many of the large private banks had been wiped out and they were struggling to preserve their solvency by delaying processing of transactions and limiting access to deposits. As a result, the payments system broke down as settlement risk became too high, enterprises were unable to access trade financing or even working capital, and output fell sharply. The government, having run out of financing sources and facing declining revenues, simply ran arrears.

In early September 1998, the Russian economy was in a dire situation. The exchange rate peg that had been the linchpin of the stabilization effort had been abandoned, with the exchange rate promptly falling from Rub 6.2 per U.S. dollar on August 1 to Rub 20.8 per U.S. dollar on September 9, and inflation soaring to 38 percent for the month of September. The banking system was in disarray—the capital of many of the large private banks had been wiped out and they were struggling to preserve their solvency by delaying processing of transactions and limiting access to deposits. As a result, the payments system broke down as settlement risk became too high, enterprises were unable to access trade financing or even working capital, and output fell sharply. The government, having run out of financing sources and facing declining revenues, simply ran arrears.

The prognosis was not encouraging. Most observers anticipated some rebound in the economy, driven by the tradable sector in response to the exchange rate depreciation, but there was no confidence that the recovery would be quick or sustained. Indeed, almost all observers predicted a significant decline in output in the year following the crisis. Not only was the economy having to deal with a massive exchange rate depreciation and a default on domestic government debt—in most countries the risk-free asset—but, unlike the Asian economies that had a history of dynamic growth and low inflation, the economy was still facing significant structural obstacles to sustainable growth. The basic issues to be addressed were well known to Russian policymakers: a large budget deficit arising from an inability to collect taxes and contain expenditure; a large short-term domestic debt; the lack of structural reform in the banking, natural monopoly, and agricultural sectors; and soft budget constraints throughout the economy. In the immediate aftermath of the crisis, it was difficult to see how the government could generate the necessary political consensus to take decisive action. Even the basic direction to be taken was up in the air, as the reformers who oversaw the 1998 meltdown were replaced by more seasoned appointees—Mr. Yevgeny Primakov as prime minister and Mr. Viktor Gerashchenko as governor of the Central Bank of Russia (CBR)—and the Duma, which had frustrated earlier attempts at more rapid structural reform, remained a questionable ally.

And yet, the crisis has been followed by four successive years of strong macroeconomic outcomes and macroeconomic policymaking. Output, after declining almost every year prior to the crisis, has increased by a cumulative 25 percent during the past four years. Barter has largely disappeared, and even the large natural monopolies—Gazprom, Unified Energy Systems of Russia (UES of Russia), and the railroads—are conducting almost all of their domestic operations in cash. The budget has recorded strong surpluses, international reserves are at record levels, and the economy has appeared immune from pressures in other emerging markets—Argentina, Turkey, and Brazil—with Russia being seen as a relatively safe haven. Furthermore, there is renewed interest in international capital markets in holding Russian financial assets: Russian bond and equity markets have been among the best performers in the world in the past couple of years.

This chapter examines how this remarkable transformation occurred. The first section discusses the crisis itself, focusing on developments in July and August 1998 and the emergency measures announced by the government. The second section examines the initial rebound in 1999, focusing on how the policy response was shaped by the specifics of the Russian situation and how the economy responded to the policy package. The third section focuses on the period of healthy growth since late 1999 and attempts to draw out the roles of the various elements that have contributed to the strong macroeconomic performance. To some degree, luck played a key part—recovery from a crisis is always easier when the prices of the major exports (oil and gas) more than double. However, other factors were also at work, including the postcrisis exchange rate depreciation and a clear strengthening of macroeconomic policymaking and fiscal responsibility, perhaps motivated by the desire to ensure that such a crisis would not happen again. The final section highlights a couple of key macroeconomic policy challenges that need to be resolved to assist in ensuring that the macro environment remains supportive of growth.

The Crisis

The question of whether the debt default and collapse of the exchange rate peg were inevitable (and desirable) or whether, with committed policy implementation, Russia could (and should) have avoided them has been debated in many forums (for example, see Kharas, Pinto, and Ulatov, 2001, and the accompanying discussion). The basic issue is whether government debt, which had increased rapidly, was on an unsustainable path. This depended on expectations of future fiscal balances, the growth rate of the economy, and the projected path for interest rates. Thus, as long as the markets believed that fiscal adjustment was coming and that the economy was breaking out of the output decline that had occurred from the early days of the transition, then the large financing needs in the near term were not critical, and Russia’s short-term debt could simply be rolled over.

In the event, abandonment of the peg came as a surprise. Russia had weathered several rounds of strong pressure on the peg during late 1997 and early 1998 by tightening monetary policy, with associated sharp increases in interest rates and some loss of reserves. The stock market bubble had already burst in the second half of 1997. The external environment was weak, as global commodity prices remained depressed in the absence of a recovery in Asia, and capital flows to emerging markets were negative. Growth, which had turned positive in the third quarter of 1997, for the first time since the beginning of the transition had returned to negative territory but no more than would be expected given the global trends. In June 1998, following a period of intense discussions, agreement was reached with the IMF and other creditors on a new international financing package that served to significantly reduce pressure on interest rates and the exchange rate—yields on GKOs (Gosudarstvenny’e Kratkosrochny’e Ob’azatel’stva; short-term treasury bills that were a key tool for financing the fiscal deficit) fell from nearly 200 percent on July 10 to 54 percent by July 15. The Executive Board of the IMF formally approved its part of the new financing package with Russia on July 20, 1998. The new IMF credits, combined with additional financing commitments from the IMF, the World Bank, and Japan, implied that $21.5 billion of financing would be available to Russia during the remainder of 1998 and 1999, provided, of course, that the programs were implemented.

These positive developments were soon overturned, however, when, in early August, the Duma refused to support key fiscal measures underlying the program with the IMF. The credibility of the government’s announced future fiscal adjustment dissipated and, by mid-August, GKO yields had risen again to almost 300 percent and reserves, during a two-week period, fell by $3½ billion to $13 billion—equivalent to just over 2 months’ worth of imports.

Despite repeated denials by senior officials, including President Yeltsin himself, that the exchange rate would be devalued, the authorities announced a series of emergency measures on August 17, 1998, in an attempt to quell the pressure on reserves. Key elements were

  • an adjustment to the exchange rate band from 5.3-7.1 rubles a dollar to 6.0-9.5 rubles a dollar, to be in effect for the remainder of 1998;

  • a default on ruble-denominated government debt maturing before end-1999, with the government announcing its intention to restructure these obligations into longer-term paper;

  • a 90-day standstill on the servicing of private sector external debt payments, including payments on forward foreign exchange contracts; and

  • an announcement that capital controls would be introduced.

