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International Monetary Fund
Public Information Notice (PIN) No. 03/59
May 9, 2003
IMF Concludes 2003 Article IV Consultation with the Russian Federation

On May 2, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federation.1


Macroeconomic developments remained generally strong, with a third consecutive year of considerable GDP growth, fiscal surplus, and large current account surplus. The economy continues to benefit from the earlier reforms and the post-crisis real depreciation of the ruble, as well as strong world energy prices. For a second consecutive year Russian financial markets were among the best performing in the world, and rating agencies provided a series of upgrades in 2002.

Real GDP grew by about 4½ percent in 2002 although it slowed toward year-end. The impetus to growth continued to come mainly from energy exports and consumption, reflecting a major rebound in real wages from post-crisis low levels and a rapid increase in real noninterest public expenditure. However, investment slowed as real wages in the industrial sector increased more rapidly than productivity, dampening enterprise profitability.

Inflation declined to 15 percent, slightly exceeding the authorities' target range of 12-14 percent in 2002. Inflation during January-April 2003 has remained high despite lower administrative prices increases this year.

Due to continued strong world oil prices, the external current account surplus in 2002 narrowed less than expected. Booming energy exports largely offset a significant domestic demand-induced growth of imports, while non-energy exports grew moderately, reflecting weak external demand. The overall balance of payments also strengthened considerably as a result of a large increase in private capital inflows, largely reflecting greater corporate access to capital markets abroad. Gross international reserves rose to over six months of imports by end-year.

Fiscal policy was loosened in 2002, broadly in line with the budget. Preliminary data indicate that the general government fiscal surplus was some ? percent of GDP, a deterioration of 2½ percent of GDP compared to 2001. The bulk of this deterioration reflected an increase in expenditures—particularly at the regional level in the latter part of the year, which continued a strong upward trend in real non-interest expenditures. Revenues increased by about ¼ percentage point of GDP due to higher oil prices and significant gains in personal income and social taxes. As a result, the deficit in the non-oil balance rose markedly.

Monetary and exchange rate policies continued to aim at slowing the pace of real ruble appreciation, while bringing inflation down, despite the pressures generated by the strong balance of payments and the weaker fiscal stance. The Central Bank of Russia (CBR) intervened to gradually depreciate the ruble against the dollar, only partially sterilizing these interventions by attracting deposits. Continued remonetization of the economy helped avoid a large deviation from the 2002 inflation target, notwithstanding ruble broad money growth exceeding its targeted rate. In early 2003, faced with a surge in inflows due to high oil prices, corporate bond issues, and privatization receipts, the CBR has allowed a modest appreciation of the ruble against the dollar and the euro. The CBR's continued intervention in the foreign exchange market raised reserves by US$10 billion between end-December 2002 and mid-April 2003.

Structural reforms slowed due to the electoral calendar and strengthening opposition from vested interests. The agricultural land law and bankruptcy law were enacted. However, electricity sector reform--while moving forward--was significantly diluted, and progress in other areas has slowed substantially, including other components of natural monopoly reform, deposit insurance, and efforts to strengthen public administration and the civil service. Corruption remains a major obstacle to private sector investment and activity.

Executive Board Assessment

Executive Directors commended the authorities for Russia's macroeconomic performance, which has been marked by strong GDP growth, a large increase in international reserves, and a further improvement in public debt ratios. While high world energy prices have contributed to these results, sound macroeconomic policies have also been critical in bringing about the improved economic and financial position, which is also reflected in a narrowing of sovereign bond spreads and signs of warming investor sentiment.

Directors discussed the challenges facing Russia's economic policy makers against the background of a continued strong balance of payments position. They agreed that cautious and flexible macroeconomic policies will be needed to manage the tension between exchange rate and inflation objectives. In addition, even if energy prices were to remain high, structural reform efforts will need to be reinvigorated and will be essential for sustained, broad-based economic growth that is less dependent on the energy sector.

Directors observed that the authorities' task of containing the real appreciation of the ruble while at the same time lowering inflation has become more challenging. They noted that, although the substantial fiscal adjustment, productivity gains, and remonetization of recent years have thus far limited the inflationary consequences of a monetary policy targeted at the real exchange rate, progress in reducing inflation has been relatively slow. In the current setting of large foreign exchange inflows and uncertainty about the future path of money demand and capital flows, this calls for a change in the mix of monetary and fiscal policies. Specifically, Directors recommended that monetary policy should give higher priority to combating inflation, while fiscal policy should be geared toward containing upward pressures on the real exchange rate.

