Section 2. Monetary and Budgetary Spheres Текст научной статьи по специальности «Экономика и бизнес»

Section 2. Monetary and Budgetary Spheres

2.1. Monetary and Credit Policy

The major development in the Russian monetary and credit policy in the year of 2006 was an explicit inflation slowdown, which has reached its historical peak; for the first time in the RF history consumer price index did not exceed 10 per cent. Though that indicator is conventional, a decrease of that indicator to the level lower than 10 per cent is considered worldwide as a major event and an explicit factor of successful monetary and credit policy of the government. One should note, that at the beginning of the year nobody could forecast such a result, only at the second half of the year the inflation has slowed down and made 9 per cent as of December-January results. Herewith, we'll try to analyze the grounds of those developments, review the trends and interrelations in the national monetary market, the inflation processes in general and outline major developments in the RF monetary and credit sphere in the year of 2006.

2.1.1. Monetary Market

In 2006 a considerable growth of gold and foreign currency reserves was observed in the RF (See Fig. 1). The basic factors of growth were the peak prices for the major Russian export commodities, primarily oil prices. Reduction of reserves (as per results of the month) was noticed only in August and was caused by pre-scheduled repayment of the external government debt to the Paris Club of creditors in the amount exceeding USD 23 bln. By the end of the year the volume of gold and foreign currency reserves has reached an absolute record in the history of Russia, USD 303.7 bln (+66.7 per cent within 2006).

1 3

3200 -3100 -3000 2900 -2800 -2700 -2600 -2500 -2400 -2300 2200 2100 2000

Monetary base in narrow definition (bln rubles) ^^Hard currency reserves (bln dollars)

Source: RF Central Bank

Fig. 1. Changes in Monetary Base and Gold and Foreign Currency Reserves

in Years 2005-2006

However, in order to restrain the accelerated stabilization of exchange rate of the national currency, the Bank of Russia was compelled to buy the foreign currency flowing into the country, thereby increasing money supply. Let us take a closer look at the money supply dynamics.

In 2006 the monetary base (in a broad sense1) increased by RUR 1.2 bln and reached RUR 4.1 bln (+41.4 per cent). It should be reminded, that as of results of the year of 2005, that indicator has grown only by 22.4 per cent. The monetary base volume in broad definition as of 1 January 2006 was RUR 2.9 trillion (See Table 1). The cash in circulation volume, including the cash balances of credit institutions, as of January 1, 2007 was RUR 3.06 trillion (+39.5 per cent as compared with January1, 2006), the correspondent accounts of credit institutions with the Bank of Russia made RUR 638.1 bln (+25.5 per cent), mandatory reserves - RUR 221.1 bln (+ 37 per cent), credit organizations' deposits with the Bank of Russia - RUR 98.1 bln (times 12.6), the value of the Bank of Russia's bonds held by credit institutions - RUR 102.2 bln (growth 2.1-fold), the reserve funds under foreign currency operations, deposited with the RF Central Bank made RUR 0 bln2 (reduced for RUR 8.8 bln). In 2006 the growth of cash in circulation (by 39.5 per cent at the background of increased mandatory reserves (by 37 per cent) have resulted in extension of the monetary base in narrow definition (cash + mandatory reserves)3 by 38.9 per cent (See Fig.1). At the same time, the gold and foreign currency reserves of the RF Central Bank also grew within a year by 66.7 per cent and amounted, as of January 1, 2007 to USD 303.7 bln. A greater portion of the national liquidity inflow was accumulated in the RF Stabilization Fund, which volume as of January 1, 2007 amounted to RUR 1,237 bln. (USD 42.3 bln, 5.7 per cent of GDP).

Monetary supply M2 in national terms has grown in 2006 by 48.8 per cent and made as of January 1, 2007 RUR 8,995.8 bln, or 33.8 per cent of GDP (as of Janu-ary1, 2006 the monetary indicator M2 was equal to RUR 6,045.6 bln (28 per cent of

GDP). 2

1 Monetary base in broad definition reflects the Bank of Russia monetary and credit liabilities in national currency, which serve as a basis of money supply growth. The RF monetary base in a broad definition, in addition to the cash in circulation issued by the Bank of Russia, and the residuals on the accounts of mandatory reserves of the funds in the national currency attracted by credit institutions and deposited with the Bank of Russia, includes the funds in corresponding accounts with credit institutions and bank deposits, placed with the Bank of Russia, reserve funds for foreign currency operations, as well as other ;liabilities of the Bank of Russia under operations with credit organizations in national currency of the Russian Federation.

2 Starting as of Julyl, 2006, the requirements for mandatory reserves and usage of special accounts for transactions with foreign currency were abolished.

3 Monetary base in a narrow definition is a monetary instrument (an indicator of monetary supply volume), which is fully controlled by the RF Central Bank. The Monetary base in narrow definition includes the cash in circulation, issued by the Bank of Russia (and the balance on the accounts of credit organizations), balances on the accounts of mandatory reserves of the funds in the national currency attracted by credit institutions in national currency, deposited with the Bank of Russia.

Table 1

Changes in Monetary Base in Broad Definition in 2006 (RUR bin)

01.01.2006 01.04.2006 01.07.2006 01.10.2006 01.01.2007

Monetary base (in broad definition) 2 914,10 2 721,00 3 285,90 3 484,20 4 121,60

including:

Cash in circulation with regard to balances in credit organizations 2 195,40 2 061,20 2 386,60 2 565,40 3 062,10

Correspondence accounts of

credit organizations of the Bank 508,6 320 430,9 443,7 638,1

of Russia

Mandatory reserves 161,4 172,1 190,2 205,8 221,1

Deposits of credit organizations in the Bank of Russia 7,2 44,2 108 109,6 98,1

Securities of the Bank of Russia in credit organizations 32,8 115,2 164,2 159,6 102,2

Reserve funds in foreign cur-

rency, deposited with the Bank of 8,8 8,3 6,1 0,1 0

Russia

Source: RF Central Bank

Therefore, as of results of the year of 2006, a more expressed growth of monetary supply was observed as compared with 2005. At the same time, in the year of 2006 active liquidity sterilization was occurring in regard to foreign currency in Stabilization Fund, which volume as of the end of the year has exceeded the amount of USD 89 bln. It should be noted, that there were some changes in the structure of monetary base growth in broad definition within the year of 2006. Thus, as of the year results, the rate of growth of cash in circulation was lower than the growth rates of monetary base in general, whereas in 2005 the rate of growth of cash in circulation was higher by 40 per cent than the growth rate of monetary base. Therefore, the above-mentioned positive trend reflected a lower role of cash in the national economy. Moreover, the amount of deposits in the RF Central Bank has been considerably increased due to the raised interest rates on the Bank of Russia deposit operations. In the preceding year the RF Central Bank has been raising the interest rate four times (with the aim to increase the role of deposit operations in monetary and credit policy). At the same time, to increase liquidity sterilization, the Bank of Russia was actively offering its securities for sale.

To assess the success of efforts taken by monetary and financial institutions with the aim to increase liquidity sterilization, an analysis is made of correlation between money demand and supply4. The dynamics of demand for money demand and supply is shown in Fig.2.

We assess the demand for money equation of the type Q^p = a° + aYt + a2APt + a3t + £t,

Mt_ _/

— a0 i aiY t 1 a2Apt 1 a3t

t

where Mt - money supply M2, GDPt - nominal GDP, value, t Y- GDP volume in prices of 1995, Apt -consumer price index, t - time. The assessment was based on the quarterly data of the years 19992006 with no regard to seasonal data. The resulting residual values can be interpreted as excess of money supply, as the left par of equation shows the actual money supply and with the help of indicators of the right part the demand for money can be estimated. 58

40%

10% 5% 0%

O •■O >0 ON r--0 a- oc Os 00 0 Ov ON ON 0 er- 0 0 0 0 0 0 rM 0 fN O rn O 0 g O fi O 0 \D 0 0

— — — — — — — — — rs r-1 n (N (N <N M <N <N c^ <N Ol <N

0 OJ 0 t> Sï y Oi ■t aj e Oi S» OJ Ö 0J aj u Ü flj

S S3 2 iÖ 2 & 3 1 3 C3 n3 g 2 ■S3 2 Ç3 2

er er ct- cr cr CT* ct- ct* CT" cr or CT" CT" CT* CT" cr ct- O* or CT* CT CT* CT"

— zz — zz S zz —

Money demand —■— Money supply

Source: RF Central Bank, IET estimates

Fig. 2. Dynamics of Demand for Money and Money Supply (Money Aggregate M2) in Q III 2006

One can note, that within 2006 money supply was exceeding the demand for money, which can cause excessive inflation pressure in 2007, caused by a delayed impact of changes in the money supply over the inflation processes. In our estimates, the lag of the monetary supply changes impact over consumer price index is one-two calendar quarters5.

It should be also noted, that despite the increased monetary supply, the money multiplier in the RF remains at a low level as compared with the countries of Eastern Europe, where, as a rule, its index value considerably exceeds 3. Against this background, the index value of 2.9, achieved by late 2006, appears very insignificant (See Fig. 3). Since mid-2002, the multiplier is characterized by an upgrading trend, reflecting the gradual development of the RF banking sphere. Till mid-2004 the multiplier' value was varying within the range of 2.15 - 2.45.

Therefore, basing on the obtained results of the estimates, the increased money supply, caused by the extensive purchases of foreign currency by the RF Central Bank, was exceeding the demand for money in 2006.Under those conditions, there is a high probability, that further slow-down of the inflation rate will be rather difficult. Let us review the inflation processes in more detail and try to detect non-monetary inflation factors in the RF.

5 Ref: "Some Approaches to Economic Indicators' Estimates", published by IET, the CPI N 89P, M.: IET, 2005.

Source: RF Central Bank, IET estimates.

Fig. 3. Money Multiplier in the RF in 1999-2006

2.1.2. Inflation Processes

Early 2006 saw dramatic acceleration in the rate of inflation (Fig. 4). As a result, there were serious doubts that by the results of the year the consumer price index in 2006 will not exceed the target value of 8.5 per cent. However, later a slowdown of inflation took place and the target value was upgraded to 9 per cent. As of the year results, CPI made 9 per cent. It should be noted that for the first time in the RF newest history the rates of consumer prices growth was restrained at the level less than 10 per cent. We are going to take a closer look at the dynamics of inflation rates throughout the year.

In the category of foodstuff prices have grown by 8.7 per cent (as compared with 9.6 per cent in 2005) (See Table 2). Throughout the year, from January to December, the upward trend in the foodstuff price growth was caused by increased prices for granulated sugar (+14.9 per cent), grits and beans (+12.1 per cent), bread and bakery products (+ 11.1 per cent), vegetables and fruit (+10.3 per cent) and alcohol (+10.1 per cent). Within twelve months of 2006 the highest growth was traditionally observed in the category of commercial services (by 13.9 per cent, versus 21 per cent in 2005); thus, in pre-school education (+28.5 per cent), as well as by housing utilities (+17.9 per cent). As concerns non-food products, their prices went up within twelve months by 6 per cent on average (versus 4 per cent within twelve months of 2005). Within January-December the utmost growth of prices took place in construction materials (+11.5 per cent) and motor petrol (+10.9 per cent). The basic CPI growth for consumer goods in general made in 2006 7.8 per cent (as compared with 8.3 per cent in the relevant period of preced-

ing year). Therefore, as of 2006 year results, the basic reasons of the expressed inflation were the accelerated growth of prices for commercial public services, construction materials, motor petrol and a number of foodstuffs.

Source: Rosstat.

Fig.4. Dynamics of CPI in RF in 2004-2006

The data of Table 2 shows, that one of basic factors of inflation throughout 2003-2006 was the growth of housing utilities tariffs, which have grown practically 1.5-fold within January 2003 - December 2006. Pre-school education takes the second place in terms of input in the accelerated inflation, the cost of their services went up by 137.6 per cent; they are followed by culture services (+98.7 per cent) and public transportation (+77.4 per cent). An accelerated upward trend was observed in the prices for motor petrol (+96.9 per cent), meat and poultry (+63.6 per cent), bread and bakery products (+74.1 per cent).

An analysis and dynamics of prices and tariffs for services of natural resources monopolies (electricity, gas, cargo transportation) in 2002-2006 demonstrates that within the period under review the highest growth rates were noticed in prices for gas and cargo transportation. As opposed to that, electricity tariffs have only slightly exceeded the growth rate of CPI.

It should be reminded, that in 2007 the RF Central Bank is planning to reduce the inflation to the level of 8 per cent. This target looks quite realistic, what is confirmed by the results of IET model forecast for 2007, where the CPI index is assessed at 8-8.5 per cent.

Table 2

Yearly Price Growth Rates as per Types of Goods and Services in 2003-2006 (% per year)

2003 2004 2005 2006 2003-2006

CPI 12,0 11,7 10,9 9,0 51,2

Foodstuffs 10,2 12,3 9,6 8,7 47,4

Bread and bakery products 30,4 16,7 3,0 11,1 74,1

Grits and beans 17,0 11,6 0,2 12,1 46,7

Pasta products 14,0 14,6 1,9 4,7 39,4

Milk and dairy products 13,1 12,8 10,5 8,7 53,2

Meat and poultry 8,9 19,6 18,6 5,9 63,6

Fish and sea food 9,9 11,5 12,7 7,8 48,9

Non-food products 9,2 7,4 6,4 6,0 32,3

Motor petrol 16,8 31,3 15,8 10,9 96,9

Commercial services to population 22,3 17,7 21,0 13,9 98,4

Housing utilities 28,7 23,5 32,7 17,9 148,7

Public transportation 13,7 18,0 15,8 14,2 77,4

Culture organizations services 21,8 19,9 17,7 15,6 98,7

Pre-school education 15,1 21,6 32,1 28,5 137,6

Source: Rosstat.

In the recent years RF Central Bank in "Basic trends of Monetary and Credit Policy" pays more and more attention to the importance of inflation targeting, rather than rouble exchange rate. In other words, the Bank of Russia id making a gradual transfer to the regime of inflation targeting. This regime is getting rather popular worldwide; many industrialized and developing countries reject alternative policies in favor of inflation targeting regime.(See Table 3).

Table 3

Countries, applying Inflation Targeting Regime

Country Date of regime introduction Inflation as of regime introduction (% per year) Inflation targeting indicator at present (% per year)

1 2 3 4

Developing countries, economies in transition

Israel Q II, 1997 8,5 1 3

Check Republic Q I, 1998 13,1 3(+/ 1)

Poland Q IV , 1998 9,9 2,5 (+/ 1)

Brasilia Q II, 1999 3,3 4,5 (+/- 2)

Chili Q III , 1999 2,9 2 4

Columbia Q III , 1999 9,3 5(+/- 0,5)

Republic of South Africa Q I, 2000 2,3 3 6

Thailand Q II, 2000 1,7 0 3,5

South Korea Q I, 2001 3,2 2,5 3,5

Mexico Q I, 2001 8,1 3(+/- 1)

Hungary Q II, 2001 10,5 3,5 (+/- 1)

Peru Q I, 2002 0,8 2,5 (+/- 1)

Philippines Q I, 2002 3,8 5 6

Slovakia Q I, 2005 3,2 3,5 (+/- 1)

Indonesia Q III , 2005 7,8 5,5 (+/- 1)

Romania Q III , 2005 8,8 7,5 (+/- 1)

1 2 3 4

Industrialized Countries

New Zealand Q I, 1990 7 1 3

Canada Q I, 1991 6,2 1 3

Great Britain Q IV, 1992 3,6 2

Switzerland Q I, 1993 4,8 2(+/- 1)

Australia Q II, 1993 1,9 2 3

Iceland Q I, 2001 3,9 2,5

Norway Q I, 2001 3,7 2,5

Source: Inflation Targeting and the IMF (2006).

Table 4

RF Compliance with Advisable Requirements of Introduction of Inflation Targeting Regime

Requirement RF compliance Comments

Institutional independence of RF Central Bank is an autonomous structure, but it is

monetary and credit control au- Partially compliant often under pressure of both, executive and legisla-

thorities tive power authorities Qualification of Experts Квалификация эксперт^

Highly professional analytics, Partially compliant Bank of Russia is sufficient for efficient inflation esti-

reliable statistics mates, but currently there is a lack of adequate statistics, required for reliable forecasts. Economic situation in the RF highly depends on natu-

Diversified market economy Incompliant ral resources' prices, some of prices are actually dependent of certain factors, and dollar equivalent in the economy is still high, though somewhat reduced. The rates of the national financial system are rather

Highly developed financial system Partially compliant high, but in comparison with other countries with transition economy, our economy is still insufficiently developed and exposed to high risks

According to the point of view, dominating worldwide till recent time, the inflation targeting is far more sensitive to institutional and macroeconomic environment factors than other regimes. Rather tough requirements to the situation, when an affective transfer to inflation targeting can be performed, made developing countries and economies in transition very prudent in terms of the new regime of monetary and credit policy. However, later on it became clear that the majority of those requirements relates as much to the regime of inflation targeting, as to any other regime of monetary and credit policy. Moreover, it is confirmed by practice, that compliance with the tough technical requirements is as important in the period of regime introduction, as in further improvement of the situation during the transfer to the inflation targeting regime6. One can see from Table 4, to what extent the Russian Federation is compliant with those requirements.

However, in our estimates, the RF is compliant with the majority of requirements, set forth to the successful transfer to the inflation targeting (See Table 5).

Therefore, one can only welcome a gradual transfer of the Bank of Russia to the inflation targeting regime, especially basing on the results of numerous surveys, demonstrating7 positive macroeconomic dynamics in the countries, where the inflation targeting was applied, as compared with the periods, when alternative

6Ref.: Survey of IMF country desk officers, 2005.

7 Ref. «Inflation Targeting and The IMF», Prepared by Monetary and Financial Systems Department, Policy and Development Review Department and Research Department, March 2006.

regimes of monetary and credit policy were in effect, as well as with the countries, applying alternative regimes. Moreover, a significant result of inflation targeting regime is a higher credibility to the monetary and credit policy of central banks on the part of economic agents and reduction of volatility of the basic macro economic indicators, which lowers the risk of financial crisis8. A the same time, a transfer to inflation targeting regime should be supported by dismissal of the guided flexible rouble exchange rate, what can be achieved in present circumstances through a strong political decision.

Table 5

RF Compliance with Necessary Requirements of Introduction of Inflation Targeting Regime

Requirement

RF compliance

Comments

Relatively large-scale economy

Prices are established on the national level

Inflation rate is less than 10%

Support to the transfer of inflation targeting on the part of government authorities

Monetary and credit control bodies firmly adhere to the declared targets

Compliant

Compliant

Compliant

Compliant

Partially compliant

RF economy id under sustained development. GDP is relatively high

Hough the RF economy is highly dependent on external markets, basically the dynamics of prices in the national market is determined by domestic factors

As of 2006 results, the CPI made 9% Currently the task of inflation reduction is a priority to the government of the country, and the inflation targeting regime is the best instrument for achievement of that target

RF CB representatives repeatedly make statements on sustainability of their objectives, but they are far from reaching all the those target objectives_

At the end of this section, let us compare the growth rates of consumer prices in the RF and other CIS countries (See Table 6).

