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250% 200% 150% 100% 50% 0 0% 2001 2002 2003 Balance of trade Oil price index (1st quarter of 1995 = 100 %, right axis) Fig.10. RF balance of trade and the oil price index in 2001 through Similarly to the situation observed in the preceding year, the general government was a net payer with respect to nonresident net payers. Its foreign liabilities declined by US $ 3.5 billion. As concerns the subjects of the Russian Federation, the increase in their foreign liabilities made US $ 0.1 billion. In 2004, the decrease in the liabilities of the monetary au thorities made US $ 0.2 billion. A decrease in the activity of the banking sector with respect to the attraction of foreign capital resulted in the fact that the increment of liabilities of this sector (US $ + 7 billion) declined by 37.8 per cent in comparison with the value of this indi cator registered in 2003. Investments of nonresidents in the real sector made US $ 24 bil lion (as compared with US $ 22.1 billion registered in 2003).

Preliminary estimates.

Without changes in foreign exchange reserves.

US $ million 23,25,20,17,15,15,15,14,13,13,12,12,12,11,9,8,Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Section 2.

Monetary and budgetary spheres In 2004, foreign holdings of residents increased by US $ 31.5 billion (as compared with the figures registered in 2003, when the respective holdings grew by US $ 27.2 bil lion). Operations of the private sector accounted for almost all this increase.

Foreign assets of the general government grew by US $ 0.2 billion, while foreign as sets of the banking sector increased by US $ 4 billion.

As concerns the sector of nonfinanical enterprises and households, the outflow of capital in this sector practically has not changed and made US $ 25.9 billion. At the back ground of an increase in the outflow of capital by items direct and portfolio investment (US $ 6.5 billion) and trade credits and advances extended (US $ 0.6 billion), the amount of cash foreign currency accumulated by this sector and the amount of indebtedness on merchandise supplies according to intergovernmental agreements have significantly de creased (by US $ 2.9 billion and US $ 1.3 billion respectively).

At the same time, in 2004 the total net outflow of capital from the nonfinancial sector made US $ 6.5 billion (in 2003, there was observed an outflow of capital amounting to US $ 1.7 billion) (see Fig. 11).

12 15% 10% 5% 10,0% 4,1,2 1,-5% -1,6 -2,2 -0,-2,-3,-4,0 -4,-2 -4,-6,-6,8 -6,-7,6 -10% ---15% --10 -20% 2001 2002 2003 Net capital outflow (US $ billion) Net capital outflow / foreign trade turnover (%) Source: RF Central Bank, IET calculations.

Fig. 11. Dynamics of net capital outflow in 2001 through It should be noted that over the first three quarters of 2004 there was observed a sig nificant (and accelerating) outflow of capital from the RF private sector. Only in the 4th quarter there was registered an inflow of capital at the level of US 10.4 billion, which can not be explained by any fundamental changes in the investment climate in the country.

Most probably, the inflow of such a large amount of capital in the country can be explained by a borrowing abroad made in order to finance the purchase of Yuganskneftegaz. In the case such a borrowing was not made, the total outflow of capital registered in 2004 could be even more significant.

US $ billion QQQQQQQQQQQQQQQQRUSSIAN ECONOMY in trends and outlooks As concerns the unofficial outflow of capital (capital flight) (see Fig. 12), in 2004 this indicator increased in real terms by 15 per cent as compared with the figures registered in the preceding year and according to the authors estimates6 made about US $ 31.8 billion.

0 0% -2.-2.-2% -3.-4.--4.5 -4.-4.9 -4.-4% -6.-6.-7.-7.-4 -6% -8.9 -8.-9.-10.6 -8% --10% -8 -12% -14% --16% -12 -18% 2001 2002 2003 Capital flight (US $ billion) Capital flight / foreign trade turnover (%) Source: RF Central Bank, IET calculations.

Fig. 12. Dynamics of capital flight in 2001 through On the whole, in 2004 there was observed an increase in the share of net capital out flow in the RF foreign trade turnover up to 2.3 per cent this (0.8 per cent in 2003). At the same time, the indicator characterizing the share of capital flight in the RF foreign trade turnover decreased from 13.1 per cent in 2003 to 11.5 per cent in 2004. It should be also noted that in contradistinction to the figures registered in 2003, last year there was ob served an increase in the amounts of both net capital outflow, and capital flight.

The outflow of capital from the private sector is still at a rather high level, what may be to a significant extent explained by the situation observed in the corporate sector (the YUKOS affair). On the whole, at the background of rather favorable macroeconomic indi cators, the worsening of the investment climate and growing risks result in an outflow of capitals from Russia.

