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Recent economic performance has confounded expectations
Economic growth since the August 1998 financial collapse has consistently exceeded expectations. The post-crisis recovery has been faster and more sustained than most observers believed possible in late 1998, with real GDP growing by an average of 6.7 per cent per year during 1999 2003. The recovery has been relatively broad-based: most major industrial sectors and services have grown strongly. However, growth has been driven primarily by export-oriented industries, particularly the oil industry, which has made by far the most important contribution to growth in recent years. In addition, rapidly growing oil exports - together with favourable terms of trade - have also been the main factor enabling the current consumption boom to unfold without putting the external balance in danger so far. However, significant increases in productivity have also been crucial, as they have helped Russian industry to stay competitive in the face of rising wages and a strengthening real exchange rate.
Living standards are rising, but health and mortality indicators have continued to deteriorate
The economic growth of the last five years has had a direct, positive impact on incomes and employment. By 2004, real wages and real disposable incomes were well above their pre-crisis peaks, while the unemployment rate had fallen from over 13 per cent in 1998 to around 8 per cent. As a result, the proportion of the population living on incomes below the officially defined subsistence minimum has fallen by roughly one-third since 1999. Until recently, however, demographic and health indicators have continued to deteriorate, despite the resumption of economic growth. Life expectancy for both men and women remains below pre-crisis levels, and the incidence of many ‘poverty-related’ illnesses has increased. Thus far, growth alone has proved insufficient to bring major improvements in health and other social indicators. This points to an urgent need for reform of the health system, which is likely to require additional expenditure, not least in order to ensure adequate treatment for the less well off.
Resource dependence presents certain problems but growth will continue to be driven by resource sectors for some time
Since 1998, Russia has confounded the sceptics. Yet concerns about Russia’s capacity for sustained growth over the long term are not without foundation, given the well known problems associated with resource dependence. The Russian authorities are well aware of the dangers of resource-dependent development and rightly regard economic diversification as a key long-term goal. For some years to come, however, Russia is destined to remain highly dependent on resource exports, above all oil and gas. Indeed, this dependence has been growing in recent years and is likely to continue to increase in the medium term. Maintaining strong growth will continue to require significant export growth, and that will in all probability mean, in the first instance, increasing hydrocarbons exports. In recent years, export growth has been driven by Russia’s private oil companies, which have rapidly been raising investment, output and exports. However, there are limits to Russia’s ability to continue to increase oil exports at current rates. At some point, therefore, it will probably be necessary for the gas sector to become one of the main drivers of export growth. This makes the restructuring of the state-dominated and largely unreformed gas sector a particularly important priority. While further developing resource-sector exports over the medium term is not without risks, these should remain manageable, given the right policies and institutional framework. In this respect, a well-managed fiscal stabilisation fund should make a significant contribution to reducing Russia’s vulnerability to international commodity price movements.
Basic economic indicators
1. Preliminary data.
Source: Goskomstat, Central Bank of Russia, Ministry of Finance, Ministry of Economic Development and Trade, Economic Expert Group, OECD calculations.
Growth has been underpinned by prudent fiscal policies
Prudent fiscal policy has probably been the government’s single most important contribution to sustaining recent growth. The federal budget has been in surplus since 2000, and budgets have consistently been drafted on the basis of fairly conservative macroeconomic assumptions. While strong growth and favourable terms of trade - particularly in the form of high world oil prices - have facilitated improved fiscal performance, the federal budget would probably have remained in rough balance even had oil prices been at long-term average levels throughout the period (see table). This achievement was also in part the result of spending restraint. Although budgetary outlays grew rapidly during the first years after the crisis, the government was remarkably successful in holding down expenditure relative to GDP during 1999 2003. General government expenditures as a share of GDP are now around ten percentage points below pre-crisis levels, but public service provision has not deteriorated, and wage and pension arrears have all but disappeared.
The general government budget
Share of GDP
1. Data for extrabudgetary funds and general government are preliminary.
Source: Ministry of Economic Development and Trade, Ministry of Finance, Economic Expert Group, Goskomstat.
Resource dependence makes fiscal discipline and low debt especially important
Given Russia’s vulnerability to commodity-price cycles, it is difficult to exaggerate the importance of continued fiscal discipline. While good policy cannot eliminate Russia’s external vulnerability altogether, it can do much to mitigate it. In this respect, it is vital to keep the budget in balance across the oil-price cycle. Fiscal policy should be based on conservative oil-price assumptions. If budgetary oil price assumptions are above long-term averages, then budgets should be drafted to achieve corresponding surpluses. Russia’s external vulnerability could further be reduced by making sure that foreign currency denominated debt - both private and state debt - remains fairly low relative to GDP, and by generally facilitating further progress in ‘de dollarising’ the domestic economy.