Table 6

Indices of Consumer Price Growth in CIS in 2000 2006, as %

2000 2001 2002 2003 2004 2005 2006'

Azerbaijan 2 2 3 2 7 10 8,9

Armenia 1 3 1 5 7 1 3,7

Belarus 169 61 43 28 18 10 5,6

Georgia 4 5 6 5 6 8 7,9

Kazakhstan 13 8 6 6 7 8 7,4

Kyrgyzstan 19 7 2 3 4 4 3,6

Moldova 31 10 5 12 12 12 12,7

Russia 20 19 15 12 12 11 9

Tajikistan 24 37 10 17 7 8 11,1

Urraine 28 12 1 5 9 14 10,6

Source: CIS Interstate Statistical Committee. (http://www.cisstat.com/).

One can notice that the inflation rates in Russia are still high in comparison with other CIS countries. As mentioned above, the reasons for sustained high rates of consumer prices in RF might be both, high growth rates of money supply (See Fig. 2), caused by a tendency to maintain a stable rouble rate, and non-monetary

9

8 Ref. Masson P., M. Savastano and S. Sharma, «The Scope for Inflation Targeting in Developing Countries», IMF Working Paper 97/130, Washington, IMF, 1997.

9 The basic information on the RF is provided as of 2006, on other countries - as of January-November.

factors, like high market monopolization, accelerated growth of commercial services (See Table 2),a as well as other reasons, not quite clear at this point.

2.1.3. State of Balance of Payments10

The RF stable situation with the balance of payments in 2006 as in years before was due largely to the peak volumes of the Russian main exports, first and foremost its energy sector. At the background of raising oil prices, the value of Russian exports has grown by 24 per cent. However, the rates of export sales growth have been reduced times 1.5 versus the preceding year of 2005, which resulted in some decline of oil prices in 2006. At the same time, the RF Central Bank has been accumulating gold and foreign currency reserves. Moreover, 2006 was also remarkable in terms of large amount of net capital inflow, which increased 13fold as compared with the relevant indicator of preceding year, when the inflow capital to the RF has exceeded the outflow for the first time.

350 300 250

g 200 +

o

-T3

Eh 150 +

100 50

0

r 70 60 50 40 30 20 10 0

1999 2000 2001 2002 2003 2004 2005 2006

] Export ♦ Share of oil, oil products and gas in export

Source: RF Central Bank

Fig. 5. Dynamics of Export Sales and Share of Energy Sector in Exports in 1999-2006

According to the tentative estimates of the RF balance of payments in 2006, published by the Bank of Russia, the surplus balance of current account surplus stood at USD 95.6 bln, i.e., has grown by 14.7 per cent versus the level of 2005 (See Table 7). Trading surplus in particular rose by 18 per cent (from USD 118.3 bln to USD 139.6 bln), with growth in exports at 24.1 per cent (from 243.6 bln to USD 302.3 bln) and imports also grew by 29.8 per cent (from USD 125.3 bln to USD162.7 bln). The share of products from the oil and gas segment of the economy made 63.4 per cent of total exports (versus 54.7 per cent in 2004, 61.1 per cent in 2005) (See Fig. 5).Therefore, as in the years before, status of Russia's cur-

10 The analysis of the state of balance is made on tentative data of the RF Central Bank.

rent account depends largely on its trade component, which in its turn is mostly determined by changes in prices for energy products and other major Russian export commodities, brought out to the world market. The data presented in Fig. 6 demonstrates that the correlation between the Russian trade account balance and the world market energy prices observed within 2002-2005, continued in 2006 as well.

Deficit in services account made USD 15.8 bln and has grown by 7.3 per cent as compared with 2005. Russian exported services amounted to USD 30.1 bln, USD 5.5 bln (or 22.2 per cent) more than the level of preceding year. At the same time, value of imported services also grew by 16.6 per cent in 2006 versus the level of 2005 and reached USD 46 bln.

Labor costs in 2006 continued to decline and made USD 4.3 bln.(In 2005 that figure was USD 1.2 bln).

Deficit of the RF investment income in the balance of payments in 2006 as compared to its 2005 level rose by 27 per cent (to USD 22.7 bln). The investment income increased from USD 15.7 bln to USD 25.4 bln due to considerable growth of the indicators of monetary and credit supervision authorities (from USD 4 bln to USD 10.7 bln.11) and non-financial organizations (from USD 8.4 bln to USD 10.3 bln). Similar growth of investment income payments at the non-financial sector (from USD 25.9 bln to USD 39.5 bln) has contributed to larger overall income payments (from USD 33.5bln to USD 48.1 bln).

The balance of current transfers in 2006 changed insignificantly as compared with 2005; that value was estimated at USD 1.2 bln.

Table 7

Major Components of the RF Balance of Payments and Dynamics of External Debt in 2004-2006 (USD bln)

Balance 2004 2005 2006

items I Q II Q III Q IV Q Year I Q II Q III Q IV Q Year I Q II Q III Q IV Q 2 Year*

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Current Account Transactions Capital Account Transactions13 Changes in Gold and Foreign Currency Reserves ( «+» - a decrease, «-» -growth of reserves)

11 The high level of income of monetary and credit control authorities is based on the beginning of investments to the RF Stabilization Fund.

12 Tentative estimates.

13 Minus changes in foreign currency reserves. 66

12,7 13,5 15 17,9 59,1 20 22,1 19,7 21,7 83,5 29,5 24,9 23,6 17,6 95,6

-3,1 -8 -8,1 11,9 -7,3 -1,4 -1,8 -10,6 3,4 -10,4 -6,3 17,4 -12,9 16,4 14,6

-6,8 -5 -6,5 -26,9 -45,2 -14,4 -18 -8,1 -21 -61,5 -21,4 -40,9 -13,8 -31,3 -107,4

1

2

10

11

12

13

14

15

16

Net Errors & -2,1 Omissions Changes in the RF external

debt («+» - _ growth,«-» - decrease of external debt)

Changes in the RF

external _

government debt Changes in the external debt of the _ RF private sector

-0,5 -0,3 -2,9 -6,5 -4,1 -2,2 -1 -4,1 -11,4 -1,7 -1,4 3,2 -2,7 -2,6

27,5 6,0 8,4 -1,1 30,6 43,9 16,1 14,9 -19,!

-0,6 -4,8 -0,6 -18,9 1,2 -23,1 4 -7,1 -24,5

28,0 10,8 9,1 17,8 29,4 67,1 12,1 22,0 4,1

* - Estimates. Source: Bank of Russia.

For the first time since 1998, a surplus was achieved in 2006 in terms of capital accounts transactions and financial instruments, which has reached USD 14.5 bln. Herewith, if the basic input in the above surplus in 1998 was made through increased loans of government sector, in 2006 the surplus of capital account transactions was formed primarily due to increased inflow of investments in private sector.

The balance of capital transfers was insignificant in 2006 and made USD 0.5 bln. Therefore, regardless capital transfers, made in 2006, the surplus of capital account was noted in the amount of USD 14 bln. $0000 45000 40000 35000

ja

= 30000

"J

25000

I Trade balance ♦ Oil price index (I quarter 1995=100%, on the right axis)

♦ ♦ ♦

ifT

nfln

20000 15000 10000 5000

"ii p3 C3

=L £. =L =

ty cr CT cr

2003

1 1 I 1 i l 1 1 1 .0

er rr er rr ty er

„ g > = = > = 5

2004 2005 2006

450% 400% 350% 300% 250% 200% I 50% 100% 50% 0%

Source: RF Central bank, IET assessments.

Fig. 6. RF Balance of Trade and Index of World Oil Prices for 2003-2006

3

4

5

6

7

8

9

Growth of the RF external liabilities in 2006 stood at USD 69.8 bln, i.e., 26.3 per cent higher than in preceding year (USD 55.3 bln).

As a year ago, federal government was still a net borrower to non-residents. Its external liabilities have been declined by USD 28.9 bln, basically due to pre-scheduled repayment of the RF external debt to Paris Club creditors. The external liabilities of the RF Subjects made USD 0.2 bln. Reduction of liabilities of monetary and credit control organizations has reached USD 7.1 bln. The expansion of activities of banking sector in terms of foreign capital involvement has resulted in the growth of liabilities of this sector (+ USD 48.5 bln). That indicator has been raised times 2.5 as compared with the relevant indicator of 2005. As per methodology of balance of payments, non-residents' investments in the real sector made USD 57.1 bln (USD 54.4 bln in 2004 r.). It should be noted, that despite an insignificant growth of investments in the real sector, their structure in 2006 has greatly changed: if in 2005 more than 75 per cent of investments were made in the form of loans and credits, in 2006 about 54 per cent of assets, involved by non-financial organizations, were made in the form of direct investments.

Foreign assets held by Russian residents have been increased in 2006 for USD 55.8 bln (in 2005 that indicator was USD 53 bln.). Practically all surplus is derived from the operations in private sector.

Foreign assets held by the RF federal government increased by USD 1.4 bln. Foreign assets held by the regulators of the national monetary base decreased by USD 7.6 bln. For the private banks the increase was by USD 23.4 bln.

Assets taken out of country in 2005 by non-financial sector and households were estimated at USD 38.6 bln, with a 15.6 per cent decrease versus the preceding year. At the background of growth in "direct and portfolio investments" (USD 20 bln), as well as in "trade credits and advance payments" (USD 0.9 bln), a significant decline was observed in the amount of cash held in foreign currency (USD 10.6 bln). In other words, in the continued strengthening of RUR in nominal terms in 2006, both, physical persons and non-financial sector actively disposed foreign currency. Value of export earnings not received timely, imported goods paid for under import contracts but not delivered and asset transfers under non-existing contracts has decreased since 2005 to the level of USD 17.7 bln.

Therefore, in out opinion, the major trend in dynamics of the balance of payments indicators in 2006 was a considerable inflow of net capital in non-financial sector in the amount of USD 40.9 bln (as opposed to outflow of capital from non-financial sector in b 2004 at the level of USD 8.5 bln and inflow in 2005 in the amount of USD 3 bln) (See Fig.7).

Source: RF Central Bank, IET assessments

Fig. 7. Net Capital Outflow Dynamics within 2002-2006

It has to be noted that as per results of the 1st quarter, there was observed an outflow of capital in the amount of USD 5.3 bln. Total capital inflow within the year was ensured during the II-IV quarters, when the net inflow of capital to non-financial sector made USD 46.1 bln and determined the outcome of the year. These capital inflows resulted mainly from national companies and banks' active involvement in attraction of foreign credits, as well as foreigners' enthusiasm in lending money to Russian companies in the face of the country sound macroeconomic dynamics. We'd like to mention once again, that the bulk of the assets, attracted by non-financial organizations, were made in the form of direct investments, rather than loans and credits, made a year earlier.

Moreover, in 2006 there was observed a restructuring in the trend of non-official capital outflow ("capital flight") (See Fig. 8), which made as per the year results, according to our estimates14,USD 21.2 bln, i.e., USD 25.1 bln less than in 2005. A relevant decrease was observed in regard to "capital flight" in external trade (from 12.6 per cent in 2005 to 4.6 per cent in 2006).

14 "Capital flight" is assessed in accordance with IMF methodology as a grand total of "trade credits and advance payments", "export earnings not received timely, imported goods paid for under import contracts but not delivered", and "net errors and omissions".

Source: RF Central Bank, IET assessments

Fig. 8. Capital Flight Dynamics within 2002-2006

Among other specifics of balance of payments of 2006, one should note high, as before, and still growing share of income from energy sources and export sales, once again demonstrating high level of dependence of Russian economy on natural resources export and market prices. On the other hand, there are high expectations for stabilization of prices in 2007, what can decrease the share of energy sources in the total export sales. Therefore, as was expected in the preceding year, in the background of further growth of net capital inflow to the RF and reduced capital outflow, the stability of balance of payments will be maintained both, by the surplus balance of current account (which might be reduced under conditions of lower prices for energy resources and growing imports), and by the account of operations with capital and non-financial instruments (accompanied by accumulation of gold and foreign currency resources).

2.1.4. Basic Measures to be Implemented in the Sphere of Monetary and Credit Policy

In January 2006 Rosstat has published basic structure of consumer expenditure weights of population, used for assessment of consumer price index for 2006. We should mention, that that structure was published for the first time, which was a serious move towards higher transparency in the IET estimation methodology.

Within 2006 the RF Central Bank has been raising four times the interest rates on financial instruments on deposit operations in national currency for credit or-

ganizations, made under "Tom-next", "spot-next", "on demand" standard terms to 2.25 per cent per annum; on the operations made under "one week" and "spot-week" terms - to the level of 2.75 per cent per annum. The interest rate increase was effected for the purpose of excessive money supply sterilization and came into effect due to some changes in national and external economic conditions, namely to the refund rate policy, pursued by Federal Reserve System of the USA and European Central Bank. It should be noted, that the raised refund rates on the RF Central Bank deposits have, in fact, increased their attraction. As per results of the year, credit organizations' deposits with the Bank of Russian have grown practically 13-fold. With the help of this measure the Bank of Russia was pursuing the policy of raising the significance of the interest rate as an instrument of the general monetary and credit policy.

In 2006 the RF Central Bank has decreased the refund rate twice, on June 26 it was reduced from 12 per cent to 11.5 per cent, and since October 23 it was established at the rate of 11 per cent. It should be noted, that the decrease of the refund rate was implemented at the background of growing interest rates on deposits of credit organizations with the RF Central Bank. The decline of refund rates was aimed at raising the significance of interest rates in monetary and credit policy. As a mater of fact, the effective refund rate is much higher than the standard rate of a bank credit, and therefore, changes in refund rate provide minimum effect in terms of monetary and credit policy. However, the raised rates on deposits has led to their increased attractiveness to the banks and made a positive impact over liquidity sterilization in the Bank of Russia.

Due to abolishment of restrictions in foreign currency operations as of January 1 2007, to achieve the aim of unrestricted convertibility of the Russian rouble, the Bank of Russia has reduced twice the reserve limit of funds for foreign currency operations and cut down to zero the quota for mandatory sale of foreign currency receipts. Soon after that, on May 29, the RF Central Bank issued a resolution on abolishment of requirements on reservation of funds on certain transactions with foreign currency. Moreover, on July 1, 2006 a demand to open special accounts for certain types of operations with foreign currency was also dismissed (i.e., special bank accounts, special deposit accounts, accounts of non-residents in the register of securities holders).Those measures were aimed at annihilation of restrictions in regard to operations with capital and at free rouble convertibility.

In May the RF State Duma has adopted in final reading the law on the RUR graphic symbol, with relevant amendments to the Law "On the RF Central Bank (Bank of Russia)." According to the new law, Russian rouble will have an appropriate visual symbol, which is subject for approval by the Bank of Russia in compliance with appropriate legislative procedure.

In June the Paris Club of Creditors has accepted the prescheduled recovery of the long-term Russian debt, which exceeded the amount of USD 20 bln. It was planned to repay 51.4 per cent of that amount at face value, whereas the balance of total debt should be recovered with an interest of about USD 1 bln. It should be reminded, that in 2005 Russia has made early repayment of its debt to IMF (in the

amount of USD 3.3 bln) and partially recovered the debt to Paris Club (in the amount of USD 15 bln). In our opinion, prescheduled recovery of external debts is a positive way of accumulated national funds expenditure, as on the one side, that measure does not bring inflation pressure in the national economy, and on the other side, reduces the liabilities to external creditors.

In August the bank of Russia has submitted to the RF State Duma a document on "Major Trends of Consolidated Monetary and Credit Policy in 2007", where, for the first time in recent years, the Bank of Russia has outlined its primary task for the year of 2007, namely - combating of inflation and bringing it to the level of 6.5 8 per cent as of the year results. As concerns the index of inflation targeting for the rouble rate in real terms, it should be held within the range of 0 per cent to 10 per cent. In our point of view, those measures will help the Bank of Russia to pursue effective monetary and credit policy, avoiding attempts to achieve several conflicting targets. Moreover, according to the Central Bank estimates, the surplus of monetary base in narrow definition will make 14-22 per cent in 2007. Gold and foreign currency reserves by the end of 2007 should reach about USD 316 bln- USD 390 bln. We consider that both estimates are somewhat lower than they should be. According to the model of approximation of short-term estimates of the RF socio-economic indicators, in the first half-year of 2007 the growth rate of the monetary base should reach

18.1 per cent, and gold and foreign currency reserves will exceed USD 384 bln.

Since October 1 of the preceding year, the Bank of Russia has increased the

rate of deductions to Mandatory Reserve Fund and under the debts of Russian banks to external credit organizations from 2 per cent to 3.5 per cent. By this means, Central Bank was making an attempt to reduce the attraction of foreign credits to the Russian banks and to protect national currency from excessive pressure. However, that measure has not bring any problems with liquidity to the banks, as the Bank, having increased the rate of deductions to Mandatory Reserve Fund, has also raised the average index from 0.2 to 0.3. Therefore, now the banks are able to withdraw at the beginning of the month and repay at the end of month up to 30 per cent of their deductions to Mandatory Reserve Fund. As a whole, those two counteracting measures, taken by the Central Bank, lead to a neutral result, but their introduction might point to the beginning of a tougher monetary and credit policy.

2.2. The state budget

2.2.1.A general overview of the budgetary system

When analyzing the main parameters characteristic of the RF budgetary system in 2006, it should be noted that last year's level of revenue and expenditure by comparison with that of 2005 changed only slightly (see Table 1): in the federal budget, the share of tax revenues in GDP decreased by 0.1 p. p. and amounted to

22.2 % of GDP, while in the budgets of RF subjects the amount of tax revenue as a percentage of GDP was the same as in the previous year (10.3 % of GDP). As a result, the share of taxes and payments in the revenues of the RF consolidated budget in 2006 amounted to 32.5 % of GDP, against 32.6 % of GDP in 2006.

According to the data on the actual execution of the RF federal budget in 2006, its revenue was 23.6 % of GDP, which is by 0.1 p. p. lower than the corresponding index of 2005. The revenue of the RF consolidated budget in 2006 amounted to 35.5 % of GDP, which is by 0.3 p. p. higher than the pervious year's index. As for the expenditure indices of the RF budgetary system in 2006, they demonstrated a certain decline against the sum of expenditure in the 2005 federal budget (16.1 % against 16.3 % of GDP), but did not change in terms of the RF consolidated budget and amounted to 27.5 % of GDP.

