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1.58 Additionally, the Russian economy is subject to conventional cyclical ups and downs that are common to market economies. In Russia these changes in business conditions are closely correlated with the movements of oil prices. It is agreed in principle and is actually followed by some countries (for example, in the EU) that it is desirable to make fiscal policy countercyclical (that is, expansionary during recessions and contractive during growth phases). This makes it possible to maintain the real value of expenditures during bad times and to smooth fluctuations in economy. Yet without proper fiscal discipline, the introduction of countercyclical budget instruments could easily become a burden for the fiscal system.

1.59 While deciding on the implementation and financing of structural reforms, the Russian government should place these decisions in the broader context of other macroeconomic and fiscal challenges that the country faces. Otherwise, macroeconomic stability and sustainable economic development could be jeopardized.

1.60 In order to deal with fiscal challenges and foster economic stability, it has become common in many countries to develop and apply fiscal rules (OECD, 2002; Kopits, 2004).

These rules are usually fixed in legislation and represent a permanent constraint on fiscal policy. They applied to budget deficit or expenditures, or both, and may be expressed in actual or cyclically adjusted terms. Kopits and Symansky (1998) argue that the strongest case for fiscal rules is based on political economy arguments -- the rules correct the bias of shortsighted governments to accumulate public debt at the expense of future generations and that avoiding time-inconsistency issues results in significant credibility gains.

1.61 The experience of other countries shows that proper fiscal rules help in carrying out sound fiscal policy. They establish benchmarks for fiscal performance that help to discipline policymakers and subdue political pressures. For example, the United Kingdom uses two fiscal rules since 1997: (i) the golden rule, which stipulates that over the economic cycle, the government will borrow only to invest and not to fund current spendings, and (ii) the sustainable investment rule, which stipulates that the net public sector debt to GDP ratio will be held over the economic cycle at a stable and prudent level. A fiscal rule introduced in Switzerland in 2003 sets a ceiling for government expenditures, which cannot exceed cyclically-adjusted revenues (OECD, 2002).

1.62 The Russian Budget Code also contains a kind of fiscal rule stipulating that the annual budget deficit of the federal budget cannot exceed the sum of budget investment and interest expenditures. It means that government borrowing cannot be used to finance current outlays, except for interest expenditures. Although, at the first glance, this rule looks similar to the British golden rule, it does not provide for sufficient fiscal rigidity. In fact, the economy could be moving to a debt trap, while be in full compliance with this rule -- new borrowing would be made to finance interest expenditures, which would increase both a stock of debt and future interest spending, thus creating a need for even larger borrowing in the following budget cycle.

1.63 Nonetheless, this legislated fiscal rule has been an important positive development. If it had been adopted a few years earlier, the rule could have been helpful as a tool of fiscal adjustment during the period of high budget deficits in the 1990s. However, in its current form the rule is not sufficient to address the present fiscal challenges that Russia confronts. There is a need for the further development of fiscal rules for Russia, which would enable the government to successfully deal with the above-mentioned major fiscal challenges: oil price volatility, the financing of structural reforms, and economic cyclicality. Each of the three fiscal challenges requires a special risk-mitigating strategy. The adoption of fiscal rules could be considered a part of such mitigation arrangements.

1.64 The rest of this section suggests three possible specific fiscal rules for Russia, which could be introduced as a part of the overall government efforts to strengthen its budget management system. Such rules could be ultimately incorporated into the Budget Code and become a part of Russias regular budget process.

1.65 Rule #1: Fiscal sustainability rule. The debt stock of the federal government may not exceed 30 percent of GDP.

Like the United Kingdom, Russia could benefit from having a formal fiscal rule related to the debt stock of the federal government. For the purpose of simplicity, the debt-to-GDP ratio could be suggested as an indicator preferable to more sophisticated ones that allow measuring debt on a net basis and in net-present value (NPV) terms. Given Russias country risk profile and a high share of foreign currency debt in its debt structure, it appears that for sustainability reason Russia should maintain a fairly low limit for its government debt. In particular, we believe that the federal debt stock level in Russia should be limited to 30 percent of GDP. Let us note that, before the 1998 crisis, the debt-to-GDP ratio for the general government was below percent, which is substantially less than the debt ratio stipulated by the Maastricht criteria. As Kopits (2004) emphasizes, markets have far lower tolerance for relatively high public debt-to-GDP ratios in emerging market countries than in advanced economies.

1.66 At the same time, following the best OECD practice, we believe that the rational longer term targeted debt level for Russia should be lower than is allowed by sustainability constraints, and it may be advisable to set such a target at 20 percent of GDP or lower. The government debt-to-GDP ratio is already below 30 percent of GDP and is heading towards a 20 percent level. Thus, the current government policy is de facto well in line with the proposed rule (i.e. in the short to medium terms this rule will not be binding for fiscal policy in Russia). However, the problem of high debt levels may re-emerge when oil prices fall and the fiscal balance deteriorates markedly. The fiscal rule that limits future debt accumulation, adopted as a separate law or as an amendment to the Budget Code, would help the government to prevent this problem.

1.67 Rule #2: Oil price rule. An oil price adjusted Federal budget is allowed to be in deficit only temporarily to finance earmarked expenditures that are related to the implementation of specific structural reforms. The size of such a temporary deficit shall not exceed 2 percent of GDP.

World oil prices are highly volatile. This volatility is driven by a number of economic and political factors on both the supply and demand sides. More or less accurate long-term forecasting of oil prices is virtually impossible and inaccuracies in forecasts are huge.However, the long-term moving average oil price, around which actual oil prices tend to fluctuate, demonstrates stability.

