Russian Federation
2007 Article IV Consultation: Staff Report; Staff Statement; and Public Information Notice on the Executive Board Discussion

The staff report for the 2007 Article IV Consultation highlights the Russian Federation’s long-term perspective, economic developments, and macroeconomic policies. Russia’s economic growth remains robust. High oil prices and sound fiscal policy underlie Russia’s long spell of robust growth. Executive Directors noted that Russia continues to face tensions in the policy mix designed to reduce inflation while preserving exchange rate stability. Raising investment levels is particularly important in light of the projected decline in the labor force and the declining prospect for continued high productivity gains over the medium term.

Abstract

The staff report for the 2007 Article IV Consultation highlights the Russian Federation’s long-term perspective, economic developments, and macroeconomic policies. Russia’s economic growth remains robust. High oil prices and sound fiscal policy underlie Russia’s long spell of robust growth. Executive Directors noted that Russia continues to face tensions in the policy mix designed to reduce inflation while preserving exchange rate stability. Raising investment levels is particularly important in light of the projected decline in the labor force and the declining prospect for continued high productivity gains over the medium term.

I. Background

A. The Long-Term Perspective

1. High oil prices, a strong catch-up potential, and sound fiscal policy underlie Russia’s long spell of robust growth. Double-digit terms-of-trade gains annually since 2003, reinforced by rapidly developing financial markets and much-improved access to foreign borrowing, have underpinned strong investment growth, punctured only by a soft spot in late 2004 in the wake of turmoil in the oil and banking sectors. However, this growth notwithstanding, the level of investment has remained low, and capital and labor have accounted for less than half of the increase in GDP since 2003, with the balance due to higher total factor productivity. Robust growth has thus owed much to Russia’s still considerable catch-up potential, as resources are reallocated to more dynamic sectors in the economy. The resulting nexus of strong productivity growth, rising real incomes, and higher consumption has been a key source of self-sustaining growth, especially in recent years as capacity constraints have slowed energy exports. With resource constraints becoming gradually more widespread—2006 was the seventh year of strong growth, despite comparatively low investment—the policy of taxing and saving Russia’s oil revenues has limited overheating and prolonged the recovery. In 2006, the budget would have been balanced at an oil price $30 per barrel.

uA01fig01

Production, Income, and Terms of Trade

(in annual percent changes)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities; World Bank; and IMF staff
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Real gross fixed capital formation and terms of trade

(annual percent changes)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Goskomstat; and staff calculations
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Annual private sector domestic and foreign borrowing 1/

(flows in percent of GDP)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

1/ Excludes net foreign borrowing by banks.Source: CBR; and IMF staff calculations
uA01fig04

Contributions to GDP

(log differences)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

1/ Capital and labor inputs have been adjusted for changes in utilization rates.Source: Staff calculations
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Real wages and real consumption 1/

(annual percent changes)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

1/ Real wages are based on the CPI index.Source: Staff calculations
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Energy export revenues and government balance

(annual changes in USD billions)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Staff calculations

B. Recent Economic Developments

2. GDP growth has strengthened and become better balanced (Table 1). Growth accelerated to 7.9 percent (year-on-year) in the first quarter of 2007, and high-frequency indicators suggest undiminished momentum in the second quarter. The acceleration took place even as oil prices fell from mid-2006 highs; in part because of the strong automatic fiscal stabilizer embedded in the oil stabilization fund, which absorbs about 85 percent of the fluctuations in revenues when oil prices change. Recent output growth reflects a pickup in investment, suggesting that growth is becoming better balanced. Consumption remains, however, the main engine, spurred by annual increases in real incomes of more than 10 percent. Higher growth also reflects further fiscal relaxation.

Table 1.

Russian Federation: Selected Macroeconomic Indicators, 2003–08

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Source: Russian authorities; and IMF staff estimates.

In months of imports of goods and non-factor services.

uA01fig07

Contributions to GDP growth

(In percent)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities; and IMF staff calculations.

3. The acceleration in growth is coming mainly from the nontradable sector. Consistent with the relatively rapid real appreciation, growth in retail trade and construction continues to gain speed, running well above 10 percent (year-on-year), while growth in manufacturing is notably slower although still robust at 6-7 percent. Growth in oil production has not recovered from the precipitous decline in 2004-05, when it plummeted from 12 to 3 percent, reflecting mainly a lack of development of new fields and limited pipeline capacity.

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Five basic sectors

(annual percent changes)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Goskomstat.
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Crude Oil Production 1/

(Quarterly, yoy growth rate)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities.1/ Including gas condensate.

