Russian Federation
2010 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
30 Jul 2010
eISBN:
9781455206483
ISBN:
9781455206483
Language:
English
Keywords:
ISCR; CR; broad money; GDP; lending; government; Nonoil balance excl. one-off receipt; Russia; foreign currency; real interest rate; monetary policy; banking system; balance of payments; Inflation; Global
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The Russian economy has improved after the recession, but recovery is fragile. Executive Directors appreciated the pre-crisis policy of taxing and saving oil revenues in a stabilization fund, which had created significant space for fiscal expansion, monetary easing, and extraordinary liquidity support to the banking system while helping to prevent an abrupt ruble depreciation. Directors agreed that the main challenges will be to implement medium-term fiscal consolidation, mitigate pressures for real appreciation and inflation, restore the health of the banking system, and improve the investment climate through ambitious structural reforms.

Abstract

The Russian economy has improved after the recession, but recovery is fragile. Executive Directors appreciated the pre-crisis policy of taxing and saving oil revenues in a stabilization fund, which had created significant space for fiscal expansion, monetary easing, and extraordinary liquidity support to the banking system while helping to prevent an abrupt ruble depreciation. Directors agreed that the main challenges will be to implement medium-term fiscal consolidation, mitigate pressures for real appreciation and inflation, restore the health of the banking system, and improve the investment climate through ambitious structural reforms.

I. Crisis Recovery

A. A Gradually Improving Economy

The Russian economy is improving, but the recovery is fragile. Inflation has come down rapidly. High oil prices and a return of risk appetite have strengthened the balance of payments. Nonetheless, the banking system is still under strain and financial markets remain vulnerable to shifts in investor sentiment and oil price declines.

1. Hit hard by the global financial crisis, the Russian economy contracted by 7.9 percent in 2009. Domestic demand fell sharply in the first half of 2009, following plunging oil prices and an abrupt reversal of capital flows that brought a multi-year credit boom to an end. Private consumption and fixed investment declined strongly, with the effects on growth compounded by a large rundown of inventories. The contribution of net exports, meanwhile, turned positive as imports contracted.

2. The economy has improved, but the recovery remains fragile. After some temporary softness in the first quarter, short-term indicators point to a strengthening of the recovery (Figure 1). While all components of demand now appear to be expanding, growth is becoming increasingly driven by consumption, reflecting to a large extent the recent 45 percent cumulative increase in pensions and other policy support.

Figure 1.
Figure 1.

Russian Federation: Production Indicators, 2008–10

(Annualized quarter-on-quarter growth rate of seasonally adjusted 3-month moving average, unless otherwise indicated)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Sources: Rosstat; Ministry of Economy; and IMF staff calculations.
uA01fig01

Contribution to GDP Growth

(Percent, SA quarter-on-quarter)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

3. Inflation has been coming down rapidly. Against the background of a large output gap, falling food prices, and an appreciating ruble, headline inflation has fallen from 14 percent (y-o-y) in early 2009 to 6 percent in May 2010. Core inflation—which excludes administered prices as well as fruits and vegetables—has fallen to around 4¼ percent.

uA01fig02

CPI Inflation

(Annualized SA 3-MMA growth rate)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

4. Labor market conditions have improved. The unemployment rate, which shot up in the second half of 2008, has recently been coming down rapidly, to about 7½ percent in May from a peak of 9 percent. At the same time, real wages and real disposable income have strengthened, underpinning the recovery in private consumption.

uA01fig03

Labor Market Conditions,

(Annualized seasonally adjusted growth)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Sources: State Statistics Office; and IMF staff calculations.

5. Following sharp deteriorations, both the current and capital accounts have strengthened. The current account surplus fell to 4 percent of GDP in 2009, from about 6 percent in 2007 and 2008. On the export side, lower oil prices and weak external demand led to a 36 percent decline in export values. This, however, was partly offset by a 35 percent drop in import values that reflected the fall in domestic demand. The current account recovered in the second half of 2009 and preliminary data indicate that it strengthened appreciably in 2010 thus far, reflecting high oil prices and a continued recovery in export volumes. At the same time, the capital account has stabilized amid periods of intermittent outflows and inflows.

uA01fig04

Trade Balance

(Billions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Source: IMF staff calculations
uA01fig05

Private Sector Capital Flows

(Billions of U.S. dollars, quarterly)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Sources: CBR; and IMF staff calculations.

