The sharp fall in global oil prices has resulted in a prolonged recession. Reduced export earnings are cutting imports and investment and severely limiting fiscal policy. The depreciation of the ruble has raised prices, squeezed real incomes, especially of the poorest, and reduced private consumption. Unemployment will continue to rise. Growth is projected to turn positive in 2017 as falling inflation and rising real incomes strengthen domestic demand. The recovery will nevertheless be slow, amid a lack of structural reforms and uncertain prospects for oil prices.

Given the large drop in real incomes, it is important to prioritise social spending and protect the incomes of the weakest. The accommodative fiscal stance is appropriate, but in the medium term fiscal policy needs to adjust to permanently lower oil prices. Returning to a fiscal rule limiting the use of oil revenues could facilitate this adjustment. The current tight stance of monetary policy seems appropriate, but easing should proceed with reductions in inflation expectations. Bank balance sheets should be monitored closely, as non-performing loans have been on the rise.

Measures to combat corruption, strengthen the rule of law, reduce state control, and reinforce skills and innovation would raise productivity. While red tape has been reduced recently, more progress is needed at the regional level. In the medium term, making the economy less dependent on rents from natural resource extraction will be the key to stronger and more stable income growth.

Oil price weakness weighs on the economy

The dramatic fall in oil prices since the end of 2014 has substantially reduced real incomes and the economy remains in recession. Geopolitical uncertainty and international sanctions and countersanctions further aggravate the situation. Lower oil prices caused a large ruble depreciation, which pushed up inflation sharply. The waning of these effects and the weak economy has reduced inflation, which stood at 7.3% in April 2016.

Oil price and domestic demand

1. In volume.

Source: OECD Economic Outlook 99 database; and Thomson Reuters.

Investment has declined strongly due to weak sentiment, elevated financing costs and limited access to international finance. Falling real incomes weigh on private consumption and imports have declined sharply in response to weak demand, reduced external purchasing power and international sanctions. Nevertheless, improved external competitiveness has helped hold up exports in real terms and import substitution has sustained activity in the food industry, chemicals and mining.

Macroeconomic indicators

High inflation has drastically reduced real incomes, especially of vulnerable groups, as wages and pensions have not kept up. While this has helped labour market adjustment and limited increases in unemployment, the poverty rate increased from 11% in 2013 to 15% in the first half of 2015. This situation has been aggravated because food prices have risen even faster than inflation, eroding the real incomes of the poorest, who spend more of their budget on food.

Monetary policy and non-performing loans

Source: OECD Economic Outlook 99 database; IMF International Financial Statistics database; Bank of Russia; and Thomson Reuters.

The current account has improved as the collapse in incomes sharply reduced imports. The uncertainty due to geopolitical tensions and sanctions has also triggered capital outflows. A balance-of-payments crisis has been avoided, however, as Russian borrowers have drawn on their foreign currency assets to pay down their foreign debt and the central bank has provided foreign exchange liquidity from its reserves.

The room for policy stimulus is limited due to high inflation and low oil revenues

The central bank faces a difficult environment of negative growth and high inflation. To deal with ruble weakness and uncertain prospects for the oil price, the central bank has kept the interest rate unchanged at 11% since August 2015. The pace of easing has also been influenced by decreasing liquidity shortages in the money market, as the government is financing the budget deficit primarily from the (oil-revenue-funded) Reserve Fund instead of borrowing. To support the economy, the central bank should reduce interest rates when inflation and inflation expectations fall.

The central bank should be vigilant with respect to foreign exchange liquidity provisions for banks and should avoid propping up insolvent institutions. Weakening bank balance sheets should be monitored closely, as non-performing loans have been on the rise.

While low oil prices have cut fiscal revenues, the ruble depreciation has sustained them in nominal terms. Fiscal policy has become expansionary to support activity and the deficit has widened as spending on social programmes, economic subsidies and national defence has risen in nominal terms. Nevertheless, public expenditures have declined in real terms.

In the recessionary environment, it is appropriate to let the automatic stabilisers operate and protect the incomes of the poor. The government intends to continue to finance the budget deficit from the Reserve Fund. But policy may need to adjust to a potential new reality of persistently lower oil prices and rapid ageing of the population by reducing and restructuring public expenditure. A return to a fiscal rule limiting the use of oil revenues could help guide policy during this difficult adjustment. There should be more support to education and provision of a fertile environment for innovation. Raising transparency and accountability in the public sector and judiciary, easing administrative barriers and lowering state involvement could make growth more inclusive.

The recession will continue in 2016

The economy is projected to remain in recession in 2016 and return to growth only slowly in 2017. Improved macroeconomic stability and lower inflation will help domestic demand to gradually recover. Global growth, increased competitiveness and an easing of financing conditions as interest rates decline will help exports and investment. Unemployment is projected to remain higher than before the crisis.

The projections assume that the current low oil price continues, the value of the ruble remains constant and sanctions continue. Improvement in any of these areas would materially strengthen growth. If geopolitical tensions deteriorate, investment and growth will face additional downward pressures and capital outflows would intensify. The opposite would have a beneficial impact on prospects for growth. There is a risk that under current difficult circumstances non-performing assets will grow fast, undermining financial stability and credit growth. A global slowdown, especially in China, but also in Europe, would reduce exports and growth in Russia.