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Considering the option of restraining the nominal exchange rate and strengthening of real exchange rate (with regard to inflation) as the most reason able one, we proceed from the assumption that currently the reduced RUR real ex change rate makes for sustainable economic growth, as compared with the value, ensuring the trade balance equilibrium. Under conditions of pronounced strength ening and maintenance of national currency rate, the majority of businesses, not involved in highly effective resource exports (under current business indicators), might become uncompetitive. As a result, the economy will be specialized in min eral resources extraction and primary processing (similar processes were ob served in Netherlands upon discovery of Slokhteren natural gas deposits in 1960s).

The policy, which does not provide countermeasures against displacement of do mestic production, processing industries, agriculture and other sectors, when rapid price growth in the sector of non trading production is happening, can not be regarded as reasonable on in the conditions of high volatility of the world markets of natural resources and limited economic resources thereof.

The necessity to pursue a restrained budget policy in the background of fa vorable external market situation is commonly recognized in both, highly industrial ized and developing countries. Thus, within 20022005, in such countries as Alge ria, Azerbaijan, Bahrein, Iran, Kazakstan, Kuwait, Libya, Oman, Catarrh, Saudi Arabia, United Arab Emirates the share of government oil revenues in the total to non oil GDP has grown from 41 per cent to 81 per cent by average. At the same time, government expenditures have been raised from 56 per cent of non oil GDP The marginal effect in R. Dornbuschs basic model (under conditions of open economy, in the absence of necessary flexibility of prices in the short term prospect) is associated with the estab lished equilibrium in the monetary market, while the interest rate is being changed, due to the in flow/outflow of capital, which affects the nominal rate, results in the external equilibrium in the changed competitiveness of economy. Herewith, the rate has an excessive trend at the beginning of the process, but in view of further income changes the exchange rate rolls back. As a result, a new equilibrium value is established, equal to the previous one in real terms. Ref.:Dornbusch, R., Expec tations and Exchange Rate Dynamics, The Journal of Political Economy, Vol. 84, No. 6. (Dec., 1976), pp. 11611176.

Section Monetary and budgetary spheres to 63 per cent. On average, only 26 per cent of surplus revenues were addressed to the current needs, 74 per cent were reserved (45 per cent were spent for acquisi tion of financial assets, 29per cent for recovery of external debts). As a result, the budget surplus has grown in those countries from 2 per cent of GDP in 2002 to nearly 15.5 per cent in 2005 on average35.

The growth of non interest budget expenditures in the conditions of extremely favorable external market situation for the Russian export creates a threat of seri ous socio political disturbances in case of oil prices decline. Understanding of this threat has brought Russia to creation of Stabilization Fund (starting from the budget year of 2004), serving as a mechanism of restriction of budget expendi tures excessive growth in the periods of high world prices for energy sources. The assessment of budget expenditure portion was made on the assumption that the budget revenues will be equal to the level of an average long term level of oil prices (USD 1820 per barrel for URALS). In this case LUKOIL surplus budget expendi tures are regarded as temporary ones, caused by favorable external market situa tion, and are addressed to the Stabilization Fund. The assets of the Fund can be used for compensation of reduced tax proceeds of the federal budget under condi tions of downfall of oil prices and for financing of non interest expenditures and ex ternal debt redemption in the periods of peak pressure of the debt burden on the budget.

Until current time the Russian government was pursuing the policy of strengthening the stabilization of the budget system and would not accept the of fers for expansion of non interest expenditures in the situation of revenues growth.

However, it looks that extremely favorable external market situation is maintained for a too long period, creating an illusion of further maintenance of high oil prices and high budget revenues in the long term prospective.

However, an analysis of oil prices within the preceding 20 years shows that those prices are rather unstable, and there is no expressed trend of one way dy namics. The statistical analysis of oil prices within a certain period of time demon strates their instability, and mathematical estimates (average values) and disper sion (deviation from average values) of oil prices are being changed with time.

Sustained oil prices at the level exceeding an average long term values for quite a long time (about four years) is supporting the theory of strengthening the volatility of prices from year to year. As one can see from the experience, the prices for en ergy sources tend to decrease, whereas the financial agents come to understand ing that the high level of prices is set up for a long term, and basing on that idea, they review their investment plans, addressing extra resources to extended extrac tion of energy sources and energy saving policy.

In such situation one can expect in future a dramatic and long term down grading of oil prices (at least USD 15 per barrel in stable dollars). Lower prices are hardly reachable in the nearest 510 years due to the growing demand for oil and oil products on the part of China and India). Apparently, the federal budget revenues will be reduced in the background of oil prices downgrading, Russian oil Regional economic outlook. September 2005, IMF, pp. 1920.

RUSSIAN ECONOMY IN trends and outlooks fields exhaustion and higher costs for oil extraction from the new and hardly ac cessible oil wells.

Despite the forecasts of international centers for oil market investigations, which do not expect a drastic downfall of oil prices, one can not completely ignore such a possibility. An extra threat to the stability in the budget sphere and in socio economic situation in general is added by an opportunity o price downfall at the end of 20072008, coinciding in time with the new political and economic devel opment cycle in the RF. It is evident, that in the pre election period the Russian government will not be able to cut down the non interest expenditures, increased in the period of high oil prices. Under those circumstances Russia can again find itself in the situation of an acute budget crisis (which might be delayed due to quickly growing government debt)36.