6. The overall balance of payments has remained in surplus, and the ruble has appreciated. Reserves increased by some $60 billion over the past 12 months. The ruble has appreciated by about 20 percent in real effective terms since its trough in February 2009, bringing it broadly back to its pre-crisis level. Although the appreciation since the Fall 2009 CGER exercise exceeds the rise in long-term oil prices over the same period, the CGER estimates—as well as the mission’s assessment—still suggest that the ruble is broadly in line with medium-term fundamentals.

CGER Results, 2009-10

(Percent deviation from estimated equilbrium)

article image

7. Financial indicators rebounded in 2009, but the recent turmoil has roiled markets. As global conditions recovered over the course of 2009, financial market indicators in Russia improved markedly. Russia’s stock market index more than doubled last year, making it one of the best performers among emerging markets. Sovereign spreads, which had peaked at over 850 bps in late 2008, fell to below 140 bps in mid-April 2010. Since then, in the wake of the crisis in Europe and the renewed decline in oil prices, markets have been volatile: the ruble has depreciated by 7 percent against the dollar, Russian sovereign spreads have risen by some 120 bps, and the stock market surrendered its gains for the year (Figure 2).

Figure 2.
Figure 2.

Russian Federation: Financial Market Indicators, 2007–10

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Source: Bloomberg.1/ The MSCI Emerging Markets Index is a commonly used float-adjusted market capitalization index designed to measure equity market performance in global emerging markets. It comprises Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela. Based in U.S. Dollars, 1997=100.2/ Tracks total returns of external debt instruments of emerging markets with an outstanding face value of at least $500 million.

8. The banking system is highly liquid, but banks have been strained by bad loans and credit has remained stagnant. Overdue loans have continued to rise and now stand at 6½ percent of total loans under Russian reporting standards. Reflecting weak demand for credit and the continuing efforts by banks to restructure their balance sheets, credit to the economy has remained largely unchanged in nominal terms since January 2009. There are signs, however, that the accumulation of overdue loans is now decelerating, and that banks are scaling back efforts to boost provisions and capital. Indeed, some of the larger banks, citing an improvement in asset quality, have signaled that they may release provisions to fund new loans later in the year. Although banks’ pre-provision income was relatively healthy in 2009, falling interest rates have squeezed interest margins and increased pressure on banks to begin lending. In this context, credit growth picked up modestly in March and April, reflecting an improvement in credit demand and moderating credit supply constraints.

B. Policy Response to the Recession

The Russian authorities responded forcefully to the recession. 1 The pre-crisis policy of taxing and saving much of the oil windfall created significant space for fiscal expansion, monetary easing, and extraordinary liquidity support to the banking system.

Fiscal Policy

9. There was a dramatic discretionary fiscal relaxation in 2009. The general government nonoil deficit increased from 8¼ percent of GDP in 2008 to 15 percent of GDP in 2009, almost entirely on account of higher spending. This was one of the largest fiscal stimuli in the G-20. However, much of the expansion was targeted at low-multiplier areas, such as strategic sectors and defense and security. Moreover, most of the stimulus was implemented in the second half of the year—too late to prevent a deep recession (Figure 3). By end-2009, the underlying federal government nonoil balance was some 9 percent of GDP above both its precrisis level and the government’s own medium-term target.

Figure 3.
Figure 3.

Russian Federation: Selected Fiscal Indicators, 2008-10

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Sources: Russian authorities; and IMF staff estimations.1/ Authorities’ definition. Includes CIT on oil companies in the non-oil revenue. Dotted line is projection.2/ Cumulative monthly non-oil balance as a share of the actual and projected annual non-oil balance.

Federal Budget Expenditure by Functional Classification, 2008—10

article image
Sources: Budget documents; and IMF staff calculations.

10. The headline deficit was easily financed. Russia’s prudent past management of its oil wealth left the country with large international reserves and low public debt. This created room to monetize the deficit—which swung from a surplus of 4¼ percent of GDP in 2008 to a deficit of 6¼ percent of GDP in 2009—by drawing down the oil funds held at the CBR without significant risks to external stability. Russia’s public debt ratio is below 11 percent.

Monetary Policy

11. Against the backdrop of a more stable external outlook and falling inflation, the CBR has steadily reduced interest rates. It cut its refinancing rate by 525 bps to 7¾ percent from its peak in April 2009. However, given the uncertain economic outlook and reflecting increased risk aversion, nominal interest rates remained stubbornly high for most borrowers throughout much of 2009. In this context, the decline in inflation has turned average real interest rates positive for the first time in many years. Only recently have deposit and lending rates begun to fall more quickly. By contrast, interbank rates have remained within the CBR’s policy corridor, reflecting the high liquidity of the banking sector (Figure 4).

