What to do with the Stabilization Fund?

By Robert Skidelsky and Pavel Erochkine

President Vladimir Putin used the bulk of his state-of-the-nation address to spell out measures aimed at improving the living standards of ordinary Russians. The measures will cost money — lots of money — but Russia can afford to spend as it is sitting on an ever-growing pile of cash thanks to high oil prices.

Billions of dollars of that cash are being held in the oil stabilization fund, which only recently has emerged as a key instrument to strengthen the economy and improve living standards.

This new role is quite controversial. The fund was set up in 2004 for two reasons: to balance the budget over the business cycle and to restrain inflation by sterilizing inflows of oil money. The way it works is this: The fund receives all oil tax proceeds above the base price of $27 per barrel. That is to say, it accumulates a surplus when the price of oil is above $27 per barrel, and incurs a deficit when it falls below this. It is an elegant way of protecting the budget against fluctuations in oil prices and thus maintaining confidence in the financial system.

However, since the fund was set up, the price of oil has steadily risen way above the base price. It now stands at $70 per barrel and is expected to go on rising as world demand continues to outstrip world supply. This means that the fund’s surplus has grown far beyond the $18 billion that was estimated to be sufficient for stabilization purposes. It now stands at $61 billion, or about 7 percent of gross domestic product at market exchange rates. World Bank chief economist John Litwark expects it to reach $2.3 trillion by 2030. So the question is, what is to be done with the ‘excess’ surplus?

On the one side is the liberal camp headed by Finance Minister Alexei Kudrin. He has so far successfully resisted calls to spend any money from the fund, arguing that it would be inflationary and undermine hard-won structural reforms. However, pressure to spend it has been growing as 2007 parliamentary and 2008 presidential elections approach.

The Communists want it to finance higher welfare spending. Nationalists call for demographic programs to reverse Russia’s population decline. The military argues for more investment on weapons. Big business lobbies for investment in infrastructure, special economic zones, and lower taxes.

From the macro point of view, the spenders are right and Kudrin is wrong. First, Russia already has more than enough cash to protect itself from economic shocks, and the fund is rapidly growing. The European Union’s Stability and Growth Pact is based on the idea that an annual budget deficit of no higher than 3 percent of GDP and a public debt of lower than 60 percent are sufficient to guarantee budgetary stability. According to this criterion, Russia, with its stabilization fund surplus at 7 percent of GDP, Central Bank reserves of $200 billion (or 25 percent of GDP), a budget surplus of 2 percent of GDP and a foreign debt of $81.5 billion (or 11 percent of GDP), would the most economically stable country in Europe.

More important, the main problem in Russia today is not inflation, but highly unbalanced growth. While the oil economy has been overheating, much of the rest, based on Soviet-era heavy industry and agriculture, has been seriously underheating. A 12 percent inflation rate coexists with 10 percent unemployment, and much higher under-employment. In technical terms, there is a large and growing “output gap.” The growth rate of the economy is much lower than it could be. In this situation, to concentrate on fighting inflation is like trying to cool down an already freezing room. What this situation means is that the restrictive fiscal policy proposed by Kudrin is too restrictive for most of the economy.

The economy requires more spending, not more saving. The task is to find a way of slowing down, or even reversing the growth of the fund. This could be done in one of two ways.

The most elegant solution would be to raise the balance point of the fund to, say, $50 per barrel. This would raise no new principle — it has already been raised from $20 to $27.

An alternative would be to split the fund into two parts. The first part could be invested in triple A rated foreign bonds as Kudrin wants. The second part would be used to stimulate economic development in the languishing sectors and regions of the economy.

It does not really matter which of the two solutions is adopted. The crucial debate should be about the proportions to be spent on “social” as against “economic” projects, and the role of tax cuts against increases in public spending. The benefits of tax cuts would depend on who gets the money. It will not help the economy if it simply swells capital flight. Therefore any tax cuts should be targeted on the poor, preferably in the form of tax credits to supplement low wages. This could be combined with a pro-natalist policy as Putin wants, with extra money going for extra children. Given Russia’s record of corruption, the state should not spend as little as possible of the excess surpluses of the fund itself, but use them, wherever possible, to stimulate private spending.

Kudrin’s dilemma arises from the fact that fiscal policy is virtually his only weapon to fight inflation. But this need not be so. In most economies today, it is monetary, not fiscal, policy that has the task of controlling inflation. This has not been the case in Russia, where interest rate policy is chiefly geared to maintaining a fixed exchange rate with the dollar. What will be the effect of switching the goal of monetary policy to fighting inflation? With inflation running at more than 10 percent, any loosening of fiscal policy would require a compensating tightening of monetary policy. But with real interest rates at zero percent a small tightening of monetary policy should not do significant harm. In so far as it deflated the “bubble” elements of the economy (such as real estate) it might even do good. The basic point is that there is so much spare capacity in the economy that if fiscal policy were well-targeted the net result would still be beneficial.