Group 2 says it will focus on analyzing external economic conditions, as well as the budget (planned general parameters of budget, expenditures, and government debt) and monetary and credit policy. Questions of taxation policy, development of institutions and business-climate will be left to other Groups. This Group has so far produced only one document, so I will take it as reflecting the thinking of the whole group.

Jeff says that ….

(This Group seems confused about a number of things: it says there should be “inflation targeting” but that it may have to be “modified” if the effect on the ruble exchange rate is too adverse; and wants to “restrict undesirable inflow of foreign capital without rejecting the idea of liberalizing the movement of capital” by “differential reserve obligation rules on ruble and foreign currency liabilities of banks”; and the evergreen issue of “crowding-out” gets a mention. But then, welcome to the real world of monetary policy making!! Two other issues are also worth noting. One issue is that the Group says “economic policy is at a crossroads. “If the priority is macro-economic stabilization, then tough measures are needed to cut government spending and quickly eliminate the budget deficit. The alternative is to use government expenditures as a way of boosting GDP growth, which results in maintaining the budget deficit and increased government debt.” But, I wonder, is there a middle way? The other issue is this claim: “Based on the taxation system of 2010, with a long-term average receipts of 34% of GDP, the broader budget of government seems to have a income fluctuation of 28-40% of GDP due to changes in oil prices and the business-cycle.” Are there are similar calculations for other countries?)

According to this Group, the main external factors affecting the Russian economy over the next decade will be the price of oil and resources that Russia exports, the volume of demand for these, availability of capital in world markets for Russian borrowers, the rate of world economic growth, and demand for Russian non-resource exports.

Turning to the internal Russian economic scene, the Group identifies some long-term threats:

(1)       Prolonged period of declining population;

(2)       Depletion of main recoverable natural deposits of hydrocarbons;

(3)       High costs of labor, electricity (which on average is close to the costs in developed countries) which will also be affected by future rise in the internal price of natural gas.

The Group says that it will thus be necessary to form a new model of economic development which secures steady long-term growth, diversification of the economy, and lowers its dependence on external market conditions. The fundamental problem for macro-economic policy is securing a reasonable degree of stability and predictability in important policy parameters in combination with adapting the economy to internal and external shocks.

Given the decline in the labor force it will be necessary to significantly increase domestic saving and capital investment. Once source of capital accumulation is the possible return of Russian funds that have left the country. Second source is increased domestic savings, which will require higher real interest rates than in the past. Third source is pension fund saving (particularly non-state schemes).

It is also necessary to maximize favorable conditions for direct foreign investment.

Budgetary Policy

The Group says that the post-crisis situation of the Russian budget is radically different to that pre-crisis, as the surplus of 8% of GDP has moved to deficit of 4% of GDP – and in addition, military spending is set to increase by another 2-2.5% of GDP.

Fluctuations in oil/gas prices lead to swings in budget income, the Reserve Fund, possibly the amount of external and internal debt, interest rates and the rate of economic growth. Until the crisis, Russian budgetary policy was pro-cyclical. In the period to 2020, main budget principles should be: conservative approach to budget planning; framework of rules for using additional non-oil/gas income of budget; step-by-step lowering of role of federal budget as basic source of financing the deficit of the Pension Fund of the Russian Federation.

Based on the taxation system of 2010, with a long-term average receipts of 34% of GDP, the broader budget of government seems to have a income fluctuation of 28-40% of GDP due to changes in oil prices and the business-cycle.  (In 2010, GDP in current prices was about $US1.5 trillion.)

Fluctuations in income suggest that a conservative approach to the budget is needed.

All oil income above an established threshold should be put in oil/gas funds (Reserve Fund and National Welfare Fund) according to pre-determined calculation. Reserve Funds should be used to finance the budget deficit only in the case of an income shortfall caused by lower than (budget) forecast oil prices. 

It is reasonable to finance the non-oil/gas budget deficit by issuing securities on the domestic market.

Key task of budget policy is to renew budget balance and to reduce its dependence on external market conditions.

Economic policy is at a crossroads. If priority is macro-economic stabilization, then tough measures are needed to cut government spending and quickly eliminate the budget deficit. Alternative is to use government expenditures as a way of boosting GDP growth, which results in maintaining the budget deficit and increased government debt.

There are pluses and minuses of both variants.

The first will renew the investment attractiveness of Russia (better macro-economic indicators), creating conditions for lower inflation and lower interest rates, and thus boosting investment activity by the private sector.

In the second variant the source of growth becomes government spending, while government borrowings increase in both the internal and external markets. But this will not be painless. Borrowing in the internal market means that resources are directed to the budget and not to financing of private capital investment. External borrowing increases the inflow of foreign currency, exerting pressure on the exchange rate and making it more difficult to keep inflation within the planned limit.

Thus, the discussion is essentially about, in the first instance a choice between an immediate forcing of faster economic growth and preparation of secure conditions for deferred more steady growth, and in the second instance, between betting on the state or private sector in the role of growth locomotive.

Monetary Policy

Issue of reducing inflation has two levels.

The first is the necessary to minimalise the dependency of internal demand on external conditions.

The second level is connected with the creation of a new “nominal anchor” alternative to the exchange rate and forming market trust in this anchor. In resource dependent economies it can be difficult to simultaneously reduce inflation and control the exchange rate. Thus, Russia needs to decide whether its priority is to lower inflation or stabilize the exchange rate. This Expert Group favors lowering inflation.

Thus, in the medium term (until 2015) the main task for the Central Bank, and the key reference points must be: 

(1)       Reducing inflation to 5% per year, with the eventual aim of moving to a policy of inflation targeting;

(2)       Rejection of the idea of establishing a narrow corridor (a limit of little more than 10% from the average rate) for the nominal exchange rate in relation to some other currency (or a basket of currencies);

(3)       Increase transparency about reasons for decisions of the board of the Central Bank (such transparency is also need to allow a move to inflation targeting and an active interest rate policy).

(4)       Moving to using interest rates as the basic instrument of monetary policy;

(5)       Minimalizing the role of direct exchange rate intervention by the Central Bank. If the exchange rate is to be allowed to be more freely determined, an if interest rates are to play a increased role, influences on the exchange rate determination must be widened. In particular, Bank Russia may move to influencing the exchange rate through the channel of bank liquidity, decreasing or increasing demand for foreign currency depending on the situation in the foreign currency market;

(6)       Differential reserve obligation rules on ruble and foreign currency liabilities. Differential provisions in reserve funds for liabilities in national and foreign currencies are one of the more effective measures to allow Bank Russia to manage the currency structure of the liabilities of banks and to restrict undesirable inflow of foreign capital without rejecting the idea of liberalizing the movement of capital.

(7)       Success in overcoming the short-term challenges and implementing medium-term monetary policy, based on:

Maintaining inflation in a 2-4% range;

Eventually introduction of inflation targeting (modified to take account of changes in world market conditions for raw materials and their influence on the exchange rate) targeting;

Allow maximum possible freedom, taking into account world market conditions and movement of short-term capital, of a floating ruble rate in relation to some currency basket;

Conduct monetary policy by using interest rates determined by open market operations.