Figure 4.
Figure 4.

Russian Federation: Monetary Policy, 2007 – 10

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Sources: CBR; and IMF staff calculations.

12. The exchange rate has become more flexible. This has, however, occurred in the context of a weaker balance of payments and a sizeable output gap, which has reduced the tradeoff between inflation and nominal exchange rate objectives. Since March 2009, the ruble has appreciated by around 15 percent against the exchange rate basket, with short-run movements sometimes exceeding 4 percent in a single week. Nonetheless, the CBR continues to intervene to avoid abrupt changes in the exchange rate, while still allowing a markedly greater degree of day-to-day volatility. While a further increase in international reserves is not the goal of the CBR’s interventions, it is clearly a byproduct of this policy in an environment of high oil prices, involving sterilization and opportunity costs.

Financial Sector Policy

13. The authorities have been exiting from extraordinary liquidity support extended during the crisis. With banks highly liquid, repo demand has effectively disappeared, and banks have used excess funds to repay their debt to the CBR ahead of schedule. This withdrawal of liquidity, together with the issuance of new CBR bonds and a pick-up in money demand, largely sterilized the monetary impact of the fiscal expansion in 2009 (Figure 5). Also, one bank has partially repaid the public capital injection it received during the crisis.

Figure 5.
Figure 5.

Russian Federation: Liquidity Indicators, 2007 – 2010

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Sources: CBR; and IMF staff calculations.
uA01fig06

Average Daily Repo Operations

(Billions of Russian rubles, volume)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

Source: Haver.

14. Other support mechanisms are also gradually being withdrawn. As of July, regulatory forbearance, in the form of easier provisioning requirements,2 will be gradually brought back in line with pre-crisis norms. Lending limits for uncollateralized loans were reduced in February, and interbank market guarantees are being unwound. Moreover, having expanded the “Lombard list” used for repo transactions during the crisis, the CBR intends to tighten eligibility over time. Collateral rules for nontraded assets used for CBR refinancing are also being strengthened. Finally, an earlier-planned public bank-recapitalization scheme has been scrapped. At the same time, the CBR stands ready to reactivate these facilities should the banking system come under renewed pressure in the face of adverse shocks.

II. Near-Term Outlook And Risks

15. The near-term economic outlook is for a moderate recovery. While the recent rebound is still dependent on policy support, a self-sustained consumption-led recovery is set to gradually take hold, not least because the adjustment of bank balance sheets now appears to have run its course, with banks poised to cautiously expand lending. Gradually rising real wages and lower unemployment should provide additional support to consumption. As a result, GDP growth is projected to reach 4¼ percent in 2010, supported by a boost to consumption and a turn in the inventory cycle (and also reflecting large base effects). However, absent sustained increases in oil prices, underlying growth momentum is expected to recover only gradually, causing annual growth to fall back to around 4 percent in 2011. Reflecting the output gap, still-weak demand, and continued ruble appreciation, inflation is projected to remain subdued, reaching 6 percent (y-o-y) at end-2010 and 5½ percent at end- 2011.

16. Short-term risks are broadly balanced. On the upside, more favorable external developments—particularly higher oil prices and greater capital inflows—or a more rapid recovery in credit could push growth higher. On the downside, external shocks—for example, those emanating from sovereign vulnerabilities in Europe with effects on oil prices or investor sentiment—present the key risk. There are few direct financial linkages, owing to the relatively modest role of foreign banks in Russia’s financial system. However, an abrupt drop in oil prices and a retrenchment in risk appetite could result in larger-than-projected capital outflows given the liquidity overhang in the banking system. A worse-than-expected growth outcome in Russia would have knock-on effects throughout the region, mainly through remittances and trade (Box 1).

Regional Spillovers from the Economic Slowdown in Russia*

The deep recession in Russia had a substantial impact on its regional partners.

  • Remittances. The remittance link is especially strong with the countries in the Caucasus and Central Asia (CCA), as well as Moldova, Belarus, and Ukraine. In the boom years preceding the crisis, Russia was an important employer of migrant workers from these countries, primarily in the flourishing construction sector. As Russia’s real estate bubble burst, however, flows to these countries declined considerably. Individual remittances from Russia to the CIS dropped by more than 30 percent in total—Armenia, Georgia, the Kyrgyz Republic, Tajikistan, and Uzbekistan each experienced a drop in inflows, mainly from Russia, by up to a third in 2009, while remittances to Moldova declined by almost 40 percent.

