Mission Concluding Statement 

Russian Federation: Staff Concluding Statement of the 2017 Article IV Mission

May 19, 2017

The economy is exiting a two-year recession that, thanks to the authorities’ effective policy response and the existence of robust buffers, proved shallower than past downturns. Growth is expected to reach 1.4 percent this year, supported by easier financial conditions and higher oil prices. Inflation continues to decline, driven by the ruble appreciation and still weak consumer demand, and is forecasted to reach the Central Bank’s 4 percent target this year and to remain close to it thereafter. Short-term risks to the economy from volatile financial markets and oil prices have diminished. Nonetheless, medium-term growth will be subdued, at about 1½ percent, due to structural bottlenecks (e.g., demographic, technological) and the lingering effects of sanctions that restrain the potential to increase investment.

In this context, the authorities’ policies need to harness the tailwinds from higher oil prices and accelerate the necessary reforms to lay the basis for a new growth model. There are four key priorities: (1) introducing a fiscal rule that anchors consolidation and generates sufficient savings and indirectly dampening the impact of oil price volatility on the economy; (2) reaching the 4 percent inflation target while continuing with gradual monetary policy easing with due regard to the trade-off between inflationary risks and risks to the recovery; (3) pursuing the current financial sector reforms to foster financial deepening and support growth; and (4) advancing decisively on the structural reform agenda to improve growth potential and rebalance growth towards non-commodity sectors.

1. Fiscal Policy

The reinstatement of the three-year budget framework in the 2017-2019 federal budget is a welcome step to reduce policy uncertainty. The pace of deficit reduction in the three-year budget is appropriate, capitalizing on the recovery, to allow a steady adjustment reflecting the reality of permanently lower oil prices. However, more permanent and better targeted measures should be envisaged, including to safeguard growth-enhancing fiscal spending. The purchase of foreign currency using the mechanism unveiled by the Ministry of Finance in February improves the predictability of fiscal policy while cushioning, and eventually replenishing, fiscal buffers. Nonetheless, this mechanism cannot be a substitute for a fiscal rule that anchors the fiscal adjustment. In designing a new fiscal rule, the authorities should consider targeting a higher level of savings to secure intergenerational equity and introducing a mechanism allowing for a smooth adjustment to persistent oil price changes.

2. Monetary Policy

Monetary policy easing initiated in March was appropriate considering the inflation outlook and the decline in inflation expectations. Interest rate cuts should continue at a gradual pace given the uncertain size of the output gap, the volatility of oil prices, and the potential reversal of the exchange-rate-driven disinflation. The Central Bank’s communication regarding prospects for meeting the inflation target should shift to a horizon beyond end-2017 by elaborating a medium-term inflation targeting framework.

3. Financial Sector Policies

Banks are now in a better position to support the recovery with better financing conditions and improved capital buffers. The authorities have increased the resilience of the banking system by setting limits on related-party lending, gradually reducing dollarization through macroprudential measures, and introducing a tiered supervisory framework. To enhance the supervisory framework, the authorities should accelerate the introduction of explicit early bank intervention procedures. The new resolution mechanism should shorten the process of open bank resolution and reduce balance sheet encumbrance. However, the authorities should work towards removing obstacles to the effective use of purchase and assumption (P&A) transactions, replacing central bank funding by federal government funds, and increasing recourse to banking industry capital. In this regard, work on statutory bail-in legislation, that would factor in financial stability implications should continue. Further strengthening the effectiveness of the AML/CFT framework, including through measures related to politically exposed persons and entity transparency, will support the authorities’ efforts to address financial crimes related to tax evasion and corruption.

4. Structural Policies

The above measures and recommendations will help support economic and financial stability and improve confidence. However, these policies need to be supplemented with structural reforms that lift potential output and accelerate convergence towards per capita income levels of advanced economies. So far, the more competitive exchange rate has not ignited a robust response from non-traditional sectors of the economy and a new growth model that is less dependent on commodities has yet to emerge. The authorities have undertaken some structural measures such as passing a PPP law, privatizing some state-owned companies, and purging weak banks from the financial system. However, a wider reform agenda is needed to jump start investment, support the reallocation of factors of production from the non-tradable to the tradable sectors, and increase productivity.

The priorities remain in the areas of property rights, governance, labor market policies, innovation, and infrastructure. In addition, it is urgent to better understand and measure the channels through which the large size of the state may be hampering economic performance. This should allow to focus the states’ activity in areas with positive spillover for productivity and competition, including at the regional level. Given the weak penetration of foreign markets by Russian companies and the need to facilitate the country’s integration into global value chains, the authorities should actively seek to expand the scope and number of their preferential trade agreements. Finally, pension reform, such as increasing the statutory retirement age, could help ease the negative demographic trend on labor markets, while an appropriately designed fiscal rule would—as noted above—shield competitiveness by dampening the impact of volatile oil prices on the exchange rate.