OREANDA-NEWS. January 29, 2013. Growth has slowed somewhat in the second half of 2012, but the Russian economy remains close to its potential. The economy is expected to expand in line with potential growth this year, with risks tilted to the downside given still significant global uncertainties. The monetary policy stance remains appropriate, but the Central Bank of Russia (CBR) should retain a tightening bias given above target inflation and limited fiscal adjustment thus far, and stand ready to undertake additional prudential measures to contain growth in unsecured lending. The authorities should continue to tighten fiscal policy and rebuild fiscal and external buffers while oil prices remain robust. In this regard, the introduction of the new fiscal rule is an important first step, and its full and transparent implementation is crucial. To achieve higher sustainable growth over the longer term, Russia needs to further strengthen its macroeconomic policy framework and accelerate structural reforms.

1. Growth has moderated, but historically low unemployment and high capacity utilization suggest that economic activity is close to its potential. In 2012, consumption-driven growth momentum slowed beginning in Q2, with economic activity dampened by a dip in oil prices and slowing investment and export growth. Annual growth is estimated at 3.6 percent. Despite decelerating economic activity, headline inflation remains above the medium-term target.

2. Against an improving global backdrop, the economy is expected to grow in line with potential in 2013, though with downside risks. The outlook is for moderate growth of about 3.7 percent this year, reflecting expectations of flat oil prices, still-weak external demand, rising imports, and moderating internal demand. Inflation is expected to ease slightly to around six percent. Current policies are broadly consistent with maintaining growth at its potential level, but inflation will remain above the medium-term target without further policy action. Downside risks are significant. On the external side, a worsening of the global economy would affect Russia primarily through the oil price channel. Domestic risks include further delays in reforms and a negative impact from rapid unsecured retail credit growth on private sector balance sheets.

3. The authorities have strengthened their policy capacity to manage volatility and crises, notably by introducing a new fiscal rule and a more flexible exchange rate policy. These steps will enable the ruble to better absorb external shocks. Reserve buffers have also risen, including an increase in the Reserve Fund to about 4.5 percent of GDP. In the private sector, banks have improved their external positions. The authorities’ stress tests suggest that Russian banks are now better prepared to withstand shocks.

4. Despite progress, important vulnerabilities linger. Fiscal policy space to respond to shocks is still limited, and Russia’s public finances remain vulnerable to a decline in oil prices. The Reserve Fund, despite increases, remains below the target of 7 percent of GDP. The government’s non-oil deficit—the overall deficit excluding oil revenues—has been reduced, but is still significantly elevated compared to the pre-crisis period. The oil reference price under the new fiscal rule implies only a moderate reduction in the federal non-oil balance of about ? percent of GDP per year in 2013-4 and of 1 percent of GDP in the outer years. At this slow pace, the non-oil fiscal deficit will stay above the level that is consistent with replenishing fiscal buffers, facilitating balanced economic growth, and adequate saving of the income from the nation's exhaustible oil resources. Due to negative demographics, the pension system is unsustainable, and recent steps to divert pension contributions from the funded Pillar II to the pay-as-you-go Pillar I scheme will further weaken the long-term viability of the pension system and hinder financial market development. Banks’ capital and liquidity ratios have been deteriorating mainly due to strong uncollateralized retail credit growth, with rising loan-to-deposit ratios.

5. The macroeconomic policy framework is moving in the right direction, but structural reforms need to be accelerated to boost sustainable growth. Action is needed in the following areas:

Strict and transparent implementation of the new oil price-based fiscal rule will help smooth spending volatility and contain spending pressures. But the implied oil reference price does not bring sufficient fiscal adjustment. This could result in additional demand pressures, resulting in real appreciation and weakened competitiveness in the non-resource tradable sector. For these reasons, the authorities should consider a gradual shift to a more conservative oil reference price rule. A tighter fiscal stance would also help contain inflationary pressures.

Fiscal adjustment will need to be underpinned by structural reforms, including of the pension system and health care systems. Securing sustainability of the pension system necessitates an increase in the effective pension age and contribution period.

Monetary policy should stay on hold for now, but maintain a tightening bias. The CBR should stand ready to take further action, especially if steps towards more fiscal adjustment are not undertaken. The mission supports the CBR’s planned move to formal inflation targeting and to bring the headline inflation rate down to the 4 to 5 percent target by 2014. To this end, further increase in exchange rate flexibility and improvements in the monetary operations framework are critical.

In the financial sector, further strengthening the supervisory framework remains key to promoting sound financial intermediation that would help underpin investment, growth, and macroeconomic stability. Key shortcomings identified in the 2011 IMF assessment of Russia’s financial sector have yet to be addressed. In particular, the CBR should be granted adequate authority to effectively supervise bank holding companies and related entities, and to address connected lending, and should also be given sufficient power to exercise discretion based on its professional judgment in applying regulations to individual banks. In addition, the CBR should stand ready to implement further prudential measures if the recently announced measures do not mitigate the emerging risk of overheating in retail lending. We support the CBR’s plans to introduce higher provisioning requirements for uncollateralized retail loans and increase risk coefficients for consumer loans.

Lifting potential growth onto a sustained higher trajectory requires reinvigorating long-stalled reforms. Russia’s recent WTO accession should strengthen the business climate by making it more rules-based and predictable, and should be seized upon to strengthen the momentum for domestic reforms. We broadly agree on the current reform plans to strengthen the investment climate, the government’s privatization agenda, and the recommendations in Strategy 2020, but more progress with regards to actual implementation is sorely needed. Efforts to reduce corruption, strengthen the rule of law, and reduce the state’s influence in the economy—including through more decisive and transparent privatization—should be prioritized in order to boost investment, productivity, and income levels.