  • Trade. Countries with strong trade links with Russia also saw a significant decline in their exports, owing to subdued demand in Russia. Exports to Russia from CIS countries started declining in the final quarter of 2008 and dropped by more than a third in 2009. Other neighboring countries experienced a similar pattern—Finland, for which Russia is the third-largest export market on account of transit trade, saw its exports to Russia drop by almost 50 percent in 2009

  • Financial. Over the course of 2008-09, facing a significant depreciation of the Russian ruble vis-à-vis the dollar, many of Russia’s trading partners were compelled to follow suit. Armenia, Kazakhstan, the Kyrgyz Republic, and Tajikistan all devalued their currencies by almost 25 percent. However, high dollarization levels in some of these countries left their financial sectors vulnerable to exchange-rate movements—depreciation impacted the balance sheets of local banks with FX exposures to unhedged borrowers, with negative knock-on effects on lending. Real credit growth has declined on average by over 60 percent in CCA countries since end-2007.

uA01bx01fig01

Imports from CIS countries, 1994-2009

(Annual, USD billions)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

As Russia gradually recovers from the crisis, its regional partners stand to benefit. There are signs that the nascent recovery in the region is being partially supported by positive spillovers from Russia. The decline in remittances appears to be slowing, with some countries experiencing an increase in inflows during the first months of 2010, for example by 15 percent (y-o-y) in Tajikistan, and more than 10 percent in Armenia. Trade channels are also gradually normalizing—after a 10 percent decline in 2009, Moldova’s exports to Russia rebounded by over 40 percent in January-April 2010.

uA01bx01fig02

Net individual remittances to CIS countries, 2007-10

(Quarterly, USD billions)

Citation: IMF Staff Country Reports 2010, 246; 10.5089/9781455206483.002.A001

* Prepared by Andrew Tiffin and Daria Zakharova based on the May 2010 REO for Middle East and Central Asia.

III. Policy Discussions

Medium-term fiscal consolidation is the overarching policy priority for Russia. With continued large oil price increases unlikely, achieving balanced growth will depend critically on an appropriately countercyclical fiscal policy aimed at mitigating pressures for real appreciation and inflation.

17. The oil fund mechanism has served Russia well, creating room for a forceful crisis response. The authorities took full advantage of the ample room for maneuver afforded by the prudent pre-crisis policy of taxing and saving much of the oil revenue and the attendant large reserves. Thus, even after a large drawdown of reserves and a sizeable fiscal stimulus, Russia faces no solvency or financing concerns. Still, the years before the crisis also saw important and growing weaknesses that were manifested in an increasingly inflationary policy mix. The steady rise in the nonoil deficit as more of the oil wealth was spent caused fiscal policy to become ever more procyclical, as private demand was very buoyant. Meanwhile, the attempt to resist the resulting upward pressures on the ruble through foreign exchange interventions caused monetary policy to become accommodative.

18. Against this background, the key challenge facing Russia is to withdraw fiscal stimulus as cyclical conditions normalize. There is a concern that, with spending pressures intensifying, fiscal policy could quickly become procyclical once again as the economy recovers, putting renewed pressure on the real exchange rate and inflation. Such concerns are heightened by the fact that most of the fiscal expansion relative to pre-crisis levels has involved permanent measures, notably large pension increases. This suggests that fiscal consolidation cannot be achieved unless urgent progress is made on long-stalled public sector reforms. Moreover, the authorities’ room for maneuver is further constrained by the fact that—with limited prospects for large increases in oil prices over the medium term—the nexus of strong growth in investment, productivity, real wages, and consumption that powered Russia’s pre-crisis growth is unlikely to return. In these circumstances, a return to an unfavorable macroeconomic policy mix of procyclical fiscal policy and monetary accommodation—coupled with continued slow progress on structural reforms—would likely take a larger toll in terms of rapid real appreciation, lower growth, and higher inflation than in the past.

A. Fiscal Policy: Consolidation through Reform

Increased pressures to spend more of the oil wealth, alongside a highly inflexible budget structure, suggest that withdrawing the fiscal stimulus is the key policy challenge facing the authorities. Meeting this challenge will require a reinvigoration of structural reforms.

19. Withdrawing the very large fiscal stimulus will be a formidable task. The underlying nonoil deficit of the federal government is projected to remain some 9 percent of GDP above its pre-crisis level in 2010. At the same time, the budget has become increasingly inflexible—three-quarters of the increase in the nonoil deficit relative to pre-crisis levels reflects higher permanent measures, with half of the increase attributable to higher pensions alone. Nonstatutory spending is now only 9 percent of GDP—equal to the size of the consolidation needed to reverse the stimulus and achieve the government’s own long-term target for the nonoil deficit of 4.7 percent of GDP by 2015.