The revenue of the RF territorial budgets in 2006 constituted 14.3 % of GDP against 13.9 % of GDP one year earlier. The expenditure of the budgets of RF subjects also demonstrated a slight growth on the year 2005 (13.6 % of GDP) and amounted to 13.7 % GDP. Due to the decreased revenue and expenditure in the federal budget, and the increased revenue and unchanged expenditure in the RF territorial budgets, the surplus in the consolidated budget, as shown by the results of the year 2006, rose on the previous year and amounted to 8.0 % of GDP (against 7.7 % of GDP in 2005), having reached its historic high of the whole post-Soviet period.

The single social tax (SST), a part of which is transferred to the federal budget, deserves a separate comment. Thus, throughout the period of 2002 -

2004, the revenues generated by this tax were declining at a stable rate, having demonstrated a noticeable fall in 2005 to the level of 1.24 % of GDP against 2.6 % of GDP in 2004. By the results of 2006, the share of revenues from this tax in GDP decreased even further - to approximately 1,19 % of GDP. The main cause of this sharp decline is the lowering of the rate of SST in 2005 - from 35.6 % to 26 %. It should be noted that, for example, in 2001, assuming the tax base was 100,000 roubles, the proportional shares of the SST rate divided between the budget and off-budget funds would be as follows: 28 % - to the federal budget, 4.0 % - to the Social Insurance Fund, 0.2 % - to the Federal Compulsory Medical Insurance Fund, and 3.4 % - to the territorial funds. In 2005 the law was amended, whereby the proportional distribution of the SST rate, at a tax base of up to 280,000 roubles, became as follows: 20 % - to the federal budget, 3.2 % - to the Social Insurance Fund, 0.8 % - to the Federal Compulsory Medical Insurance Fund, and 2.0 % - to the territorial compulsory medical insurance funds. Thus, the diminished share of transfers to the federal budget in 2005 was the direct consequence of the sharply decreased standard deduction rate established for the aggregate revenue from this tax.

The budget of the RF general government, by the results of 2006, was executed in respect of revenue at the level of 40 % of GDP against 39.7 % of GDP in

2005. Expenditure amounted to 31.5 % of GDP against 31.6 % of GDP in 2005. The growing revenue of the general government's budget alongside the reduction in its expenditure as a share of GDP was conducive to an increased budget surplus -from 8.1 % of GDP in 2005 to 8.5 % of GDP in 2006.

Table 8

The execution of the revenue and expenditure of the consolidated budget, the federal budget and territorial budgets (in % of GDP)

1999 2000 2001 2002 2003 2004 2005 2006

Federal budget

Tax revenues 11.7 1 4.5 16.3 18.9 18.2 18.6 22.3 22.2

Including from SST15 - - - 3.13 2.75 2.60 1.24 1.19

Revenue 1 2.7 15.5 17.8 20.3 19.5 20.1 23.7 23.6

Expenditure 14.0 1 4.2 14.8 18.9 17.8 15.8 16.3 16.1

Deficit (-) /Surplus (+) -1.1 1.4 3.0 1.4 1.7 4.3 7.4 7.5

Territorial budgets

Tax revenue 11.1 11.8 11.0 11.5 10.8 11.4 10.3 10.3

Revenue 13.4 1 4.1 14.5 15.1 14.6 1 4.1 13.9 1 4.3

Expenditure 13.3 1 3.4 14.5 15.5 14.9 1 3.9 13.6 1 3.7

Deficit (-) /Surplus (+) 0.1 0.7 0.0 -0.4 -0.3 0.2 0.3 0.6

Consolidated budget

Tax revenue 22.8 26.3 27.3 30.4 29.0 30.0 32.6 32.5

Revenue 25.2 28.5 29.3 32.1 31.1 32.3 35.2 35.5

Expenditure 26.3 25.6 26.4 31.1 29.7 27.8 27.5 27.5

Deficit (-) /Surplus (+) -1.1 2.8 2.9 1.0 1.4 4.5 7.7 8.0

General government's budget

Tax revenue 31.4 35.7 35.7 35.6 34.6 35.3 36.9 36.9

Revenue 33.8 38.3 38.4 37.8 37.1 37.5 39.7 40.0

Expenditure 35.3 34.3 35.2 36.3 36.0 32.9 31.6 31.5

Deficit (-) /Surplus (+) -1.5 4.0 3.2 1.5 1.1 4.6 8.1 8.5

Source: the RF Ministry of Finance; the lET's estimations.

Against the background of a sufficiently favorable situation on the international market for oil and metals (the average per annum price of Urals was $ 60.97 per barrel against $ 50.2 per barrel16 in 2005), the stabilization of budget revenue occurred due to the changed amounts of revenues from individual taxes, which will be discussed in more detail later.

The actual indices of oil prices being in excess of the target ones set in the 2006 budget resulted, just as in the previous year, in a surplus over the planned revenues of the budgetary system, and therefore on 1 December 2006 a law was passed, in accordance with which the revenue of the RF federal budget was increased to 6,170.48 billion roubles (in the initial draft - to 5,046.14 billion roubles), the expenditure - to 4,431.08 billion roubles (in the initial draft - to 4,270.11 billion roubles).

15 From 2001, SST replaced the previously existing contributions to the state off-budget social funds. From 2002, a part of the aggregate SST rate has been transferred to the federal budget.

16 The data published by the Energy Information Administration of the US Department of Energy www.eia.doe.gov. For a more detailed discussion if the situation on the oil market, see the corresponding section of this report.

2.2.2. An analysis of revenues from the main taxes in the RF budgetary system

The data concerning the amounts of revenues from the main taxes received in the RF budgetary system in 2006 are shown in Table 9.

Table 9

Revenues from the main taxes in the budget of the general government of the Russian Federation in 1998 - 2006 (in real terms, in % of GDP)

1998 1999 2000 2001 2002 2003 2004 2005 2006

1 2 3 4 5 6 7 8 9 10

Tax revenues in real terms (trillion roubles)

Tax revenue* 0.84 0.88 1.10 1.15 1.20 1.26 1.38 1.53 1.63

Profits tax 0.10 0.13 0.17 0.19 0.14 0.14 0.20 0.26 0.28

Personal income tax 0.07 0.07 0.07 0.09 0.11 0.13 0.13 0.14 0.15

VAT17 0.16 0.17 0.19 0.23 0.24 0.24 0.24 0.28 0.25

Excises18 0.07 0.06 0.07 0.09 0.08 0.09 0.06 0.05 0.04

Revenues from foreign economic activity 19 0.04 0.05 0.10 0.12 0.10 0.12 0.20 0.32 0.38

Payments for use of mineral resources 0.02 0.03 0.03 0.05 0.10 0.11 0.13 0.18 0.20

Sales tax 0.00 0.01 0.01 0.02 0.02 0.02 0.00 - -

Allotments to off-budget funds20, including 0.21 0.20 0.22 0.23 0.13 0.14 0.14 0.17 0.19

SST to RF Social Insurance Fund - - - 0.01 0.01 0.01 0.01 0.01 0.01

SST to Federal Compulsory Medical Insurance Fund - - - 0.00 0.00 0.00 0.00 0.01 0.01

SST to territorial compulsory medical insurance funds - - - 0.02 0.02 0.02 0.02 0.02 0.02

Insurance contributions to

mandatory pension insurance - - - - 0.09 0.11 0.11 0.12 0.16

in RF

Tax revenues in % of GDP

Tax revenue* 31.9 31.4 35.7 35.7 35.6 34.6 35.3 36.9 36.9

Profits tax 3.7 4.6 5.4 5.7 4.3 4.0 5.1 6.2 6.3

Personal income tax 2.7 2.4 2.4 2.9 3.3 3.4 3.4 3.3 3.5

VAT 6.0 5.9 6.2 7.2 7.0 6.7 6.3 6.8 5.7

Excises 2.6 2.2 2.3 2.7 2.4 2.6 1.4 1.2 1.0

Revenues from foreign economic activity 1.4 1.8 3.1 3.7 3.0 3.4 5.0 7.8 8.7

Payments for use of mineral resources 0.8 0.9 1.1 1.4 3.1 3.0 3.4 4.3 4.5

Sales tax 0.03 0.40 0.47 0.50 0.46 0.43 0.04 0.00 0.00

17 The value added tax on the commodities produced in the territory of the Russian Federation and imported into its territory.

18 The excises on excisable goods produced in the territory of the Russian Federation and imported into its territory, without the oil excises.

19 Customs duties, customs levies and other revenues from foreign economic activity.

20 Prior to 2002 - the aggregate allotments to the off-budget social funds. From 2002 - taxes and contributions to social needs, without the deductions of SST being transferred to the federal budget.

1 2 3 4 5 6 7 8 9 10

Allotments to off-budget funds, including 7.9 7.1 7.3 7.2 3.8 3.9 3.7 4.2 4.3

SST to RF Federal Social Insurance Fund 0.24 0.23 0.22 0.25 0.22 0.21

SST Federal Compulsory Medical Insurance Fund 0.04 0.05 0.04 0.04 0.14 0.21

SST to territorial compulsory medical insurance funds 0.59 0.71 0.66 0.62 0.38 0.37

Insurance contribution to mandatory pension insurance in RF 2.76 2.94 2.80 2.88 3.51

* - the data prior to 2005 incorporate the revenues of target budget funds.

Source: the RF Ministry of Finance.

Fig. 9. Dynamic of revenues from main taxes in real terms in 1998 - 2006 (trillion roubles)

As seen from the data presented here, the whole period from 1998 to 2006 is characterized by growing tax revenues in the budget of the general government of the Russian Federation Russian in real terms (see Fig. 9): the per annum growth rate of this index was fluctuating between 4.3 % (in 2003) and 25.1 % (by the results of 2000), which was mainly due to the substantial growth in the revenues from the profits tax, VAT and export customs duties. However, if we look at the period after the introduction of basic changes to tax legislation, the maximum growth of tax revenues in real terms was demonstrated by the results of 2005 - 11.1 %. Similar changes were observed in the indices of tax revenues as a percentage of GDP, which by 2005 had reached its historic high of the whole period under considera-

tion (36.9 % of GDP). In 2006 the share of tax revenues remained at a constant level - 36.9 % of GDP.

Among the main factors responsible for the growing tax revenues within the budgetary system we can point to the favorable situation existing for Russian export commodities, primarily oil, natural gas and metals; the expansion of the tax bases for many taxes due to Russia's economic growth; improved tax administration; and a partial reduction in the arrears of taxes. In the period prior to 2004 a number of taxes and levies were abolished, which had an additional impact on the behavior of tax revenues. In particular, this abolition involved the sales tax, the tax for the upkeep of the housing fund and the objects in the cultural sphere (prior to 2001 the tax was levied at the rate of 1.5 % of turnover), the tax on purchase of motor cars, the tax on the sale of fuels and lubricants; besides, the rates of the motor road tax and the tax on the owners of motor cars were lowered, and later these two taxes were completely abolished altogether.

The behaviors of revenues from individual taxes differed greatly. Thus, the highest volatility both in real terms and in % of GDP was displayed by the revenues from the tax on profit of organizations. From Table 9 it can be seen that before 2001 the revenues from this tax had been growing due to the increasing balances of enterprises' financial results, improving payment and settlement procedures in the national economy, as well as the introduction, in 2001, of the municipal profits tax at the rate of profit by way of compensation for the abolished tax for the upkeep of the housing and utilities sector. However, the results of 2002 demonstrated a substantial fall in the revenues from the tax on profit of organizations, which constituted approximately 26 % in real terms and 1.4 p. p. in % of GDP. In 2003 the revenues from this tax in real terms slightly grew, while as a percentage of GDP they became even lower, having decreased from 4.3 % to 4.0 % of GDP.

The principal factors responsible for the fall in the revenues from the profits tax in 2002 and 2003 were as follows: the enactment of the new provisions of the Tax Code concerning this tax, in particular changes (upward) in the structure and volume of costs to be deducted when determining the tax base; the lowered tax rate - from 35 % to 24 %; the application of a "transitory provision" concerning the estimation of tax base on the accrual basis; altered depreciation deductions; and the general reduction in the net financial results of enterprises' activity. As estimated by the RF Ministry of Finance, in 2003 approximately 0.12 % of the aggregate reduction in the revenue share in GDP resulted from the changes in the part concerning the determination of tax base for the profits tax. Only in 2004 the trend of declining tax revenues became reversed, and revenues increased by 48 % in real terms, or by 1.1 p.p. in % of GDP, and this growth continued in 2005 and 2006.

The main factors responsible for the increased revenues from the profits tax in 2004 were economic growth and the favorable economic situation in respect of international prices of energy carriers, and in particular, the growing oil prices. Against this background, a considerable expansion of the taxation base was observed: while in 2003 the net balance of the financial activity of enterprises and organizations decreased by 12 %, in 2004 it rose by 50 %, and in 2005 - by 35 %.

Besides, the growth of revenues in 2004 can be to a certain extent explained by the termination of a number of exemptions from the profits tax granted prior to the 2002 tax reform. The growth of revenues in 2005 is partly a consequence of the transfer to the budget, in Q I 2005, of the payment against the tax arrears of 'Yukos".

As seen by the results of 2006, the revenues from the profits tax somewhat increased on the pervious year and amounted to 6.3 % of GDP. This increased revenues can be explained by an expanded tax base (in the first ten months of 2006 the net balance of the financial activity of enterprises in the RF rose by 26 %). Besides, production growth in industry (3.9 % per annum) and in other types of economic activity, coupled with growing producer prices (in industry - 10.5 %) could also be conducive to increased tax revenues.

The revenues from the personal income tax in real terms remained at a sufficiently stable level until 2001. However, from 2002 the real revenues from this tax began to grow, and this growth continued throughout the following period. At the same time, growth in % of GDP could be observed only until 2004 inclusive, after which the share of revenues in GDP demonstrated a certain decline. Only in 2006 the revenues from this tax in % of GDP, as demonstrated by the year's results, once again grew and amounted to 3.5 %, whereas the revenues from SST remained at the same level as in 2005 (2 % of GDP). At the same time, according to the RF Rosstat, in 2006 the population's incomes in real terms increased by 10 %, while the growth of an average monthly salary in real terms was 13.5 %. During the same period, the growth of GDP in real terms amounted to 6.7 %. Thus, in 2006 the value of the effective rate of SST and the personal income tax in real terms turned out to be lower than in 2005.

The behavior of the revenues from the personal income tax should be viewed with due regard for the fact that in 2001, as a result of reform, a flat rate of 13 % was introduced for this tax. Thus, it can be noticed that as early as 2001 the annual results demonstrated a certain growth of tax revenues. One of the growth factors was that prior to reform the lower margin of the tax rate had been 12 %, and therefore its increase by 1 %, given the assumption that the tax base remained unchanged or expanded, resulted in a noticeable growth in revenues (according to different estimations, by approximately 0.1 % of GDP), even though the marginal rate established for that part of the population that had been paying the tax at a higher rate had become lower (a fall in revenues by approximately 0.05 % of GDP). Besides, according to estimates, approximately 0.2 % of the growth in revenues from the personal income tax in % of GDP was generated by the expanded tax base. The subsequent growth was largely due to the overall rise in the population's incomes produced by economic growth, as well as to the partial legalization of incomes.

Prior to and through the year 2003, the revenues from excises both in real terms and in % of GDP varied to a noticeable degree. However, overall revenues were growing, having reached in 2001 their historic high of the entire post-crisis period. Later on, from the year 2004 onward, a rather significant decline followed.

The initial growth of revenues in 2001 - 2003 was produced by the introduction of the excises on diesel fuel and engine oils, the increased rates of the excises on alcoholic beverages and on petrol (more than threefold)21, as well as of the excises on natural gas in response to its growing international prices. The reversal of the upward trend in the growth of excises, registered in 2004 and resulting in the onset of the aforesaid decline in their sum in real terms and in % of GDP, was largely due the abolition, from 1 January 2004, the excise on the natural gas, the revenues from which in 2003 amounted to approximately 45 % the total revenue from excises received by the budgetary system.

A substantial portion of the tax revenues in the budget of the general government is represented by the revenues from the value added tax. While their amount in real terms until 2005 was mainly growing, in % of GDP it grew only until 2001, which was followed by a three-year decline in revenues. A noticeable improvement was seen only by the results of 2005, and then in 2006 these revenues once again demonstrated a marked drop. The growth of 2000 - 2001 was largely due to the switchover to the payment of VAT "by the country of destination" in the trade relations with the CIS member states, as well as to the abolition of some exemptions. However, as early as 2001 a noticeable growth in the volume of VAT refunds was seen, which had a negative impact on the level of revenues from this tax in 2001. This phenomenon also to a certain extent accounted for a decline in the revenues from VAT in 2002 - 2004. At the same time, in 2004 the additional decline in the volume of revenues from VAT was produced by the lowering of the tax rate from 20 % to 18 %. At the same time, the decrease in the total share of revenues in GDP amounted to only 0.4 p. p. against the expected figure of approximately 0.6 % of GDP, which can be in part explained by a noticeable reduction in the volume of VAT refunds in respect of exports transactions.

In 2006 the share of revenues from the value added tax fell significantly - to 5.7 % of GDP from 6.8 % of GDP in 2005. Among the main factors responsible for the declining revenues from VAT, we should point to the increased tax deductions and the shrinkage of the tax base, associated with the changes in legislation that entered into force in 2006.

Besides, an important item of revenue in the budgetary system of the Russian Federation are the payments for the use of natural resources, a considerable part of these being constituted by the revenues from the tax on the extraction of mineral resources (TEMR). While prior to 2001 such revenues remained relatively insignificant, from 2002 onward they began to display a stable growth due to the growth of the international prices of energy carriers. Since the rate of TEMR was directly linked to the level of international oil prices, the improved situation on the global market of energy carriers was automatically producing changes in the level of revenues from this tax, and consequently in the amount of aggregate revenues generated by the payments for the use of natural resources.

21 Such a substantial increase in the rate of the excises on petrol was designed to compensate for the abolition of the tax on the sales of fuels and lubricants and for the lowered rate of the tax on users of motor roads.

Rather similar behaviors were demonstrated by the revenues from foreign economic activity, which during the greater part of the period under consideration were growing as a result of the growth of both the Russian economy and the foreign trade turnover, and of the changes in the export duties on oil, which from the year 2002 onward were calculated on the basis of the international oil price.

As for the tax revenues in 2006, the share of payments for the use of natural resources in GDP rose from 4.5 % of GDP (against 4.3 % of GDP in 2005), while the growth of revenues from foreign economic activity amounted to 0.9 p. p. of GDP (a rise from 7.8 % to 8.7 % of GDP). The main source of the growing revenues was the improving situation on the international oil market, as well as on the metals market (during that year, the prices of nickel and other metals reached their absolute historic highs). As for foreign trade, by the results of 2006 its volume was approximately $ 470 billion (exports - $ 304.5 billion, imports - $ 163.9 billion), having increased by 27 % (growth in exports by 25 %, in imports - by 30.8 %).