Market reaction to the package of emergency measures was, predictably, extremely negative. Uncertainty about the terms of the debt restructuring, the announced intention to introduce capital controls, and the absence of any new initiatives to solve the underlying fiscal problem created a surge in demand for dollars as nonresidents sought to exit and residents sought a safe haven.

The IMF, while not fully supporting the package, acknowledged that the failure to restore market confidence in late July and early August had required drastic measures to stem the reserve loss, including a change in the exchange rate regime (IMF, 1998a, 1998b). On this basis, although the IMF opposed the unilateral restructuring of debt, it did not rule out continued disbursements under the existing program (the next disbursement was scheduled for mid-September) and urged the authorities to work with creditors to try to find a cooperative solution to the debt issue. The message from the IMF clearly stressed, however, that the prompt passage by the Duma of the necessary measures to strengthen the fiscal situation was essential.

Rather than the government and the Duma uniting to push through the fiscal measures that were so badly needed, more political uncertainty ensued. Prime Minister Sergei Kiryenko was fired on August 23, 1998. President Yeltsin proposed that Mr. Viktor Chernomyrdin, who was prime minister from December 1992 through March 1998, replace him, but this was rejected twice by the Duma. Faced with the choice of proposing Mr. Chernomyrdin a third time—thereby forcing the Duma to either accept him or, consistent with the constitution, to be dissolved, thus requiring new elections—President Yeltsin nominated, instead, Mr. Primakov—a former member of the Central Committee of the Communist Party and, from 1996, the minister of foreign affairs. Mr. Primakov, with broad political support, including from both the Communist Party and the reformist Yabloko Party, was approved by the Duma in its first vote on September 11.

In the face of the political vacuum and despite large-scale interventions by the CBR, the ruble quickly fell to the edge of the new exchange rate band and the band was abandoned on September 2, leaving the exchange rate to float. The ruble sank to 20.83 per U.S. dollar on September 9 but stabilized by the end of the month at 16.1 rubles per U.S. dollar. The stock market, which was in mid-August already down two-thirds relative to its end-September 1997 peak, halved in value again by end-September.

Policy Response

The new government that was formed in mid-September faced the daunting task of designing a policy package to address these issues. The policy package needed to lay the foundation for the restoration of growth and stabilize the exchange rate and prices, against the background of a collapse in output and basic market mechanisms. To be credible, the package would also need to address the longer-term issues (especially the fiscal policy stance) that had generated the crisis in the first place. Not surprisingly, it took time for a consensus to emerge on the overall policy package. In fact, it was only on October 31 that the government formally adopted an anticrisis plan—the Maslyukov Plan. While containing several elements that were ultimately implemented—an export tax to capture the windfall gains from the exchange rate depreciation, a reduction in the profit tax rate, and indexing of specific export taxes—the plan did not constitute a viable policy option. Rather, it mostly served to highlight the internal contradictions faced by policymakers who desired a more active role for the state in managing the transition but lacked financial resources (Box 2.1). The plan included a series of fiscal policy initiatives to support growth—reductions in tax rates, subsidies to the industrial sector, public works programs, and a strengthened social safety net—that would have produced a sharp increase in the fiscal deficit and, absent massive external financing, was inconsistent with the targeted reduction in inflation to about 50 percent in 1999.

The delay in formulation of a credible policy response resulted in a decision by the international community not to provide a large external financing package in late 1998 (or even to continue with disbursement of the financing package announced in July 1998). This was naturally a cause of considerable frustration for senior Russian officials. However, the reluctance of official creditors to provide unconditional financing reflected a history of financing programs that were only selectively implemented. The assessment was that providing substantial financing would have just postponed (again) the much-needed adjustment, especially to the public finances. Thus, the provision of financing was delayed until the authorities had developed a clear strategy, achieved its passage through the Duma, and demonstrated their commitment to seriously tackle the fiscal imbalances by pursuing politically difficult measures to raise revenues. Ultimately, the delayed provision of financing ensured a strong program owned by the authorities.

Public Perceptions of the Crisis and the Needed Policy Response

The political response to the crisis was to bring back to power some of the older, more seasoned, politicians and move away from the younger reformers who were perceived as having brought on the crisis. Thus, the old hands—Primakov, Maslyukov, and Gerashchenko—were restored to power and, given their background, set about (at least in their public statements) creating a more active role for the state in guiding the economy.

The political changes appear to have been broadly consistent with the mood of the public at that time—a desire to see a stronger state taking more control over the fate of the economy but stopping well short of a return to socialism. The Russian living standards measurement survey conducted in November 1998 included questions on attitudes to both market reforms and a return to socialism. While only 23 percent of respondents favored ceasing market reforms, 52 percent favored carrying out market reforms in a different way, and only 7 percent supported a continuation of the previous strategy (Eble and Koeva, 2002). In terms of the return to socialism, 38 percent were in favor, but 49 percent of respondents saw a need to adjust the present course and only 3 percent supported a continuation of the existing course. Perhaps reflecting the fact that older generations had been least protected during the transition, the desire for a return to socialism and a halting of market reforms increased with age.

While the government and the Duma struggled with how to balance their desire for a more active fiscal stance with the limited availability of resources and the need to avoid a lapse into hyperinflation, key policy areas—fiscal policy in particular—were simply allowed to drift. Indeed, it was only with the approval of the 1999 budget in the first quarter of 1999 that a clear macroeconomic strategy emerged. In the interim, the CBR had responded actively to address the payment system issues but could not, absent a coordinated fiscal policy, achieve a stabilization of prices and the exchange rate.

Banking Sector

The CBR acted swiftly to address the problems in the banking system (see Chapter 6). The response was on two fronts: first, to inject additional liquidity into the banking system to unlock the payment system; and second, to try to prevent a run on deposits by transferring the deposits of those banks that were clearly insolvent to Sberbank (where there is a state guarantee on deposits).

Liquidity was injected via a combination of a reduction in reserve requirements, the regular standing facilities, a new system of rehabilitation credits for the ailing potentially systemic banks at below-market rates (secured by shares in the bank), and foreign exchange credits to selected banks. The latter credits were, in fact, extended immediately before the crisis on the basis of unclear selection criteria, raising concerns about the transparency of CBR operations in this period.

The liquidity situation of the banking system improved fairly rapidly and balances, both in correspondent accounts held at the CBR and in the CBR’s deposit facility—effectively a risk-free asset—increased sharply in September and October. While the levels of these balances are difficult to interpret, as they largely reflect the concentration of liquidity in the stronger banks, the CBR started to curtail its liquidity injections into the banking system in October and November. Beginning in mid-March 1999, the CBR started to raise reserve requirements.

Action aimed at addressing the more fundamental issues of bank solvency was, for the most part, simply delayed. While banking legislation constrained the ability of the CBR to take action against insolvent institutions, the CBR also exercised significant regulatory forbearance during this period.