Besides, basing on the analysis of the balance of payments, it should be noted that the revenues from the export of energy resources still make more than half of the total ex port revenues and the share of energy resources in the general structure of exports is growing for several years running. All these facts once again confirm the significant de pendence of the Russian economy on the export of raw materials and the respective price situation. At the background of deceleration of the rates of structural reforms, it may be an Flight of capital is calculated in accordance with the IMF methodology as a sum of items trade credits and advances ex tended, non repatriation of exports proceeds, non supply of goods and services against import contracts, and net errors and omissions. US $ billion QQQQQQQQQQQQQQQQSection 2.

Monetary and budgetary spheres evidence of a gradual decrease in the competitiveness of the Russian economy across a number of industries and deterioration of the prospects of its further development in the case the price situation on the world market of energy resources changes.

2.1.7. Key Actions of the RF Central Bank in the Field of Monetary Policy The fact that the Bank of Russia animated direct and reverse REPO transactions was one of the characteristic features of the RF monetary policy in 2004, since this action serves as a monetary policy tool which is commonly used in global practice, especially for sterilizing excessive money issuance and maintaining liquidity of the banking system.

The RF Central Bank reduced the refinancing rate down to14% on January 15, 2004.

The last time the Bank of Russia changed the refinancing rate (from 18 to 16%) was on June 21, 2003.

In the quarter 2 of the previous year, the Bank of Russia began to apply a new benchmark that was used for determining of an exchange rates policy. The benchmark was represented by a weighted geometric average of exchange rates of basic foreign cur rencies to the RUR. The basic currencies were represented by the USD and the EURO. The EURO weight was set at 10 to 20% for a start. This measure, however, led to no real changes in the RUR exchange rate to these currencies, as indicated above.

In June 11 the Bank of Russia announced a reduction (from 9 to 7% since June 15) in mandatory contributions due by banks to the Compulsory Reserve Fund out of RUR funds they borrowed from legal entities and foreign currency funds they borrowed form legal en tities and physical bodies. At the same time, the Bank of Russia reduced the refinancing rate from 14 to 13% per annum, as well as extended list of securities that could be used as collateral in entering into direct REPO transactions with banks. Such measures were caused basically by low liquidity in the Russian financial market. It should be noted that changes in the refinancing rate have no such a substantial impact on the economy of the Russian Federation as it does in most of the developed countries. Nevertheless, by ex tending the list of securities that could be used as collateral in borrowing funds from the RF Central Bank, the Bank of Russia managed to improve liquidity management in the RF banking system. Later on, as problems raised in the banking sector, the reservation regu lations were reduced once again (on July 8, 2004) to 3.5% on liabilities to residents of the Russian Federation and to 0% on liabilities to non resident banks. However, the latest rise (up to 2%) was announced on August 1.

Since August 16, 2004 the Bank of Russia started to issue modified bank notes of 1997 (as modified in 2004) denominated in RUR10, 50, 100, 500 and 1000. The issuance was intended to increase protection of these bank notes as well as make it easy for the general public to verify their authenticity. The modified bank notes retained basic composi tion of the 1997 ones. The bank notes of 1997 remain as legal tender as the modified ones.

In August 2004, the Bank of Russia extended the list of securities that can be used as collateral by banks in borrowing from the Bank of Russia. The list included bonds issued by constituent entities of the Russian Federation, as well as bonds of mortgage agencies and credit organizations secured by public warranty. By extending the list, the RF Central Bank managed to improve liquidity of the RF banking system. However, the use of newly listed securities was restricted. For example, they were not supposed to be used for REPO transactions.

In November 2004, the Board of Directors of the RF Central Bank approved a docu ment: Basic Guidelines of Unified Public Monetary Policy for 2005. Inflation forecast for 2005 remained unchanged in the document in spite of the fact the forecast for 2004 failed, RUSSIAN ECONOMY in trends and outlooks which obviously led to growth of inflationary expectations of economic agents. Hence, price advance rates are very unlikely to slow down to 6.58.5% in 2005.

It is specified in the document that the real effective RUR exchange rate is the basic focus of the monetary policy. However, the calculation methodology for this indicator is quite questionable, which in practice gives no way of identifying direct relationship be tween the real effective RUR exchange rate and competitiveness of Russian manufactur ers. In addition, inflation remains high enough in the Russian Federation, and we believe that it is the inflation that the Bank of Russia should focus on.

