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Moscow Times
March 3, 2005
Smoother Sailing for the Good Ship Russia
By Yaroslav Lissovolik
Yaroslav Lissovolik is chief economist at United Financial Group. He contributed
this comment to The Moscow Times.
The fleet of the world economy appears to have weathered well the storms of last year, which were characterized by high commodity prices, persistent global macroeconomic imbalances and lingering geopolitical concerns. In fact, according to calculations by Deutsche Bank, growth of the world economy reached 4.9 percent in 2004, while inflation remained subdued. These results might have been less impressive if it had not been for the policy anchors of some of the international fleet's leading vessels. These anchors -- economic policy rules -- are widely credited with having taken much of the discretion out of the hands of state bureaucracies, resulting in lower inflation and fiscal imbalances over the course of the past few decades.
The superiority of rules over discretion in macroeconomic policy was elaborated by Edward Prescott and Finn Kydland, who were awarded the Nobel Prize in Economics last year. In one of their seminal works addressing this issue, Prescott and Kydland argued that without commitment to rules, governments face a credibility problem, which tends to get exacerbated by any attempt to use discretion to tame public expectations. The contrast between rules and discretion is quite telling in the macroeconomic policy of two of the world's heavyweights, the European Union and the United States.
In the fiscal domain, the presence of formal rules in the EU (which include a 3 percent of GDP ceiling on the budget deficit as well as a 60 percent of GDP cap on the size of public debt) stands in contrast to the excesses of the discretion-driven U.S. fiscal policy. More generally, policy rules remain necessary in all three key areas of economic policy: the fiscal, monetary and structural spheres. The "unholy trinity" of the world economy is America's runaway fiscal deficit, Europe's lack of structural reforms and Asia's monetary policy of de facto fixed exchange rates.
In Russia, the high dependence on world commodity prices, as well as the past history of low credibility of the state, all favor the use of economic policy rules. The fateful anchor that kept the Russian oil tanker firm amid the storms raging in the world economy last year was the stabilization fund. Yet, the fallout from the monetization of benefits attests to the lingering gaps in the fiscal framework, including at the regional level. In particular, excessively conservative fiscal forecasting gives too much scope for ad hoc fixes and delays in disbursing the needed expenditures.
The good news is that these drawbacks in Russia's fiscal policy are being addressed by the Finance Ministry. In particular, the budget will move to a three-year framework, which would increase predictability in the fiscal sphere. In the area of fiscal federalism, some of the resources allocated to the regions are to be disbursed on the condition that certain criteria are met, or, in other words, in return for prudent fiscal policy. Both of these measures represent the kind of fiscal rules that should lead to greater transparency and efficiency in fiscal policy.
In the monetary sphere, the Russian vessel is suffering from a contradictory orientation associated with targeting both inflation and the real effective exchange rate. One target undermines the other, as the weakening of the ruble gives rise to inflationary pressures. The higher inflation rate increases the real appreciation of the ruble, which undermines competitiveness and reduces growth. To add to the disorientation, there is also a third target -- traced implicitly -- for the nominal ruble-to-dollar exchange rate.
The way out of this Bermuda triangle is to accord top priority to lowering inflation and making the exchange rate an effective anti-inflationary tool. Encouragingly, the authorities in recent weeks have sent signals that they hope to do precisely that. In early February, the Central Bank issued a press release, in which it vowed to eschew the "dollar approach" toward exchange rate policy, while emphasizing the need for greater exchange rate flexibility. These measures, if implemented, would represent important steps toward the introduction of a full-fledged inflation targeting regime, which could become the key anchor for Russia's monetary policy in the medium term.
While inflation targeting has not been widely discussed in Russia thus far, more attention has been paid to capital account liberalization and the introduction of full ruble convertibility. A more open capital account raises the cost of inefficient policies, as capital flight increases, while at the same time enhancing the benefits of structural reforms, as foreign direct investment increases. Also, capital account liberalization puts greater pressure on countries to pursue market-friendly reforms in an environment characterized by growing competition for foreign investment. Accordingly, capital account liberalization can be viewed as yet another device that reinforces the disciplinary role of other rules in the macroeconomic sphere.
Russia has made some headway in capital account liberalization by adopting the law on foreign currency regulation that entered into force in 2004. More recently, the Central Bank announced further measures directed at lowering the reserve requirements on capital inflows into and outflows from Russia. While some of these measures may have been designed to offset the adverse effects of rising interest rates set by the U.S. Federal Reserve, the disciplinary role of the greater openness of the capital account should act as a constraint on Russia's political excesses.
While fiscal and monetary rules support economic stability at the macro level, in the structural sphere they are frequently based on a conditionality framework provided by international organizations or regional trading arrangements, or on greater competition introduced via trade liberalization. For some economies in transition, the role of external anchors was played by EU accession, whereby progress in attaining membership was conditional on the pursuit of structural reforms. In Russia's case, that role in the past was performed by IMF conditions, but that anchor was broken off by the 1998 storm.
With the rules in the macroeconomic sphere now devised by Russia itself, the external anchor has now shifted to the structural sphere, where WTO membership is increasingly taking on this role. The accession-driven process of trade liberalization exerts greater pressure on Russia to reform at the micro level of individual sectors and enterprises. Furthermore, external trade liberalization may reinvigorate competition inside the country and effectively reinforce its disciplinary role. Finally, once Russia wears the straightjacket of a WTO member, it will be guided by the organization's rules and navigation maps for successive rounds of trade liberalization.
Thus, it appears that Russia is gradually moving towards adopting a full set of policy anchors that should render it less vulnerable to the vagaries of the world economy. The pillar of a rules-based framework in the fiscal sphere in the form of the stabilization fund is to be further complemented by inflation targeting in the monetary sphere and WTO membership in the structural sphere. But even if Russia were to adopt all of these economic policy rules, the crucial outstanding question concerns their integrity, which is in turn dependent on the rule of law. The discipline, lawfulness and professionalism of the crew are all key ingredients to setting the vessel on an even-keeled course away from political storms and from the reefs of rent seeking and vested interests.