The interventions in the banking system were, on one level, extremely successful—the blockage to the payments system was removed, enabling the real economy to restart; a general run on deposits was avoided without having to introduce a blanket deposit guarantee scheme or a freeze on deposits; and the fiscal cost appeared minimal. However, on a deeper level, the assessment is not so straightforward. First, the amount of liquidity injected into the system from early August to end-September was substantial—indeed, significantly larger than the rundown in ruble deposits during this period. While some of the additional liquidity was retained on correspondent account balances, a significant portion hit the foreign exchange market, putting greater pressure on the exchange rate and on the limited amount of foreign reserves. Second, much of the support was extended through special facilities, at below-market rates, in exchange for collateral of uncertain value and on the basis of unannounced criteria. This implied a potentially substantial decapitalization of the CBR, as well as governance concerns. Third, the regulatory forbearance shown was unusually generous and permitted some of the more dubious banks to further strip assets. Finally, the decision to concentrate deposits at Sberbank (the former national savings bank that is now a majority state-owned general bank), while clearly beneficial for the short-term stability of the banking system, helped reinforce Sberbank’s dominant role in the system and sent a clear signal that it would not be treated as though it were an ordinary bank.

Monetary Policy

Monetary policy was largely reactive through end-1998 and included a combination of the liquidity injections to support the banking system, the provision of financing to the government, and purchases in the foreign exchange market to limit the loss of official reserves associated with meeting debt-service payments on Russia-era debt. As a result, monetary conditions remained relatively loose through the end of 1998, and there was no clear brake on either inflation or the slide in the exchange rate. Indeed, after declining in October, inflation accelerated in November and December, contributing to renewed pressure on the exchange rate and fears that the economy could be lapsing into another period of hyperinflation (Box 2.2). Monetary policy was tightened in early 1999 and, as it became clear that fiscal policy would support financial stabilization, inflationary pressures began to subside. The exchange rate stabilized and even appreciated in nominal terms against both the U.S. dollar and the major European currencies during the second quarter of 1999.

In August and September 1998, monetary policy focused on providing support to the banking system to relieve the bottlenecks in the payments system. Net central bank credit to banks thus increased sharply, driving the increase in net domestic assets (NDA) of the central bank. International reserves, however, fell very sharply during the quarter as a result of large sales of foreign exchange in July and August, prior to the abandonment of the peg, as demand for rubles collapsed. Indeed, net international reserves, measured as gross official reserves of the CBR and the government minus short-term foreign liabilities (mostly loans from the IMF), declined by a massive $8.2 billion during the quarter, with gross reserves falling to just $12.6 billion.

Was the Monetary Policy Stance Too Loose, Too Tight, or About Right?

Assessment of the monetary policy stance during the 1998 crisis, even after the event, is extremely difficult, and complicated by the fact that the Central Bank of Russia (CBR) was trying to weigh multiple and competing objectives: (1) bringing down inflation, (2) preserving the banking system, and (3) avoiding choking off domestic demand. The CBR did achieve a reasonable balance between these objectives, while possibly erring on the loose side.

The CBR’s actions to stabilize the banking system involved significant injections of liquidity to preserve the payments system and avoid further disruption to the real sector. As noted above, the liquidity injections provided to the commercial banks were, with hindsight, somewhat larger than the amount strictly needed to offset the pressure on deposits, and part of these injections leaked into the foreign exchange market, causing further pressure on the exchange rate. Tightening the stance through lower injections of credit to banks would have been unlikely to further depress domestic demand unless it triggered further disruption to the payments system that appears to have been a low risk after September 1998. The monetary stance in the fourth quarter of 1998 was, though, largely driven by the fiscal position.

Pass-Through From Exchange Rates to Prices

article image
Source: Collyns and Kincaid (2003).

Cumulative devaluation from month prior to the crisis.

Cumulative inflation from month prior to the crisis.

Ratio of cumulative inflation to cumulative devaluation over indicated horizon.

Short-term pass-through computed at one-month horizon instead of three months.

Index not meaningful since the nominal exchange rate appreciated in year two.

Inflation did ultimately come down, but the stabilization took time—longer than in most other crisis countries—and there was, in late 1998, a clear risk that the economy was lapsing into hyperinflation as inflation remained high and the exchange rate continued to depreciate.

Exchange rate pass-through was relatively high by crisis-country standards. Thus, the monetary injections that hit the foreign exchange market did have a significant impact by sustaining the momentum of inflation. Key factors in bringing down inflation were the continued depressed level of domestic demand, as wages and pensions declined sharply in real terms, and an explicit decision to permit a large real reduction in utility tariffs.

NDA continued to increase sharply in the fourth quarter, this time driven by significant financing provided to the government. Financing was provided in the form of foreign exchange credits to Vnesheconombank (VEB)—a wholly government-owned bank—that were on-lent to the government for external debt-service payments.1 Liquidity was also injected through sizable purchases by the CBR in the foreign exchange market, which served to limit the decline in gross reserves. As a result, base money increased fairly rapidly during the quarter, in line with inflation.2

The monetary stance tightened progressively during 1999. The fiscal position strengthened, reducing the injection of credit via the government, and the liquidity position of the enterprise sector also strengthened, allowing the CBR to reduce its net credit to banks. Base money declined slightly in the first quarter—in part a reversal of the strong seasonal demand for currency at year-end associated with the Russian holiday season that begins in late December and continues through mid-January—but increased sharply in the second quarter, driven by a strong accumulation of international reserves as the balance of payments strengthened. The relatively high rate of money growth did not exacerbate inflation at this time, since money demand was rebounding rapidly as the economy recovered and the structural measures to reduce the use of barter began to have an effect.

Fiscal Policy

There were no significant fiscal policy changes introduced in the immediate aftermath of the crisis. Despite widespread discussion of the desirability of relaxing the fiscal stance to support output, as reflected in the extensive coverage of such issues in the Maslyukov Plan, there were few actual policy adjustments until the 1999 budget was approved in February 1999. Moreover, the changes that were introduced were designed to achieve a significant fiscal adjustment in support of financial stabilization, with relatively few specific interventions directly aimed at stimulating output.

Revenues fell sharply in the months after the crisis. The collapse of output, combined with the problems in the payments system, produced a reduction in federal government cash revenues from 10¾ percent of GDP in the first half of the year to just 7 percent in the third quarter, with only a modest improvement to 8½ percent of GDP in the fourth quarter. While it is difficult to judge how large an impact the disruption to the payments system had on cash collections (or to what extent this was simply used as an excuse for delaying payments by enterprises keen to preserve liquidity), it was clear that the slide in revenues could not be permitted to continue.

Given the low level of revenues and the limited financing sources available, and in the absence of adjustments to nominal expenditure commitments, the budget simply ran arrears in the third quarter of 1998. Indeed, noninterest expenditure arrears of the federal budget increased by more than 3 percent of GDP during the third quarter. These arrears were partially cleared during the fourth quarter, financed through a combination of a sharp increase in the use of offset operations, large credits from the CBR, and privatization revenues from the sales of Gazprom shares.