Directors urged the authorities to resist calls to spend the windfall gains from high oil prices and called for a tightening of fiscal policy in 2004. By helping to sterilize the foreign exchange inflows and lower pressures on prices of non-traded goods and services, this policy stance would slow the real appreciation of the ruble. A tighter fiscal policy would also put the budget in a better position to help meet demands on public resources that will arise from planned structural reforms. Directors underlined that the further reduction in tax rates for 2004 and beyond decided by the authorities recently would loosen the fiscal stance unduly, even if it improves future growth prospects by lowering the tax burden. Accordingly, they encouraged the authorities to ensure that the tax reductions are offset by measures to broaden the revenue base and/or reduce expenditure.

Directors endorsed the view that medium-term fiscal policy should aim for a roughly balanced budget based on a conservative oil price benchmark, as this fiscal stance would best support the authorities' macroeconomic objectives. They accordingly urged the authorities to work toward adopting a fiscal rule to formalize the balanced budget constraint. Directors considered the establishment of an oil stabilization fund as proposed by the authorities as a helpful tool in support of a disciplined fiscal stance. They stressed that such a fund should be managed in a transparent and accountable way, and be fully integrated in a coherent medium-term budgetary framework. Directors also welcomed the establishment of a high-level commission to examine public spending. In particular, they encouraged the authorities to improve the efficiency of public expenditure and to address the problem of unfunded mandates, which has undermined the financial position of local governments.

Directors generally agreed that, to achieve the authorities' macroeconomic objectives, monetary policy will need to give higher priority to reducing core inflation in order to avoid the risk of entrenching inflationary expectations. This will entail preparedness to increase sterilization--along with the development of additional money market tools to do so--as well as acceptance of greater exchange rate flexibility. Directors were encouraged by recent signs of the authorities' willingness to move in this direction. A few Directors nevertheless saw a continuing need for efforts to slow the pace of real ruble appreciation. While acknowledging the authorities' concern about large capital inflows, a few other Directors were concerned that the recent cuts in short term interest rates could risk fueling inflation. Directors welcomed the authorities' interest in starting to prepare for the adoption of inflation targeting when the conditions for making this transition--including financial market conditions and a medium-term fiscal framework--are in place.

Directors expressed disappointment at the recent slowdown in the pace of structural reforms and urged the authorities to reinvigorate the process in order to boost Russia's long-term growth and employment prospects by improving the investment climate, diversifying the economy, raising productivity, and sustaining real wage increases. Key areas of reform include the public administration, the civil service, the judiciary, natural monopolies, and housing and communal services. These, along with trade reforms in the context of World Trade Organization accession, should result in a significant strengthening of governance and the rule of law and a reduction of distortions in the economy.

Directors underscored that sounder financial institutions and stronger financial intermediation will be key to improving the climate for private sector activity, particularly for small and medium-sized enterprises. They welcomed Russia's participation in the Financial Sector Assessment Program, and encouraged the authorities to press ahead with implementing its recommendations. Directors underscored the importance of strengthening the CBR's ability to effectively supervise banks and, in this context, regretted the delay in introducing full International Accounting Standards. In particular, they cautioned that the planned introduction of deposit insurance may prove counterproductive if unsound banks are allowed to participate. Directors called for further steps to reduce the role of the state in the banking sector and, in this context, encouraged the authorities to initiate a strategic review of Sberbank that would address the problems associated with its dominance in the banking sector. Directors commended the significant progress made by Russia in implementing an effective anti-money laundering and anti-terrorist financing regime, and looked forward to further efforts in the period ahead.

Directors supported the authorities' plans to speed up the redevelopment of the government ruble bond market, and encouraged further efforts to develop domestic capital markets to help reduce reliance of the corporate sector on foreign currency borrowing. Directors welcomed the legislative proposals to liberalize foreign exchange transactions, and urged the authorities to ensure that a strengthening of the financial system and better enforcement of prudential norms go hand in hand with liberalization. They encouraged the authorities to remove the remaining exchange restrictions under Article VIII, and considered that, in the current environment of sizable capital inflows, the authorities should avoid introducing new controls.

Directors welcomed the authorities' decision to proceed with new data and fiscal transparency Reports on the Observance of Standards and Codes, and encouraged them to resolve the outstanding issues related to subscription to the Special Data Dissemination Standard.

Directors noted that with its strong balance of payments and foreign reserves position Russia is well placed to make voluntary advance repurchases on its outstanding obligations to the Fund, and a number of Directors encouraged the authorities to do so at an early opportunity.

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