4. While productivity growth remains high, resource constraints continue to tighten, not least in the labor market. Production capacity is being expanded at a relatively fast pace, reflecting rising investment and continued high TFP growth as the economy is still realizing catch-up gains. Nevertheless, labor markets continue to tighten, with acute shortages in high-growth areas, high and increasing labor utilization rates, and high and accelerating growth in real wages, to 18.5 percent during the year through April 2007. Beyond the labor markets, the rapid real appreciation and the increase in the leakage of domestic demand to imports also point to tightening resource constraints. In line with this, standard output gap analysis—which is subject to notable conceptual and statistical problems in a structurally changing economy like Russia’s—also suggests that GDP is close to potential.

uA01fig10

Real effective exchange rate

(average annual percent changes)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

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Import Leakage

(Imports in percent of real dom. demand)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities; and IMF staff
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Unemployment and labor utilization

(in percent)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Goskomstat; and REB
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Total factor productivity

(Annual percent change)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Staff calculations

5. The decline in inflation has halted. After having halved from almost 14 percent (year-on-year) in April 2005 to 7.4 percent in March 2007, inflation firmed in recent months, to 7.8 percent in May 2007. The decline reflected in part the impact of lower administered-price increases compared to previous years, an effect that accounted for about half of the decline in headline inflation in 2006. The slowdown was also a reflection of lower tradable-price inflation, as a change in exchange rate policy allowed a modest appreciation of the ruble in nominal effective terms—a notable break from the previous policy, which geared the CBR’s foreign exchange interventions toward ensuring a steady depreciation of the ruble. The recent uptick in inflation has followed the return to a less flexible exchange rate policy since mid-2006.

uA01fig14

Headline and Core Inflation

(Annual percent change)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities; and IMF staff calculations.
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Inflation and Nominal Effective Exchange rate

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities; and INS.1/ Increase in index represents a depreciation of the ruble in nominal effective terms.

6. The balance of payments has strengthened further as a lower current account surplus has been more than offset by sharply higher capital inflows (Table 2). Reserves increased by a record $156 billion during the year through May 2007, to $403 billion.

Table 2.

Russian Federation: Balance of Payments, 2003-08

(In billions of U.S. dollars, unless otherwise indicated)

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Source: Central Bank of Russia; and IMF staff estimates.

Excluding repos with non-residents to avoid double counting of reserves.

Excludes arrears.

Net of rescheduling.

  • The current account surplus is declining as a result of continued strong import growth and a notable slowdown in energy export growth. Propelled by robust domestic demand, import growth has accelerated, doubling to about 40 percent in January-April 2007 (year-on-year) compared to the same period last year. Moreover, whereas the increase in the non-energy deficit had until recently been more than offset by large increases in both oil prices and oil-export volumes, lower oil prices and the marked slowdown in oil-output growth are now causing a rapid decline in the overall current account surplus. The surplus relative to GDP in Q4 2006-Q1 2007 was only half that of a year earlier.

  • The ruble is still undervalued in real terms, but competitiveness is eroding. Estimates using the Fund’s standardized CGER approach suggest that the ruble is undervalued by 20 percent according to the external-sustainability approach and by 1 percent according to the macro-balance approach, implying a mid-point undervaluation of about 10 percent. This compares with the degree of undervaluation of 15 percent estimated last year. This weakening of competitiveness is confirmed by indices of relative unit-labor costs, which have increased steadily and are now estimated to be above the level just before the 1998 financial crisis. Nonetheless, staff estimates suggest that wages in Russia are still competitive internationally.1 So, while profit margins are facing increasing pressure, competitiveness is not yet a major concern—non-primary commodity exporters have maintained their market share and annual growth in the manufacturing sector is robust at 5-7 percent.

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Current account balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: CBR; and IMF staff calculations.
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Unit labor costs in US dollars1

(Index, 1997=100)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Sources: Russian authorities; WEO; IFS; and IMF staff estimates.1 For manufacturing sector, except Russian ULC, which is for industries.
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Russia: Equilibrium US-dollar wages and actual wages, 1993-2006

(Manufacturing sector)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Staff estimates.
  • Net private capital inflows are surging across all major categories. The underlying increase is even larger if loans related to ownership transfers in the energy sector are excluded. Russia has become a major FDI recipient among emerging market economies, with gross inflows of 3 percent of GDP. Net FDI and portfolio inflows have been boosted by increased merger and acquisition activity and greenfield investment, reflecting strong investor sentiment buoyed by Russia’s growth potential and rapidly rising incomes. Another important development is the surge in overseas borrowing by banks to fund their domestic loan portfolios, reflecting an arbitrage opportunity created by high domestic lending rates and expectations of continued ruble strength. Large share issuances by two state-owned banks boosted capital inflows in the first quarter of 2007.

Net private capital flows, excluding errors and omissions

(in billions of US$)

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For Q1 2007, excludes FDI and portfolio investment in commercial banks.

For Q1 2007, includes FDI and portfolio investment

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External debt

(in USD billions)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: CBR
  • Russia’s external vulnerability is low by most measures, but nongovernment indebtedness is rising rapidly. From end-2004 to end-2006, the government’s external indebtedness dropped from $106 billion to $49 billion, while that of the nongovernment sector rose from $109 billion to $261 billion. This reflects, in part, large-scale foreign borrowing by state-controlled firms (Tables 3 and 4).

Table 3.

Russian Federation: Indicators of External Vulnerability, 2003–06

(In percent of GDP, unless otherwise indicated)

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Source: Russian authorities; and IMF staff estimates.

Gross debt of the general government.

RTS index, end of period.

S&P long-term foreign currency debt rating, eop.