1.68 This makes it possible to design a fiscal rule based on the long-term average price of oil.6 Such an oil price adjusted budget could be recalculated using the counterfactual oil price of 20 US$/bbl for crude Russian oil. While the actual budget outcome may turn out to be in deficit or in surplus, the oil price adjusted budget (or budget in the long-term) needs to be balanced.

1.69 However, given the above-discussed needs for financing structural reforms in Russia, we believe it is important to include a special covenant in the fiscal rule which would permit accommodation of reform-related fiscal costs in the budget.1.70 The first group of structural reforms, discussed above, requires just temporary budget financing for their implementation. Thus, the fiscal rule #2 would provide a binding fiscal framework for financing these reforms. In addition, the rule could help bridge the financing of the second group of structural reforms that result in permanent additional government spending. Specifically, for each reform belonging to the second group, special budget financing from the structural reforms fund (SRF) could be provided on a decreasing basis. For instance, it could cover 100 percent of incremental costs during the first year, 50 percent during the second year, and 0 percent during the third year. Such an approach would give the government time to identify and implement measures necessary to create fiscal room in the Pinto (1987) estimated a standard forecast deviation at US$10.7 per barrel.

The latter is estimated at $18-20 per barrel for the Russian Urals after accounting for the ongoing price boom.

Beetsma and Debrun (2004) find -- in the context of the Euro areas Stability and Growth Pact -- that sometimes fiscal rules may need to be relaxed for countries that are actively pursuing much-needed structural reforms.

budget for new liabilities that would emerge as a result of the reforms. Controlling the overall size of the SRF would allow the monitoring of whether the second fiscal rule is adhered to.1.71 The proposed oil price rule should be applicable for the federal budget, as it demonstrates the much higher oil price sensitivity of its revenues than subnational budgets.

The reason behind it is that almost all tax revenues, which are directly dependent on oil prices (oil export duties, mineral resource extraction tax on oil), accrue to the federal budget.

1.72 Rule #3: Structural fiscal balance rule. The structural budget should be kept in balance.

It happens quite often that countries enjoying rapid economic growth boost their budget expenditures, which gives an additional (albeit temporary) impetus to their GDP growth. At the same time, such a pro-cyclical fiscal policy makes the public sector compete for resources with the private sector and pushes up interest rates. When the growth phase of an economic cycle comes to an end, then it becomes very difficult to cut back the inflated government expenditures and restructure them in order to expand the counter-cyclical spending components.

1.73 This is why, for example, the countries in the euro area have been discussing a modification of their budget rules to allow for a cyclical adjustment.9 The budget adjusted for the impact of economic cycles is called a structural budget. The same approach, in principle, could be applied in Russia in order to prevent pro-cyclical budgetary expansion during booms (e.g., when GDP growth rate is above 5 percent) and to allow for countercyclical budgeting during recessions (e.g., when GDP growth rate is less than one percent).1.74 This rule would require that during booms, which in Russia are highly correlated with the periods of high oil prices, the government should adhere to the budget surplus of 1-percent of GDP to avoid the pro-cyclicality in non-oil expenditure. Similarly, during recessions the government could allow the budget deficit of 1-2 percent of GDP. Meanwhile, the structural budget would be balanced in both cases.

1.75 However, it appears that the formal or informal adoption of the oil price fiscal rule precedes the adoption of the third fiscal rule. The fiscal management of oil shocks and structural reforms should be given the highest priority in the Russian case. Moreover, Russia has not yet gone through a completed economic cycle. Therefore, at this stage it appears that the establishment of rule #3 could not be done quickly because the reliable estimation of the structural budget would require additional time. Instead, a proper development of this rule should be considered as part of the longer term efforts to upgrade the fiscal management system in Russia.

As discussed, the third group of structural reforms is fiscally neutral in terms of their costs.

This approach was made explicit in the revised 2001 Code of Conduct of the European Union.

Perry (2004) argues that Latin American economies, which are subject to high macroeconomic volatility, ought to follow a rule that incorporates a countercyclical stance through a structural balance target or a stabilization fund.

E. IMPLICATIONS FOR FISCAL POLICY 1.76 In this section we discuss some implications of the proposed fiscal rules, especially the oil price rule (rule #2), for fiscal policy. The oil price rule is largely a modification of and a potential legal basis for a de facto fiscal policy currently carried out by the Russian government. Indeed in drafting the 2004 budget the government used the price of 20 US$/bbl and the budget became law with the 0.5 percent of GDP surplus at this counterfactual price.

Still, the governments fiscal strategy could be further strengthened in a number of aspects.

1.77 Stabilization Fund settings. The regime of a financial reserve (before 2004) and a stabilization fund (since 2004) does not allow for saving all extra revenues associated with oil prices exceeding 20 US$/bbl. Overall, the enlarged budget has been saving only about percent of the extra oil revenues that it receives (World Bank, 2004a). Moreover, taxes on gas, which price is strongly correlated with the oil price with a six-month lag, as well as general taxes on goods and services that also tend to grow in response to oil price increases, are not accruable to the stabilization fund in the course of the fiscal year. Because the government saves too little of the available oil windfall, this makes its budget policy too pro-cyclical. In particular, the government used a part of the oil windfall to expand the financing of its public investment program by 1.4 percent of GDP by 2002 (see Table 1.1, above).

1.78 Stabilization fund regulations need further strengthening to broaden the revenue base for within the year transfers to the fund beyond taxes paid by oil companies, to include additional non-oil tax revenues actually received by the federal budget compared to the expected amount of tax revenues budgeted at the counterfactual oil price of 20 US$/bbl.

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