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Challenges for the Russian Economy* by Andrew Dean, OECD Economics Department, 7 July 2004
The fifth OECD Economic Survey of Russia is released today and I am pleased to be here in Moscow to present the main points of the Survey and to provide Minister Sharonov and representatives of other Ministries and agencies with an opportunity to respond to the Survey’s findings and recommendations.
The positive post-crisis performance
Any economic assessment of Russia must surely begin with its exceptional growth record in recent years. The recovery that began in 1999 has been stronger and more sustained than most observers believed possible in the immediate aftermath of the August 1998 financial crisis. This recovery has had a direct, positive impact on wages, incomes and employment, which are now well above pre-crisis levels. The living standards of the population as a whole - and not merely the better off - have improved significantly.
Some argue that Russia has been lucky. The recovery, after all, was kicked off by a massive devaluation and then boosted by an unexpected rise in oil prices, which has lasted longer than most observers expected. However, these factors should not be exaggerated. Russia has made the most of its luck. Industry has increased productivity at impressive rates in order to remain competitive, even as wages recovered and the effects of the devaluation wore off. The government, for its part, has pursued responsible macroeconomic policies. Fiscal policy, in particular, has been exemplary.
Continuing concerns and policy challenges
In short, since the crisis, Russia has confounded the sceptics. Yet there remain grounds for concern. Russia’s growth depends chiefly on the ability of a small number of resource-exporting sectors, led by the oil industry, to increase output and exports at very rapid rates. As most of you know, there are dangers associated with such resource-dependent development, including vulnerability to external shocks and the risk of ‘Dutch disease’ with the distorted development that is often associated with heavy reliance on natural resource sectors.
There are thus going to be two major challenges for Russia over the coming years:
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The first challenge is to adopt policies that mitigate the risks associated with such resource-dependent growth. After all, growth prospects will continue to depend heavily on resource sectors, for some time - even if policies aimed at economic diversification are successful. Contrary to what some well-known economists have argued, natural resource wealth is not necessarily a ‘curse’. It does, however, present policy-makers with specific challenges, particularly for macroeconomic management.
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The second challenge is the challenge of diversification. The Russian authorities are well aware of the dangers of resource-dependent development and rightly regard economic diversification as a key long-term goal. This will require the implementation of a range of structural reforms designed to create an environment conducive to investment in non-resource sectors.
The Survey’s principal recommendations reflect these two major challenges.
Macroeconomic imperatives
With respect to the first challenge - that of successfully managing a resource-based economy- it is difficult to exaggerate the importance of good fiscal policy. Fiscal prudence cannot eliminate Russia’s external vulnerability altogether, but it can do much to mitigate it. Fiscal irresponsibility, by contrast, would tend to magnify, rather than mute, the effects of commodity-price movements, contributing to boom-and-bust cycles. It is therefore vital to keep the budget in balance across the oil-price cycle. If the oil price assumptions underlying the budget are above long-term averages, then the budget should be drafted to achieve a corresponding surplus. It is for this reason that we are concerned at the apparent relaxation of fiscal policy that appears to be planned for next year. The outlines of the draft 2005 federal budget released last month, when adjusted for the oil price, imply a significant loosening of policy.
We are likewise concerned about plans to use a significant share of the windfall revenues generated by above-average oil prices to finance the planned cut in the Unified Social Tax rather than accumulating them in the new stabilisation fund. The creation of the fund is a most welcome development. If properly managed, it can provide an important tool for maintaining fiscal stability and limiting potentially disruptive exchange-rate movements in response to oil-price fluctuations. However, we believe that the fund’s target level of Rb500bn may well be too small and the temptation to use windfall revenues accruing above the Rb500bn level to finance tax cuts or higher spending should be resisted. This would be strongly pro-cyclical and would thus increase the risk of overheating. It would also risk jeopardising the fiscal position as and when oil prices eventually fall.
The urge to spend at least some windfall revenues is, of course, understandable, given the many urgent calls on the public purse. So is the desire to ease the tax burden on business. However, if the authorities wish to use windfall revenues to finance sustainable tax cuts or expenditure increases, then the best strategy would be to use surplus revenues in the first instance for early debt repayment. This would reduce the government’s future liabilities and thus allow for higher spending or lower taxation in later years - without betting on continued high oil prices. Lower debt would also help to reduce the risk of currency crises and to limit the impact of such crises if they occur.
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. While the latter concern is understandable, further disinflation is likely to require a clearer focus on inflation reduction as the main objective of monetary policy. The authorities should therefore be prepared to allow for a somewhat faster rate of exchange-rate appreciation than in the recent past. That said, upward pressure on the exchange rate during times of high oil prices or large capital inflows could be partially offset without adding to inflationary pressures by enlarging the range of non-inflationary sterilisation instruments - for example, by enabling the central bank to issue bonds.