Besides a retreat from the principle of average long term price in formation of federal budget expenditure part, i.e., a violation of one of the conditions of the federal budget stability in the situation, when the budget revenues are highly de pendant on oil prices volatility, the negative impact of expansion of non interest budget expenditures is an accelerated inflation and growth of RUR exchange rate in the background of low sterilization. The second basic task of Stabilization Fund is to prevent those processes. IET assessments confirm that return of the assets, de posited at the Bank of Russia on government accounts, to the economy, will lead to excessive growth of monetary base and later on to multiplier growth and inflation acceleration due to enlarged volume of uncommitted funds at the banks. Apart from evident social consequences, expansion of inflation will negatively affect the rates of economic growth in general through the accelerated process of RUR ex change rate strengthening in real terms and tougher competition with imports.

Therefore, basing on the assumption of necessity to maintain the low RUR rate in real terms in the conditions of surplus balance of external trade, the policy, pursued by the RF Central Bank and the Ministry of Finance, is basically rather sound. Nevertheless, due to the extremely high prices for energy sources, sus tained within the past two years, financial authorities experience the lack of instru ments for sterilization of excessive money supply, resulting from Central Bank in terventions of foreign currency37. As a result, the inflation, which has not come down lower than 910 per cent within recent years, brings forward accelerated RUR strengthening by 810 per cent per year.

Coping the inertial inflation and formation of counter inflation expectations are the key measures for inflation reduction. The international experience shows that reduction of inflation expectations is a slow process. The actions of monetary As per IET assessments, downgrading of the world oil prices to the level of an average long term level of USD 20 per barrel will result in the budget deficit in the amount of 4.55.0 per cent of GDP.

Stabilization Fund of the Russian Federation will be completely expired within 34 years (in case of expenditures maintained at the level of 2006).

Ref. P. Kadochnikov External Factors of Monetary and Credit policy in the RF Research Works Series, No. 49. .: IET, 2002; S. Drobyshevsky, P. Trunin. Correlation of Capital Flows and Basic Macroeconomic Indicators in the Russian Federation. IET Research Works, No. 94. .: IET, 2006.

Section Monetary and budgetary spheres and credit authorities provide an impact over the financial agents behavior only af ter a long term lag (up to 1 year).

The absence of negative reaction on the part of the RF government and Cen tral Bank (adherence to moderately strict monetary and credit policy, avoidance of extra budget expenditures, maintenance of stability in foreign currency market and banking sector, restricted growth rates in regard to prices and tariffs) can ensure inflation reduction by 1 p.p. per year.

The growth of monetary supply ensures a comparable share of total price growth in line with the inertial inflation. Despite active sterilization measures, taken by the RF government and Central Bank, within the past two years the average yearly growth rates of money supply 2 made 3540 per cent, GDP in monetary terms has grown from 15.8 per cent (as of end of 2000) to 28.0 per cent (as of end of 2005).

Reduction of price growth flexibility in regard to money supply growth restricts attainable level of inflation downgrading with the help of tightening of monetary and credit policy. However, extended monetary supply can provoke an outburst of con sumer prices, i.e., in the background of inflation upswing its flexibility versus money supply growth will be considerably higher.

As per our estimates, under conditions of yearly monetary supply growth de crease at the rate of 2025 per cent, which will maintain and strengthen the trend to GDP monetization, required to support high economic growth rates, the current inflation level can be reduced by 1.52 p.p. per year within 23 years.

Sterilization of excessive monetary supply in Russia is achieved by several in struments: surplus of the extended government budget (accumulated assets at the accounts of government bodies and Stabilization Fund), accumulated reserve fund of commercial banks with Central Bank38 and securities of the Bank of Russia.

In monetary policy one should take into account, that sterilized interventions, though have no immediate impact over the monetary base and inflation, do have an influence39, first of all, on a higher growth of RUR assets (versus foreign currency funds) and its impact on interest rates and capital inflow. Moreover, even sterilized interventions, means of their implementation, their time frames and volumes serve as indicators of current priorities of monetary and credit policy to the market par ticipants, who can also affect the interest rates and market balance.

To cut down the growth of monetary supply under favorable external market situation and transparent Russian economy in general and in view of complete lib eralization of financial operations, planned for 2007, in particular, the following measures can be proposed.

Firstly, preservation of Stabilization Fund functions as a basic instrument for sterilization. There should be considered an issue of allocation a section within the IET estimates point out, that there is a coordination in dynamics of funds, accumulated at the ac counts of government authorities and excessive reserves of commercial banks; i.e., accumulation of commercial banks reserves is most likely implemented with due account to financial authorities policy.

Ref. the Survey (Sarno, Taylor, 2001).

RUSSIAN ECONOMY IN trends and outlooks Fund or formation of a special fund (based on similar principles) to be used for ac cumulative pension fund for the Russian citizens (in favorable market conditions).

When the amount of deductions to Stabilization Fund is being determined, the cut off price should not be increased, it should be rather decreased to an average yearly value (USD 20 per barrel), as the upgrading of the cut off price reduces the budget system sustainability and pretty soon will lead to the federal budget deficit, even in case the oil prices are higher than long term average values.

Secondly, upgrading of interest rates and transfer to the policy of tight money are necessary, namely, expansion of variety of instruments for commercial banks assets involvement with the help of the Bank of Russia securities or increase of interest rates on commercial banks deposits with the Bank of Russia.

Naturally, in view of additional sterilization of potential capital inflow and monetary supply adjustment for the amount of interest rates to be paid to commer cial banks, those measures will complicate the implementation of monetary and credit policy. The correlation between the amount of funds involved and interest rates upgrading can be assessed by analysis of input/output effects of such policy and its benefits in terms of inflation reduction and a slow down of the process of RUR real exchange rate strengthening40.

However, such policy might have a negative impact over credit processes in the real sector, but in favorable external market situation the majority of businesses are capable to finance the investments at their own expense.

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