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Weekly UpdatesINTRODUCTION
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.
We start from a fairly standard model and adapt it to the specificity of the Russian economy. Therefore the model highlights the impact of the oil price, private sector confidence and changes in fiscal policy. With respect to the importance of the oil price, we separately model oil exports (A.3) and other exports (A.4) and the oil price is allowed to affect the exchange rate, modelling possible Dutch disease effects. Also government revenues (A.12) and expenditures (A.13) are modelled as a function of the oil price, a typical feature of the Russian economy (see Rautava, 2004; Kirsanova and Vines, 2002). Vladimir Putin became acting president in 2000, after the surprising New Year's Eve resignation speech of President Yeltsin and after having won Duma support in the December 1999 elections. After an initial power struggle with the oligarchs, this led to a period of relative political and economic stability since 2001. Therefore we can expect changes in consumption and investment due to increased confidence. We capture the economic effects of increased private sector confidence by means of dummy variables in equations A.1 and A.2. The Putin administration also introduced more active policies regarding government revenues and expenditures (cf. infra for the OSF). Again we try to capture the effects by means of dummy variables in equations A.12 and A.13. In the next paragraphs we elaborate on the implementation of these specific characteristics in the model.
Real private consumption in (A.1) is a function of real disposable income. Real private investment in (A.2) is specified as a function of real output and the real interest rate. Both the consumption and investment equation are augmented with a dummy variable ([d.sub.c] and [d.sub.i] respectively) that takes the value 1 from 2001:I onwards (the first year of President Putin's office is considered to be instable). These dummy variables capture the possible positive effect of increased private sector confidence on investment and consumption. Admittedly, this is a crude approach to a no-doubt very complicated issue. But confidence and trust are hard to measure accurately and the average Russian would note on the effects of the Putin administration that it at least managed to establish 'nemnogo poryadka' (some order) in the country. It is therefore not unimaginable that increased confidence led to such a shift-effect. Finally, its simplicity is appealing in terms of the simulation exercise and the approach seems to work quite well.
We model oil exports as a reduced form equation. Since Russia is a price-taker on the world market, it faces a flat demand curve for USD-denominated oil. On the supply side the main determinants are, next to the oil price, the level of proven oil reserves, the capital invested in extraction, the investment climate for oil extraction, the export infrastructure, the management of this export infrastructure. A detailed analysis of the latter variables is outside the scope of our model. We proxy these unobserved institutional supply shifters by the evolution of world trade. We estimate the export equation in values rather than in volumes. If we were to use the oil export volume as dependent variable it would imply that both the long- and short-run oil price elasticity are restricted to one. Our approach puts this constraint to the test rather than assuming it. We expect the short-run elasticity to differ from one because of the predominance of term contracts in the oil market. Therefore nominal USD-denominated oil exports are modelled in (A.3) as a positive function of the oil price and world trade. Note that USD-denominated oil exports do not feed directly into ruble-denominated GDP, since they are converted into rubles through the exchange rate, which is also a function of the oil price. In equation A.4 we model the non-oil exports as an increasing function of world trade and a decreasing function of the real exchange rate. In the model, non-oil exports are therefore directly affected by real exchange rate swings: a real ruble devaluation or depreciation makes the non-oil exports more competitive on world markets and vice versa. In (A.5) ruble-denominated real imports are modelled as an increasing function of both real output, capturing import demand and the real exchange rate, since a real ruble appreciation makes import products more competitive on the Russian market. The nominal exchange rate in (A.7) is also driven by the oil price, with higher prices related to appreciations, and by changes in the interest rate. For obvious reasons, this relation will only be estimated for the period of managed float since the beginning of 1999. This implies both import substitution after a real ruble depreciation, and a Dutch disease effect after a real ruble appreciation due to higher oil prices that crowds out non-oil exports.
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