Reflecting the drawn-out discussion on the appropriate fiscal stance—both within Russia and between Russia and international financial institutions (IFIs)—approval of the 1999 budget was delayed until February. As a result, the fiscal stance became very contractionary at the beginning of 1999 as, by law, in the absence of an approved budget, monthly non-interest expenditures were set at one-twelfth of the previous year’s level, implying a significant reduction in real terms.

The 1999 budget that was ultimately approved targeted an overall federal deficit of 2½ percent of GDP, an improvement of 2¾ percent of GDP compared with the outcome for 1998. The implied primary balance (the overall balance excluding interest payments) was a surplus of 1¾ percent of GDP. Slightly more than half of the targeted adjustment would come from revenues, with the remainder from real cuts in expenditure.

The increase in revenues was to come from the reintroduction of export taxes on a range of commodities (including oil and ferrous and non-ferrous metals), a new tax on luxury automobiles, automatic indexation of specific excises, and changes in the sharing rules between the federal and local governments for revenues from the personal income tax and the value-added tax (VAT)—in both cases to increase the federal share at the expense of the regions. To provide some support to the economy, the budget also incorporated a reduction in the profit tax rate, but a reduction in the VAT rate from 20 percent to 15 percent, which had been approved by the Duma, was vetoed by the president.

Barter and Noncash Payments in the Economy

A unique feature of transition countries has been the extensive use of noncash payments in settlements—barter transactions, promissory notes, and various offset schemes. While the precise nature and significance of these schemes have varied between transition countries, the problems stem from institutional weaknesses that prevent the effective imposition of hard budget constraints in the economy. As a concrete example, if one enterprise ships raw materials to a second enterprise and the second enterprise simply states that it will not pay in cash but will instead provide a share of its production, absent an effective legal system capable of protecting the first enterprise’s claim, there is little the first enterprise can do but accept the goods.

The incidence of noncash payments spread quickly throughout the economy and, by 1998, the share of industrial sales conducted in barter had reached 50 percent. The problem was particularly acute in the energy sector, where government ministries often ran payment arrears on their utility bills and, in return, the utility companies ran tax arrears (leaving both sides able to claim that they would have paid the other if only they had received their payment). The energy companies also “tolerated” substantial arrears from enterprises, with cash collection ratios at, for example, Gazprom at about 20 percent in 1997. Enterprises, claiming cash shortages, also simply delivered goods or services to the government to extinguish tax liabilities.

Breaking the chain of arrears was one of the key achievements of 1999-2000. There were several key contributing factors.

  • A federal government decision to insist on tax payments in cash, beginning in 1999. From 2000, this included the federal government share of taxes collected at the subnational level.

  • Introduction of a commitment registration system to ensure that budgetary entities paid their utility bills.

  • A sharp increase in liquidity in the economy, as international energy prices rose sharply beginning in the second half of 1999.

  • Greater use of available bankruptcy procedures—initiations of bankruptcy cases increased from about 600 a month in the first quarter of 1999 to about 900 a month by the third quarter. Much of this increase was due to the government aggressively pursuing its claims.

  • Increased pressure on the utilities to raise their cash collection ratios.


Share of Barter in Industrial Sales


Source: Russian Economic Barometer.

On the expenditure side, the “adjustment” was to be achieved by simply approving a level of noninterest expenditures in nominal terms that implied a decline in real terms on a plausible assumption for inflation. Thus, for example, the increases in wages and benefits were held well below the actual rate of inflation.

The fact that a budget that was clearly counter to the government’s anti-crisis plan approved just a few months earlier, and which involved large cuts in expenditures and the reallocation of resources away from the regions, would be approved by the Duma was testament to the support that Mr. Primakov commanded. Indeed, while the budget was the foundation of a new agreement with the IMF, the principal concern was that the expenditure cuts assumed were simply too large and would prove to be unsustainable in a preelection year. There was also concern that the expenditure cuts were ad hoc, rather than based on a clear expenditure rationalization strategy. Perhaps reflecting the political support that Mr. Primakov had mobilized, he was summarily fired by the president in April (after the budget was approved). He was replaced by the minister of internal affairs, Mr. Sergei Stepashin, a younger, relatively unknown politician who did not have the same clout with the Duma.

The budget of February 1999 marked a watershed in fiscal relations in several key areas that helped shape future budget outcomes.

  • An explicit decision was taken to halt the use of offsets at the federal government level (Box 2.3). This involved both the refusal to accept payments of federal taxes in noncash forms, as well as ensuring that budgetary entities did not enter into contracts for which they did not have financing (including for utilities).

  • A new determination emerged to improve tax compliance, particularly in the energy sector. Oil companies that were not meeting their tax obligations would be denied access to the oil export pipeline. In the case of Gazprom, which had been negotiating tax payments significantly below its statutory obligations, payments were increased substantially and were to be increased to full statutory obligations in 2000. Other steps were also taken to strengthen tax administration more generally. This represented a clear break from the precrisis period when the inability to sanction large tax delinquents made statutory obligations mostly irrelevant to many large taxpayers, who negotiated their payments essentially independently of such obligations, and when political intervention in tax enforcement abounded.3

  • Greater expenditure control was achieved through efforts to further strengthen the treasury. While the treasury system had been progressively strengthened, the decision was taken to bring the so-called power ministries (defense, security, internal affairs) and extrabudgetary funds under its auspices. The power ministries had been a continuing source of unbudgeted expenditure commitments that became arrears, while the extrabudgetary funds were responsible for almost 10 percent of GDP in expenditures but had very weak accounting structures.

  • Measures were taken to centralize revenues. Given the limited financing sources available to local governments, and without adjustment to federally mandated expenditures incurred at the local level (such as payments to invalids), this forced additional fiscal adjustment in their budgets. Local governments had the authority to introduce certain types of taxes and they were, for example, encouraged to introduce a local sales tax to compensate for the loss of VAT revenues. Nonetheless, much of the adjustment came through simply cutting back expenditures and, in some cases, ad hoc disruptions to service provision and the incurrence of expenditure arrears.

The balance of the extrabudgetary funds also improved strongly—by almost 2 percent of GDP in 1999 relative to 1998—permitting the elimination of the stock of pension arrears that had been accumulated in early 1998. The improved financial position did, however, result purely from a sharp decline in the real value of pension payments, as nominal increases in pension rates were held below the rate of inflation (Figure 2.1). The only positive result was that the pensions were finally paid on time.

Figure 2.1.
Figure 2.1.

Real Pension Rate


Source: Russian State Statistics Committee.