Progress in structural reform but much to do
Since the previous OECD Economic Survey, Russia’s progress with structural reform has been impressive. The government has embarked on a major restructuring of the electricity sector, an overhaul of the pensions system, the reform of the railways and a major overhaul of commercial law. A large body of new legislation touching virtually every sphere of economic activity has been adopted. However, the implementation of much of the new legislation has so far been extremely uneven. Improvements in the law have not yet been matched by improvements in the quality of the institutions that implement or enforce it. 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 other structural reforms.
Reform of state institutions is thus an increasingly urgent priority, not least as a necessary precondition for the establishment of secure, clearly defined property rights. As some disturbing recent events have highlighted, the arbitrary exercise of state power, at both federal and regional levels, remains one of the principal threats to the security of property rights in Russia, as well as a major barrier to the development of many businesses. Creating a more favourable environment for the emergence and growth of such enterprises will be important to Russia’s prospects for gradually diversifying its economic structure over the long term. This means establishing a level playing field for businesses (in particular, by reducing barriers to entry), reducing the burden imposed by heavy regulation and an often corrupt bureaucracy, and strengthening the financial system. It will also require strengthening the independence of a judiciary that is still too easily manipulated by political and commercial forces outside the judicial system. A policy of focusing on improvements in such basic institutions as these would be a better way to facilitate the long-term diversification of economic activity than would direct state intervention in specific sectors.
Perhaps the most ambitious structural reform undertaken in recent years is electricity reform. The overall approach embodied in the reform is promising and the reform plan is well thought out. However, there are significant risks ahead. The first is that the aims of the reform could be subverted by special-interest lobbying during the lengthy implementation phase. The second danger is that the state will use the many commercial and regulatory levers at its disposal to ‘manage’ the liberalised wholesale market. A stable legal and regulatory framework, with predictable policies, will be needed to assure market participants that this is not the case and to attract investment over the long term. The absence from the entire scheme of plans for a strong, independent regulator must cause concern. This is an area where the reform might yet need to be amended.
Recent events with respect to the power sector reinforce both these concerns. The increased activity of special-interest lobbies, as well as the government’s vacillation with respect to some key elements of the reform and the missed deadlines on approving restructuring arrangements undermine confidence in the reform as a whole and, in particular, in the government’s own commitment to it. If investors and other market participants lose confidence, it is less likely that the power sector will attract the badly needed investment that is one of the chief aims of the reform.
Efforts to reform the natural gas sector also appear to have stalled, apart from Gazprom’s recent commitment to separating its accounts by line of business from 2005. This latter development is certainly to be welcomed, but it represents only a very limited step. Both Gazprom and the government acknowledge that non-Gazprom production must grow rapidly if the gas industry is to develop successfully. This potential for accelerating the growth of non-Gazprom production and making gas supply in Russia more competitive cannot be realised as long as Gazprom controls both the information flows and the infrastructure. There is thus an immediate need to increase transparency in the sector and also to transfer what are essentially regulatory functions from Gazprom to the state. Over the medium-to-long term, Gazprom’s infrastructure provision functions should be separated from its production activities. This will be a long and complex process, which should not be undertaken in haste, but nevertheless it is therefore important that measures to increase competition and transparency within the sector be undertaken soon.
The OECD welcomes the acceleration of banking reform since the last Survey. There is not sufficient time now to assess all the various initiatives undertaken in this important sphere, but it is important at least to note that the various strands of reform complement each other well, which reflects the coherence of the authorities’ overall strategy. This is promising, although one important gap remains: the authorities have still to articulate clearly their plans for the future of state-owned banks. The real test of the authorities’ banking reform strategy, however, will be in implementation. The reforms challenge numerous vested interests and their successful realisation will require considerable political will as well as the development of regulatory capacities of a very high order. Recent turbulence in the sector has highlighted the nature of the problem and has exposed apparent differences in the views of different state institutions with respect to banking reform. The risks are real, but the authorities must not be deterred from pursuing the course they have set. The criteria applied for admission to the new deposit insurance system, in particular, must be applied in a manner that is consistent, rigorous and transparent. The banking problems of the last few days only underline the need for the authorities to continue with banking reform so as to establish a more stable longer-term environment for savers and investors in Russia.
Building on past achievements
In closing, I would like to underline our overall assessment. The Survey pays a great deal of attention to the pitfalls and problems that lie ahead with respect to both macroeconomic and structural policies and sets out a series of recommendations to deal with these concerns. However, the concerns and criticisms should not obscure the fact that both economic performance and economic policy during the period covered by the Survey have been impressive. We wish you and your colleagues every success in building on these achievements in the years to come.
* Introductory remarks at a conference in Moscow to release the July 2004 OECD Economic Survey of Russia organised by the Ministry of Economic Development and Trade.
To view the OECD Economic Survey of Russia 2004 homepage, click here.
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