20. Fiscal policy is likely to be relaxed further. The original 2010–12 medium-term budget appropriately targeted a gradual withdrawal of stimulus—the nonoil deficit was slated to decline to 9½ percent of GDP in 2012. However, in June, the government passed a supplementary budget which—in addition to previously-announced tax expenditure measures—would lead to a slight increase in the federal nonoil deficit in 2010, compared to reduction of some ¾ percent of GDP implied by the original budget. A second supplementary budget—entailing civil service wage increases—could be passed in the fall. Moreover, the authorities appear to be revisiting the planned pace of medium-term consolidation.

Supplementary Budget for 2010

article image
Sources: Budget documents; and IMF staff calculations.

21. Staff recommended that the fiscal consolidation start now, and be stepped up in 2011–12. With recovery underway, and given the magnitude of the fiscal consolidation needed to reverse the stimulus, striking an appropriate balance between short-term cyclical considerations and medium-term consolidation suggests that the withdrawal of stimulus should begin in 2010. In this context, staff disagreed with the expansion of the federal government’s nonoil balance implied by the 2010 supplementary budget, and warned against another supplement in the fall. In staff’s view, the previously-planned target of reducing the nonoil deficit to 9½ percent of GDP by 2012 remains broadly consistent with the current outlook for economic activity. Looking further into the future, the target of a nonoil deficit of 4.7 percent of GDP implied by the government’s long-term fiscal framework remains an appropriate long-term fiscal anchor.

22. The authorities and staff agreed that fiscal consolidation could only be achieved through a reinvigoration of long-stalled public-sector reforms. However, such reforms had been idle for several years and the authorities acknowledged that there was little momentum for restarting them at this stage. Nonetheless, they were hopeful that progress could be made following the elections in 2012. In this regard, they indicated that a gradual increase in the retirement age and a rationalization of social protection benefits through more rigorous means-testing were being contemplated. The authorities are also considering revenue measures. In particular, they saw scope to: (i) further raise excise taxes and the extraction tax on gas; (ii) introduce market-based valuation for property tax; and (iii) streamline tax-breaks and privileges. Staff expressed concern that delayed implementation of reforms would make it impossible to withdraw the stimulus in a timely manner, noting that the associated macroeconomic risks would increase as cyclical conditions improved. It agreed that an increase in the retirement age was needed to strengthen the viability of the pension system, and indicated that cross-country comparisons suggest that significant savings can be achieved in health and social protection without compromising the quality of service delivery. Staff welcomed the revenue measures under consideration, but noted that most of the adjustment would need to take place on the expenditure side, through reforms and reductions in discretionary spending.

23. Staff and the authorities also concurred on the need to strengthen the fiscal policy framework.

  • Staff underscored that the policy of taxing and saving much of the oil wealth through the Reserve and National Welfare Funds had served Russia well, and created room for a large countercyclical response to the crisis and recession. Preserving this policy would be key to macroeconomic stability.

  • The mission urged the authorities to avoid the use of supplementary budgets. Such budgets have been passed in every year since the 1998 crisis, reflecting persistent spending pressures. Since 2004, with the exception of the recent crisis, the changes implied by the supplementary budgets have invariably increased the procyclicality of fiscal policy.

  • Staff encouraged the authorities to refocus fiscal policy on the nonoil deficit. Use of the nonoil deficit provides an anchor for fiscal policy, given the volatility of commodity prices. Moreover, to ensure an effective countercyclical fiscal response, focusing fiscal policy firmly on the nonoil deficit would help to ensure that spending does not rise and fall with commodity prices. In this regard, staff expressed concern about the use of less conservative oil prices in the 2011–13 medium-term budget.

  • Ministry of Finance officials agreed that the supplementary budgets reflected underlying pressures to spend more of the oil wealth. Nonetheless, while acknowledging that such budgets had increased the procyclicality of fiscal policy, they noted that the Ministry of Finance had had some success in limiting spending pressures. Still, they concurred that it would be preferable to strengthen the fiscal policy framework by avoiding the use of supplementary budgets and focusing on the nonoil deficit. In the area of fiscal risk management, the authorities explained that they intend to develop a methodology for assessing the sustainability of borrowing by quasi-sovereign enterprises, reducing borrowing costs, and introducing limits on the size and profile of external borrowing.

B. Monetary Policy: Focusing on Inflation

The CBR’s policy of allowing greater exchange rate flexibility is a welcome step toward focusing monetary policy more firmly on inflation control. However, the authorities’ commitment to this policy remains to be tested.