Windfall revenues accumulated during periods of high oil prices must be carefully managed
In view of the importance of ensuring fiscal sustainability across the oil-price cycle, the creation of a fiscal stabilisation fund is a welcome development. However, current plans imply that the maximum size of the fund might be too small relative to GDP. The fund will need to be rather large in order to ensure that the budget is adequately insured against oil-price drops. At some point, however, the fund may reach a level sufficient for this purpose, raising the question of what is to be done with any further windfall revenues arising from high oil prices. It would then be advisable to use surplus revenues for early debt repayment. The authorities might also wish to consider accumulating additional oil windfalls in the fully funded pillar of the state pension system. The latter option could be a macroeconomically responsible way of distributing the windfall to the population. The temptation to use windfall revenues not needed by the fund to finance tax cuts or higher spending should be resisted, as using such windfalls in this way would be strongly pro-cyclical, would thus counteract the purpose of stabilisation, and would risk jeopardising the fiscal position should oil prices unwind thereafter.
Tax policy could help foster economic diversification
The government’s desire to increase the tax burden on resource sectors (not only the oil sector) in order to reduce it for the rest of the economy is in principle commendable. Such a shift could help to foster greater diversification of economic activity and also to reduce the risk of ‘Dutch disease’. The recent abolition of turnover taxes, levied without reference to profitability, is also a positive step in this respect, as it will tend to benefit processing industries more than resource extraction sectors. A reduction in the Unified Social Tax would likewise be of particular benefit to processing industries. This could be financed by increasing certain price-independent resource taxes to make up the losses to the pension system resulting from such a cut. However, a careful balance must be struck here: given the importance of resource exports to continued growth, it would be undesirable to place too heavy a burden on those sectors. Moreover, any shift towards greater taxation of resource extraction would increase the vulnerability of the state budget to commodity price changes. This makes it all the more important to establish a large stabilisation fund and balance the budget across the oil price cycle.
Monetary policy has tried to balance the competing goals of competitiveness and disinflation…
Monetary policy in recent years has been characterised by a fundamental tension between two conflicting goals: reducing inflation and limiting the rate of appreciation of the real effective exchange rate (REER). While the authorities are rightly concerned that the REER not strengthen too rapidly, some degree of exchange-rate appreciation is desirable. It helps to limit inflation, increases households’ purchasing power, puts pressure on Russian industry to restructure further and eases the burden of foreign debt service. In current conditions, REER appreciation is also all but unavoidable. In recent years, high oil-driven foreign-exchange inflows have maintained constant upward pressure on the rouble. Until 2002, large net outflows of private capital helped to reduce the pressure on the rouble, and fiscal sterilisation also played a significant, if secondary, role. In 2003, however, the importance of both these factors declined and the central bank increasingly sought to reduce the pressure on the exchange rate by buying foreign exchange. Given the limited sterilisation mechanisms available, this resulted in very rapid increases in the money supply, with rouble M2 growing by over 50 per cent in 2003 alone. Nevertheless, the monetary authorities have so far managed to keep inflation on a gradual downward trajectory, aided by strong money demand and smaller increases in regulated prices than in past years.
…but there is a need to focus more clearly on inflation reduction
While a loose monetary policy may have been understandable in terms of the desire to prevent overly rapid real appreciation of the REER, it is highly unlikely that further sustainable disinflation could be achieved with monetary expansion continuing at anything like the rates seen in recent years. In this connection, the increase in core inflation in late 2003, after two years of steady decline, is a source of concern. It is very important to keep inflation on a downward trend, as otherwise expectations might shift to increasing inflation, which would make future disinflation much more costly. Given that large foreign exchange inflows can be expected to continue for awhile, at least as long as oil prices remain high, reducing inflation while avoiding excessive appreciation of the REER will require greater capacity to sterilise such inflows in a non-inflationary way. The newly established fiscal stabilisation fund will help, particularly in conjunction with increased taxation of windfall profits in the oil sector. Nevertheless, it will also be important to strengthen significantly the central bank’s capacity to sterilise the monetary effects of its interventions on the foreign exchange market. This could be done in part by enabling the central bank to issue its own bonds. The need to expand the range of sterilisation instruments at the central bank’s disposal is all the greater in view of the further liberalisation of capital movements that is set to occur under legislation adopted in late 2003. However, under a high oil price scenario and with private net capital flows turning inwards, monetary sterilisation alone is unlikely to be sufficient to counteract remaining inflationary pressures. The authorities should therefore be prepared to allow for somewhat faster real and nominal appreciation of the rouble than in the recent past.
