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If during periods of stable economic development that does not matter, under conditions of economic shocks (when government actions are the most important), inflation targeting leads to the need of the monetary authorities to address the problem of intermediary optimization with rigidly defined local conditions, and herewith, they have to take into regard the consequences of their previous decisions.

5. On October 18, the RF Central Bank reported on the recovery from January 1, 2011 of the approaches to the formation of a list of the Bank of Russia, which were in force until February 2009. We would like to recall, that the companies included in this list, enjoy the majority of the Central Bank credits, granted to commercial banks.

Like before the crisis, the List of the Bank of Russia will include organizations, whose rating of the long-term creditability in foreign currency under the assessment of at least one of the foreign rating agencies is at the level not less than B- by rating agencies Standard & Poor's or Fitch Ratings or B3 under classification rating agency Moody's Investors Service.

In addition, the Bank of Russia will excluded from the listing the entities, included in the list of strategic organizations, approved by the Governmental Commission on Sustainable Development of the Russian economy. Herewith, the liabilities of systemically important institutions, which will serve as loans to the Bank of Russia as of January 1, 2011, will remain in the pledge before their maturity.

Thus, the Bank of Russia took another step on the exit from the crisis management measures to support the banking system, increasing quality requirements for collateral under the loans granted to them, which can be considered correct and timely measure. At the same time, due to a small number of systemically important institutions included in the List and at the same time having to use a significant amount of debt liabilities, this move will hardly have a serious impact on the Russian economy.

6. In early November, the RF Central Bank has submitted to the RF State Duma the General Directions of monetary policy in 2011 and for 2012 and 2013. In that document the Bank of Russia has clearly outlined its major task for 2011-2013, which should be inflation curbing within 5-7% per year. Herewith, the RF Central Bank does not set quantitative indictors in the dynamics of the ruble rate and declared the continuation of the movement toward a free exchange rate, while smoothing the volatility of the exchange rate. In our view, such a formulation of the purposes of the Bank of Russia allows it to conduct monetary policy more effectively without trying to simultaneously achieve two largely conflicting goals: reducing inflation and maintaining exchange rate. At the same time, it is obvious that in the medium term the Bank of Russia will be unable to restrain from interfere in the exchange rate (in addition to smoothing volatility), due to the high dependence of the Russian economy from external economic situation. Herewith, the intervention of the RF Central Bank is likely to increase in periods of abrupt changes in supply and demand in the foreign exchange market. We believe that namely in such periods the willingness of the Bank of Russia to the free exchange rate regime will be tested in practice.

Among other monetary and credit policy indicators in the medium term are the follows:

enhancing the role of the RF Central Bank interest rate policy in reducing inflation and inflationary expectations (the narrowing interest rate corridor) within the framework of this purpose, the RF Central Bank plans to gradually reduce the difference in interest rates on credits provided to banks and resources attracted from them, in case of significant volumes of transactions between the Bank Russia and banks and the restriction of the corridor will more accurately affect the interest rates in the RF;

Section 2.

Monetary-Credit and Budgetary Spheres cutting down counter-crisis measures;

consolidation and capitalization of the banking sector;

taking into account the situation on financial markets when conducting monetary and credit policy, the question is, in particular, about the decision to change monetary policy, taking into account the dynamics of not only inflation, but also prices in financial markets;

increased transparency and improvement of monetary and credit policy analysis.

With regard to the macroeconomic forecast, included in the Guidelines, the growth of the monetary base in narrow definition in 2011, according to the forecast the RF Central Bank will make 7.7-19.4%. International reserves at the end of 2011 could reach from 478 to billion dollars. The forecast is based on three versions, with an intermediate variant, based on the price of oil in 2011 at the level of 75 dollars per barrel, which is consistent with macroeconomic forecast of the Russian government. In general, the forecast of the Bank of Russia, in our opinion, is fairly realistic and roughly coincides with the IEP assessments. Implementation of the Central Bank estimates in terms of monetary growth will largely depend on the dynamics of capital flows. In the version of "Guidelines", submitted to the RF States index of private capital outflows from Russia for 2010wqszxd has been increased from 9 to 22 billion dollars, which demonstrates once again the volatility and poor predictability of this index, as its outlook has changed several times in During the year, and actual results for the year several times differed from the forecast of the Bank of Russia, given at the beginning of the year.