The strategy of achieving fiscal adjustment by holding the increases in benefits and budgetary wages below the rate of inflation clearly helped to bring the deficit under control. But it also had negative consequences for income distribution and living standards, particularly of benefit recipients. Poverty had already increased as a consequence of the crisis. Lokshin and Ravallion (2000), using data drawn from the Russia longitudinal monitoring survey (RLMS), estimate that poverty increased from 21.9 percent of households in 1996 to 32.7 percent in 1998, with the increase concentrated in urban households. Similar results, but with somewhat higher poverty estimates, were found by Kolenikov and Yudaeva (1999). Goskomstat data on the proportion of the population living below subsistence levels show a more modest increase at the time of the crisis, but then a sharp increase in 1999 as inflation eroded the real value of fixed incomes (Figure 2.2). While real wages and pension benefits have subsequently recovered, it was only in late 2001 that real wages exceeded their precrisis highs.

Figure 2.2.
Figure 2.2.

Unemployment and Poverty


Source: Russian State Statistics Committee.

Support from the International Community

Having demonstrated a commitment to the pursuit of macroeconomic policies consistent with achieving stabilization, including a strong fiscal adjustment, and early signs of a desire to reinvigorate the structural reform agenda, Russia was able to garner additional financial support from the international community. On July 28, 1999, the IMF approved a new Stand-By Arrangement covering the period through end-2000, in an amount of $4-5 billion. The World Bank approved a new comprehensive Structural Adjustment Loan on August 6 amounting to $1.5 billion, which, together with existing projects, would provide $1.1 billion in financing in 1999. The new World Bank loan was also co-financed by the Japanese government to the tune of $0.7 billion.

While these amounts were significant, an important component of the new arrangement with the IMF was that it unlocked a new rescheduling agreement with the Paris Club. The new agreement was reached in August 1999 and provided for the rescheduling of arrears, as well as maturities falling due on Soviet-era debt in the period from July 1999 to December 2000, estimated at over $8 billion, into 16-20 year instruments with grace periods between 1 and 1½ years and graduated payments (see Chapter 7). The agreement with the Paris Club also provided a benchmark for restructuring agreements with the London Club of commercial creditors, finalized in August 2000, as well as various other Soviet-era debts. These debt restructuring operations significantly reduced the near-term pressures on the balance of payments and the budget, through both the write-down element of the restructurings and the lengthening of maturities. They have also provided clear signals to the markets, including the various rating agencies, of Russia’s commitment to normalize its relations with international creditors, and this has helped drive down the spreads on Russia’s Eurobonds and facilitate Russia’s reaccess to the sovereign capital markets, if it so desires.

How Did the Real Sector Respond?

After dipping sharply in the first few months after the crisis, output grew very strongly—indeed, the initial rebound was both quicker and stronger than anticipated by most observers. Enterprises throughout the economy were able to rapidly increase production, despite the limited role of the banking system and the low investment in previous years. Imports fell to less than half the late 1997 level and did not start to recover until 2000. International commodity prices began to strengthen as the economies in Asia began to emerge from their recessions, providing a further stimulus to the export sector. Profitability of the tradable sector was also facilitated by the weakness in the labor market, which ensured that the postcrisis inflation produced a decline in real wages.

The strong improvement in output was facilitated by the modest wealth effect of the crisis, as private sector wealth was largely held outside the banking sector and in U.S. dollars. The level of cash dollars held outside the banking system (the infamous “mattress money”) has been estimated at $30-40 billion, while capital flight had been on the order of $20 billion a year for most of the transition period. In comparison, total ruble deposits held within the banking system at end-1997 (prior to the depreciation and prior to the rundown in deposits in early 1998) were $40 billion, with foreign currency deposits of $14 billion. The stock market crash did, however, imply a massive write-down in market capitalization—the capitalization of the SKATE index (a stock market index) declined from $151 billion in September 1997 to just $20 billion in September 1998. It is unclear how large an impact this had on domestic demand, as nonresidents held a significant portion of Russian equity holdings.

In addition, there does not appear to have been a significant credit crunch, as real credit to the economy fell relatively modestly in the aftermath of the crisis before growing strongly from the second half of 1999 (Figure 2.3). The relatively marginal role played by the banking sector in providing credit to the economy meant that the constraints on banks’ balance sheets did not significantly disrupt the flow of financing, as enterprises continued to rely on their own funds for investment financing. Although it is difficult to identify how much of the credit growth represented evergreening of the loan portfolio (rescheduling to prevent the loan from becoming nonperforming), there was a significant expansion of credit from Sberbank—which previously had played only a marginal role in crediting the economy—and several of the other more liquid banks that, in the absence of the government securities market, needed to find an outlet to invest their resources.

Figure 2.3.
Figure 2.3.

Real Credit to Economy


Source: IMF, International Financial Statistics.

Other balance sheet-related channels, which had played key roles in extending crises in other parts of the world, were also largely absent. For example, the depreciation only had a slight effect on enterprises’ balance sheets as the corporate sector generally had relatively little foreign currency debt (such debt was concentrated in natural resource exporters with large foreign currency income streams).4 Similarly, enterprise balance sheets were largely protected from the default on government securities since, in many cases, securities held by enterprises were redeemed on schedule at face value.

Rapid Growth and Massive Current Account Surpluses, Late 1999 to Mid-2001

The macroeconomic policy environment changed dramatically in late 1999. Just as signs were emerging that the output recovery was slowing sharply, energy prices and some other international commodity prices began to increase very rapidly. From February 1999 to November 2000 the price of Urals oil more than tripled, before settling back somewhat in 2001, with similar (but lagged) developments in gas export prices. Such a sharp increase in the price of the major export naturally had a substantial impact on all areas of the economy: the current account of the balance of payments moved into a massive surplus, permitting a strong buildup in international reserves; fiscal revenues rose sharply, contributing to overall budget surpluses; and substantial investment in the energy sector contributed significantly to growth. Moreover, beyond the direct impact of the increase in oil and gas prices, the energy sector boom had spillover demand effects on other sectors, restored liquidity to the crisis-battered banking system, and led to direct investment in other sectors, both domestic and foreign.

It is easy to dismiss the macroeconomic outcomes in this period as being purely a by-product of the spike in the oil price. While it is, of course, true that the economy would not have turned around so rapidly if the oil price had not increased so sharply, the strong outcomes in this period stem, as will be discussed below, from a combination of three factors: the oil price shock; the continuing effects of the real depreciation in late 1998; and the determined implementation of responsible macro-economic and structural policies by a strong federal government.

It is no coincidence that this period has been one of unusual political stability. Since Mr. Putin became acting president on December 31, 1999, there have been no changes in the prime minister, minister of finance, minister of economy, or, until March 2002, governor of the CBR—a stark contrast to the procession of prime ministers in 1997-98. In addition, following the parliamentary elections in December 1999, the government has enjoyed a highly supportive Duma, which has worked constructively with the government to advance the reform agenda and ensure responsible macroeconomic policies—again, in stark contrast to the earlier antagonistic relationship. The political stability has enabled the government to reestablish the authority of the federal government, and the powers of the oligarchs, regions, and other vested interests are being reined in.