24. The authorities and staff agreed that the monetary easing cycle should now be paused. At its June meeting, the CBR kept policy interest rates unchanged. Staff concurred and suggested that the next move should likely involve initiating a tightening cycle. The authorities felt that, as yet, such a move was premature, and expressed concern about the possible impact of higher interest rates on capital inflows. However, they pointed out that monetary conditions were indeed being tightened—given the gradual unwinding of crisis support to the banking system—and that the CBR stood ready to raise reserve requirements, if necessary, in the event of a resurgence of inflation pressures. In this context, staff urged the authorities to aim for a further reduction in inflation from current levels. Finally, the CBR agreed that the continued monetization of the fiscal deficit would pose additional challenges to monetary policy, but considered these to be manageable. In this regard, CBR officials highlighted their recent success in sterilizing excess liquidity through the issuance of central bank bonds (OBRs).

25. Staff reiterated its recommendation that monetary policy be focused on inflation control, in the context of a flexible exchange rate. The mission welcomed the CBR’s more flexible exchange rate policy, and stressed that low inflation would be critical in expanding the availability of long-term ruble financing and reducing dependence on foreign funding. However, with weak cyclical conditions and low capital inflows, the CBR’s commitment to a flexible exchange rate policy still remained to be tested. In this regard, staff felt that the authorities’ monetary policy framework was unclear. It expressed concern that—should pressures on the ruble intensify—the authorities might once again resort to a policy of resisting nominal appreciation, leading to rapid growth of money and credit. These concerns were heightened by the lack of a clearly articulated inflation objective. Indeed, CBR officials conceded that exchange-rate considerations might again be given priority if tensions arose between the objectives of achieving low inflation and limiting appreciation. They felt that—given Russia’s dependence on global commodity prices—the economy was not yet ready to cope with the exchange rate volatility implied by a completely free float.

26. The mission supported the authorities’ technical preparations for an eventual move to formal inflation targeting. Recent enhancements in the CBR’s public communications were playing a key role in preparing the public for such a move. These included regular, preannounced monetary-policy meetings and the issuance of press releases describing the rationale for policy rate decisions. The CBR noted that they were steadily putting in place other key technical prerequisites for a successful transition to inflation targeting. However, in line with the view that the economy was not yet prepared for a flexible exchange rate policy, they did not foresee the adoption of formal inflation targeting in the near future.

27. The authorities and staff agreed that the more flexible exchange-rate regime, alongside cuts in policy interest rates, had helped deter speculative capital inflows. They concurred that a return of capital inflows to pre-crisis levels was unlikely. However, should persistent, large-scale inflows resume, the authorities noted that they might consider the reintroduction of differentiated reserve requirements—by residence and currency—to prevent the accumulation of vulnerabilities in the banking system. They were also taking steps to reduce tax incentives for foreign borrowing, and were discussing ways in which the borrowing plans of state-owned enterprises might be more closely aligned with the authorities’ macroeconomic stabilization goals. Staff agreed that there were circumstances—such as a period of surging inflows caused by persistent and large oil prices increases—where such measures, including capital controls, could be useful, but cautioned that they were likely to lose effectiveness over time and could have undesirable multilateral effects. It noted that exchange-rate flexibility should serve as a first line of defense against a renewed increase in capital inflows, alongside strengthened prudential regulations and supervision aimed at curtailing excessive credit growth (Annex). Both staff and the authorities agreed that reserves were adequate.

C. Restoring the Health of the Banking System

Restoring the banking system to health is critical to ensuring a sustained recovery in credit expansion. This will require decisive action to improve provisioning standards and enhance the CBR’s supervisory powers.

28. Despite improvements in recent years, weaknesses in the regulatory and supervisory framework remain. Generous accounting and provisioning rules, and the lack of comprehensive consolidated supervisory powers, continue to make it difficult to gauge the extent of systemic risks, the severity of the deterioration of the loan portfolio, and the adequacy of capital. In particular, given the sizeable pool of nonperforming and restructured loans, some banks may not have sufficient provisions to deal with unexpected shocks. Indeed, the stock of bad assets is likely to weigh on profitability going forward, making banks vulnerable to an increase in interest rates or a deterioration in economic conditions.