2.2. National budget 2.2.1. Assumptions of the 2010 budget policy An international crisis of 2008 2009, ever growing debt challenges in Greece, Spain, Ireland and Portugal in 2010 prompted the Government of the Russian Federation to revise the approach to the policy of irresponsible build-up of government expenses and obligations. A trend to curb budget expenses emerged back in 2010 while the budget was corrected and has continued while a budget was shaped for the next three year- period.

We have to confess, however, that our national budget system remains in an extremely unstable condition and strongly depends on the world market prices on energy carriers. Regardless of the planned cuts in expenses expressed in GDP per cent shares, the level of these expenses is still very high exceeding that of 2008. In this situation, a budget crisis objective possibility should be accounted for as early as possible; to prevent such a crisis, to sustain the balance of the national financial system in a long-term perspective must become an inherent condition of formulating a present-day budget policy. Otherwise a future Russia can as well repeat its experience of the 1998 crisis should external economic parameters change unexpectedly.

A main cause of the 1998 financial crisis was inability of any of the Russian governments during three years after the USSR had collapsed to approve and execute a realistic budget:

government expenses exceeded government revenues from year to year manifesting a sustained trend. Impossibility to cover the expenditures by the tax revenues led to monetary financing (up to 1995) and growing borrowings at the internal and external financial markets thus making the national economy vulnerable and sensitive to internal and external shocks.

Restructuring expenses including their serious reduction should have become a key factor in budget balancing. The RF Government being fully aware of political and social implica RUSSIAN ECONOMY IN trends and outlooks tions of such a decision made punctured attempts to streamline expenses of the federal and local budgets; in June-July 1998, Cabinet led by S. Kirienko developed a special program in this area that was duly approved.1 However, these actions were targeted at streamlining of some expenditures only; they looked like attempts to identify and remove inefficient expenditures while the problem was much more complicated: the government had to refuse implementing a considerable portion of its commitments that were impossible to be executed without a dangerous build-up of government debts; the government also had to seriously reform the budget funding system. No such action was done. As a result of the Government hesitancy to cut down the expenditure obligations, a financial crisis developed, and the national budget system collapsed.

The following years up to 2008 went by in a favorable external market situation; it helped improving budget revenues and running a considerable budget surplus (see Table. 6).

Table Implementing budget revenues and expenditures at all the government levels in 19992009, in GDP % 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Federal budget Revenues 12,7 15,5 17,8 20,3 19,5 20,1 23,7 23,3 23,4 22,5 18,Expenditures 14,0 14,2 14,8 18,9 17,8 15,8 16,3 15,9 18,0 18,3 24,Deficit () /Surplus (+) 1,3 1,4 3,0 1,4 1,7 4,3 7,4 7,4 5,4 4,2 6,Consolidated budgets of the RF subjects Revenues 13,4 14,1 14,5 15,1 14,6 14,1 13,9 14,1 14,6 15,0 15,Expenditures 13,3 13,4 14,5 15,5 14,9 13,9 13,6 13,6 14,4 15,1 16,Deficit () /Surplus (+) 0,1 0,7 0,0 0,4 0,3 0,2 0,3 0,5 0,2 0,1 0,Budget of the enlarged government Revenues 33,8 38,3 38,4 37,8 37,1 37,5 39,7 39,6 39,8 38,6 35,Expenditures 35,3 34,3 35,2 36,3 36,0 32,9 31,6 31,2 33,8 33,8 41,Deficit () /Surplus (+) 1,5 4,0 3,2 1,5 1,1 4,6 8,1 8,4 6,0 4,8 6,Source: Federal Treasury, IEP estimates.

Consolidated expenditures continued growing till 2003 inclusively against the sustained growth of the budget revenues; after 2003, they reduced by 4-5 p.p. of GDP. There were two reasons behind such correction of the budget policy.

