Russian Economic Policy and the Global Financial Crisis
Transcript of speech given at an Institute event
Dear friends, it's a great pleasure for me to speak today among fellow economists. This weekend, in Washington, we have organized major meetings among the G-8 ministers of finance. Tonight, we've scheduled a meeting of the G-20, and there will be a spring meeting of the International Monetary Fund (IMF) and the World Bank. We're meeting in uneasy times.
I remember many friends present here, including my colleagues in the IMF who worked in the early 1990s and who taught Russia to observe tough financial discipline and to keep fundamental indicators of the economy stable. And perhaps many of my colleagues from the IMF in the 1990s at present have difficulties answering why many developed countries of the West are violating tough financial rules at present. Naturally, no one can predict how these major financial stimulus programs adopted by many countries will work, what will be their impact, and to what extent in the future we will be protected from the consequences of very weak financial policy. So there's much to be done by economists, including members of this respected Institute. But I will repeat that we would have been surprised even five years ago at the measures taken by developed countries, so this means that we have much to learn to understand what this practice produces in the future.
But let me make two comments on the side of this presentation. The longest-serving minister of finance was Gordon Brown, who served as minister of finance for 11 years. And perhaps now I'm standing as a dean of the financial community, but let me mention that the recent successes of the Russian economy are due to better financial discipline and to strong financial reserves. These were helped by political consolidation under the leadership of Vladimir Putin, who supported several measures in the fiscal sphere. I should tell you that it was quite difficult to maintain very restrained and conservative policy in the midst of high oil prices to create the stabilization and reserve fund and the national Commonwealth fund, the systems of goal-oriented budgeting, and the targeted policies that have provoked criticism. But many believe that we are creating reserves instead of establishing major industrial enterprises that will liberate the country from its dependency on oil. And due to the support of the leadership of the country, we managed to maintain this restricted and restrained economic policy.
But I think that in terms of fiscal and monetary policy, it was still mild. I think that we need to have a tougher fiscal policy. Over the recent years, the money supply grew to 50 to 60 percent, too much I think, which means that we had a fiscal policy that was too mild. And the growth of loans to the real estate sector in 2007 amounted to 50 percent over one year, and in 2008, when we felt the first indications of the financial crisis, the amount was 35 percent. And I cannot say that all these loans were good or unproblematic. We have difficulties assessing risks related to the cyclical nature of the economy, especially in connection to the acute crisis that we face today. Even if we had not lacked managers in the banks who had experience producing quality loans, we still would have had some difficulties. It is not enough to have experienced management in the banks. Of course, we sense the additional risks related to some specifics that we have today in Russia.
But nevertheless, it is not easy for the government and for the Ministry of Finance to act accordingly despite the presence of major reserves. Russia's dependency on exports of oil, natural gas, metals and other raw materials was too large, and today this has created additional shrinkage of demand inside Russia. In this sense, we are observing the curtailment and shrinkage of the sectors that ensured supply and demand domestically in Russia. Judging from the outcome of the first quarter, the shrinkage was worse than we expected. We thought that the drop in GDP in the first quarter would be 7.5 percent, but it turned out to be 9.5 percent. We thought that industry would drop 10.5 percent, but it dropped 14.3 percent. Investments decreased 15 percent, and the biggest decrease was observed in the processing industry, 22.8 percent, and in construction and building, 19.3 percent. Unemployment is growing and that has forced us to reconsider our assessments and forecasts for this year's prospects. We are going to publish new forecasts next week, but I must tell you that the forecasts of the IMF are close to the assessments made by our analysts.
We are dependent to a great degree on the world economy. The first glimmers of hope for positive growth in the United States and in the world have emerged. There are feelings that the situation will improve. I would like very much to cooperate on that, and the measures adopted by the United States have had an impact on what is happening in the world and in the developing markets, including Russia. However, there are some alarming indicators that tell us that the crisis could be protracted, for instance the failure to use the full capacity of industrial potential, so the shrinkage is only starting, even in the United States. And perhaps it will continue and perhaps we will feel the impact of that factor. Currency reserves have also started to decline. The financial sector is not yet stable enough and no substantial improvement can be observed despite some income indicators we saw recently. I must tell you that those indicators are quite unstable and volatile. We will need to take this into account in our policy. Today, it is obvious that we must calculate our capacity for a longer period, longer than one or two years, and expect a slow upturn coming out of crisis.
In Russia, we are planning our measures based on the assumption that we must be on guard, facing a long-term siege of negative factors. So we intend to keep strong reserves at 7.5 percent, despite the budget deficit this entails. Perhaps our economy will call for even greater deficits so as not to reconsider major programs that the government has announced. Next year, in 2010, and 2011, we are going to decrease this deficit, and we have announced preliminary deficit figures of 5 percent in 2010 and 3 percent in 2011. This is a rather strenuous task, but we are going to keep to this promise to preserve macroeconomic stability so as not to deplete our resources rapidly.