29. Staff urged the authorities to improve provisioning standards. In the mission’s view, strengthening the loan classification and provisioning system is essential to gaining a full understanding of banks’ capital adequacy. In particular, loan risk assessment should be improved and provisioning should be made more forward-looking by taking into account likely future loan losses. Doing so may reduce reported capital adequacy—and in this event, undercapitalized financial institutions should be recapitalized, restructured, merged, or closed. To the extent that better provisioning leads to healthier loan portfolios over time, the risk that increases in interest rates would damage bank earnings and balance sheets will be reduced. While noting the mission’s concerns, the authorities stressed that the situation in the banking system had stabilized—the accumulation of overdue loans had slowed; bank provisions had increased dramatically; and capital adequacy levels were high. Looking forward, therefore, although a few banks might run into problems, the vast majority would be able to handle shocks without much difficulty.

30. Staff welcomed the authorities’ decision to unwind regulatory forbearance. The mission noted, however, that grandfathered loans would require close monitoring and an eventual return to stricter standards. The authorities concurred, but emphasized the importance of avoiding abrupt changes to provisioning or classification requirements. In this regard, they pointed out that most grandfathered loans had a relatively limited maturity, and so would naturally cease to benefit from forbearance in the near future.

31. The authorities and staff agreed that the CBR should be afforded greater supervisory powers. They concurred that priority should be given to enhancing the CBR’s authority to conduct consolidated supervision—including over connected lending. Strengthening regulations on connected lending would be critical to compel appropriate disclosure, ensure that suitable (market) terms are applied to such loans, and enable the imposition of sanctions. The authorities noted that relevant legislation had been drafted or was under preparation in these areas, and that they were proactively analyzing the extent of connected lending in the banking system.

D. Reinvigorating Structural Reforms

Improving the investment climate remains the overarching structural reform priority for Russia. Absent reform, and in an environment of moderate oil price increases, potential growth is likely to be low.

32. Russia’s economy remains heavily dependent on primary commodities. Structural reforms have stalled in recent years, although there are increasing calls to modernize the economy and reduce its dependence on oil. Russia’s nontradable sector is vulnerable to overheating, given its low capacity, while the tradable sector has stagnated in recent years. The crisis has further increased the dominance of the state in Russia’s economy, and reducing inefficient and weak enterprises’ dependence on state support, accompanied by significant restructuring, will be a central, yet difficult, challenge in the years ahead.

33. Staff raised concerns that potential growth could remain low absent structural reforms. Russia’s labor force is shrinking and its demographic trends are not auspicious. Moreover, the unfavorable investment climate—confirmed by Russia’s low ranking on international comparisons in this area—suggests that investment is likely to remain more subdued than in the pre-crisis years. Finally, the scope for further catch-up gains in productivity will inevitably decline over time. These factors point to the need for deep restructuring of the economy, which can only begin once the investment climate is significantly improved.

34. In this context, staff stressed that the key structural reform priority is to improve the investment climate. Civil service and public administration reforms are needed to curtail the pervasive influence of government on economic decision making. Other reforms would help assure investors that property rights will be protected and that the playing field for investing is level. Moreover, moving ahead with the recently announced privatization program would be a useful step toward rolling back the increased state dominance of the past few years. Finally, WTO accession—alongside a reversal of crisis related emergency trade measures—holds the promise of making the investment environment more predictable and rules-based, while reducing dependence on primary commodity sectors.

IV. Staff Appraisal

35. The stabilization fund mechanism allowed a forceful response to the crisis. The pre-crisis policy of taxing and saving much of the oil windfall and the attendant large increase in reserves left significant scope for a vigorous response. Policy-makers took full advantage of the room for maneuver by providing a dramatic countercyclical fiscal stimulus, supported by monetary accommodation as the fiscal deficit was monetized. Moreover, they helped the private sector cover large unhedged foreign exchange exposures by providing massive liquidity injections and easing lending criteria, and above all by allowing a substantial reserve loss, before undertaking a large step-devaluation well into the crisis. This almost certainly averted severe distress in the banking system. Undoubtedly, the crisis has shown that the stabilization fund mechanism is serving Russia very well.

36. Looking forward, the main challenge is fiscal consolidation. With cyclical conditions set to gradually normalize, and with lower potential growth, the authorities should plan on fully withdrawing the large fiscal stimulus in the coming years. Given the scale of this stimulus—some 9 percent of GDP—striking an appropriate balance between short-term cyclical considerations and medium-term consolidation suggests that the withdrawal should have begun already in 2010. The further increase in the federal government’s nonoil balance implied by the supplementary budget is, therefore, regrettable, and another supplement in the fall should be avoided. More worrisome, with most of the stimulus having taken the form of permanent measures—not least higher pensions—advancing long-stalled public sector reforms is now becoming critical to preventing renewed overheating and excessive real appreciation as private demand recovers. The continued lack of support for such reforms and the prospect of only limited, if any, progress before the 2011-12 elections pose major and increasing risks to macroeconomic stability going forward.