The macroeconomic policy challenges created by the oil price spike should not be underestimated. Notwithstanding the newfound harmony between the government and the Duma, it should not be forgotten that Russia had a history of lax fiscal policy and a fragile financial stabilization based in large measure on sharp real budgetary expenditure cuts. Thus, the fact that the government has been able to resist the temptation to simply spend the oil windfall is testament to how far macroeconomic policymaking has come.

Macroeconomic Policies

The oil price shock was extremely large: energy exports increased by more than $20 billion in 2000 relative to 1999 (more than 10 percent of 1999 GDP) and remained at that level in 2001, despite a moderate decline in the oil price. Given that the oil sector is largely privately owned, this windfall accrued in the first instance to the private sector, though the government subsequently received a portion as tax revenues. Absent a policy response, the exchange rate would have appreciated sharply to reduce the size of the current account surplus, which reached 17½ percent of GDP in 2000. However, the authorities, concerned that the oil price spike was likely to be temporary, sought to prevent unnecessary volatility in both nominal and real exchange rates. Such volatility would be likely to have real costs and could potentially trigger a new wave of problems in the banking system.

The policy response consisted of running large fiscal surpluses combined with large-scale foreign exchange purchases by the CBR. The foreign exchange interventions had the twin benefits of avoiding a sharp appreciation of the nominal exchange rate and enabling the CBR to quickly build up a comfortable cushion of international reserves. The interventions were partially sterilized by the accumulation of government deposits at the CBR.5

The volatility of oil prices has complicated budget design. Budgets for 2000 and 2001 were, appropriately, based on conservative projections for world oil prices and consistent macroeconomic assumptions but, in the event, both oil prices and nominal GDP were significantly higher than assumed. Given that the budget fixes expenditures in nominal terms, and that adjustments to expenditure in the context of supplementary budgets at end-year have been fairly modest, the result has been that the government has run much stronger-than-budgeted surpluses and that expenditures have been lower than budgeted in real terms.

The federal government ran overall surpluses of 1 percent of GDP in 2000, compared with a target of a deficit of 1 percent of GDP, and 2½ percent of GDP in 2001, compared with a balanced budget target. The primary surplus of the federal budget improved by a stunning 6 percent of GDP from 1998 to 2001. Much of the improvement at the federal level came from energy sector revenues—the ratio of federal cash revenues to GDP doubled over this period—while noninterest expenditure increased by only 1½ percentage points of GDP, and this partly reflected increased transfers to the regions in response to the greater centralization of revenues. Looking at a broader measure of government reveals a somewhat different pattern of fiscal adjustment. As shown in Figure 1.4 and Table 2.1, a key factor behind the adjustment in the enlarged government balance was the decline in expenditure, by over 5 percent of GDP between 1998 and 2000. Assessing the degree of fiscal adjustment is, however, complicated by the impact of changes in quasi-fiscal operations (Box 2.4).

Table 2.1.

Budgetary Revenue Performance

(Annual changes in percent of GDP, unless otherwise indicated)

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Source: IMF staff estimates.

Excluding end-year non-cash revenue and offset, which was estimated at 1 percent of GDP.

The strong fiscal outcomes do, however, mask a modest easing of the fiscal stance in 2001, once the impact of oil prices is corrected for. The fiscal relaxation has come from the revenue side, as the authorities have taken the opportunity of the strong oil sector revenues to ease somewhat the tax burden on the enterprise sector, by simplifying the tax system and lowering certain key tax rates (see Chapter 4 for more details). Thus, even though fiscal revenues at both the enlarged government level and the federal level increased in relation to GDP in 2001, revenues of the non-oil sector declined somewhat.

The ability to resist pressures for increased expenditure, so that additional revenues could be largely saved, is undoubtedly one of the major achievements of macroeconomic policymaking and has been key in achieving the desired sterilization of balance of payments inflows. During 2000 and 2001, the government reduced its outstanding credit from the monetary authorities by Rub 250 billion, equivalent to 30 percent of the increase in net international reserves that occurred. Without such strong support from fiscal policy, monetary policy would have been overwhelmed and the real exchange rate would have appreciated even more rapidly than it did.

The Impact of Quasi-Fiscal Operations on Fiscal Adjustment

Assessing the degree of fiscal adjustment is complicated by large quasi-fiscal operations in Russia. One important element—the focus of a number of studies—is the magnitude of the implicit subsidies provided through the regulation of natural monopoly tariffs, particularly for gas and electricity, where the prices paid by domestic consumers are tightly regulated. In the aftermath of the crisis, increases in the tariffs of the natural monopolies were held significantly below the rate of increase of other producer prices. Railroad tariffs for the transportation of certain kinds of goods actually decreased in nominal terms. It is difficult to quantify the magnitude of this effect: the lower effective prices of the natural monopolies were offset by an increase in payment discipline and a reduction in the use of barter transactions. Thus, OECD (2002) concludes that the implicit subsidy probably did not increase in the aftermath of the crisis and, rather, stayed at the precrisis figure of about 5.5 percent of GDP.


Real Consumer Prices for Utilities

(Index, July 1998=100)

Source: IMF staff estimates.

Quasi-fiscal subsidies were also extended through the Central Bank of Russia’s operations supporting the banking sector. These undoubtedly weakened the central bank’s balance sheet, through the provision of below-market interest rate rehabilitation credits, the acceptance of equity in insolvent institutions as collateral, and the acceptance of promissory notes on insolvent banks as part of the transfer of deposits to Sberbank. The net cost of these operations is not known.

Apart from a very modest nominal appreciation in mid-2000, the CBR has orchestrated its interventions in the foreign exchange market to offset the pressure for a nominal appreciation of the ruble against the U.S. dollar. In fact, the CBR has gone further and actually pushed the nominal rate to depreciate modestly throughout the period, in an apparent attempt to delay the pace of the real appreciation. Given the strength of the U.S. dollar against other currencies in this period, the intervention strategy has still permitted the effective exchange rate (the average of trading partners’ exchange rates, weighted by trade shares) to appreciate (Figures 2.4-2.6).

Figure 2.4.
Figure 2.4.

Effective Ruble Exchange Rates


Source: IMF, International Financial Statistics.
Figure 2.5.
Figure 2.5.

Bilateral Ruble/US$ Exchange Rate

Sources: Russian authorities; and IMF staff estimates.
Figure 2.6.
Figure 2.6.

Bilateral Ruble/Euro Exchange Rate

Sources: Russian authorities; and IMF staff estimates.