First of all, any further step up of the budget expenditures would have been against the task of financial stability assurance in the country by curbing inflation. The task of sustaining macroeconomic stability and further de-regulation of economic relations within the administrative Federal Government resolution No 600 On approval of the program of government expenditures saving passed on June 17, 1998 in pursuance of Decree of the President of the Russian Federation of May 26, 1998 No 597 On measures to ensure government expenditures saving was targeted to cut down inefficient social benefits, state investments and subsidies to certain sectors. According to the assumptions of the program developers, the implementation of the program would have decreased budget expenditures by RUR 41.9 billion (1.6% of GDP). To resolve this issue, other governmental resolutions were adopted, among them: RF Government resolution of May 12, 1998 No 438 On measures to strengthen financial discipline, Decree of the President of the Russian Federation of May 14, 1998 No 554 On measures to strengthen financial discipline and implementation of the Budget laws of the Russian Federation, Resolution of the RF Government of July 17, 1998 No 970-r and others.

Section 2.

Monetary-Credit and Budgetary Spheres reform could not be implemented because of the previous budget policy. To reduce inflation to 4%-5.5% per year and to maintain stability and predictability of the Ruble exchange rate, a well-thought budget policy was required together with restrained growth of federal budget expenditures (not exceeding 16.5 - 17 p.p. of GDP); besides such policy was to be combined with slower growth rates of tariffs on gas, electricity, railway transportations, utilities (within 5% - 8% per year) that were controlled by the government.

Secondly, there was an acute need in inventory and reduction of the created, in the previous years, enormous burden of social obligations that could never be realized or that inadequately reflected the then social, economic and demographic situations; this manifested in development of tougher requirements to budget allocations, implementation of an end-result oriented budgeting process and attempts to optimize the network of budget funded institutions.

In 2004 there was a major cut in budget expenditures when the share of federal budget expenditures (as a % share of GDP) fell down by 2 percent points. Such major reduction occurred in a situation when the decision to pursue a conservative budget policy (establishment of a Stabilization Fund, among others) coincided in time with a sharp and unexpected improvement of the external economic environment.

Table Federal budget in 1998 2009: actual and forecasted parameters Federal budget ex- Federal budget exGDP, in current Urals price/barrel, in penditures, penditures as a % Inflation, in % prices, in RUR bln USD in RUR bln share of GDP forecast actual forecast actual forecast actual forecast actual forecast actual 1998 2 840 2 629,6 499,9 379,4 17,6 14,4 5,7 84,4 16,0 17,1999 4 000 4 823,2 575,0 677,2 14,4 14,0 30 36,5 12,0 20,2000 5 350 7 305,6 855,0 1 034,9 16,0 14,2 18 20,2 16,4 27,2001 7 750 8 943,6 1 193,4 1 324,1 15,4 14,8 12 18,6 21,2 24,2002 10 950 10 830,5 1 947,3 2 046,0 17,8 18,9 12 15,1 23,5 23,2003 13 050 13 243,2 2 345,6 2 354,9 18,0 17,8 1012 12 21,5 27,2004 15 300 17 048,1 2 659,4 2 695,6 17,4 15,8 10 11,7 22,0 34,2005 18 720 21 625,4 3 047,9 3 514,3 16,3 16,3 7,58,5 10,9 28,0 50,2006 24 380 26 903,5 4 270,1 4 281,3 17,5 15,9 78,5 9 40,0 61,2007 31 220 33 258,1 5 463,4 5 983,0 17,5 18,0 6,58,0 11,9 61,0 68,2008 35 000 41 444,7 6 570,2 7 566,6 18,8 18,3 7 13,3 53,0 89,2009 51 475 39 063,6 9 024,6 9 636,8 17,5 24,7 8,5 8,8 95,0 59,Source: Ministry of Finance of Russia, Federal Service of State Statistics One can see from Table 7, that in 2004 the revenues of the federal budget were estimated following the macroeconomic forecast estimates that were based on the average annual price of Urals crude for the last 10 years (19942004) 22 USD/barrel. At the same time, the expenditures of the federal budget were estimated from the crude price of 20 USD/barrel. In reality the 2004 price of crude reached its maximum for the previous 30 years hitting an average annual of 34.2 USD/barrel. As a result, the Stabilization Fund that began functioning in January 1, 2004, was considerably replenished reaching RUR 522.3 bln (or 3.1% of GDP) following the 2004 year results.

RUSSIAN ECONOMY IN trends and outlooks Another important factor causing the expenditure reduction (as a % of GDP) was an understated forecast of inflation which initially was planned at 10%. In reality the inflation rate was 11.7%. Thus the expenditures reduced both in real terms and as a per cent of GDP.

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