37. The fiscal framework needs to be strengthened. Supplementary budgets have been adopted every year since the 1998 crisis—in some years there have been several such budgets. With the exceptions of the recent crisis, the change implied by the supplementary budgets have, since 2004, invariably run counter to what would have been required from a cyclical perspective. Thus, to ensure an effective countercyclical fiscal stance and anchor fiscal policy over the medium term, the authorities should eschew the use of supplementary budgets, and firmly focus annual and medium-term budgets on the nonoil deficit.

38. Monetary policy should give priority to controlling inflation, not the exchange rate. The monetary easing cycle has appropriately been put on hold, and the next move should likely involve initiating a tightening cycle. The increased flexibility of the exchange rate during the past year is much welcome. However, the commitment to a flexible exchange rate policy remains to be tested in an environment that involves a sharper trade-off between inflation and the nominal exchange rate objectives. The mission’s discussions suggest that the CBR is still not ready to commit fully to giving priority to inflation control. Risks in this regard would increase significantly going forward absent decisive action to reduce public expenditures.

39. Strengthening banking supervision is critical. Much progress has been achieved already, but loan risk assessment should be strengthened further and provisioning should be made more forward-looking. Moreover, the CBR should be afforded greater supervisory powers, particularly with respect to consolidated supervision and connected lending, which remains a potentially serious threat. Given the significant stock of international reserves, the authorities are well-positioned to continue to handle emerging threats to financial stability. Staff’s main concern is that failure to decisively deal with the overhang of nonperforming and restructured loans will deter economic growth by hampering banks’ ability to expand credit on a sustained basis and by directing available resources to struggling clients, away from dynamic enterprises seeking to boost investment.

40. A key priority remains reinvigorating structural reforms. With a shrinking labor force, adverse demographic trends, an unfavorable investment climate, and inevitably declining scope for further catch-up gains in productivity, post-crisis potential output growth is likely to be lower than pre-crisis levels. This points to the need for rapid and decisive action to advance structural reforms, with a focus on improving the investment climate and boosting the potential for productivity gains. Progress toward WTO accession is therefore welcome, as it, coupled with a reversal of emergency trade restrictions imposed during the crisis, would help to make the investment environment more predictable and rules-based.

41. The overarching challenge facing Russia is to ensure that consumption of its immense oil wealth does not get ahead of the expansion of its still-limited productive capacity outside the primary commodity sectors. Russia’s record in this regard prior to the recent crisis was somewhat disappointing as the steady increase in the nonoil deficit in the face of buoyant private demand, combined with stalled structural reforms, caused rapid real appreciation and attendant signs of “Dutch Disease.” Encouragingly, the sharp contraction in output as a result of the crisis, and the prospect—absent another prolonged period of rapidly growing oil prices—of Russia’s emerging from the crisis with lower potential growth, are fuelling calls for change. Preventing an overvalued exchange rate by taxing and saving oil revenues, while moving decisively to strengthen the investment climate, remain key to modernization and diversification of the Russian economy.

Table 1.

Russian Federation: Selected Macroeconomic Indicators, 2007–11

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Sources: Russian authorities; and IMF staff estimates.

Excludes one-off tax receipts from Yukos in 2007 and one-off transfers from Nanotechnology and Housing Funds in 2009.

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

Table 2.

Russian Federation: Balance of Payments, 2007-11

(Billions of U.S. dollars, unless otherwise indicated)

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

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

Excludes arrears.

Net of rescheduling.

Includes indebtness of repos by the monetary authorities.

Table 3.

Russian Federation: Fiscal Operations, 2007–11

(Percent of GDP)

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Sources: Russian authorities; and IMF staff estimates.

Based on the staff’s revenue projections and nominal expenditures in the 2010 budget, inclduing the June supplementary budget.

Excludes a one-off receipt of tax arrears from Yukos in 2007 and one-off transfers from Nanotechnology and Housing Funds in 2009.

Table 4.

Russian Federation: Monetary Accounts, 2007–11

(Billions of rubles, unless otherwise indicated)

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Sources: Russian authorities; and IMF 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.

Table 5.

Russian Federation: Medium-Term Framework and Balance of Payments, 2008-15

(Percent of GDP, unless otherwise noted)

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

Russian Federation: Low Growth Scenario Under Unchanged Policies, 2008-15

(Percent of GDP, unless otherwise noted)

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Sources: Russian authorities; and IMF staff estimates.