Despite the strong contribution from fiscal policy, sterilization of the reserves accumulation has been incomplete. Facing an uncertain demand for money, the CBR has tended to err on the side of permitting a more rapid increase in money supply than is desirable after the fact, and it has only acted to constrain the rate of money growth after there were clear signs of a pickup in inflation. As a result, inflation has run somewhat above its target path (Table 2.2). While the limited sterilization undertaken by the CBR can, to some extent, be viewed as a result of the narrow range of policy instruments available to it, coupled with concern over the CBR’s income position, it also reflects a reluctance to unnecessarily tighten monetary policy for fear of slowing output growth—in turn a reflection of the multiple objectives pursued by the CBR.

Table 2.2.

Monetary Policy Targets and Outcomes, 1999-2002


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From CBR’s Guidelines on Monetary Policy, presented to the Duma annually in accordance with CBR law.

Amended upward to 50 percent in the authorities’ July 1999 Statement of Economic Policies supporting their request for a Stand-By Arrangement with the IMF.

The massive foreign exchange market intervention and repeated overshooting of the CBR’s own inflation and monetary growth targets reveal a clear preference by the CBR for the objective of slowing the (real) appreciation of the ruble. This means that the real appreciation dictated by fundamentals took place through inflation rather than through nominal appreciation. This policy has, from the authorities’ point of view, been successful in slowing down the real appreciation of the ruble. But the real exchange rate will still move over time to the level determined by the real fundamentals, and in the meantime Russia will have experienced higher than necessary inflation.

What Has Driven the Output Rebound?

Postcrisis growth performance has been very strong and a clear break from the trend decline that had been seen during the pre-crisis transition. Initially, growth was driven by a strong increase in net exports, principally due to a contraction in import volumes, which in turn resulted from the combination of the large real exchange rate depreciation, a decline in private consumption, and the termination of coverage by international export credit guarantee agencies. By 2000, however, high oil prices had contributed to a sharp rise in investment in the economy and, as household incomes started to recover with increases in real terms in both pensions and wages, domestic consumption surged. The rising domestic demand created some increase in imports so that the contribution of net exports to growth declined (Figure 2.7).

Figure 2.7.
Figure 2.7.

Decomposition of Demand Growth

(Annual percent change)

Sources: Russian authorities; and IMF staff estimates.

The contribution of the oil price spike to growth can be considered from a variety of angles. The direct impact of the energy sector on output growth is not very large: the energy sector, including the associated transportation, contributes about 20 percent of GDR In addition, the price elasticity of energy exports, at least in the short term, was comparatively low, owing to infrastructure constraints: oil companies had not been investing significantly in new production capacity in the precrisis period because of low oil prices and financing constraints, export pipelines have limited capacity, and natural gas is mostly sold through long-term contracts with fixed volumes. While the oil companies were quick to invest as the oil price recovered, it was only in 2001 that a significant volume response occurred.

The indirect impact of the oil price spike was much larger. Even after some revisions to the tax system to capture part of the windfall profit accruing to the energy sector, post-tax profits in the sector increased dramatically. This effectively eliminated the financing constraint on investment in the energy sector—given the small banking system and limited access to international capital markets, most investment in Russia has been financed by retained earnings—and investment increased dramatically. Indeed, the share of total investment accounted for by the fuel sector increased from 16 percent in the second half of 1998 to 24 percent in the first half of 2001, while the share of the transportation sector (which includes the pipelines) increased from 16 percent to 23 percent, both within a rapidly increasing level of total investment. This surge in investment had a direct impact on other sectors of the economy and partially explains the strength of construction and machinery output, in particular during 2000-01.

There were many other indirect channels through which the oil price spike influenced the rest of the economy. For example, it significantly increased the level of liquidity in the economy, facilitating the reduction of barter and the recapitalization of the banking system. While some of the windfall gains were undoubtedly invested abroad, higher profits in the energy sector translated into a sharp increase in demand for Russian assets. Thus, the energy companies invested in enterprises outside their sectors, the broad equity market surged, and the price of Russia’s bonds (including Eurobonds) increased sharply.

The contribution of other factors to the growth performance should not be understated. The large real exchange rate depreciation in the latter part of 1998 had provided a strong boost to the competitiveness of the tradable sector and this was quickly translated into a surge in the output and profitability in many sectors of the economy. Indeed, the initial recovery in growth was broad-based, with particularly strong increases recorded in construction, machinery, ferrous metals, and, more recently, retail trade, in addition to the energy sector (Table 2.3).

Table 2.3.

Growth of Basic Sectors

(Year-on-year percentage change)

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Source: Goskomstat.

The contribution of the structural reform program to growth in this period is difficult to assess. Some elements, such as the efforts to reduce the tax burden and harden budget constraints, resulted in clear improvements in the business climate and likely stimulated both investment and consumption. In addition, the extensive privatization of the economy completed in the mid-1990s likely facilitated the broad response of the economy to the real exchange rate adjustment. However, many of the broader reforms are relatively recent, having been approved only in 2001, and it is likely that they will need some lead time before they improve growth performance. Indeed, a growth accounting exercise that decomposes growth into the elements that can be explained by increased inputs of capital and labor, and a residual (TFP, or total factor productivity) suggests that the role of TFP in explaining growth so far in the transition is very low—much lower than the rates seen in the transition economies of Eastern and Central Europe at a similar stage (IMF, 2000). While the results of such an exercise have to be interpreted cautiously, the implication is that the productivity growth typically resulting from structural reforms has not yet played a significant role in driving output. On the one hand, this is quite a negative result, confirming the need to continue with the determined implementation of a comprehensive structural reform agenda, unlike the earlier reform effort. On the other hand, it does point to the room that remains for achieving high rates of growth for a sustained period of time.

One by-product of the acceleration in the structural reform agenda is that international capital markets see it as a clear signal that Russia is headed in the right direction at a time of great uncertainty in other emerging markets. As a result, access to international capital markets has been restored and tremendous interest is being generated in Russian assets, which is helping to relieve financing constraints stemming from the limited domestic financial system.

Is Growth Sustainable? The Lesson of Late 2001 and the Agenda for the Future

The external environment weakened considerably in the latter part of 2001; a slowdown in the major economies (even before September 11) combined with falling international prices for energy products, prompting pressures from OPEC for a reduction in export volumes. The impact on the economy was immediate: growth slowed markedly, the current account surplus contracted sharply, and between November 2001 and January 2002, for the first time since the beginning of 1999, gross international reserves of the monetary authorities actually declined for three months in a row. In addition, profitability indicators narrowed considerably in 2001, with the performance of the nonenergy sector becoming much more varied, suggesting that the combination of the real exchange rate appreciation and recovery in real wages had eaten into profit margins (Table 2.4).

Table 2.4.

Enterprise Profits, 1997-2002

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Source: Goskomstat.