At the end of the year, the management of the Bank of Russia stated that the struc ture of gold and foreign exchange reserves could be changed. Prior to that the structure of gold and foreign exchange reserves was as follows: 70% of USD, nearly 25% of EURO and nearly 5% of other hard currencies. Perhaps, such intention of the RF Central Bank was most likely to be caused by a continuous fall of the USD exchange rate against other basic currencies.

2.2. State Budget 2.2.1. General Description of RF Budgetary System in Table Execution of Revenues and Expenditures of Consolidated, Federal and Local Budgets (% of GDP) 1998 1999 2000 2001 2002* 2003 Federal Budget Tax Revenues 8.8 10.7 13.2 16.2 18.6 18.0 18.Including single social tax 3.1 2.7 2.Revenues 11.3 12.9 15.4 17.6 20.1 19.4 20.Expenditures 14.5 14.0 13.1 14.7 18.7 17.7 16.Deficit () / Surplus (+) 3.2 1.1 2.4 2.9 1.4 1.7 4.Local Budgets Tax Revenues 11.5 10.4 10.2 9.6 10.0 10.0 10.Revenues 14.8 13.6 14.4 14.3 14.9 14.5 14.Expenditures 15.2 13.6 14.0 14.3 15.3 14.9 14.Deficit () / Surplus (+) 0.3 0.0 0.5 0.0 0.4 0.4 0.Consolidated Budget Tax Revenues 20.3 21.1 23.4 25.8 28.6 28.0 29.Revenues 24.5 25.2 28.5 29.3 32.1 31.1 32.Expenditures 28.1 26.3 25.6 26.4 31.1 29.7 27.Deficit () / Surplus (+) 3.6 1.1 2.8 2.9 1.0 1.4 4.* Since 2002, including revenues from single social tax and consequently expenditures to finance public extra budgetary funds.

Data source: the RF Ministry of Finance; IETs estimates.

It is noteworthy that general description of the RF budgetary system in 2004 shows much higher revenues and less expenditures as compared to 2003 (refer to Table 2). At the end of 2004, the revenues of the federal and consolidated budgets reached their maximum over the last six years. The federal budget revenues in 2004 increased by 1 per centage point of GDP, 20.4% of GDP, as compared to the previous year. In 2004, the con solidated budget revenues were nearly 1.2 percentage points of GDP thus reaching 32.3% Section 2.

Monetary and budgetary spheres GDP. It should be noted that expenditures in 2004 continued its downward trend which started as early as 2002. Federal budget expenditures in 2004 decreased by more than 1.percentage points of GDP to account for 16.1%, as compared to the previous year. Local budget expenditures decreased by nearly 0.8 percentage points of GDP, while the con solidated budget accounted for 1.9 percentage points of GDP. Thus, by the end of 2004, Russia achieved the biggest budget surplus ever in the history of the post Soviet era, namely 4.5% of GDP for the consolidated budget and 4.4% of GDP for the federal budget.

High oil prices is one of the key factors making the budgetary revenues grow, and consequently the volume of mineral tax revenues and export duties to the consolidated budget in 2004 exceeded that of the previous year by 0.5 percentage points of GDP and 1.7 percentage points of GDP correspondingly. This resulted in that on October 27, 2004, the RF State Duma approved amendments to the 2004 federal budget on increasing budg etary revenues by RUR531 billion up to RUR3273,8 billion and consequently increasing budgetary expenditures by RUR108,6 billion up to RUR2768,1 billion.

2.2.2. Analysis of Basic Tax Revenues A series of amendments to the tax law came into force in 2004. The most essential ones are: VAT reduction from 20 to 18% with the reduced rate remaining at 10%; from January 1, 2004, increase in the basic mineral tax rate in relation to oil production from RUR340 up to RUR347 per 1 ton of raw material, as well as ad valorem tax rate on produc tion of gas condensate from 16.5 up to 17.5%; changes in the export tax rate in relation to crude oil from the middle of 2004; abolishing sales tax on January 1, 2004.

Table Basic Tax Revenues to RF Budgetary System (% of GDP) 1999 2000 2001 2002 2003 Profit tax 4.6 5.4 5.7 4.2 4.0 5.Income tax 2.5 2.4 2.8 3.3 3.4 3.VAT 8.8 6.2 7.1 6.9 6.6 6.Excises 2.2 2.3 2.7 2.4 2.6 1.Mineral Tax* 1.2 1.6 1.6 2.5 2.5 3.Foreign trade taxes 1.8 3.1 3.6 3.0 3.4 5.single social tax, to the RF 3.1 2.7 2. consolidated budget Data source : the RF Ministry of Finance.

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