The level of allotments to social off-budget funds in 1998 - 2001 remained rather stable, but noticeable changes occurred from the year 2001 onward, which can be explained mainly by the amendments to legislations, which entered into force in 2001. When discussing the period of 2002 - 2006, it should be noted that in 2003 (less the amount of SST transferred to the federal budget) there occurred an increase in the amount of allotments in % of GDP, followed in 2004 and 2005 by a decline. In 2006 the revenues transferred to the off-budget funds markedly grew also as a percentage of GDP and amounted to 4.3 %. At the same time, from 2002 an overall decline in the social allotments was observed.

If we look at the structure of allotments to off-budget funds, it will be noticed that in 2001 - 2004 their share in GDP was remaining at a sufficiently stable level, whereas by the results of 2005 and 2006 a noticeable fall in the revenues transferred to the social insurance fund and the territorial compulsory medical insurance funds was observed. The main reason for this substantial decline was the changed proportional distribution of the revenues from SST. Thus, for example, if in 2001 4.0 % of the rate of SST was transferred to the social insurance fund (the tax being under 100,000), in 2005 its size was revised and decreased to 3.2 %. The corresponding indices of 2001 and 2005 for the allotments to the territorial compulsory medical insurance funds were 3.4 % and 2 %, respectively. On the contrary, the growth in the share of allotments to the Federal Compulsory Medical Insurance Fund in 2005 from 0.2 % to 0.8 % was conducive to the growth of revenues transferred to the Fund in 2005 and 2006. And finally, the revenues from the insurance contributions to mandatory pension insurance throughout the period of 2002 -2005 remained at a rather stable level of approximately 2.7 % - 2.9 % of GDP, and only by the results of 2006 increased to 3.51 % of GDP.

The structure of tax revenues in the budget of the general government is shown in Table. 10.

Table 10

The share of tax revenues in the aggregate revenues of the general government's budget in 2000 - 2006, in %

1998 1999 2000 2001 2002 2003 2004 2005 2006

Tax revenues 89.9 93.0 93.3 92.8 94.2 93.2 94.3 92.9 92.2

Profits tax 10.3 13.5 14.1 15.0 11.3 10.7 1 3.6 15.5 15.7

Personal income tax 7.6 7.2 6.2 7.4 8.8 9.3 9.0 8.2 8.7

VAT 16.8 17.6 16.2 18.6 18.4 1 7.9 16.7 17.2 1 4.2

Excises 7.3 6.7 5.9 7.1 6.5 7.0 3.8 3.0 2.5

Revenues from foreign economic activity 3.9 5.3 8.2 9.6 7.9 9.2 13.5 19.6 21.7

Payments for use of mineral resources 2.4 2.7 2.8 3.8 8.1 8.0 9.1 10.8 11.2

Sales tax 0.08 1.18 1.23 1.31 1.22 1.15 0.10 0.00 0.00

SST* 15.1 10.9 9.9 9.3 5.0 4.9

TOTAL REVENUE 100 100 100 100 100 100 100 100 100

* - aggregate revenues from SST.

While discussing the structure of tax revenues in the general government's budget, it should be noted that in some of the years within the period under (1998 -2006) the ratio between the main taxes as percentages of the aggregate revenue of the consolidated budget was changing. Thus, until 2004 the highest shares in the aggregate budget revenue were constituted by the profits tax, by VAT and - from 2001 - by the single social tax. Their aggregate share in 2002 - 2004 amounted to approximately 58 % of the aggregate revenue of the general government's budget. Later on, rather noticeable growth was demonstrated by the share of revenue from foreign economic activity, which in 2005 and 2006 became the biggest component of the tax revenues in the general government's budget. On the contrary, the share of tax revenues from SST during the last two years showed a marked decline of the indices registered at the beginning of the period under consideration. In addition, some attention should be paid to the rather high volatility of the share in the aggregate revenues of the general government's budget constituted by the tax on profit of organizations. Thus, throughout the whole period it fluctuated between 10.3 % of GDP 1998 and 15.7 % of GDP in 2006.

2.2.3. The expenditures of the budgetary system

From 1 January 2005, the budgetary classification has been changed, and so it is impossible to adequately compare the main items of expenditure in the budgetary system for the years 2005 - 2006 and earlier. In this connection, below we are going to analyze separately the data prior to 2004 and the actual execution of the budgets of all levels in 2005 - 2006. The main characteristics of the expenditures of the RF budgets of all levels in 2002 - 2004 are shown in Table. 11.

Table 11

The expenditures of the federal, territorial and consolidated budgets in 2002 - 2004 (in % of GDP)

2002 2003 2004

Federal Territorial budgets Consolidated Federal Territorial budgets Consolidated budget Federal Territorial budgets Consolidated

budget budget budget budget budget

1 2 3 4 5 6 7 8 9 10

State administration

and local self- 0.5 0.8 1.4 0.5 0.9 1.4 0.5 0.8 1.3

government

Judicial authority 0.2 0 0.2 0.2 0 0.2 0.2 0.0 0.2

International activity 0.3 0 0.3 0.2 0 0.2 0.3 0.0 0.3

National defense 2.7 - 2.7 2.7 0 2.7 2.6 0.0 2.6

Law-enforcement activity and state security 1.7 0.5 2.2 1.9 0.4 2.3 1.9 0.4 2.3

Fundamental research

and promotion of scientific and technological 0.3 0 0.3 0.3 0 0.3 0.3 0.0 0.3

progress

Industry, power engi-

neering and construc- 1 1.3 2.3 0.5 2 2.5 0.5 1.9 2.3

tion

Agriculture and fishery 0.3 0.3 0.5 0.2 0.3 0.5 0.2 0.3 0.5

Transport, motor road

system, communica- 0.1 0.4 0.5 0 0.3 0.3 0.0 0.2 0.3

tions and informatics"

Housing and utilities sector 0 2.3 2.3 0 1.9 1.9 0.0 1.7 1.7

Public education 0.7 3 3.8 0.8 2.8 3.6 0.7 2.8 3.5

Culture, art and cinematography , 0.1 0.4 0.5 0.1 0.3 0.5 0.1 0.3 0.4

Mass media 0.1 0.1 0.2 0.1 0.1 0.2 0.1 0.1 0.1

Public health care and physical culture 0.3 2.1 2.4 0.3 1.9 2.2 0.3 1.9 2.2

Social policy 4.4"" 1.3 5.7"" 1 1.4 2.4 0.9 1.5 2.4

Government debt servicing 2 0.1 2.2 1.7 0.1 1.8 1.2 0.2 1.4

Financial support to budgets of other levels 2.7 0 - 6.0""" 0 3.2""" 5.4 0.0 3.0

Military reform 0.1 0 0.1 0.1 0 0.1 0.0 0.0 0.0

Motor road system 0.4 0.4 0.7 0.3 0.5 0.8 0.3 0.2 0.5

Target budget funds 0.1 1.4 1.6 0.1 1.1 1.2 0.1 1.0 1.1

Total expenditure 18.7 15.3 31.1 1 7.7 14.9 29.7 16.1 14.1 27.8

Source: the RF Ministry of Finance.

* In 2001 - including the expenditures on the road system upkeep.

** Including transfers to the RF PF for the financing of the basic component of pension at the expense

from the part of SST centralized in the federal budget.

*** From 2003 this section reflects the transfers to the state off-budget funds.

Table 12

Expenditure of the federal, consolidated and territorial budgets in 2005 and 2006 (in % of GDP)

2005 2006

Consolidated budget Consolidated budget

Federal budget Territorial budgets Federal budget Territorial budgets

General state issues 3.5 2.3 1.2 3.1 2.0 1.1

of these, servicing of state and municipal debts 1.1 1.0 0.1 0.7 0.6 0.1

National defense 2.7 2.7 0.0 2.6 2.6 0.0

National security and law-enforcement activity 2.7 2.1 0.6 2.7 2.1 0.6

National economy 3.5 1.2 2.4 3.6 1.3 2.3

Housing and utilities system 2.2 0.0 2.1 2.4 0.2 2.2

Environment protection 0.1 0.02 0.08 0.1 0.02 0.06

Education 3.7 0.8 2.9 3.8 0.8 3.0

Culture, cinematography and mass media 0.7 0.2 0.5 0.7 0.2 0.5

Public health care and sports 2.6 0.4 2.1 2.8 0.6 2.3

Social policy 2.4 0.8 1.6 2.4 0.8 1.6

Interbudgetary transfers 3.5 5.8 0.1 3.4 5.6 0.1

Total expenditures 27.5 16.3 13.6 27.5 16.1 13.7

Source: the RF Ministry of Finance.

The main items of expenditure of the federal, consolidated and territorial budgets of the RF in 2005 and 2006 are shown in Table 12.

The structure of the RF budgetary system's expenditure in 2006 did not demonstrate any significant changes by comparison with the previous year. Just as one year earlier, a substantial volume of financing was allocated to the items "General state issues", "National defense", "National security and law-enforcement activity", "Education", "Public health care and sports", and "Social policy". At the same time, certain changes occurred in some of the sections of the functional classification of the consolidated budget's expenditures, which should be pointed out. Thus, the majority of sections demonstrated either a marked decline or the same figures as in the previous year. The most noticeable decline was seen in the item "General state issues", where the amount of expenditures decreased from 3.5 % to 3.1 % of GDP. This happened due to the diminished volume of costs relating to the servicing of government and municipal debt. The greatest upward shifts occurred in "Housing and utilities system" (growth from 2.2 % to 2.4 % of GDP), "Education" (from 3.7 % to 3.8 % of GDP), and "Public health care and sports" (from 2.6 % to 2.8 % of GDP), which can be explained by the onset of the implementation of national projects, that is, projects in the socially important spheres of the national economy.

No marked changes were observed on the expenditure side of the federal and the territorial budgets of RF subjects, either: the share of the corresponding items in GDP either somewhat decreased against the index of the previous year, or remained unchanged. It is noteworthy that, despite the stability of expenditure in respect to GDP, its further growth at the rate higher than that of economic growth in a situation of an excessive inflation pressure creates additional problems, which di-

83

minish the effect of the anti-inflation measures being implemented by the government. Despite the fact that, according to the results of 2006, the government has succeeded in keeping inflation at a predetermined level, any further growth in non-interest expenditures may cast doubts as to the efficiency of the government's actions aimed at further reduction of the growth rate of consumer prices in the short and medium term.

2.2.4. The estimation of budget parameters cleared of the share of the oil and gas sector and the impact of international oil prices

The rather strong dependence of the Russian budgetary system on the export of energy carriers, and consequently, on the situation on the international markets, is fraught with serious risks of a potential destabilization of the balance of the budgetary system. It was, to some extent, to neutralize the impact of this factor that in 2004 the RF Stabilization Fund was created, whose purpose is to accumulate the "situational" revenue in order to sterilize the excessive money supply and to cover the loss of revenues in the future, when the international prices of energy carriers will fall. Besides, the RF Ministry of Finance suggests that the concept of a budget not including the revenues (or expenditures) of the national economy's oil and gas sector should be introduced in legislation. It is suggested that the resources generated by the export of raw materials and accumulated in the so-called oil and gas fund should be used to cover fully or in part the budget deficit not associated with the oil and gas sector. The estimates of the RF federal budget's oil-and-gas balance made by the Ministry of Finance and by the International Monetary Funda (IMF), as well as the lET's estimations, are shown in Table 13.

From this Table it follows that the balance of the budgetary system of the Russian Federation cleared of the oil-and-gas balance is negative. Besides, as estimated by the IMF, prior to 2004 the deficit was gradually declining in relation to GDP (from - 5.2 % to - 4.3 % of GDP), whereas from the year 2005 onward it began to grow, and consequently by the the results of 2006 it may amount to approximately - 7.4 % of GDP. It we look at the IET's estimations, for the year 2005 they will be rather close to those of the IMF, while for 2006 the discrepancy between the two is much higher. Moreover, the IET's estimations for 2006 are compatible with the estimations of the RF Ministry of Finance, judging by which the year 2006 saw a certain improvement of the federal budget's balance cleared of the oil-and-gas balance (in % of GDP).

Table 13

The value of the oil-and-gas balance of the RF federal budget cleared of the oil-and-gas balance (in % of GDP)

2002 2003 2004 2005 2006

Balance of RF consolidated budget, in % of GDP 1.0 1.4 4.5 7.7 8.0

Balance of RF federal budget, in % of GDP 1.4 1.7 4.3 7.4 7.5

Balance of RF federal budget less oil and gas balance, in % of GDP (IMF's estimation) -5.2 -4.6 -4.3 -5.9 -7.4

Balance of RF federal budget less oil and gas balance, in % of GDP (IET's estimation) - - - -5.5% -5.1

The estimations cited here demonstrate that when the situational component of the budgetary system's revenue is eliminated it can be seen that in the last 5 years expenditure has been markedly higher than revenue. It is obvious that the revenue from the oil and gas sector in the state budget cannot be disregarded entirely, because the raw materials sector plays a very important role in the national economy; however, these estimations do confirm the timeliness of the proposals as to the necessity for these revenues to become structured and subsequently used in accordance with legislatively established mechanisms.

In addition to the estimation of the consolidated and federal budgets' balance cleared of the oil-and-gas balance, it is necessary to analyze the influence of the international prices on individual budget indices. In particular, the situational (determined by the behavior of international oil prices) and the structural (independent of their behavior) components of tax revenues should be separated. For this purpose, the IET has applied regression-based estimations of the dependence of the main budget items on the oil prices. According to the obtained results, the elasticity of the tax revenues in the federal budget (in % of GDP) relating to the prices of Urals amounted to approximately 0.28, that is, the growth of the international oil price by $ 1 increases the tax revenues by 0.28 % of GDP. In this connection, the value of the situational component of the tax revenues was determined on the basis of the estimated elasticity and the difference between the actually registered price of Urals and its long-term average price (for the period between 1990 and 2006). The structural component, on the contrary, represents the difference between the actual share in GDP of the tax revenues in the federal budget and the value of the situational component. The estimated values of the structural and situational components of the tax revenues in the federal budget in % of GDP, as well as the actual share of the tax revenue in GDP, are shown in Table 14.

As seen from the Table, throughout the period of 1996 - 1999 the situational component of the tax revenues in the federal budget in % of GDP remained negative. Later on, in 2000, there occurred a marked growth of this index from -2.1 % of GDP to 0.5 % of GDP, after which in 2001 and 2002 it once again remained negative due to the fall in oil prices during that period. Since 2002, the improving situation on the international oil market was conducive to a noticeable growth of the situational component which, by the results of 2006, has reached its historic high of the whole period under consideration and amounted to approximately 7.0 % of GDP.

Table 14

The estimated structural and situational components of tax revenues in the RF federal budget (in % of GDP)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Actual tax revenues 11.0 10.9 8.8 10.7 13.2 16.2 18.6 18.0 18.8 22.3 22.2

Structural component of tax revenues 12.3 12.7 12.5 12.8 12.7 16.7 18.9 17.4 16.1 15.8 15.2

Situational component of tax revenues -1.3 -1.8 -3.7 -2.1 0.5 -0.5 -0.3 0.6 2.7 6.5 7.0

2.2.5. The main developments in the budget sphere and the changes introduced in tax legislation

The RF Government in 2006 was paying much attention to the issues of improving tax legislation and tax administration, managing the resources accumulated in the Stabilization Fund and the RF's debt policy, as well as to the forecasting of the parameters of budgeting policy in the short- and medium-term perspective.

First of all, throughout the year 2006 representatives of the Ministry of Finance were voicing proposals concerning the improvement of existing tax legislation, as well as offering comments in respect of the proposals put forth by some members of the government for certain changes to be made to tax legislation. Thus, according to the estimations of the Ministry of Finance, if tax legislation is amended as proposed, in 2007 - 2009 the tax load on the national economy may be decreased to the level of less than 27 % of GDP. In particular, in 2005 the tax load cleared of the influence of oil prices amounted to 27.4 % against 33.6 % in 2001. One group of new provisions concerning taxes came into force during 2006, whereas the rest is to become effective from 1 January 2007. Among the latter is the shortened and simplified procedure for VAT refunds to exporters, the abolition of the restriction of the carry-forward of the tax losses of the past years within the tax base for the profits tax, and the abolition of the provision concerning the determination of the efficiency of results and expenditures relating to research and development. It is also planned that, from 2008 onward, solutions should be provided to a number of problems associated with the taxation levied on the use of objects of aquatic and biological resources.

While discussing some of the proposals concerning the changes in the parameters relating to individual taxes and levies in Russia, the issue of lowering the rate of the single social tax should not be overlooked. Thus, during the year, some proposals were put forth that the rate of SST should be lowered to 13 - 14 %. However, as estimated by the Ministry of Finance, in this case, in order to compensate for the unreceived revenues, the level of wages and salaries in the private sector of the national economy should be increased and become, on the average, in the region of $ 2,000 - 2,500. Otherwise it would be necessary to look for supplementary sources, by way of compensation for the unreceived revenues. The arguments put forth by the Ministry of Finance are based on the statistics of the revenues received by the budget and off-budget funds and generated by taxes and levies after the rate of SST had been decreased to 26 %, with the expected resulting growth in the volume of legal wages and salaries. However, as seen by the results of 2005, the budget and the Pension Fund incurred losses in the sum of approximately 295 billion roubles as compared to the results that would have been achieved should the rate remain unchanged. According to RF Minister of Finance S. Shatalov, the taxable base increased only slightly. No additional legalization of incomes has been observed so far as a result of a lowered SST rate: on the whole, the volume of shadow remuneration and the use of various tax evasion schemes remained at the same level as before. According to a variety of estimations, approximately 30 -

35 % of the remuneration money in Russia is still changing hands "below the counter".

During last year, the issue of reforming the value added tax was also the subject of an active discussion. Thus, toward the year's end, the Ministry of Finance had planned to complete the work relating to the establishment of a special column for the entry of VAT in the order for payment form. Besides, in 2007 a law may be adopted concerning the introduction of a system for registration of VAT payers from the year 2008 onward. The main purpose of such registration will be to relieve many companies - at least small-sized ones - of the responsibility to pay VAT and to register for this purpose. Also, the registration will make it possible to significantly reduce the number of companies with the right to tax deductions. At present, in the RF there exist more than 2 million registered juridical persons, many of whom are formally VAT payers but do not submit any tax reports.

According to the Ministry of Finance, the federal budget's revenues generated by the value added tax (VAT) will grow, and by 2009 their sum will be equal to approximately 7.8 % of GDP. Thus, the revenues from VAT in 2006 amounted to 5.7 % of GDP, the forecast for 2007 is in the region of 6.6 % of GDP, and that for 2008 is 6.7 % of GDP. The very low rate of growth in the revenues from VAT in 2008 is associated with the fact that the refunds of VAT to exporters will be granted not in the permitting procedure (as it is done now), but in the advising procedure. Besides, in legislation it is envisaged that the tax should be paid on a quarterly basis, instead of the current monthly basis.