Estimated using data for the first half of 2002.

Reacting to these tendencies, the focus of macroeconomic policies shifted. The fiscal stance that had been the key element in the financial stabilization was relaxed substantially in the 2002 budget. While it was clear that there was some room to relax the fiscal position over the medium term, consistent with maintaining stable and sustainable debt balances, the approved budget implied a relaxation (calculated at the same average oil price as in 2001) of 2 percent of GDP at the enlarged government level, which was on the high side.

As fate would have it, oil prices strengthened in early 2002, contributing to a resumption of growth and a return to the familiar concerns of how to deal with the strength of the balance of payments. Asset prices have also surged again, reflecting a combination of the perceived low political risk in Russia, an assessment of underlying improvements in the investment climate, and recognition of the continuing strength of the fiscal and external positions and the comfortable external reserve position.

The episode did, however, bring home once again the message that, while the macroeconomic successes of the past three years have been spectacular, Russia is not yet out of the woods. Economic fortunes remain highly dependent on energy and the vagaries of oil prices. Reducing the dependence on energy will not happen overnight. It will ultimately depend on the success in implementing the structural reform agenda, and the response of the authorities to a number of macroeconomic policy challenges over the medium term will have a significant impact on the growth transition. While the passage of time will undoubtedly provide new challenges, two issues are highlighted here: the appropriate stance for fiscal policy and how to ensure its implementation; and the conduct of monetary and exchange rate policy.

Fiscal Stance over the Medium Term

The strength of the fiscal position in the past few years has both facilitated the economic rebound and, looking forward, enabled Russia to put its debt situation on a very solid footing. The genuine concern in the early years of the millennium on the need for additional debt restructuring and worries about how the spike in debt-service payments in 2003 was to be met (see Chapter 7) has completely disappeared; public sector debt (domestic and external) has been brought down from close to 90 percent of GDP at end-1999 to just 35 percent at end-2002. Public sector external debt has declined from $145 billion to $98 billion at end-2002—a particularly modest amount given that official international reserves stood at more than $65 billion in May 2003.

Absent the anchor of the need to save to avoid a future debt crisis, the question arises as to what should underpin the fiscal targets and, given the target, how to ensure implementation. These questions are especially difficult in countries such as Russia where the budget remains highly dependent on revenues from a single, historically volatile, sector. Permitting discretion in setting annual budget targets in such an environment is likely to result in procyclical fiscal policies with expenditures increasing during periods of strong revenues and, owing to financing constraints, expenditures declining in downturns. Avoiding such inefficient swings in expenditures requires the adoption, in some form or other, of a fiscal rule based around a medium-term objective that would be consistent with the government remaining solvent. One option would be a balanced budget rule based upon some notion of a long-term equilibrium value for the oil price.6

The budget can be even further insulated from the oil price if this rule is formalized through a formal stabilization fund that would provide clear and transparent rules for transferring budget revenues to the stabilization fund as well as clear definitions of when resources could be provided from” the fund to the budget. A “stabilization fund has the advantage that it can provide additional separation of the fiscal rule from the annual political discussion on the budget but international experience with such funds has been mixed: governance issues and the temptation of borrowing from the fund beyond the legislated amount have proven to be the Achilles’ heels of a number of such efforts.

Monetary and Exchange Rate Policy

While inflation has been brought down, it is likely to remain in double digits (at least through 2003)—a higher rate than in most emerging markets and one of the highest rates among transition countries. To some degree, the continuing high level of inflation reflects the slower pace of adjustment of regulated utility prices to cost recovery levels during the early years of transition (and particularly in 1998 and 1999).7 However, even extracting the impact of such adjustments in regulated prices, inflation was in double digits in 2002 and the pace of disinflation has been much lower than in other successful transition countries.

The cause of the comparatively high rate of underlying inflation can be traced to the massive inflows through the balance of payments and the authorities’ attempts to balance the twin objectives of reducing inflation and smoothing the path of the nominal exchange rate. The implications of the policy dilemma have been discussed above—essentially, the inevitable real exchange rate appreciation occurs through higher inflation rather than through a nominal appreciation. Avoiding this inflationary bias requires the CBR and the government to agree that the central bank should give precedence to the inflation objective. Coupling this focus with a fiscal rule that provides automatic sterilization of the strong inflows from high oil export receipts could ensure consistency between the exchange rate and inflation targets.

As has been described, macroeconomic policymaking and the macroeconomic policy constraints have evolved substantially since the 1998 crisis. Within a comparatively short period, Russia has navigated a course from default on both external and domestic payments—to bondholders, companies, and pensioners alike—to one of the shining stars of emerging markets with a very modest debt level, several years of strong growth, budget surpluses, and a comfortable reserve cushion. By any standard, this has been a successful period. But macroeconomic challenges remain and it is essential that they are addressed so that the strong foundation laid in the last few years does not go to waste.


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This indirect mechanism of financing the government was employed because of the provisions of the central bank law approved in April 1995 prohibiting the provision of direct credit to government (except as specified under separate federal laws).


Given the existence of a lag between an increase in money and the resultant inflation, a decline in real money balances is a sign that money was providing a brake on inflation. The assessment for the fourth quarter is, however, complicated by strong seasonal factors in both ruble money demand and inflation.


When the emergency tax commission began to initiate bankruptcy procedures and seize assets of tax delinquents at the end of 1997, it was overruled at the highest political levels and when the tax service sought to seize Gazprom assets for nonpayment of taxes in mid-1998, the Duma intervened.


Indeed, many enterprises, particularly the large exporters, likely had large foreign assets—that may or may not have been shown on their balance sheets—meaning that they would have enjoyed a positive wealth effect.


The effectiveness of sterilized intervention in this case is not obvious. Sterilized intervention involves purchases of foreign exchange by the CBR, which then adjusts its policy instruments to absorb the additional ruble liquidity injected, leaving ruble base (and broad) money unaffected while increasing international reserves and lowering net domestic assets. The absorption of the ruble liquidity would require raising ruble interest rates. In a world of perfect capital mobility, increased ruble interest rates would attract private capital inflows that would offset the sterilization action. In such a situation, the impact of sterilization would be largely limited to influencing agents’ expectations of future exchange rate/monetary policy. However, Russia is far from the perfect capital mobility world, with capital controls (of dubious effectiveness), small, ineffective banks, and lingering concerns following the debt default making Russian assets less than perfect substitutes and permitting sterilized intervention to be effective, at least in the short run.


One difficulty with this approach is that many commodity prices, including oil, appear to follow random walks, making the notion of a long-run equilibrium price meaningless. In such circumstances, the rule can best be thought of as being based on a historical average price.


The direct and indirect effects of adjustments in regulated prices are estimated to have contributed about 5 percentage points to inflation in 2001 and 2002, and as much as 6½ percentage points in 2000.