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Moscow Times
August 24, 2004
Russia Should Store Up for Lean Years Ahead
By Rudiger Ahrend and William Tompson
Rudiger Ahrend and William Tompson are economist and senior economist for Russia
and the NIS in the economics department of the OECD. They contributed this
comment to The Moscow Times.
In a recent comment on these pages ("Diverse Economy Key to Long-Term Growth," Aug. 4), Laza Kekic, director for Central and Eastern Europe at the Economist Intelligence Unit, criticized the Organization for Economic Cooperation and Development and other multilaterals for recommending what he sees as foolish advice to Russia, particularly in advocating tight fiscal discipline. While in principle acknowledging the importance of fiscal rectitude for Russia, Kekic argues that Russia should use windfall revenues to increase spending on health and education. His concern for those sectors is understandable, given the urgent need to improve both education and healthcare, but some of the advice he gives is dangerous and a number of the assumptions that underlie it are unwarranted.
Before examining the economics underlying Kekic's position, it is worth noting that merely pouring money into Russia's underfunded social sectors in the absence of well-designed and effectively implemented reforms would probably achieve little. Yet Kekic has nothing to say about what appropriate health and education reforms might look like.
That caveat aside, the question is what level of expenditure the state can responsibly afford. The OECD position remains that Russia should maintain fiscal balance across the oil price cycle. Government budgets should be based on long-term average oil prices and windfall revenues from above-average prices should be managed with great care.
Kekic does not specify what he would regard as an appropriate level of expenditure but he clearly sees the OECD position as too restrictive, stating explicitly that oil windfalls should be used to finance increases in current expenditures. This would be pro-cyclical, stimulating the economy needlessly during boom times while necessitating even more fiscal tightening than would otherwise be needed when the economy slows due to worsening terms of trade. Across the cycle, this would almost certainly reduce average growth, which in turn would reduce the state's ability to finance social expenditures.
Moreover, unless oil prices stayed at current high levels for years to come -- which Kekic himself regards as unlikely -- windfall-financed spending increases would be unsustainable. When oil prices fell, expenditures would have to be cut in response to revenue shortfalls that had not been adequately provided for in the good times, and social spending might well end up at even lower levels than at present. The experience of many commodity-exporting countries suggests that public investment in things like health and education is among the first to be cut when government revenues fall.
If the government wishes to use windfall revenues to finance sustainable increases in social expenditures, then it would be wiser to use surplus revenues for early debt repayment. This would reduce its future liabilities and thus allow for sustainable higher social spending in subsequent years.
One could argue that increased investment in education and healthcare would rapidly increase Russia's underlying trend rate of GDP growth. This might leave it better off when oil prices decline. Kekic does not address this issue directly. But since he does not expect high oil prices to continue indefinitely and he is unlikely to advocate unsustainable expenditures, this must be his position.
Unfortunately, international experience suggests that this is simply wishful thinking. While higher health and education expenditures are, of course, positively correlated with growth over the long term, there is little to suggest that such spending leads rapidly to increases in potential output. There is, alas, no reason to believe that Russia is exceptional in this respect.
Kekic founds his argument for fiscal loosening on the need to foster the diversification of economic activity as rapidly as possible. He advances a very strong and rather simplistic version of the well-known "resource curse" argument. "Since World War II not a single natural resource-dependent economy has managed to sustain respectable growth over several decades in average real GDP per capita," he writes. "Astonishingly, few such economies have seen even positive growth."
It is difficult to provide a rigorous evaluation of this argument, since Kekic defines neither "natural resource-dependent economies" nor "respectable growth." However, Australians, Canadians, Norwegians and Finns, among others, might be very surprised to learn that they are living at, or only slightly above, 1945 living standards.
Certainly, we agree that resource dependence presents certain dangers and challenges for Russia. But the strong version of the resource curse hypothesis found in some of the earliest articles about resource dependence and growth has recently been challenged by more sophisticated economic and econometric analyses. The so-called resource curse appears to be much less of a certainty than initially claimed, and clearly is no fatality.
In any case, the Russian economy will continue to depend heavily on resource sectors for some years to come. Resource-dependent development is not an OECD recommendation: It is a Russian reality. The issue, therefore, is to identify policies appropriate to that reality. The recent OECD "Economic Survey" of Russia provides a number of suggestions as to how Russia can manage a resource-based economy while acting to mitigate the risks associated with resource-dependent growth, and how it can foster economic diversification over time.
What the survey does not offer is a formula for engineering successful diversification overnight, because no such miracle cure exists. There are, however, plenty of false panaceas: International experience tells us a great deal about what does not work when it comes to accelerating economic diversification, and throwing fiscal prudence to the winds certainly falls into this category. It would do little good for the diversification of the economy, as it would result in higher interest rates (and thus less private investment) and -- if not corrected relatively fast -- would in all probability lead to a balance of payments crisis further down the road.
Kekic argues that there would be no risk of such a crisis for many years yet. Given the large current account surpluses Russia has recorded of late, this might at first glance seem plausible. But Kekic, apparently forgetting the history of the 1990s, underestimates the speed at which the current account surplus could disappear if the current highly favorable terms of trade deteriorated. If oil prices fell back to long-term average levels ($19 per barrel for Urals crude), with export volumes growing at a respectable 6.5 percent per year (the average for 19952003) and import growth slowing to around 10 percent per year (roughly half the rate seen in recent years), the current account surplus would disappear in mid-2005. And commodity prices could indeed fall well below long-run averages.
In theory, current account deficits could be financed by capital inflows, as Kekic suggests. In reality, however, such structural dependence on foreign capital inflows would be extremely imprudent given continuing large-scale capital flight, Russia's extreme vulnerability to terms-of-trade shocks, and the absence of strong, stable foreign direct investment inflows. The increasing FDI inflows to which Kekic refers have yet to materialize and would in any case be likely to slacken if oil prices fell sharply.
In short, Kekic recommends a pro-cyclical fiscal policy in an economy already highly vulnerable to commodity-price fluctuations. This would sharply increase the risk of a balance of payments crisis. A policy of using windfall revenues to finance ongoing current expenditures, even on such worthy objects as health and education, could only make sense if oil prices were to remain high indefinitely or the potential output of the economy were to increase very rapidly as a result of such spending. The latter hypothesis is obvious nonsense, while the former would be an extremely dangerous assumption on which to base policy.
There is no denying that the proposals Kekic offers sound attractive indeed: The prospect of faster diversification and higher social spending is hard to resist when the state's coffers seem to be overflowing with oil revenues. Like the song of the sirens, however, calls to begin spending current windfalls are as dangerous as they are appealing. Heeding them would ultimately risk leading the economy onto the rocks.