At the same time, RF Minister of Finance A. Kudrin said that is was not at all impossible that, from 2009 onward, the rate of VAT might be lowered to 15 % - 16 %, if the federal budget expenditure continued to grow. In other words, it would be possible to take advantage of the potential offered by the reduction in this tax only if the budget expenditure remained relatively stable. Thus, for example, in 2006 the level of the budget's non-interest expenditures was approximately 15.4 % of GDP, in 2007 it may become 15 5 % of GDP, and in 2008 - 16 %. At the same time, the average level of such expenditures between 2000 and 2005 amounted to approximately 14.7 % of GDP. The Ministry of Finance's standpoint is that the government must maintain this level and avoid any further increase of expenditures.

By 1 January 2007, the arrears of VAT refunds had been estimated as equal to approximately 140 billion roubles. The goal of the tax agencies is not only to refund the currently paid VAT, but also to provide some additional settlements so that, during 2007, "it (the arrears) could be brought to minimum values". By comparison, as of 1 January 2006, the volume of arrears against VAT refunds was approximately 197 billion roubles. And this outstanding debt continued to grow, because the prices of commodities and trade turnover were also increasing. On the whole, for the next three years the Ministry of Finance is planning no changes in the rate of VAT, the personal income tax and the profits tax, nor is it planning to bring down the rate of SST, because the budget is bearing a substantial burden of supporting the budgets of off-budget funds.

As for the other taxes, in 2006 the law on the introduction of a reduced rate of the tax on the extraction of mineral resources for nearly exhausted deposits was adopted, the criterion being the exhaustion level of 85 % of reserves. The law also envisages the granting of tax holidays in respect to the tax on the extraction of mineral resources to the newly developed deposits in Eastern Siberia and the continental shelf. At the same time, in the event of prospecting of such deposits, the tax holiday may be extended with due regard for the period of prospecting. Besides, in 2007 no indexation of the excises on oil products is envisaged. However, in 2007 it is planned to levy excises on oil refineries. Previously, excises were levies on sellers and resellers, and not on producers, which resulted in a distorted distribution of revenues between regions. Now the regions receive 10 %, while another 50 % of the collected excises is redistributed through the federal treasuries.

From 1 January 2007, for purposes of excise taxation, the upper margin of the price of tobacco products has been set, on the basis of which the excises are to be calculated. The information concerning this upper margin should be printed on the package of a tobacco product. This has to do primarily with the ad valorem component of the excise on cigarettes. In this connection, according to the estimations made by the Ministry of Finance, it is expected that the average price growth should be no more than 1 rouble in all categories of tobacco products. Moreover, from 2007 onward the rate of excise on tobacco products will be raised by 30 %, and later on, in 2008 - 2009, will be increasing at a rate approximately twice as high as the rate of.

The sufficiently high oil prices throughout 2006 were conducive to further growth in the volume of resources accumulated in the RF Stabilization Fund. In particular, as of 1 January 2007 its size was approximately 2,346.9 billion roubles. A part of the resources of the Stabilization Fund in 2006 was spent on the redemption of the RF government debt. Thus, in early April the RF Government considered the issue of an early repayment of a part of the RF's debt to the Paris Club and put forth its proposals to the Club's representatives. During the negotiations it was decided that the residual debt should be repaid before the end of August. In August the Russian Federation effectuated the relating transfers, which settled the whole sum of debt due to the Paris Club. Therefore, the total savings of the interest payments in the federal budget for the period until 2020 will amount to $ 12.0 billion.

Besides, in 2006 a number of decisions were made concerning the rules for managing the resources of the RF Stabilization Fund. Thus, in November the Ministry of Finance announced that before 1 December it planed to present the concept of a future generations fund. This will be done within the framework of the Ministry's modeling of Russia's strategy for the use of oil and gas resources and the preparation of the concept of a future generations fund. It is intended that the Stabilization Fund should be divided into two parts, to be invested in securities in accordance with two different strategies. It these strategies that are going to determine the specific distinctive features of the two parts of the Fund, one earmarked for spending in the event of declining oil prices, while the other is to remain invested in a sufficiently diversified portfolio of securities. As for the list of assets

available for investing in, the RF Ministry of Finance is planning to expand it and to place the Fund's resources accumulated in excess of the reserve part into the less conservative assets. It should be reminded that presently it is allowed for the Fund's resources to be placed only in the securities issued by a number of developed countries with the highest credit ratings as established by the leading rating agencies. At present the Stabilization Fund's resources are deposited with the RF CB: 45 % in USD, 45 % - in euro, and the other 10 % - in UK pounds.

The volume of the investment fund in 2007 may exceed 160 billion roubles, whereas its size for the year 2007 is planned at the level of 95.8 billion roubles, including the saved interest payments resulting from the redemption of the remaining part of the RF's debt to the Paris Club ahead of schedule, the final settlement against which took place in July - August 2006, as well as the the investment fund's resources unspent in 2006 (approximately 59 billion roubles), which will be carried forward to the 2007 investment fund, its total amount being potentially in excess of 160 billion roubles.

During the year, the indexation of salaries in the budget-funded sphere was carried out. Thus, according to the information released by the Ministry of Finance, the indexation of the salaries of the budget-funded employees in 2005 - 2007 will result in their remuneration in real being increased by 1.5 times. In 2007 the salaries of this category of employees will be raised by 15 % from 1 September. The total amount of allocations to this indexation will be approximately 127.8 billion roubles.

Also in 2007, much attention was paid to the issues of social support to the population. In particular, in March the Ministry of Finance responded to the proposals put forth by the RF President in his presidential message to the RF Federal Assembly and aimed at supporting maternity and childhood. As a result, in 2006 a corresponding law was adopted, which came into force from 1 January 2007. According to Minister of Finance A. Kudrin, a total of 30-40 billion roubles per annum will be required for these measures to be sustained. In this connection, for the implementation of all the measures designed to provide additional social support, a certain adjustments will have to be introduced in the three-year financial plan.

And finally, during last year the forecasts of the basic parameters of the RF's debt policy in the period until 2009 were published. According to these data, the total RF government debt from 2007 will begin to grow in nominal terms, while continuing to decline in respect to GDP. As stated by Minister of Finance A. Kudrin, the government commission for budget projecting on the whole has approved the RF's debt policy for the years 2007 - 2009. Thus, the government debt in 2007 will become as high as 2 trillion and 878.9 billion roubles, in 2008 - 3 trillion and 30.1 billion roubles, in 2009 - 3 trillion and 246.4 billion roubles. On the whole, in 20072009 the government debt's volume will be increased by 145.1 billion roubles. The forecasted volume of the RF's domestic debt invested in government securities as of the end of 2007 will amount to 1 trillion and 238.7 billion roubles, as of the end of 2008 - to 1 trillion and 445.6 billion roubles, and as of the end of 2009 - to 1 trillion

and 644.2 billion roubles. The total RF government debt in 2007 will be 9.78 % of GDP, in 2008 - 9.16 % of GDP, in 2009 - 8.71 % of GDP.

2.2.6. The 2007 federal budget

The Law on the 2007 federal budget was developed on the basis of the forecast of the RF's socio-economic development in 2007 prepared by the RF MEDT (see Table 15). Within this forecast's framework, two alternative scenarios of the RF national economy's development were considered. The first is inertia-based and reflects the Russian economy's development in a situation of stabilized volumes of hydrocarbon exports, being characterized by a diminishing competitive capacity of domestic product and its substitution with imports, alongside a continuing deterioration of domestic product's competitive capacity in terms of pricing. The forecasted preconditions in this scenario imply a relatively unchangeable situation on the international markets of energy resources - the fall in the price of Urals from $ 63 per barrel in 2006 to $ 61 per barrel in 2007. In this case, the growth of exports in terms of value is forecasted to be at the rate of 0.4 %, while oil production growth will be by 1.2 %. Under this scenario, the growth rate of GDP by 2007 should decline to 5.0 %.

The second scenario is oriented to a relative improvement of the competitive capacity of Russian businesses and to the intensification of structural shifts due to the implementation of a set of measures designed to enhance economic growth. Within the framework of the forecast in accordance with this scenario, the behavior of oil prices will be similar to that in the first one, whereas the growth of exports is forecasted to be at the rate of 1.4 %, and GDP growth - at the level of 6.0 %. This scenario is the basic one for the development of the federal budget for 2007 and the prospective financial plan for the period until 2009.

At the same time, for purposes of assessing the realistic value of the main macroeconomic indices for the year 2007, the IET calculated several scenarios of the development of the RF's economy in 2007 on the basis of a structural econometric model of the Russian economy. The exogenous parameters applied in that model were the prices of Brent, the index of investments in fixed assets, the growth rate of the population's incomes in real terms, and the growth rate of money supply M2.

Within the framework of the model, three scenarios of the RF economy's development in 2007 were considered. Under the first scenario, the average per annum USD / euro exchange rate was 1.30, the price of Urals - $ 40 per barrel, the growth rate of money aggregate M2 - 25 %, the growth rate of investments in fixed assets by the year's results - 10 %. The second scenario is more optimistic and implies a slight decline of oil prices ($ 50 per barrel). Besides, in accordance with the second scenario, the growth rate of investments in fixed assets is plotted at the level of 12 %, the USD / euro exchange rate by the end of 2007 is to remain at the level of 1.30, and the growth rate of money supply - 30 %. Scenario 3 is the most optimistic of all and implies the preservation of high prices of Urals at the level of $ 60 per barrel in 2007. Also, in accordance with the third scenario, the growth rate of

investments in fixed assets will be at the level of 13 %, the USD / euro exchange rate by the end of 2007 will remain at the level of 1.30, while the growth rate of money supply will be 35 %

Table 15

Main forecasted indices of the RF's socio - economic development in 2006 and 2007

RF MEDT I ET

2006 2007 2007

Variant I Variant II Scenario 1 Scenario 2 Scenario 3

Exogenous factors

Price of Urals, $ per barrel 63 61 40 50 60

Oil extraction, million tons 482* 488 492 - - -

Gas extraction, million tons 648* 652 654 - - -

Oil exports, million tons 255* 261 264 - - -

Gas exports, billion m3 200* 193 - - -

USD / euro exchange rate 1.26 1.29 1.3 1.3 1.3

Growth rate of investments in fixed assets, in % 13.5 7.6** 10.4** 10.0 12.0 13.0

Forecasted values

GDP growth in real terms, in % 6.7 5.0 6.0 4.5 5.2 5.6

GDP, trillion roubles 26 621.3 29 857 30 388 30 842

Growth rate of CPI, in % 9.0 6.5-8.0 8.2 8.4 8.7

RRb / USD exchange rate, in real terms 27.1 26.5 27.3 27.1 26.8

Exports, $ billion 304.5 305.7 308.8 284 299 309

Imports, $ billion 163.9 193.8 199.3 186 190 193

Growth rate of retail turnover, in % 13.0 9.3 10.5 5.1 7.2 9.9

Growth rate of IPI, in % 3.9 2.8 4.2 2.5 3.2 3.8

Growth rate of population

money incomes in real terms, 10.0 8.2 10.2 5.8 7.1 8.2

in %

Tax revenue of RF consolidated budget, in % of GDP 32.5 - - 32.4 32.7 32.9

- estimation.

** - in the RF MEDT's forecast this index is not exogenous.

It can be seen that in the IET's model the values of exogenous parameters under Scenario 3 are more compatible with the parameters forecasted by the RF MEDT. At the same time, it is in Scenario 3 that the IET's model yields the forecasted values of socio-economic indices which are close to the parameters taken as the basic ones in developing the budget for the year 2007. The differences under the other two scenarios are more dramatic. The realistic value of the preconditions assumed within the model's framework is confirmed by the forecasted data on the sum of taxes in the RF consolidated budget. Thus, within the framework of the three scenarios, they amount to between 32,4 % and 32.9 % of GDP, against 32.5 % of GDP in the results of 2006. In view of the slowdown in the growth rate of tax revenues against the backdrop of the high growth rate of the national economy as seen by the results of 2006, these differences can be explained quite easily.

In our opinion, the most important shortcoming of the macroeconomic forecast on which the 2007 federal budget is based, especially considering the forecast's time horizon (2007 - 2009), is that the two scenarios differ only slightly. In the final analysis, the slight variations in the forecast's resulting figures display no

qualitatively different features. At the same time, one qualitatively different scenario (crisis-based) is not considered at all. Our estimations have made it possible to obtain sufficiently cautious values relating to the behavior of the RF economy's basic macroeconomic indices both when oil prices are high and when they are low. Thus, in our scenarios a fall in oil prices, in fact, implies that events will be developing according to the worst variant, and the authorities must be prepared to resort to measures designed at least to somewhat softened the negative consequences noted by us. As for the situation of high oil prices, all the scenarios appear rather conservative, indicating the lower margin of the possible variants of the national economy's development.

Now we are going to analyze directly the parameters established by the law on the 2007 federal budget. The sums of revenue of the RF federal budget in 2006 and 2007 are shown in Table 16.

Table 16

The basic characteristics of the RF federal budget's revenues

in 2006 and 2007

2006 - approved 22 2006 - fact 2007 - law

million roubles % of GDP million roubles % of GDP million roubles % of GDP

Revenue including: 6 146 277.6 22.6 6 276 298.6 23,6 6 953 317,2 22,3

tax revenues23 5 873 279.5 21.6 5 901 974.6 22.2 6 698 042.8 21.5

non-tax revenues 272 998.1 1.0 374 323.6 1.4 255 274.4 0.8

GDP 27 220 000 26 621 300 31 220 000

* - in the 2006 prices.

On the basis of the data presented in Table 16 it can be concluded that in 2007 the forecasted revenue of the federal budget in absolute terms may be markedly higher than both the indices initially stated in the budget for 2006 and the actually registeted values. At the same time, if we take the relative indices (in % of GDP), the revenue of the 2007 budget would become somewhat lower than both the indices approved by the law on the 2006 budget and the values demonstrative of the budget's actual execution (23.6 % of GDP). The decline of the share of revenues in the 2007 budget in % of GDP against the actual budget execution in 2006 can be explained by the changes introduced in the RF tax and budget legislation. However, the resulting decline was partially compensated for by the revision of the basic macroeconomic indices of the RF, as well as by the influence of some other factors.

While taking a look at the main growth factors influencing the forecasted macroeconomic indices of the RF, we should point to the growth of GDP; the changing volumes of imports and exports; the increasing profits of enterprises, the volumes

22 By Law "On the 2006 Federal Budget" as of ot 1 December 2006.

23 Including: (1) the profits and income taxes; (2) the social taxes and contributions; (3) VAT and excises on the commodities sold in the territory of the RF and imported into the territory of the RF ; (4) the taxes on aggregate income; (5) property taxes; (6) taxes, levies and regular fees for the use of natural resources; (7) State duty; (8) arrears and settlements in respect of abolished taxes, levies and other mandatory payments; (9) revenues from foreign economic activity.

of production and sale of excisable commodities, the volumes of the extraction of mineral resources and other quantitative parameters; the changing prices of Urals and the export prices of natural gas.

The main innovations in the taxation sphere that influenced the decline in revenues in % of GDP by comparison with the indices of the 2006 budget execution were the switchover from the permitting to the advising procedure for the refunds of VAT being paid to exporters in compensation for their payment of VAT on stock supplies; the diminishment, by taxpayers, of their tax base for the tax on profit of organizations by the amount of losses incurred by them in the previous years; the shortened periods for writing off the costs of research and development against the tax on profit of organizations; and the establishment of a downward coefficient for the rate of the tax on extraction of mineral resources, designed to promote further development of oil deposits at the final stage of exploitation, and the introduction of a zero rate of the tax on extraction of mineral resources for new oil deposits. The partial decline in revenue resulting from changed introduced in tax legislation was compensated for by the changed rates of excises in the RF Tax Code. As for changes in budget legislation, we should note the transfer, to the budgets of RF subjects, of the federal part of the tax on extraction of mineral resources levied on extracted diamonds, and of lumpsum payments for the use of subsoil resources in instances specified in licenses for the use of revenue resources in the RF territory, relating to deposits of natural diamonds.

If we consider the enlarged structure of the 2007 federal budget revenue, we can notice the substantial growth of the budget's tax revenues in absolute terms as compared to the indices established by the Law on the 2007 budget and the indices of its actual execution in 2006. At the same time, it is forecasted that in nominal terms in 2007 the non-tax budget revenues will be somewhat decreased against the 2006 indices. In relative terms (in % of GDP) their behavior was slightly different. Thus, while the share of tax revenues in the 2007 budget must be approximately 21.5 % of GDP against 21.6 % and 22.2 % of GDP, as established by the Law on the 2006 budget and the actual budget execution in 2006, respectively, the share of non-tax budget revenues in the 2007 budget is noticeably lower than the indices established by the Law on the 2006 budget (1.0 % of GDP) and the indices of the actual budget execution (1.4 % of GDP).

The structure of tax revenue in the 2007 federal budget, by main taxed, is shown in Table 17.

Judging from the data presented in Table 17, it can be concluded that the revenues from all the main taxes, except the tax on the extraction of mineral resources, in 2007, according to the forecast, will grow in nominal terms. However, if we take the relative indices (in % of GDP), their values in respect to many taxes did not changed, or slightly rose by comparison with the values of 2006. This, the highest growth is forecasted for the value added tax (from 5.7 % (by the results of 2006) to 6.6 % GDP). On the contrary, the revenues of the federal budget from foreign economic activity may decline from 8.7 % to 7.9 % of GDP, whereas the revenues from the tax on the extraction of mineral resources - from 4.1 % to 3.3 % of

GDP. The main downward factors may become the lower rate of oil production, as well as the stabilization of oil prices on the international market, which directly determine the rate of the tax on extraction of mineral resources and the exports duty levied on oil.

Table 17

The structure of tax revenues in the federal budget in 2006 and 2007 (in % of GDP)

Tax 2006 Law Actual budget execution in 2006 2007 Law

million % of million % of GDP million % of

roubles GDP roubles roubles GDP

Tax on profit of organizations 485 681.7 1.8 509 914.6 1.9 580 408.8 1.9

SST, transferred to federal budget VAT 310 412.1 1.1 315 839.8 1.2 368 773.9 1.2

1 534 485.3 5.6 1 510 903.4 5.7 2 071 792.3 6.6

Excises 107 560.9 0.4 110 487.9 0.4 126 683.4 0.4

Revenues from foreign economic activity 2 301 236.5 8.5 2 306 318.7 8.7 2 455 079.8 7.9

Tax on extraction of mineral 1 083 188.2 4.0 1 094 319.3 4.1 1 037 739.6 3.3

* - in the 2006 prices.

