Russia: Facing 'Dutch Disease' Reform
The Russian Federation (BBB- long-term foreign currency sovereign credit rating) has been confronted by the threat of the rapid appreciation of the Russian ruble due to massive oil revenue windfalls and the concomitant lack of competitiveness in the rest of the economy. Russia has attempted to neutralize the problem by intervening heavily in the foreign exchange markets over the past several years – particularly during the second half of 2004 – in an attempt to lessen the strength of the ruble.
The authorities were quite successful in preventing the real effective exchange rate (REER) of the ruble from appreciating significantly in 2002-2003. Real effective appreciation amounted to just 2.4 per cent over these two years, thereby suppressing the “Dutch Disease” phenomenon. The REER appreciated by 6.1 per cent last year against a planned maximum 7 per cent, (see Chart 1). However, the Central Bank of Russia (CBR) continues to face serious problems in trying to keep the REER of the ruble from appreciating, and has already had to increase its intervention in the foreign exchange markets significantly in 2005.
Standard & Poor’s believes that the policy of intervention is becoming unsustainable, and that – following a nominal appreciation – Russia would benefit from a policy of real appreciation of the ruble without heavily intervening in the markets. This will pressure Russia’s domestic industry to reform. The Russian economy must be restructured in order to benefit from its wealth and from its growing integration into the world economy, especially in the context of its future membership in the World Trade Organization. The rapid real appreciation of the ruble will force restructuring of obsolete domestic industry by undermining its competitiveness.
CBR’s primary goal during most of the post-crisis (August 1998) period was to accumulate reserves and prevent nominal appreciation of the ruble, despite large current account surpluses. Trends in monetary and exchange-rate management in 2004 were similar to those pursued in 2000-2003, although monetary management has been increasingly difficult. Given the continuing large current account surplus in 2004, CBR actively intervened in the currency markets to reduce the real effective appreciation of the ruble; it continued to do so through January 2005. Large purchases of US dollars by CBR resulted in foreign exchange reserves (excluding gold) rising to US$119bn at year-end 2004 from US$73bn at year-end 2003. Hefty fiscal surpluses and the resulting increase in government deposits at CBR served as the main method of sterilizing large foreign exchange inflows. However, sterilization became insufficient in keeping the ruble from real appreciation in 2004, as rising revenue from exports of oil, gas, and other commodities put unprecedented pressure on the nominal exchange rate.
The combination of a large balance-of-payments surplus (see Chart 2 and 3), weak monetary instruments, and the central bank’s policy of limiting ruble appreciation resulted in increasingly loose monetary policy in 2004. As a result, the goal of policymakers to reduce CPI inflation to less than 10 per cent by year-end 2004 was not achievable, with inflation reaching almost 12 per cent (see Chart 4).
The conflict between the two monetary objectives – keeping the ruble relatively stable in the nominal terms and reducing inflation – has been relatively benign thus far. However, this is likely to become ever more difficult in the future. Another issue is how consistent current monetary policy is with regard to long-term growth strategy.
Named after the 1970s crisis in the Dutch manufacturing sector, Dutch Disease arises when a natural resource windfall generates a sudden increase in export earnings. Although improving the economic and fiscal accounts in the short run, the impact of the windfall can lead to strong real appreciation of the currency and have other negative effects on the economy (e.g., inflationary pressures from higher demand in the economy if no appropriate policy response is forthcoming). The creation of the Stabilization Fund (SF) in Russia to save current high oil revenue for the future and prevent excessive current spending has been an important stabilizer, particularly in reducing inflationary pressures. The fund, established Jan. 1, 2004, is to accumulate windfall oil revenue until it becomes large enough (estimated at Russian ruble [RUR] 500bn, or US$17bn – enough to finance three years of budget deficit should the price of oil fall below US$20 per barrel). At current high oil prices (averaging US$36 per barrel for Russian Ural oil), the SF accumulated to RUR522bn (or about US$19bn) by year-end 2004, almost double the earlier-targeted RUR278bn. The rapid accumulation of funds in the SF, well ahead of earlier projections and reflecting much higher oil prices, elicited a variety of schemes for using these funds beyond repaying debt.
The dramatic increase in the SF has been accompanied by the rapid strengthening of the ruble. The situation is a reflection of Dutch Disease, of which Russia is fast becoming a classic victim. Commodity export sales bring a tide of hard currency, boosting the local currency to a level where locally produced goods cannot compete on the domestic market with better-quality and relatively good value imports. The government has been weakening the real appreciation of the ruble primarily to avoid or delay the structural adjustment that would necessarily follow the loss of competitiveness of domestic industries and the nonnatural resources export sector. Nevertheless, this enforced prevention against “market” real appreciation seriously undermines the restructuring of these sectors and of the economy at large. Moreover, as shown in the Dutch Disease models, real appreciation will happen over the medium term, regardless of intervention. In the meantime, preventing real appreciation stalls both the necessary restructuring of viable activities and the liquidation of obsolete and inefficient companies.
Russia is a typical mineral economy. Recent estimates indicated that oil and gas alone contribute more than 20 per cent of GDP, 55 per cent of exports, and almost 40 per cent of total federal revenue. The inclusion of ferrous and nonferrous minerals intensifies the dependence of the Russian economy on natural resources, to over an estimated 80 per cent of exports in 2004.
One potential explanation of the recent slowdown in industrial performance in Russia (see Chart 5) is the Dutch Disease effect, which, as seen with the recent appreciation of the ruble, starts to shrink manufacturing. Previous strong growth in some domestically oriented and capital-goods industries (machinery, retail, food, construction, etc.) started to slow significantly in the second half of 2004, suffering from increasing symptoms of Dutch Disease.
As a result, the new estimates for growth in Russia for 2005 and beyond are now increasingly less buoyant than only a few months ago, albeit remaining respectable at 5 per cent or slightly higher. The slowdown in the recent, very robust growth rate is inevitable, as most factors behind it start to peter out. Rising oil prices have started to decline, the recapitalization of the economy and rapid household consumption are tapering off, and the economy has increasingly used up previously underutilized spare capacity. The previously sound macromanagement has also been increasingly dented. While fiscal policy continues to be strong, the conduct of monetary policy has weakened (as noted above).
However, sound fiscal policy may not be enough to keep the economy on the sustainable high growth path envisaged by President Vladimir Putin. In Standard & Poor’s view, policy should be complemented by more-effective sterilization and by more-efficient allocation of Russia’s oil windfall in the economy at large. The broadening of the economy could help counter the decrease in the competitiveness of domestic production, which remains one of the most serious negative impacts of Dutch Disease.
The deteriorating investment climate is also one of the major factors arresting the potential for economic growth in Russia, aggravating Dutch Disease in the country, and discouraging its entrepreneurial spirit. Other factors include:
A more sustainable policy would involve accelerating enterprise reform in the sectors outside oil and gas in order to compensate for the cost of additional imports. Protecting domestic producers from competition encourages inefficient production methods and increases distortions in the market. The economic and institutional restructuring of Russia is crucial for future economic development. The government should strengthen the legal system and regulatory framework and improve financial discipline and corporate governance. These are essential to providing an effective market environment for small and midsize enterprises, especially those in the production of consumer goods and services. In particular, this could decrease inflationary pressure in the nontradables sectors and even increase import substitution of some tradable goods that are now heavily imported (notably consumer goods).