Unlike in the West, we also face the risk of inflation as a result of the recent devaluation of the ruble against the dollar, almost 50 percent against the dollar and somewhat less, 40 percent against a basket of currencies. So this devaluation affects imports, and during last year's economic growth we increased our imports, so depending on the impact of imports, we will have negative results in terms of a price surge. Inflation is now slowing down and we expect that the indicators for the year at 13 percent will be preserved. However, the high budget deficit that will be financed through reserves and not through borrowing in the open market will produce another inflation risk and this is a reason why we are going to preserve a moderate deficit. I mentioned the deficit of 7.5 percent. Together with subordinated loans to the banks, altogether it will amount to 8 percent. According to international rules, perhaps it will be somewhat higher due to other risks.
The first measures we took in the markets were measures to maintain financial stability. Last October, when we understood that perhaps we would face the prospect of devaluation and when the first indicators of crisis appeared, the market's confidence in banks decreased considerably, and people, remembering their experience from 1998, made a run on the banks, withdrawing up to $15 billion from their accounts. For some banks, this was more than 10 percent of deposits and accumulated assets. Russia issued subordinated loans to the banks for the amount of $40 billion that helped save the banking system and maintained its stability. Moreover, those subordinated loans were allocated or earmarked from the National Commonwealth Foundation and from the budget. We offered greater liquidity to the market, which supported the banks but also contributed to the outflow of capital. The central bank opted for a strategy of smooth devaluation. That was highly debated, but again we took into account two considerations: first, the concern that a shock devaluation could produce a run on the banks; and second, corporate clients' large amount of external foreign debt. This would create the risk of nonpayment and nonreturn of credit for major enterprises. In the smooth decline, the banks restructured their portfolio and in October foreign liabilities surpassed foreign assets. In February, they reconstituted 100 percent of the banks' liabilities, restructured in such a way as to be combined with 100 percent of their foreign assets. The banks accumulated or repaid a part of their foreign debts or accumulated reserves in foreign exchange so as to repay their debts and to protect themselves from currency exchange risks. Those measures turned out to be quite expensive but they helped to maintain stability and permitted us to continue this work.
So the situation is quite satisfactory at the initial stage, especially as far as it concerns the financial sector. The second set of measures we used was to reduce taxes. We reduced income tax from 24 percent to 20 percent, and increased the amortization premium for upgrading and modernization from 20 percent to 30 percent. In other words, 30 percent of equipment supplied this year will be equal to a 30 percent reduction in taxable income. This was a stimulus for reequipping industrial enterprises, especially those that work at the high stage of modernization through received loans.
Let me discuss a package of measures adopted this week, a major program to support small businesses. We reduced taxes on enterprises. We nearly doubled the list of small enterprises and we also provided fiscal facilities for such enterprises by reducing twofold their taxes. We increased by several billion dollars the guarantees on lending facilities, allocated additional resources to support regional small-business foundations, and adopted a package of legislation limiting inspections by law enforcement and fiscal agencies during the coming years, especially this year. So a set of measures to support small business were adopted. The total volume of tax reductions has reached approximately 1.5-2 percent of GDP. That is the part of the anticrisis package that is related to the easing of the taxation burden, while other parts of this package relate to the support of the pension system, since the proceeds in the pension system have decreased due to the crisis and due to the decrease of the wages as well. So we adopted a number of measures to support individual industries, such as the auto industry, the aircraft manufacturing industry, shipbuilding, and some others. We are also supporting export industries. We provided additional guarantees to stimulate exports from Russia.
If I add it all up then, the fiscal package has increased the initial budget by approximately 6 percent of GDP. Quite often in Russia, they mention the figure of 10 percent, or 12 percent of GDP, but that's not quite accurate because that includes the volume of liquidity that has been provided by the central bank and the government on a temporary basis to the market. But the volume of the fiscal package in Russia including taxes amounts to approximately 6 percent of GDP. That would be a more accurate figure. We believe that this is an adequate package. Increasing it now could result in greater risks in the area of inflation and capital flight and could deplete reserves. So we believe that the chosen strategy is well balanced and it will help us to maintain the stability of the Russian economy and of the financial system for this year and the years to come.
Indeed, we have a serious challenge in front of us regarding the optimization of state spendings. It covers all areas such as roads, culture, education, and defense. We're preparing a new program for the coming three years, starting from 2010 to last until 2012, and these programs will provide some priorities for this government. This is related to the point that this year, in 2009, the budgetary revenues decreased by 30 percent compared to 2008. The crisis had a large influence on the budget. This is related mainly to oil and gas, and the quick shrinkage of GDP. And this shows that Russia is more vulnerable than other countries regarding the structure of its exports, the structure of its own economy, and of course this creates greater need to promote diversification in the coming years. Therefore, taxes will be restructured to stimulate innovation and transferred to technology. We are preparing a major program on energy efficiency and economical use of energy resources. We'll provide additional programs to reform the housing and utility sectors to make them more efficient and I should say that expenditures for the state management will be cut by 12 percent. I repeat that these programs are intended to optimize our life and they will be implemented in many different areas.