Below, see the comparison between the volumes of expenditure in the RF federal budget in 2006 and 2007, presented in Table 18.

Table 18

Basic expenditure parameters of the RF federal budget in 2006 and 2007

2006 - law24 2006 - fact 2007 - law

million roubles % of GDP million roubles % of GDP million roubles % of GDP

Expenditure including: 4 431 076.8 16.3 4 281 329.2 16.1 5 463 479.9 17.5

fixed as % 171 466.5 0.6 169 058.7 0.6 156 845.3 0.5

not fixed as % 4 259 610.3 15.6 4 112 270.5 15.5 5 306 634.6 17.0

* - in the 2006 prices.

When comparing the values shown in the table, it can be concluded that the 2007 budget is oriented to a marked increase in the volume of federal budget expenditure in absolute terms both as compared to the 2006 budget law and to the actual budget execution. In respect to GDP the 2007 budget expenditure was also noticeably higher than that established by the 2006 law (16.3 % of GDP) and the indices of budget execution in 2006 (16.1 % of GDP). At the same time, as can be seen from Table 17, the aggregate growth of budget expenditure was due exclusively to the increased non-interest expenditures, which rose up to 17.0 % of GDP against the 15.6 % of GDP established by the 2006 budget law, and the 15.5 % of GDP as seen by its actual execution in 2006. One of the main reasons for this noticeable growth in 2007 of the federal budget non-interest expenditures was the response to the Presidential Message to the RF Federal Assembly, where a number of priority directions of state policy in 2007 were determined. In particular, among

these priorities was the finding of solutions to a whole set of problems in the sphere of social policy, the national economy and interbudgetary relations. Besides, in the 2007 budget expenditure a certain sum was earmarked to the implementation of the Message's provisions aimed at improving Russia's demographic situation.

Now let us look at the structure of expenditure in the 2007 RF federal budget and compare it to the structure of expenditure in 2006 - both as stated in the law on the 2006 budget and with the changes that occurred later (Table 19).

Table 19

The structure of federal budget expenditure in 2006 and 2007

2006 2007

law25 fact law

(million rou- % of GDP (million rou- % of GDP (million rou- % of GDP

bles) bles) bles)

General state issues 623 208.39 2.3 529 666.7 2.0 808 196.48 2.6

of these, servicing of state and municipal debts 171 466.48 0.6 169 058.7 0.6 156 845.30 0.5

National defense 686 148.28 2.5 681 802.9 2.6 822 035.93 2.6

National security and law-enforcement activity 556 337.12 2.0 550 232.5 2.1 662 867.23 2.1

National economy 358 628.27 1.3 345 015.0 1.3 497 229.53 1.6

Housing and utilities system 54 336.28 0.2 52 697.3 0.2 53 024.46 0.2

Environment protection 6 816.09 0.0 6 642.0 0.02 8 096.53 0.0

Education 211 976.79 0.8 212 371.3 0.8 277 939.33 0.9

Culture, cinematography and mass media 55 834.65 0.2 55 219.7 0.2 67 804.67 0.2

Public health care and sports 160 347.54 0.6 147 525.0 0.6 206 373.53 0.7

Social policy 216 506.39 0.8 201 243.3 0.8 215 565.76 0.7

Interbudgetary transfers 1 500 937.01 5.5 1 498913 5.6 1 844 346.45 5.9

Total expenditures 4 431 076.81 16.3 4 281 329.2 16.1 5 463 479.90 17.5

* - in the 2006 prices.

If budget expenditure is analyzed by item of the functional classification, on the whole the structure of expenditure in the 2007 budget is comparable both with the structure established by the law on the 2006 budget and with the actual execution of that budget as shown by the results of 2006. The most noticeable changes in the volume of expenditure occurred in the following items and subitems of the budgetary classification: "General state issues" (growth from 2 % to 2.6 % of GDP), "National economy" (growth from 1.3 % to 1.6 % of GDP), "Interbudgetary transfers" (growth from 5.6 % to 5.9 % of GDP). As for the other items and subitems, the differences displayed by the relative indices (in % of GDP) were found to be less pronounced. The main items of expenditure in the 2007 budget, as before, are interbudgetary transfers, general state issues, national defense, national security and law-enforcement activity, and national economy. The aggregate share of these items of expenditure is 14.8 % of GDP against the 13.6 % as demonstrated by the results of budget execution in 2006. Thus, the aggregate value of the main items

25 By Law "On the 2006 Federal Budget" as of 1 December 2006.

and subitems of budget expenditure as a percentage of GDP in 2007 markedly rose on the previous year.

Table 20

Federal budget surplus and the sources of financing for ederal budget deficit in 2006 and 2007

2006 - law26 2006 - fact 2007 - law

million roubles % of GDP million roubles % of GDP million roubles % of GDP

Deficit (-) / surplus (+) of federal budget 1 739 407.8 6.4 1 825 910.3 7.5 1 501 837.3 4.8

* - in the 2006 prices.

The decline of revenue in the 2007 federal budget, coupled with a market growth of expenditure, resulted in a significant fall in federal budget surplus (Table 20). Thus, while the law on the 2006 budget stated that it was 6.4 % of GDP, and by the year's end it went up to 7.5 % of GDP, in accordance with the law on the 2007 budget it may amount to approximately 4.8 % of GDP.

As for the structure of the sources for domestic financing of federal budget deficit, in 2007 it planned than, through the placement of government securities, the sum of 293,633.3 million roubles should be attracted, while the redemption of government securities will amount to 80,109.7 million roubles. Thus, the net balance of resources attracted on the domestic market will amount in 2007 to approximately 213,523.6 million roubles. The 2007 budget contains revenues from the sale of state-owned and municipal property in the amount of 49,000 million roubles, as well as resources specially earmarked to a potential fulfillment of RF government guarantees in the amount of 3,649.4 million roubles.

If the structure of the sources for external financing is analyzed, it can be seen that in 2007 no placement of government securities denominated in foreign currencies is planned. Besides, among the external financing sources in 2007, no tied loans granted by foreign governments or international financial organizations are listed. At the same time, the planned volume of attracted tied loans from foreign governments and international financial organizations 2007 is at the level of $ 763.6 million (20,251.6 million roubles), which is by $ 349.2 million (or by 11,576.6 million roubles) less than that of 2006. The planning of the use of tied loans was compatible with the main directions of the RF's debt policy established for the current and the next years, which envisaged that no credits from foreign states should be attracted in the future, as well as with the prospective financial plan for the years 2007 - 2009. The current policy will make it possible to round up the use of tied loans as early as 2007 (that is, two years earlier than the initially established timeline).

Also in 2007 it is expected that the volumes of repayments against external debt will be decreased, which has become possible due to the large-scale redemption of Russia's government debt, at the expense of the RF Stabilization Fund, in the amount of $ 44 billion during the period of 2005 - 2006. In 2007 it is planned to

earmark to the redemption of the Rf's foreign debt the sum of approximately $ 6,850.3 million (or 181,670.6 million roubles). In this connection, more than 47 % of this sum will be spent on the payments against old government securities denominated in foreign currencies. It is also planned that in 2007 a eurobond loan in the amount of $ 2.4 billion (or 63,648.0 million roubles) will be redeemed, along with an increased volume of redemption against RF eurobonds with maturities in 2010 and 2030. Besides, certain resources are earmarked in the budget to the potential fulfillment of guarantees in support of the export of industrial products from the RF in the amount of $ 158.3 million (or 4,198.1 million roubles). Thus, the government continues its course toward the expansion of its domestic debt and reduction of its foreign debt in circulation.

On the whole, the law on the 2007 federal budget can be characterized as being rather conservative, because no significant changes in its structure of revenue and expenditure are planned. At the same time, by comparison with the 2006 budget, one can observe the stabilization of revenue, coupled with a marked growth of non-interest expenditures. Any further pursuance of the policy aimed at increasing such expenditures at a rate higher than that of GDP growth may result in an additional inflation pressure, which will make even more difficult the implementation, by the RF Central Bank, of measures designed to maintain the rate of price growth within the planned margins. Besides, the stabilization of the situation on the international raw materials markets, alongside with the changes introduced in the tax and budgetary sphere, may play down the risks associated with the reduction in the amount of the situational share of revenue and losses of tax revenues in the budget. It also should be noted that the volume of federal budget revenue as stated in the budget (both in % of GDP and in nominal terms) is close to the estimated values yielded by the medium-term macroeconomic structural model of the Russian economy developed at the IET.

2.3. Forecast Models of the RF Economic Development and Restrictions in Economic Policy over a Medium-Term Prospective

If one compares the situation, when for several years the international markets have been demonstrating high prices for oil and other energy carriers as opposed to the situation, when the oil prices are low, it will be noted that one of the main distinctive features characterizing the external conditions for implementing monetary, credit and exchange rate policies will be characterized by differences in the balances of payments and the equilibrium values of real exchange rate (that is, equilibrium from the point of view of balance of payments).

During the period of high prices for energy sources, an extensive capital inflow, based on high export revenues, results in strengthening of nominal exchange rate, growth of import and reduction of export. In other words, oil prices growth and surplus of trade balance contribute to strengthening of the real exchange rate, contributing to equilibrium of trade balance. Dynamics of capital flow balance also supports the above statements, and as a result, the real exchange rate is strength-

ened either due to domestic prices growth (under stable exchange rate), or stabilization of exchange rate. Herewith, in case of an upward breakthrough of external market, a higher value of equilibrium of real exchange rate versus the current rate is established and vice versa, a lower equilibrium value occurs under the external market downfall27.

In our opinion, despite a seeming symmetry of situations, characterized by a decline or growth of oil prices, with regard to inflation and exchange rate fluctuations for population and their impact over economic growth, monetary and credit policy trends should be significantly different in the above situations.

Basing on certain assumptions28, one can demonstrate that in the situation, when the energy sources prices in the external market are high, the most effective policy for Russia would be moderate (restrained) rates of rouble exchange policy in real terms with rather low inflation. In fact, this is a policy of one-way inflation targeting (with regard to restricted volume of foreign currency inflow and growing reserves with nominal exchange rate kept up at the same level), i.e., maintaining the upper limit of yearly growth rates of prices preferably decreasing from year to year). The RF Central Bank policy in the external market depends on its capacity for sterilization of emission, resulting from maintaining the stable nominal exchange rate to ensure required real rouble rate growth in the situation of effective inflation. In the situation of downgrading energy sources prices, the effective measure of monetary and credit policy would be gradual, but rather fast decrease of nominal rouble rate to the values, ensuring the equilibrium balance of current account operations.

The situations with both, high and low prices for energy sources were observed within the past decades in the world market. High prices, noted in the late 1970-s and the beginning of 1980-s served for the stabilization of socialist regime, while an explicit downfall of the world prices in 1985-1988-s was a major factor of budget crisis, which has caused the breakdown of the Soviet Union29. A similar downfall of the world prices for energy sources played a significant role in development of financial crisis of 1998 in Russia.

A case study of the 1998 financial crisis can be reviewed as an example of unfavorable prices for energy sources in the external market.

27 Basing on zero volatility of capital flows balance and exports from Russia at the real exchange rate and imports volatility with the real exchange rate accounting to 0.8-0.9, one can assess the rate, at which import will reach the volume, enough to cover the excessive foreign currency supply in the market (matching accumulated external reserves). Those simple assumptions help to define, that the nominal exchange rate to maintain the equilibrium trade balance (in case of a single rouble revaluation) made RUR 16-18 for USD 1 as of the end of 2006.

28 Se for ref.: Clark P.B., Logue D.E., Sweeney R.J. (1977). The Effects of Exchange Rate Adjustments. Washington, D.C.: U.S.; Morley S.A. (1992). On the Effect of Devaluation During Stabilization Programs in LDCs // The Review of Economics and Statistics. Vol. 74. Issue 1 (Feb., 1992). P. 21-27 etc.

29 For detail of the financial and budget crisis mechanism in the USSR at the end of 1980s, see "The Empire Breakdown. Lessons for Modern Russia", E.T. Gaydar. - M.: ROSSPEN, 2006.

The basic grounds for financial crisis, happened in summer 1998, can be

30

categorized as fundamental factors and external shocks . The fundamental factors that caused the crisis were created by the national policy of financial stabilization, pursued by the country, characterized by rigid monetary and soft budgetary measures. Quasi-fixed exchange rate of foreign currency under conditions of high inflation brought up the growth of real rouble rate, extended imports and deterioration of balance of payments. High level of budget deficit (5-8 per cent of GDP in 19951998) caused the high rates of government debt growth. By the year of 1998 the total debt burden accounted to nearly 50 per cent of GDP. That indicator is not so high as it is, but the domestic debt was made in the form of short-term "GKO" (state treasury bills), and the amount required monthly only for redemption of the issued GKO, have reached 10-15 per cent of monthly GDP by the first half-year of 1998.

The situation was aggravated by the external shocks: downgrading of the world market prices for energy sources, outflow of short-term capital investments from the financial markets of developing countries and transition economies, which

31

made the financial crisis inevitable . The crisis, which has reached its peak in August 1998, was characterized by the stock market downfall, banks' collapse and deficiency of external resources. Measures were taken on introduction of a flexible rouble exchange rate, three-month moratorium on redemption of the Russian banks' external debts and mandatory restructuring of GKO-OFZ liabilities. Threefold rouble devaluation took place, and inflation rate jumped up to nearly 40 per cent in September 1998.

The government, headed by the Prime Minister Mr. E. Primakov, despite populist approaches, was pursuing a restrained monetary and credit policy, which allowed to stabilize the situation be the end of the year. A vast-scale rouble devaluation, which brought up the national currency exchange rate to the level of 1994, has ensured equilibrium of external trade balance and served as a basic factor of economic growth, started at the end of 1998. Nevertheless, reviewing the background of transfer to the economic growth in Russia, one should not forget the successful developments, achieved by 1997 in the sphere of financial institutions: liberalization of economy, privatization, monetary and budget stabilization and finalization of economic stagnation of transitional decay32. An important role played also the commenced growth of oil prices in the world market.

Rouble devaluation acted as a measure of social support to the domestic producers, which has reduced the competition of the imported goods and stimulated

30 Economy of Transitional Period. Outline of Economic Policy in Post-Communist Russia. 19982002. - M.: Delo, 2003, PP. 29-86.

31 Materials of Scientific Conference "Financial Crisis: Background and Consequences". - Series "Research Works", No. 18P. - M.: IET, 2000.

32 Economy of Transitional Period. Outline of Economic Policy in Post-Communist Russia 19982002. - M.: Delo, 2003, PP. 114-128; R. Entov, O. Lugovoy, E. Astafyeva, V. Bessonov, I. Vosko-boynikov, M. Turuntseva, D. Nekipelov "Factors of Economic Growth of the Russian Economy" - Series "Research Works", No. 70P, M.: IET, 2004.

national production33. All other conditions being equal, devaluation has increased relative price of imported goods, shifting the economy to the equilibrium balance, characterized by lower welfare level with a reduced share of imported goods in the total consumption volume. The aggregate effect of lower consumption level for domestic and imported goods in the background of relative prices dynamics was formed under the influence of import restructuring and income factors (together with income dynamics, based on the changes in the structure of relative prices, a noticeable impact on the demand was provided by reduction of income, caused by the crisis).

The effect of restructuring significantly differed as per economic sectors, depending on volatility of consumption, preference in favor of imported goods, capacity for prompt regulation of import volume and extension of domestic production. One can assume that rouble devaluation in 1998 caused a transfer to consumption of competitive domestic goods (with no return to preference of imported commodities), which was kept up in the consequent years in the background of rouble strengthening in real terms. Russian economy, with its technologies and labor sources, was capable to produce a wide assortment of goods, the demand for which was almost totally covered by import. One should note, that against a considerable share of natural resources in the total export volume and favorable situation in the external market, the real exchange rate provides an insignificant impact on the exports, and restructuring is observed primarily in the domestic market. The experience of the 1998th has demonstrated that an intensive import consumption restructuring was taking place in the background of a sharp downfall of real exchange rate.

Therefore, basing on the Russian experience of economic development after the financial crisis of 1998, we come to conclusion, that in the conditions of aggravated external market situation, the reaction of financial authorities should be different from the policy, pursued in favorable market conditions. Herewith we will demonstrate, that under favorable trading conditions there is no reason to use the nominal exchange rate for trading balance compensation., firstly, due to desirability to maintain a decreased real exchange rate, and secondly, to avoid excessive reaction of the nominal exchange rate to the external shocks.

In line with the analysis of the effect of import restructuring, the assessment of exchange rate upward/d own ward trends should take into account, that those trends have other consequences, including import restructuring due to the changes in relative prices and real income of consumers, variable rates of external debt services, different export revenues, changes in the bank interest rates, depending on the currency of deposits, etc. Among basic negative impacts of national currency devaluation one should mention accelerated inflation, caused by higher prices for imported goods, lower level of welfare of the individuals, who

33 O. Dynnikova. "Macroeconomic Perspective of Rouble Strengthening and Foreign Currency Policy // Instruments of Macroeconomic Policy for Russia" - M, 2000; O. Dynnikova "Is a Weak Ruble a Key Factor of Economic Growth? // Banking Business. - 2002. No. 1. P. Kadochnikov, S. Sinelnikov-Murylev, S. Chetverikov "Imports Restructuring in the Russian Federation in1998-2002", M., 2003. 100

keep their savings in national currency; pessimistic expectations of further rouble exchange rate downgrading on the part of both, domestic and external investors, which might provoke extended demand for foreign currency and capital outflow from the country.

Moreover, one should take into regard that devaluation could be blocked by political measures, taken by high-rank officials, whose career is brought up at risk in that situation. Whereas in the period of financial crisis the state of external reserves could not restrain a transfer to the floating currency rate, in the situation of considerable currency reserves, accumulated during favorable external market conditions, financial authorities can for some time maintain (or prevent from downfall) the nominal exchange rate of national currency. Nevertheless, it should be pointed out, that vast-scale sales of foreign currency, arranged by the Central Bank (for the purpose of gradual devaluation or maintenance of stable rate of national currency, rather than an abrupt downfall), leads to reduction of the monetary base, followed by relevant depression tendencies in the economy, caused by the monetary supply deficiency, and to the crisis of financial system in general.

In view of the above considerations, one can come to conclusion that in unfavorable conditions of external trade a reasonable policy would be an accelerated downgrading of rouble nominal exchange rate (with due regard to political restrictions and a "margin", serving as a reserve for its growth under the conditions of further cyclic growth of prices for energy carriers. Political feasibility of such model can be ensured by gradual and predictable rate of devaluation (in case that rate is denounced in advance) with the help of foreign currency interventions, made by the Central Bank to support the rouble rate, gradually decreased in the course of time.