Monetary growth and inflation
Year-on-year growth rates
Source: Central Bank of Russia, Goskomstat, Economic Expert Group, OECD calculations.
The authorities have pursued an ambitious structural reform agenda…
During 2000 03, the Russian authorities seized the opportunity provided by a combination of economic recovery and political stability to pursue a number of important structural reforms. Since the previous OECD Economic Survey, the government has embarked on a major restructuring of the electricity sector, further tax reforms, an overhaul of the pensions system and reform of the railways. New land, labour and customs codes have been adopted since 2001, as well as new laws on joint-stock companies, bankruptcy and money laundering. A package of laws designed to reduce bureaucratic interference in businesses’ activities has already brought about a limited but nevertheless palpable improvement in the business climate. The on-going reform of technical regulation, which includes not only an overhaul of the regulations themselves but also a reform of the process whereby new regulations are formulated and adopted, is of particular importance. After years of delay, the government and the central bank have stepped up the pace of banking reform. Finally, an overhaul of the judicial system has resulted in the adoption of new codes of procedure for the various courts, eliminating some gaps and contradictions in Russian legislation that had often facilitated the abuse of judicial processes. Implementing these reforms will, of course, be much more difficult than adopting them. It is already clear that the implementation of much of the new legislation is extremely uneven, owing to the weaknesses of the state administration and the courts.
… but much remains to be done, especially with respect to administrative and judicial reform
While the structural reform record of the last few years has been impressive, there is still a great deal to be done, especially with respect to the reform of the state itself. To date, improvements in the quality of legislation have not been matched by improvements in the quality of the institutions that implement or enforce that legislation. At present, the weakness, inefficiency and, in many cases, corruption of the state administration, the judiciary and the law-enforcement agencies are among the most important factors limiting progress with respect to implementing structural reforms. Reform of these institutions is thus an increasingly urgent priority, not least as a necessary precondition for the establishment of secure, clearly defined property rights. The arbitrary exercise of state power remains one of the main threats to the security of property rights in Russia as well as a major barrier to the development of many businesses, especially small and medium enterprises. However, reform of the state administration and law-enforcement agencies, though widely discussed since 2000, has barely begun. With respect to the courts, in particular, the mandatory publication of all significant judicial decisions would be a significant step forward. This reflects a more general need for greater transparency in the operations of state bodies at all levels, a need which underscores the importance of free and independent media in combating corruption and making state institutions more open and accountable.
The success of pension reform will depend on reform progress in other areas
The accountability, transparency and integrity of state and private institutions alike will be critical in determining the fate of the pension reform begun in 2002 03. The current overhaul of the pension system is perhaps the most far-reaching social reform now under way. Its success or failure will have enormous implications for both fiscal policy and financial market development, as well as for the welfare of ordinary Russians as they reach retirement age. Yet its success will depend not only on the design of the pension reform itself but also on reform progress in other areas. Given the role assigned to private management companies in the fully funded segment of the new system, both improved corporate governance and financial market reform will be critical. It will also be important that the state manages the system in a consistent, transparent manner in order to establish the credibility of the reform in the eyes of ordinary Russians. Finally, the authorities will need gradually to increase the pension age in order to ensure the fiscal sustainability of the reformed system over the long term while maintaining pensions at satisfactory levels.
Strong growth can be sustained but will require further difficult reforms in many areas
The Russian economy has the potential to sustain strong growth over the longer term, but, given Russia’s inherently fragile economic structure, continued adherence to prudent macroeconomic policies will be essential to achieving this goal. Realising Russia’s full long-term growth potential will also require further structural reform in a large number of areas, to render both the Russian state and the economy more efficient. In addition to those reforms that are the focus of the present survey, Russia faces daunting challenges with respect to health and education, fostering innovation, competition policy, trade and the environment. Fortunately, the Russian authorities have committed themselves to a wide range of needed structural reforms and also to continued macroeconomic discipline. Implementing many of these reforms is likely to prove far more difficult than designing and adopting them, however, and will place great demands on the political will and administrative capacities of the state. Nevertheless, if the authorities are able to deliver on their reform commitments, the Russian economy may well carry on surprising the sceptics.
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