Russia from bust to boom and back: oil price, Dutch disease and stabilisation fund.(Report)

INTRODUCTION

Russia is the largest neighbour of the enlarged European Union (EU). The economies of the EU and Russia are increasingly integrated through rising flows of goods, services, capita! and people between the two blocks. Russia also plays an important strategic role as a supplier of energy and raw materials to the EU, decreasing the EU's dependence on Middle East energy sources. Gaining insight in the economy of this strategic partner to the EU is therefore not without importance. In this paper we model Russia's macroeconomic evolution during the last decade (1995-2007) and use this model to simulate Russia's economic future under several scenarios. The period of transitional recession before the Russian crisis of 1998 was marked by high inflation, failing stabilisation and disappointing macroeconomic performance. Although the Russian government embarked on an exchange rate-based stabilisation in 1995, it did not succeed to balance its budget and had to draw increasingly on foreign lending to fund its recurrent deficits. This unsustainable policy mix and the prolonged political and economic instability culminated in a severe economic and political crisis in August 1998. The Russian government was forced to abandon its exchange rate policy, devalue the ruble, suspend payments on government paper and announce a moratorium on the Russian foreign debt. By 20 September the ruble had fallen from 6 to 22 rubles per dollar. (1)

Rather than the expected final blow, the crisis turned out to be Russia's economic catharsis. (2) Indeed, real GDP growth after 1999 averaged 7% annually and the volatility of nominal variables such as prices, wages, interest rates and exchange rates has declined markedly. Several explanations for the recent good macroeconomic performance of Russia have been suggested. Ahrend (1999) claims that the deadly stabilisation of 1995-1997 was the consequence of an inappropriate exchange rate policy. The overvaluation of the ruble during the period of the 'corridor' policy yielded stabilisation at the cost of a prolonged economic recession. In the line of this argument the devaluation of the ruble in August 1998 kickstarted economic growth through a broad process of import substitution across all sectors. Others put forward that Russia's economic boom is largely explained by the oil price. Owing to a string of external events oil prices increased rapidly after 1998 from a relatively low level below $15 to more than $90 per barrel in 2007. As largest crude oil producer and second-largest crude oil exporter of the world, Russia strongly benefited from higher world oil prices. Finally, some political economists argue that the political and economic stabilisation brought by president Putin reduced economic and political risk, which supposedly created the confidence and trust so badly needed for economic recovery (see, eg, Berglof et al., 2003). This also allowed the Putin administration to initiate a number of interesting fiscal policy reforms.

We develop and estimate a dynamic open economy macro-model of Russia. The model contains the basic macroeconomic relations that govern macroeconomic adjustment, (3) but it is also specifically tailored to capture the effects of the oil price, private sector confidence and fiscal policy reform on the Russian economy. Our main variable of interest is the oil price. In our view, it is not sufficient to estimate the oil price elasticity of exports, the current account or government revenues. Fiscal policy, the exchange rate and exports are only three direct channels through which the oil price affects the Russian economy. Indirectly, all other variables in the model will be affected through second-order effects. We then employ the model to simulate Russia's economic future under different scenarios regarding the oil price, private sector confidence and fiscal policy. The simulations suggest that the Russian economy is vulnerable to downward oil price shocks. We find two mechanisms that mitigate the economic effects of oil price shocks, namely the stabilisation brought by the Oil Stabilisation Fund (OSF) and the Dutch disease effect. The effect of a negative shock in private sector confidence on real GDP turns out to be comparable in magnitude to the effect of an oil price shock, although the transmission of both shocks runs along different channels. The fiscal policies of the Putin administration are found to temper the economic fluctuations caused by oil price shocks.

In the next section we present the model. The subsequent section describes the data and the estimation methodology and comments on the estimation results. In the penultimate section we evaluate how oil price shocks, changes in private sector confidence and in fiscal policy influence Russia's economic future by means of a set of simulations. The final section summarises and presents conclusions.

A MACROECONOMIC MODEL OF THE RUSSIAN ECONOMY

In this section we construct a small, stylised model of the Russian economy. A complete dynamic general equilibrium model of the Russian economy would not be appropriate for theoretical and empirical reasons. Financial sector inefficiencies for example imply that most Russian consumers feel forced to consume their current incomes instead of optimally smoothing their consumption as implied by Dynamic Stochastic General Equilibrium (DSGE) models. Instead, we estimate a dynamic open economy macromodel (see Merlevede et al. (2003) for CEECs and Basdevant (2000) and Aivazian et al. (2003) for Russia), consisting of a set of macroeconomic relations (A.1)-(A.13), a policy rule (A.14) and a set of definitions (A.15)-(A.21). The theoretical model is presented in its long-term form in Appendix A. This model is suited to analyse macroeconomic adjustment in the short run to various types of macroeconomic shocks. The model is build around four blocks and a monetary policy rule. The real side is captured in the IS block that contains the relations governing consumption, investment, exports and imports. The monetary block is made up by equations for the money supply, the exchange rate and consumer and producer prices. The labour market is incorporated in the model via wage and employment equations. Finally, in the fiscal block government expenditures and revenues are modelled.