The situation with high energy sources prices is observed currently in the Russian market, where there is a tendency to rouble strengthening, which can be beneficial to equilibrium of payment balance. However, the Central Bank is restraining this process with the help of foreign currency interventions, increasing foreign currency reserves and money supply as a result. Whereas there are no effective mechanisms of sterilization of interventions, implemented by the Central Bank, the inflation is restraining the process of rouble strengthening in real terms.

Equilibrium of current account operations could have been reached by strengthening of nominal rouble rate in case the Central Bank would have canceled or reduced the interventions to the amount, insufficient for maintenance of a stable nominal exchange rate. The above options of the simple model of equilibrium of current account operations provide similar results in the background of dynamics of exchange rate in real terms, though detailed analysis reveals a noticeable difference between those options.

In case the nominal exchange rate is used as an instrument of adaptation to the new economic situation, is hindered by the excessive reaction of exchange rate to external changes, as well as potential negative pressure on rouble rate on the

part of external participants of foreign currency market34. As a result, in the background of floating RUR exchange rate dynamics of the external trade markets can lead to immediate drastic changes in relative prices and competitive capacity of domestic producers, exceeding the values, required for equilibrium.

If the Central Bank restrains the nominal exchange rate volatility with the help of foreign currency interventions, the trend of real exchange rate to shift to equilibrium can be implemented gradually. In this case high competitive potential of economy involves high growth rates in the periods, when the real exchange rate is getting close to equilibrium. As a result, one can expect that when the real exchange rate comes up to equilibrium value, the economy will reach the peak level (in terms of GDP share per capita). In its turn, it will form an additional demand for transactions with real cash balances, resulting in the background of low inflation to the reduced equilibrium of real exchange rate, than in case of immediate nominal devaluation.

Considering the option of restraining the nominal exchange rate and strengthening of real exchange rate (with regard to inflation) as the most reasonable one, we proceed from the assumption that currently the reduced RUR real exchange rate makes for sustainable economic growth, as compared with the value, ensuring the trade balance equilibrium. Under conditions of pronounced strengthening and maintenance of national currency rate, the majority of businesses, not involved in highly-effective resource exports (under current business indicators), might become uncompetitive. As a result, the economy will be specialized in mineral resources extraction and primary processing (similar processes were observed in Netherlands upon discovery of Slokhteren natural gas deposits in 1960s). The policy, which does not provide countermeasures against displacement of domestic production, processing industries, agriculture and other sectors, when rapid price growth in the sector of non-trading production is happening, can not be regarded as reasonable on in the conditions of high volatility of the world markets of natural resources and limited economic resources thereof.

The necessity to pursue a restrained budget policy in the background of favorable external market situation is commonly recognized in both, highly industrialized and developing countries. Thus, within 2002-2005, in such countries as Algeria, Azerbaijan, Bahrein, Iran, Kazakstan, Kuwait, Libya, Oman, Catarrh, Saudi Arabia, United Arab Emirates the share of government oil revenues in the total to non-oil GDP has grown from 41 per cent to 81 per cent by average. At the same time, government expenditures have been raised from 56 per cent of non-oil GDP

34

The "marginal" effect in R. Dornbusch's basic model (under conditions of open economy, in the absence of necessary flexibility of prices in the short-term prospect) is associated with the established equilibrium in the monetary market, while the interest rate is being changed, due to the inflow/outflow of capital, which affects the nominal rate, results in the external equilibrium in the changed competitiveness of economy. Herewith, the rate has an excessive trend at the beginning of the process, but in view of further income changes the exchange rate rolls back. As a result, a new equilibrium value is established, equal to the previous one in real terms. Ref.:Dornbusch, R., Expectations and Exchange Rate Dynamics, The Journal of Political Economy, Vol. 84, No. 6. (Dec., 1976), pp. 1161-1176. 102

to 63 per cent. On average, only 26 per cent of surplus revenues were addressed to the current needs, 74 per cent were reserved (45 per cent were spent for acquisition of financial assets, 29per cent - for recovery of external debts). As a result, the budget surplus has grown in those countries from 2 per cent of GDP in 2002 to nearly 15.5 per cent in 2005 on average35.

The growth of non-interest budget expenditures in the conditions of extremely favorable external market situation for the Russian export creates a threat of serious socio-political disturbances in case of oil prices decline. Understanding of this threat has brought Russia to creation of Stabilization Fund (starting from the budget year of 2004), serving as a mechanism of restriction of budget expenditures excessive growth in the periods of high world prices for energy sources. The assessment of budget expenditure portion was made on the assumption that the budget revenues will be equal to the level of an average long-term level of oil prices (USD 18-20 per barrel for URALS). In this case LUKOIL surplus budget expenditures are regarded as temporary ones, caused by favorable external market situation, and are addressed to the Stabilization Fund. The assets of the Fund can be used for compensation of reduced tax proceeds of the federal budget under conditions of downfall of oil prices and for financing of non-interest expenditures and external debt redemption in the periods of peak pressure of the debt burden on the budget.

Until current time the Russian government was pursuing the policy of strengthening the stabilization of the budget system and would not accept the offers for expansion of non-interest expenditures in the situation of revenues growth. However, it looks that extremely favorable external market situation is maintained for a too long period, creating an illusion of further maintenance of high oil prices and high budget revenues in the long-term prospective.

However, an analysis of oil prices within the preceding 20 years shows that those prices are rather unstable, and there is no expressed trend of one-way dynamics. The statistical analysis of oil prices within a certain period of time demonstrates their instability, and mathematical estimates (average values) and dispersion (deviation from average values) of oil prices are being changed with time. Sustained oil prices at the level exceeding an average long-term values for quite a long time (about four years) is supporting the theory of strengthening the volatility of prices from year to year. As one can see from the experience, the prices for energy sources tend to decrease, whereas the financial agents come to understanding that the high level of prices is set up for a long term, and basing on that idea, they review their investment plans, addressing extra resources to extended extraction of energy sources and energy saving policy.

In such situation one can expect in future a dramatic and long-term downgrading of oil prices (at least USD 15 per barrel in stable dollars). Lower prices are hardly reachable in the nearest 5-10 years due to the growing demand for oil and oil products on the part of China and India). Apparently, the federal budget revenues will be reduced in the background of oil prices downgrading, Russian oil

35 Regional economic outlook. September 2005, IMF, pp. 19-20.

fields exhaustion and higher costs for oil extraction from the new and hardly accessible oil wells.

Despite the forecasts of international centers for oil market investigations, which do not expect a drastic downfall of oil prices, one can not completely ignore such a possibility. An extra threat to the stability in the budget sphere and in socioeconomic situation in general is added by an opportunity o price downfall at the end of 2007-2008, coinciding in time with the new political and economic development cycle in the RF. It is evident, that in the pre-election period the Russian government will not be able to cut down the non-interest expenditures, increased in the period of high oil prices. Under those circumstances Russia can again find itself in the situation of an acute budget crisis (which might be delayed due to quickly growing government debt)36.

Besides a retreat from the principle of "average long-term price" in formation of federal budget expenditure part, i.e., a violation of one of the conditions of the federal budget stability in the situation, when the budget revenues are highly dependant on oil prices volatility, the negative impact of expansion of non-interest budget expenditures is an accelerated inflation and growth of RUR exchange rate in the background of low sterilization. The second basic task of Stabilization Fund is to prevent those processes. IET assessments confirm that return of the assets, deposited at the Bank of Russia on government accounts, to the economy, will lead to excessive growth of monetary base and later on - to multiplier growth and inflation acceleration due to enlarged volume of uncommitted funds at the banks. Apart from evident social consequences, expansion of inflation will negatively affect the rates of economic growth in general through the accelerated process of RUR exchange rate strengthening in real terms and tougher competition with imports.

Therefore, basing on the assumption of necessity to maintain the low RUR rate in real terms in the conditions of surplus balance of external trade, the policy, pursued by the RF Central Bank and the Ministry of Finance, is basically rather sound. Nevertheless, due to the extremely high prices for energy sources, sustained within the past two years, financial authorities experience the lack of instruments for sterilization of excessive money supply, resulting from Central Bank interventions of foreign currency37. As a result, the inflation, which has not come down lower than 9-10 per cent within recent years, brings forward accelerated RUR strengthening by 8-10 per cent per year.

Coping the inertial inflation and formation of counter-inflation expectations are the key measures for inflation reduction. The international experience shows that reduction of inflation expectations is a slow process. The actions of monetary

36 As per IET assessments, downgrading of the world oil prices to the level of an average long-term level of USD 20 per barrel will result in the budget deficit in the amount of 4.5-5.0 per cent of GDP. Stabilization Fund of the Russian Federation will be completely expired within 3-4 years (in case of expenditures maintained at the level of 2006).

37 Ref. P. Kadochnikov "External Factors of Monetary and Credit policy in the RF" -"Research Works" Series, No. 49P. - M.: IET, 2002; S. Drobyshevsky, P. Trunin. Correlation of Capital Flows and Basic Macroeconomic Indicators in the Russian Federation. - IET Research Works, No. 94P. - M.: IET, 2006.

and credit authorities provide an impact over the financial agents' behavior only after a long-term lag (up to 1 year).

The absence of negative reaction on the part of the RF government and Central Bank (adherence to moderately strict monetary and credit policy, avoidance of extra budget expenditures, maintenance of stability in foreign currency market and banking sector, restricted growth rates in regard to prices and tariffs) can ensure inflation reduction by 1 p.p. per year.

The growth of monetary supply ensures a comparable share of total price growth in line with the inertial inflation. Despite active sterilization measures, taken by the RF government and Central Bank, within the past two years the average yearly growth rates of money supply M2 made 35-40 per cent, GDP in monetary terms has grown from 15.8 per cent (as of end of 2000) to 28.0 per cent (as of end of 2005).

Reduction of price growth flexibility in regard to money supply growth restricts attainable level of inflation downgrading with the help of tightening of monetary and credit policy. However, extended monetary supply can provoke an outburst of consumer prices, i.e., in the background of inflation upswing its flexibility versus money supply growth will be considerably higher.

As per our estimates, under conditions of yearly monetary supply growth decrease at the rate of 20-25 per cent, which will maintain and strengthen the trend to GDP monetization, required to support high economic growth rates, the current inflation level can be reduced by 1.5-2 p.p. per year within 2-3 years.

Sterilization of excessive monetary supply in Russia is achieved by several instruments: surplus of the extended government budget (accumulated assets at the accounts of government bodies and Stabilization Fund), accumulated reserve fund of commercial banks with Central Bank38 and securities of the Bank of Russia.

In monetary policy one should take into account, that sterilized interventions, though have no immediate impact over the monetary base and inflation, do have an influence39, first of all, on a higher growth of RUR assets (versus foreign currency funds) and its impact on interest rates and capital inflow. Moreover, even sterilized interventions, means of their implementation, their time frames and volumes serve as indicators of current priorities of monetary and credit policy to the market participants, who can also affect the interest rates and market balance.

To cut down the growth of monetary supply under favorable external market situation and transparent Russian economy in general and in view of complete liberalization of financial operations, planned for 2007, in particular, the following measures can be proposed.

Firstly, preservation of Stabilization Fund functions as a basic instrument for sterilization. There should be considered an issue of allocation a section within the

38 IET estimates point out, that there is a coordination in dynamics of funds, accumulated at the accounts of government authorities and excessive reserves of commercial banks; i.e., accumulation of commercial banks' reserves is most likely implemented with due account to financial authorities' policy.

39 Ref. the Survey (Sarno, Taylor, 2001).

Fund or formation of a special fund (based on similar principles) to be used for accumulative pension fund for the Russian citizens (in favorable market conditions). When the amount of deductions to Stabilization Fund is being determined, the cutoff price should not be increased, it should be rather decreased to an average yearly value (USD 20 per barrel), as the upgrading of the cut-off price reduces the budget system sustainability and pretty soon will lead to the federal budget deficit, even in case the oil prices are higher than long-term average values.

Secondly, upgrading of interest rates and transfer to the policy of "tight money" are necessary, namely, expansion of variety of instruments for commercial banks' assets involvement with the help of the Bank of Russia securities or increase of interest rates on commercial banks' deposits with the Bank of Russia.

Naturally, in view of additional sterilization of potential capital inflow and monetary supply adjustment for the amount of interest rates to be paid to commercial banks, those measures will complicate the implementation of monetary and credit policy. The correlation between the amount of funds involved and interest rates upgrading can be assessed by analysis of input/output effects of such policy and its benefits in terms of inflation reduction and a slow-down of the process of RUR real exchange rate strengthening40.

However, such policy might have a negative impact over credit processes in the real sector, but in favorable external market situation the majority of businesses are capable to finance the investments at their own expense.

Thirdly, some limitations could be introduced in regard to external loans for government companies. That measure looks effective as a supplementary instrument for cutting down an excessive foreign currency supply in the domestic market. Moreover, the growth of those loans might result in an upswing of the future government budget expenditures, if the debts of government companies will have to be recovered from the federal budget.

There are restrictions in the effective sterilization of foreign currency interventions with the help of shares of the Bank of Russia and increased interest rates on the deposits of commercial banks with the Central Bank in the form of practical difficulties of control over the investments made by non-residents, enlarging the volume of foreign currency inflow to the national economy, which is reflected in capital account balance of payments. If non-residents' assets are admitted only through certain banks, placements of the Bank of Russia securities will result in reduction of monetary supply and depend on the volume of excessive capital inflow, which will raise the demand for interventions, made by Central Bank in foreign currency, and hence, the need for sterilization.

Various measures of limitation of foreign capital inflow, transferred to the RF

40 The analysis of monetary and credit policy, pursued in USA in 1980s shows, that the high interest rates make for sterilization of excessive money supply, resulting from budget deficit monetization and external credits' involvement, with the help of substantial reserve funds of the banks. Moreover, high interest rate allows to increase the volume of assets in national economy, which firstly, reduces the necessity of emission for recovery of budget deficit, and secondly, raises the demand for money in view of transactions, necessary for the accumulated assets transfer to investments or agents' current expenses. 106

in view of the interest rate growth (such as supervision of banks activities in involvement of external loans, limited share of external obligations for the banks, a demand for reserve guarantees on short-term foreign investments in the national economy, etc.), get in conflict with the effective policy of financial operations liberalization. Therefore, the above measures are rather restricted.

Apparently, the requirement for higher volumes of guaranteed reserve can not be regarded as an effective instrument of control over monetary supply growth in the nearest future. This is explained by essential differentiation of the Russian banks' financial position in the background of underdeveloped market of inter-bank credits and poor mechanisms of refinancing for commercial banks, implemented by the Central Bank. In such a situation tightening of FMR requirements (Fund of Mandatory Reserves) aggravates the risk of liquidity crisis. Therefore, before wide implementation of FMR standards as instruments of monetary management, measures should be taken for improvement of credit mechanisms for the banks, which are in need for liquidity assets.

Abolishment of a requirement for obligatory repatriation of a part of foreign currency revenue can be considered as an instrument that reduced the demand for sterilization of the Central Bank operations in the foreign currency market. However, the application of that measure depends on the effectiveness of the system of tax control over operations of the national companies, made through their foreign accounts, which is currently far from being perfect.

In general, the common trend of monetary and credit policy in medium-term prospective should apparently become a more distinctive differentiation between the instruments of monetary and credit and fiscal policies. Currently the basic tasks of monetary and credit policy in management of monetary assets are resolved through budget instruments. In the recent years those instruments include as accumulation of surplus in the budgetary sphere and Stabilization Fund, as well as budget expenditures, for instance, expenses for the support (crediting) of various economic sectors.

To estimate quantitative and qualitative results of the above instruments of monetary and credit policy in the situations with high and low oil prices, IET has reviewed seven optional models of the RF economic development in the medium-term prospective (5 years, up to 2011).

The first four models are based on the situation the situation, when oil prices are rather high in the international market within the period under review (no less than USD 45 per barrel41 for Brent oil).

Model I describes, in fact, an inertial option of economic development in the RF. It is assumed, that upon President's election in 2008 the government will keep the growth of federal budget expenditures within the level of 18.5 per sent of GDP (growth of budget expenses within pre-election period will not exceed 2 p.p. of 2006 GDP). The existing tax system will be sustained, the guidelines of Stabilization Fund accumulation will not be reviewed and the yearly growth rates of prices and tariffs for goods and services, provided by big natural monopolies, will exceed the inflation rate maximum by 2-2.5 p.p. The RF Central Bank will maintain the policy of

41 As USD in 2006.

accumulating gold and foreign currency reserves, making for relevant growth of monetary supply, including the funds for the support of high GDP growth rates, as well as restraining the RUR real exchange rate. Therefore, in that model there are no provisions for the trend to nominal RUR strengthening at the expense of gold and foreign currency reserves. We presume, that favorable external market situation and macroeconomic indicators will make for both, direct investments inflow and financial capital to the country. To facilitate estimations, exchange rate for the entire period under review is understood as EURO 1 to USD 1.2-1.30.

The other three models, where high oil prices are regarded, are based on dynamics of certain indicators of Model I, whereas other parameters stay unchanged.

Model II differs from Model I in terms of expanded budget expenditures at the background of sustained high oil prices and budget revenues. For instance, we assume some extension of federal budget expenditures (by 2-2.5 p.p. of GDP i.e., up to 21.0 per cent of GDP by 2009). Therefore, the trend to extended federal budget expenditures under high oil prices is maintained.

Model III presumes achievement of yearly inflation in the amount of 4 per sent by 2011, which allows to estimate the level of required extra volume of sterilization of foreign currency interventions, effected by the bank of Russia.

In 2006 the Central Bank has implemented nominal RUR strengthening versus USD by 8.5 per cent. Model IV regards the version of policy changes on the part of the RF Central Bank, when financial authorities abandon the policy of accumulation of gold and foreign currency reserves and allow nominal RUR strengthening in regard to foreign currencies, resulting in the zero balance of the RF current account.

Models V-VII are based on the situation, when oil prices in the international market get down to the average long-term level (USD 25 per barrel of Brent).

In Model V such a decrease is happening gradually (by 2009), whereas in Model VI and VII an aggressive downfall takes place already in 2007. The basic approaches of economic policy are the same, that are taking place under high oil prices, and the Stabilization Fund is used for replenishment of federal budget deficit. Nevertheless, we presume that a noticeable capital outflow will take place in the course of oil prices downgrading.

Model VI, together with a presumption of oil prices downfall from USD 65 to USD 25 per barrel already in 2007, reviews the policy of the RF Central Bank, which releases the RUR exchange rate, preserving the volume of gold and foreign currency reserves, resulting in the brief RUR denomination.

Model VII presumes an opposite policy: RUR nominal rate maintenance (versus USD for simple computation) and interventions, until gold and foreign currency reserves are totally expired.