JPMorgan EMBIG Russia Sovereign Spread.

Table 4.

Russian Federation: External Debt Sustainability Framework, 2002-12

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, p increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

C. Macroeconomic Policies

Fiscal policy

7. Fiscal policy has become increasingly expansionary (Tables 5 and 6). Since 2005, fiscal policy at the general government level has added a notable impulse, by allowing more of Russia’s oil-revenue windfall to pass through to the economy (last line in accompanying table), contributing to a gradual increase in demand pressures as resource slack has been used up. This relaxation has been reflected in a deterioration in the general government’s non-oil balance, even as higher oil revenues caused the headline surplus to increase through 2006. The non-oil balance is set to decline further under the 2007 budget, by 0.9 percent of GDP. (In addition to this discretionary relaxation, a further impulse is arising from the automatic stabilizers, to the extent that reduced public savings will absorb the bulk of the negative impact on the economy of somewhat lower oil prices.)

Table 5.

Russian Federation: Fiscal Operations, 2004-08

(In percent of GDP)

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Sources: Russian authorities; and IMF staff estimates.
Table 6.

Russian Federation: Federal Government Budget, 2006-10 1/

(In percent of GDP)

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Sources: Russian authorities; and IMF staff estimates.

For differences between the authorities’ and staff’s projections, see footnote 2 of paragraph 18.

uA01fig20

General Government Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: Authorities; and IMF staff calculations.

Fiscal Indicators of the General Government and Energy Exports

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Sources: Russian authorities and Fund staff estimates.

Calculated as (Xt - Xt-1)/GDPt

8. The relaxation reflects higher recurrent expenditures and a decline in social contributions. Federal primary spending increased by 2¾ percentage points of GDP during 2005-07, mostly because of higher recurrent expenditures in the social and security sectors. A substantial part of this increase was due to higher transfers to extrabudgetary social funds, notably to the pension fund, which saw a sharp deterioration in its financial position as a large discretionary tax cut and continued compliance problems caused a decline in revenues by 4 percent of GDP. At the level of the consolidated general government, primary expenditures rose by 0.4 percentage points of GDP while non-oil revenues declined by 2.6 percentage points of GDP during 2005-07.

Monetary policy

9. Monetary policy has become more accommodative with the CBR’s resumption of a fixed nominal exchange rate policy. Against a backdrop of rapid real appreciation and increasing political concerns about competitiveness, the CBR has been resisting further nominal appreciation of the ruble vis-à-vis a EUR-U.S. dollar basket since mid-2006. This represents a reversal of the policy introduced in early 2005, wherein the CBR had been allowing some, albeit limited, appreciation. The return to a fixed exchange rate has been associated with a surge in capital inflows, record-high interventions, and a sharp acceleration in base money growth, to 41 percent through April (year-on-year). Importantly, the perception that the CBR will eventually have to allow renewed appreciation, in order to keep control over inflation, is exacerbating capital inflows, not least through the banking system. In this regard, the CBR has found that its policy of refraining from active sterilization is resulting in much-faster base money growth, as the source of foreign exchange inflows is shifting from oil revenues, which are sterilized automatically through the stabilization fund, to the capital account.

uA01fig21

Monetary aggregates

(Monthly, real, annual percent changes)

Citation: IMF Staff Country Reports 2007, 351; 10.5089/9781451945881.002.A001

Source: CBR; and IMF staff calculations.

10. Growth in broad money and bank credits is accelerating sharply. Broad money growth (including foreign currency deposits) reached 48 percent by April (year-on-year)—and growth of ruble broad money was even faster at 57 percent, reflecting continued stagnation in foreign-currency denominated deposits. The rapid de-dollarization is also evident from further large cash sales of foreign exchange by households.

11. Rapid credit growth is fueled by ample liquidity and structural changes in the financial sector. Increased liquidity in the banking system has been reflected in real credit growth of close to 40 percent year-on-year—from a low base. Consumer lending is growing particularly fast, reflected in the rising share of household loans in newly extended credit, from 20 percent in 2003 to 33 percent in 2006. Rapid credit growth is also a result of ongoing structural changes in the financial sector, as discussed in Box 1.

12. Banks’ financial soundness indicators are strong, but weaknesses remain in the banking system and in supervision (Table 8). Bank profits have surged, boosted by wide interest-rate margins and high credit growth; aggregate NPL ratios are low; and liquidity buffers remain relatively high. However, NPL and loan concentration ratios are believed to be underreported as the financial sector continues to be plagued by poor prudential data, limited transparency, and weak governance, as discussed below. In addition, concentration of ownership is high and connected lending is a concern.

Table 7.

Russian Federation: Monetary Accounts, 2004–08

(In billions of rubles, unless otherwise indicated)

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Sources: Russian authorities; and Fund staff estimates.

Data calculated at accounting exchange rates.

Represents the government’s use of NIR resources and calculated in flow ruble terms.

Inclusive of valuation gains and losses on holdings of government securities.

The increase in the multiplier in 2004 includes a reduction in reserve requirements from 7 to 3.5 percent in July 2004.

Historical data from IFS. A positive number implies real effective appreciation.