Russia Needs A Stabilisation Fund

The perception that Russia’s recent recovery has been largely the result of high oil prices and that the economy remains vulnerable to adverse terms of trade shocks is widespread. There is a debate underway in Russia about the virtues of creating a stabilisation fund. We judge that the advantages are overwhelming. For;

• It would reduce the dependence of the budget on commodity exports.
• It could turn into a useful macroeconomic management tool, helping to ease pressures on the ruble.
• Its creation would send a powerful signal to investors that the government is duly concerned with long-term fiscal management.

The issue is unlikely to go away; key officials understand that the establishment of such a fund would be the most bullish news to come out of Russia in a long time. The debate is likely to intensify ahead of Duma consideration of the 2002 budget in late November.

Investor Worries

One of the more strongly held opinions among international investors about the recent evolution of the Russian economy is that “it is all about oil.” That is, Russia has benefited in a major way from the sharp recovery of oil prices that began in early 1999 - with prices rising by close to 170% in dollar terms between February of 1999 and September of 2001 - and the timing of the next crisis will be determined to a large extent by the next sustained reduction in the price of oil. More recently there has been gradual recognition that a cautious fiscal policy in the aftermath of the 1998 financial crisis has made an important contribution to the recovery and that progress in the implementation of structural reforms could further reduce the vulnerability of the Russian economy to external shocks. But, still, the overwhelming perception remains that Russia’s fate is determined by the evolution of its commodity exports, the prices of which are determined abroad. This view, perhaps unfair in the light of the serious recent attempts on the part of the government to push forward with reforms in a number of key areas, finds some echo in Soviet and Russian history.

The Last Two Crises

There is broad consensus that the collapse of oil prices that took place in 1986 was a precipitating factor in the future unraveling of the Soviet economy and, later on, the Soviet Union. Indeed, Russian taxpayers are still suffering the economic consequences of that oil shock. Faced with rapidly declining income from energy exports, the Soviet government borrowed abroad in a major way; between 1986 and 1990 the external debt more than doubled and these Soviet-era debts are still being serviced (and will continue to be serviced for the next 30 years) by the federal budget, limiting the ability of this and future governments to respond more effectively to urgent social and other needs.  Likewise, there is little doubt that in 1998 declining oil prices made the task of fiscal adjustment very difficult. The Russian budget was too weak and ruble debts too high and too short-term, for the public finances to be able to sustain a sharp erosion in the price of Russia’s key commodity export.

The Urals oil price
($/barrel)

For all these reasons, when it emerged earlier this year that the government was discussing the idea of creating a stabilisation fund, investors were very encouraged. What are the pros and cons of a stabilisation fund and would it be in the interests of Russia to create one? We look at the issues, but first a word of clarification. At present the draft 2002 budget does not have within it a stabilisation fund, despite occasional official pronouncements to the contrary. Rather, it has a reserve of close to $4bn dollars which can be used to finance unforeseen contingencies (including a possible drop in energy prices). But this is a one-time arrangement and there is no certainty that any of these funds would actually be left over by the end of the 2002 fiscal year.

What Is A Stabilisation Fund?

A stabilisation fund is a formal institutional mechanism whereby the government collects and invests on an on-going basis a share of the taxes paid by, say, the oil and gas sectors. These resources accumulate over time and there are fairly detailed guidelines as to how the money may be invested and used. Such a fund is usually regulated by special legislation and, once created, is taken off the political agenda. Its primary purpose is to build up a cushion of resources which can be used to deal with unforeseen contingencies (eg, a sustained drop in the oil price) or with fully foreseen contingencies, such as the ageing of the population which will put pressure on pension resources, or the gradual exhaustion of oil supplies. Thus, a stabilisation fund is ultimately a tool of long-term fiscal management.

The Norwegian Experience

It is useful to review, by way of illustration, the key features of the most successful such fund presently in operation, the Norwegian Government Petroleum Fund (NGPF). The NGPF was established in 1990 and the primary motivation of the authorities was two-fold. First, the need to smooth short-term fluctuations in oil and gas revenues. Second, the realisation that oil and gas revenues would eventually run out and the government have to confront rapidly rising expenditures on old age and disability pensions. By exchanging physical oil and gas reserves with financial assets in the NGPF the government hoped to reduce the country’s future dependence on energy revenues.

On 30 June 2001 the market value of the assets accumulated in the NGPF was about US$60 billion, equivalent to 35% of GDP. The NGPF did not actually begin to accumulate resources until early 1996 and thus its recent performance has been impressive. Projections done by the ministry of finance indicate that, by the end of 2010, the NGPF will have assets equivalent to well over 120% of GDP.

The income of the NGFP is derived from the net cash flow from oil and gas activities (net of investments), plus the return earned on the assets of the fund. More specifically, the revenues are derived from four main sources: from the sale of oil and gas owned by the state; from the profit taxes paid by the private oil companies; the profit taxes paid by the gas company; and investment returns. The expenditures of the NGPF are the transfers made to the government budget to finance non-oil activities. The NGPF is thus fully integrated into the government public finances. Increased government expenditures or lower tax revenues from non-oil activities result in smaller allocations to the NGPF. The NGPF consists of an account denominated in krone at the Norges Bank, the central bank. The Norges Bank in turn buys a corresponding amount of financial instruments abroad in its own name. The assets in the NGPF are managed separately from central bank FX reserves.

All the funds accumulated in the NGPF are invested abroad. This helps offset the impact of inflows associated with the current account surpluses and reduces pressures for a stronger exchange rate and/or lower interest rates. Thus the NGPF also plays a key role in macroeconomic management, protecting the economy from some of the effects of high oil revenues. This is a key policy consideration in Russia, given the problems the authorities have had in managing liquidity inflows through the balance of payments. The large current account surpluses of the last couple of years have boosted ruble balances, put upward pressure on prices and complicated exchange rate management.

What About Russia?

There would appear to be no downsides to the creation of such a stabilisation fund in Russia. The existence of such a mechanism would send a powerful signal to investors that the country is being managed cautiously, that provisions are being made to reduce the country’s dependence on commodity exports. Some politicians may dislike the idea of being constrained not to spend all revenues from all sources this year. But by agreeing to set some revenues aside, politicians are acting like credible statesmen, thinking about the well-being of the population and not giving undue attention to short-term political considerations.

There is not a single credible argument why the Russian government should not follow the Norwegian example. In fact, Russia is far more dependent on commodity exports than Norway. It has a more vulnerable economy, with a private sector that is only now emerging from a prolonged crisis. Foreign investment remains low, partly because investors worry about the possible effects of the next oil shock. Will the currency come under pressure? Will the government be forced to seek debt relief? This negative environment of uncertainty can be greatly improved by establishing a stabilisation fund. There can be little doubt that if Russia, like Norway, managed to accumulate over time a sizeable cushion of resources (and it would not have to be as large as Norway’s), investment to Russia would pick up in a major way, providing investors with the “insurance policy” which they feel they now lack.

The issue is unlikely to go away; key officials in the government and in parliament understand that the establishment of such a fund would be the most bullish news to come out of Russia in a long time. It would lead to credit ratings upgrades and accelerate Russia’s return to the international capital markets. The debate is likely to intensify ahead of Duma consideration of the 2002 budget in late November.