Now let me speak about the new program for the banking system. The main challenge here is bad loans and the increasing volume of nonperforming or nonreturnable loans. These nonperforming loans account for 3 percent of loans in the Russian system but Russian standards are different from international standards, in which the nonperforming loan is the whole amount of loan downpayments. So that means approximately 7.5-8 percent of loans are problematic, bad loans or loans that have some problems in terms of servicing in accordance with international standards. Ten percent for us is a kind of threshold and then we will need to provide some additional support to the banking sector. Therefore, this week, two days ago, the government announced a new program to support the banks, with an additional $28 billion in the form of subordinated credit. This includes support for the national bank and SpareBank on the part of the state as the main shareholder and the cofinancing of subordinated credits, together with the shareholders in private banks. We will offer, in the form of subordinated credit, three rubles from the state for every ruble from private shareholders. That is the second stage of the subordinated credit program, which in total, if will include both state-owned banks and private banks, is worth $28 billion. I think that 10 percent may be not the last boundary, the last threshold of bad loans that we will have. In such a deep crisis, it can be more and the resources of the government, the state, will allow us to provide additional support should the risks get higher.
And of course, I want to say a few words about our international relations. I arrived here from a meeting with the US trade representative, and we discussed issues of trade and Russia's accession to the World Trade Organization (WTO), and I also had a meeting with the new US commerce secretary. But I should say that the WTO is just a part of the problem in our bilateral relations. The agenda is much larger, of course, and it includes the problem of nuclear disarmament, antiballistic missle issues, cooperation with NATO, economic cooperation, the investment regimes of our nations, US investment in Russia and Russian investment in the United States, supporting trade with members of the WTO, and therefore trade relations affect various sensitive areas. Education and culture is also on the agenda and these matters were included in my discussions during my meetings in the State Department this morning.
I should also say that I participated in the meeting of our presidents, Presidents Medvedev and Obama, in London. I must say that the restart process is underway and today, after the meeting, it is acquiring very specific features. We expect that the president of the United States, Mr. Obama, will visit Russia in July and we are preparing some decisions that can be drafted at that summit. And I think that this is a very short period of time, and I think that we must do our best to come up with specific solutions and decisions so that there's a mood of good relations between our presidents. We expect that our relations will improve in many areas and I believe that the coming months are going to be very important in order to implement these expectations that we have in our relations.
Naturally, after the London summit, the role of emerging markets is growing regarding world regulation, a serious program was developed to improve the regulation of the world financial markets. The discussion was between the European representatives and the United States and the United Kingdom in the G-20 summit in London. I think that it was not an empty discussion. There are objective differences in approaches toward the ways out of the crisis and on how to maintain financial discipline and how to regulate markets. Countries such as Russia and China have a new format for our work that provides a break from our normal work with Brazil, Russia, India, and China. While meeting regularly in this format, we had the last meeting in London and after this speech, I am heading to the BRIC ministers' meeting here. And among us, we will discuss the role of our countries in deliberating on these new rules. We will discuss the involvement of our countries in the deliberation of measures to combat the crisis and the provision of additional resources.
So the questions that were raised, not only during this crisis but before the crisis, where whether or not the IMF is representative of all groups of countries, especially stronger countries like the emerging markets, and do IMF decisions take account of the interests of all countries. But I think the IMF, the World Bank, and other financial institutions should increase the role of developing and emerging markets to reflect their capacity and role. Therefore, we note with satisfaction that our countries have been included in the Financial Stability Forum, which is now called the Financial Stability Board, the Basel Committee. And this process has been launched and by next year in the World Bank and by 2011 in the IMF, we'll see more decisive changes in quotas and the representation of our economies in these institutions. Accordingly, we think that the responsibility of world markets is growing, not only with developing nations but developed nation too. For Russia and China, the prospects of the US dollar are still important because our investment of our resources is preserved in this market. We would like to know the prospects of the euro area and we must be sure about these prospects. Therefore, both the United States and the European Union such bear responsibility for their fundamental indicators. This is also probably a matter for international regulation and that is what we were discussing at our meetings, whether this regulation is going to be voluntary, soft, mild, whether it is going to regulate only financial markets and instruments or macroeconomies too. And we also discuss the extent to which the developed nations will bear responsibility for their macroeconomic fundamentals, what is going to be discussed and regulated, and who will have responsibility. This probably requires additional discussions and debates in order to work out new rules and therefore, I think that the meetings that we had in London and that we will have today and tomorrow here in Washington, DC, are related to the creation of a new world financial architecture that will be very different from the financial architecture we have had until present. And Russia will be involved in these processes.
I think I probably didn't cover all of the questions that were of interest to you and therefore I'll be very happy to answer your questions. Thank you very much.