It should be noted, that we are using formal mathematic computation for quantitative analysis of economic models, basing on the assumption of reliable and conservative behavior of economic agents to get equilibrium values of variables under given conditions for each model, which is unattainable in practice. This assumption is especially true for the models, applicable under decreasing oil prices.

IET estimates provide rather prudent valuations of basic macroeconomic indicators' dynamics for both situations, under high and low oil prices. In case of low oil prices the situation will be developing in a negative direction, so the financial authorities should be ready to take measures for affordable mitigation the negative consequences, detected in the estimates. Potential models, developed for the situations of high oil prices, are conservative and provide a lower margin of economic development.

Modeling of the RF basic economic indicators dynamics in general, and monetary sphere in particular, was performed on the basis of IET approximation of medium-term socio-economic indicators modeling42. The basic parameters were taken from initial estimates of the year 2006 results. Dynamics of macroeconomic indicators by models are given in Table 21.

Table 21

Dynamics of Macroeconomic Indicators by Models of Economic Development in the RF in 2007-2011

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II +2121.5 7.0 1 7.0 5.7 29-30 +39-40 310-320 17

III +26-27 4.0 1 1 .0 4.8 28.5-29.5 +29-30 440-450 27

IV +11-12 4.0 15.0 5.2 22-23 +44-45 300 25

V +5.56.5 6.0 16.3 5.4 40-42 -8-9 90-100 0 (2010)

VI -0.5-1 4.5 16.7 5.4 37-38 -6-7 300 0 (2009)

VII -3-4 3.0 (2009) 18.3 5.7 27.0 +19-20 0 (2009) 0 (2009)

According to the estimates, under inertial model of the RF economy development (Model I) the aggregate growth of GDP in real terms within 5 years (20072011) will make about 25 per cent, with regard to the decrease of yearly GDP in real terms by 3.5 per cent by the end of the period. The reduction is explained by downgrading of cost-effectiveness of oil and gas sector and stabilization of export volumes in the conditions of sustainable structure of natural resource industry. With

42 Model description in detail is published in the works by M. Turuntseva, A. Yudin, S. Drobyshevsky, P. Kadochnikov, S. Ponomarenko, P. Trunin "Some approaches to economic indicators modeling", "Research Works", No.89P, M.: IET, 2005, and some model elements are provided also in the works by S. Drobyshevsky, V. Nosko, R. Entov, A. Yudin "Economic Analysis of Basic Macroeconomic Indicators Dynamic Series" "Research Works" No. 34P, M.: IET, 2001; R. Entov, V. Nosko, A. Yudin, A. Kadochnikov, S. Ponomarenko "Some Macroeconomic Indicators Approximation", "Research Works" № 46P, M.: IET, 2002.; G. Karasev, S. Chetverikov "Structural Models of RUR Exchange Rates", No. 88P, M.: IET, 2005.

regard to RUR growth rate in real terms, by 2001 Russia will reach the GDP volume of USD 1.5 trillion (as per current exchange rate).

Despite some decrease of national revenues (approximately to 22.5-23 per cent of GDP) due to a decline of tax rates for the oil sector and general decrease of cost-efficiency level in the economy, there is still a surplus in the federal budget balance (at least 4 per cent). As a result, by the end of 2011 the Stabilization Fund will reach 25-26 per cent of GDP (USD 380-390 bln).

The Central Bank policy in terms of accumulation of gold and foreign currency reserves accumulation and in view of restriction of RUR yearly rates of strengthening with the help of sterilization of foreign currency interventions will result in achievement of the level of gold and foreign currency reserves in the amount of USD 405-415 bln. Within five years the total effective growth of RUR in real terms will make about 35 per cent (+48 per cent versus the pre-crisis period of 1998). Herewith, the nominal RUR rate will make by the end of 2011 about 29.5-30.5 for USD 1.

As a result of that policy, the trading account balance will reach a zero value by 2009-2010, i.e., the growth of gold and foreign currency reserves will be made purely due to capital inflow. Starting from 2010, the growth rates of money supply, though somewhat decreased (to 9-10 per cent in 2010-2011), will stay higher than inflation rates. Monetization will be sustained at the level of 34-35 per cent of GDP. According to out estimates, the inflation can not be reduced in such a situation lower than 6,0 per cent. The aggregate growth of prices within five years will make at least 40 per cent.

Sustained high oil prices, revenue growth in economy in general and real wages in particular, at the background of rather high inflation, as well as RUR strengthening will keep up a trend to stronger differentiation between incomes of population and higher living standards. We presume, that within five years, by 2011, the share of income of the first group of population (20 per cent with the lowest level of income) will be decreased from 5.4 per cent to 4.9 per cent, while the share of population, whose income is beyond the minimum living standard, will be cut down from 15.8 per cent to 12.1 per cent43.

Extra budget expenditures (expected in the amount of two per cent points of GDP according to Model II) will negatively affect a number of indicators. Thus, an aggregate GDP growth will not exceed 21.5 per cent, and inflation will be not less than 7.0 per cent within the period under review.

Accordingly, differentiation of income as per population groups will be reduced: the share of income of the first group of population (20 per cent of population with the lowest income) will grow from 5.4 per cent to 5.7 per cent. However, despite the increased budget expenditures, the share of population with the in-

43 It is assumed in the framework of the Model, that the minimum living standard is varied in proportion to GDP per capita, though it is generally incorrect. Under conditions of high oil prices and excessive regulated tariffs GDP deflator should be higher than the minimum living standard growth rates. Therefore, our estimates of reduced share of population with minimum income level are rather pessimistic. 110

come lower than the minimum living standard will be also increased from 15.8 per cent to 17.0 per cent.

Federal budget surplus will be relevantly reduced by 2011 to 1.0 per cent of GDP, the aggregate RUR growth in real terms will reach 39 per cent (+52 per cent versus the pre-crisis period of 1998), the amount of Stabilization Fund will not go beyond 17 per cent of GDP.

Compared with the inertia model, achievement of lower inflation rates by 2011, (up to 4per cent as per Model III) without budget expansion will require surplus sterilization of monetary supply in the amount of RUR 200 bln per year. That level of sterilization can be reached with the help of Stabilization Fund assets and additional monetary instruments of the Central Bank policy, described above. The aggregate CPI within the five years will not exceed 35 per cent. Herewith, due to slower growth RUR rate in real terms (not over 30 per cent), the aggregate growth of GDP within the five years will be not higher than under Model I.

Like in the first Model, the trend is kept up to stronger differentiation of income by population groups and higher living standard, which will result in increased share of income of the first group population (20 per cent with the lowest income) from 5.4 per cent to 4.8 per cent by 2011 and the share of population with the income lower than the minimum living standard will be increased from 15.8 per cent to 11.0 per cent.

In Model IV, where the nominal RUR strengthening is foreseen, changes in the dynamics of macroeconomic indicators are more expressed. Thus, at the sustained volume of Central Bank reserves at the level of the end of 2006 (approximately USD 300 bln), the nominal RUR rate by the end of 2007 will be strengthened to RUR 18 for USD 1 (by 30-35 per cent within a year), which will result in trading account balance deficit at the turn of 2007-2008. The growth of RUR in real terms within 2007-2011 will make up to 45 per cent (55-60 per cent versus July 1998).

Accordingly, the aggregate growth of the RF GDP in real terms will not exceed 11.5 per cent within five years, and the trading account balance deficit can reach USD 35-40 bln by 2011 (about 15 per cent of exports). At the same time, in view of moderate scale of foreign currency acquisition and monetary emission, the yearly rate of money supply growth will be reduced to 4.5-5 per cent, which will result in reduction of inflation yearly growth rate to nearly 4 per cent per year (not over 35 per cent within five years).

Thereafter, differentiation of income as per population groups will be slowed down: the share of income of the first group of population (20 per cent of population with the lowest income) will get down from 5.4 per cent to 5.2 per cent. However, the share of population with the income lower than the minimum living standard will be stay rather high, not lower than 15.0 per cent.

According to Model IV, the volume of the Stabilization Fund will reach 20-25 per cent of GDP by 2011.

Therefore, the analysis of four Models in the situation with high oil prices brings us to the following conclusions in terms of consequences of alternative measures of economic policy.

Under the terms of inertia Model rather high economic indicators are demonstrated. The rates of real GDP growth are the highest among other models, and in our opinion, the inflation is within reasonable limits. RUR growth rate in real terms results in decreased balance of trading account, but in the background of sustained average growth of GDP there created favorable conditions for external capital inflow and expansion of natural resource sector of the economy.

The Model, where extended budget expenditures are foreseen, demonstrates, in fact, according to the estimates, insignificant differences in macroeco-nomic indicators from those ones of the basic model. It can be explained by relatively moderate scale of extra expenditures and suspended budget expansion under stabilized oil prices at the level of USD 45 per barrel.. Nevertheless, the estimates evidently demonstrate, that with such scale of downgrading of rigid budget policy the government actions provide negative impact over the economy in general.

Comparative analysis of the two versions of economic policy under high oil prices (which differ by extra sterilization and admitted increase of RUR exchange rate in nominal terms) shows, that the first version is preferable. The level of additional sterilization is not excessive as compared with the inertia model, and in view of additional measures, mentioned above, the sterilization volume could have been even higher. In other words, under this model lower inflation level could be achieved, comparable with the level of the model, where strengthening of RUR exchange rate in nominal terms is foreseen. However, in the fourth model such low inflation level is achieved through downgrading of economic growth rates.

Model V (where gradual decrease of oil prices is considered) outwardly demonstrates the dependence of the RF economy on oil prices. In fact, there is a threat of a crisis, even regardless the drastic qualitative changes in expectations and behavior of economic agents in case of oil prices downfall.

According to the estimates, under such model, when oil prices are getting down, the aggregate growth of real GDP within five years (2007-2011) will make no more than 6 per cent, whereas in 2010-2011 the yearly rates of real GDP growth will be in deficit (up to - 2.0 per cent). In 2011 GDP will not exceed USD 900 bln (as per currently effective exchange rate), i.e., nearly 40 per cent less than in the first model.

Federal budget revenues will be decreased lower than by 14.5 per cent, so that the deficit of the federal budget is expected already by 2008 (under oil prices at the level of USD 30 per barrel). In such a case Stabilization Fund assets will be totally expired by 2010 at the background of federal budget deficit in the amount of at least 4.5 per cent of GDP in 2010-2011.

In the framework of that model we assumed, that the RF Central Bank policy will be restricted to gradual RUR devaluation through foreign currency interventions. It is evident, that such policy is hard to be implemented due to potential attacks at rouble. However, regardless expectations of economic agents, according to the estimates, by the end of 2011 RUR will be devaluated 1.5-fold as compared with 2005 and reach more than RUR 40 per USD 1, which will run the Central Bank

"in the expense" of USD 200 bln of gold and foreign currency reserves (with the balance of gold and foreign currency reserves by the end of 2011, not exceeding USD 110 bln).

Within five years the effective RUR exchange rate in real terms will get down by approximately 8-9 per cent, but due to oil prices decline there will occur a deficit in the trading account balance.

As far as an option of surplus recovery of budget deficit and monetary emission in the economy in the critical situation are not considered in the framework of the model, the growth rates of money supply will practically reach zero, GDP mone-tization will drop down to 30-31 per cent. Nevertheless, in the background of exchange rate impact on prices, there will be no adequate reduction of inflation rates. The accumulated index of consumer prices within five years will reach nearly 40 per cent, and in 2011 the trend to lower inflation rate will be broken, prices will grow faster than in 2010.

As mentioned before, Model six, where the Central Bank restrains from the control over the exchange rate in the background of oil prices downfall, is rather conventional. Practically, in view of qualitative changes in behavior of market participants and clear political prospects of such events to financial authorities, such situation is hardly possible.

According to our estimates, in the situation of stable position of other market participants, in the background of preset downgrading of prices for energy sources, the yearly decrease of nominal RUR exchange rate versus USD will exceed 25 per cent, within total period under review RUR will be devaluated approximately by 40 per cent, i.e., less than in the model, where gradual oil prices decline is foreseen.

Under the negative impact of the collapse, the rates of GDP growth in real terms will come to negative value already by 2008 and remain at that level within the total period (aggregate GDP decrease will not exceed one per cent within five years), but already in 2011, due to imports restructuring and adaptation of the economy to low oil prices, there will be observed a trend to rehabilitation of GDP growth rates. Remarkably, export surplus balance will be sustained within all those years.

The worst impact of oil prices downfall will be provided on budgetary sphere: Stabilization Fund assets will be expired already by the end of the third year upon prices landslide (in 2009), while the budget deficit will be within 5.0-5.5 per cent of GDP (with no regard to prepositions of reduced expenditures of federal budget, required in that situation).

In that model we do not make assumptions of surplus emission addressed at recovery of the federal budget deficit, and relatively, the rates of money supply growth are lower than in Model five. Rigid monetary and credit policy allows to reduce the impact of the declined exchange rate on the prices, and in 2011 the inflation get down to 4.5 per cent.

In terms of living standard of population, according to out estimates, that model makes for maintenance of the situation to a large extent. Thus, the share of

population of the first group (20 per cent of population with lower income) will stay practically at the sale level (about 5.4 per cent) and the share of those, whose income is below the living standard, will be increased up to 16.7 per cent.

An alternative to the policy of nominal devaluation is the policy of keeping up the RUR exchange rate at a fixed level (Model VII). According to the estimates within the framework of that model, gold and foreign currency reserves will be sufficient to keep up the exchange rate for four years, in case the RUR rate is maintained at the level of RUR 27 for USD 1, and by the beginning of 2011 those reserves will be expired. Nevertheless, as mentioned above, quantitative results, obtained for that model, are rather conventional, as in practice the policy of keeping up the fixed RUR rate in the situation of oil prices downfall means, that RUR will be inevitably attacked within the first year, and gold and foreign currency reserves will be expired faster, than is forecasted by the model estimates.

Moreover, the level of living standard decline is also underestimated within the model. According to the model estimates, the share of monetary income of the first group (20 per cent of population with the lowest income) will be somewhat increased from c 5.4 per cent to 5.7 per cent, while the share of those whose income is below the living standard, will grow from 15.8 per cent to 18.3 per cent.

Comparative analysis of the results of three crisis models brings us to the following conclusions in terms of their consequences.

In the situation, when oil prices are getting down, there is no chance to avoid a severe decline of growth rates and stagnation in economy. However, there is a chance for Russia to avoid the crisis, comparable with the situation of the second part of 1998.

The minimum losses for economy will take place, if in case of oil prices downfall the choice is made in favor of policy of nominal RUR devaluation, though political limitations should be taken into regard in implementation of such policy option. Moreover, in this case one can expect a trend to economic growth due to the effect of import restructuring in the background of national currency downgrading, like in the IV quarter of 1998-1999.

Alongside with that, it should be noted that preset conditions for critical situations were rather rigid in terms of time frames. Thus, we were considering the case of low oil prices within three-four years in a row.

There is a low probability for a steep (two-fold) downfall of oil prices within one year. Therefore, the fifth model is most likely in terms of oil prices dynamics, and apparently, economic policy measures will be applied within the framework of that model. Accordingly, releasing of RUR rate by the Bank of Russia under the higher, though declining, oil prices, when the economy is rather sound, reduces impartial difficulties of practical implementation of such policy.

It should be also noted, that the model might overestimate the dependence of Russia on oil prices, as for a number of preceding years an important factor of economic growth were investments, and in the first turn, the model reflects interrelations between the dynamics of natural resources prices and the economic growth of Russia.

* * *

Analysis of various optional models of economic development in Russia in the situations with high and low energy sources prices allows to chose those policy measures, which will ensure the best results in economic development in both situations.

The best policy in the situation with high oil prices is the highest sterilization of Central Bank interventions in foreign currency markets in line with accumulation of gold and foreign currency reserves. The basic disadvantage f such policy is that positive results of its implementation are observed in a long- and medium-term prospective, whereas all difficulties of rigid monetary policy, implemented by financial authorities, are experienced immediately.

The best policy measure in the situation with lower oil prices is RUR devaluation. It is very important to declare at the initial stage of energy sources price decline, before they reach the lowest point, that financial authorities will make no efforts to support the RUR rate at a certain level with the help of gold and foreign currency reserves, regardless any political consequences. This measure will bring potential attacks to RUR to minimum and reduce the crisis impact in the economy.

2.4. Interbugetary Relations and Subnational Finance

Last year saw no drastic changes in the system of interbudgetary relations. The structure of tax revenues and tax powers exercised by different tiers of government has remained basically unchanged. At the federal level, there continued to exist channels of financial support to regional budgets, which have been stable over recent years 44. Against the background of the increasing revenues to the federal budget in real terms, the financial situation of subnational budgets, with account of the federal financial aid, can be characterized as relatively stable.

But the complex of decisions made and/or promulgated in 2005-2006 allows conclusion that Russia continues to progress along the path of formation of the corporate federalism. In the previous review, we have already highlighted peculiarities of such a model: at the federal level, a uniform legislation on all the critical matters is complemented by the administrative and political control over regional administrations, with the federal authorities viewing regions as branches of a single corporation. This is proved by such decisions as considered in the last year's review actual cancellation of elections of regions' heads, the federal center's unilateral decisions on the "monetization of benefits", division of powers and implementation of the so-called "national projects". These tendencies have further intensified in 2006, which can be evidenced by the already passed Act on the 2007 federal budget, which provides for a considerable increase in the proportion of subsidies and subventions in interbudgetary transfers. This proves that the subnational authorities are increasingly assigned the role of "executive executors" of certain measures planned, funded and controlled by the federal center.

44 See: Russian Economy. Trends and Outlooks. M., IET (issues 21-27)

2.4.1. Evolution of Budgetary Federalism in Russia

The Russian federalism has advanced in a "pendulum" mode, when the centralized structure of the USSR was substituted by a serious decentralization of the 1990s. However, the latter was in turn again replaced by the prevailing tendency to centralization. Underlying the tendencies to centralism in Russia were several causes:

1) First, the institutional environment of the Russian federalism was extremely flexible, or, more precisely, nascent - the Constitution has failed to set a closed list of rights and obligations of the Subjects of the Federation, with a considerable part of critical for the society governmental powers falling under the "joint jurisdiction". The balance of division of government powers could be easily broken either in favor of a further decentralization (up to the country's break-up), or towards centralization (up to a de-facto unitary state). The selection of either option was dependent on who, regions or the federal center, would be able to concentrate in his hands financial and state power resources. Other causes for the centralization explain why the shaky equilibrium of the 1990s has been replaced by the current centralization.

2) In the conditions of economic crises (those of the early 1990s and in 1998) and an uneven dispersion of production, numerous regions had no sufficient financial resources in hand to exercise the powers granted by the federal center. As a result, the latter acquired additional powers associated with redistribution of resources between regions, most of whom were keen to participate in such a redistribution.

3) Many regions pursued incompatible interests; regional authorities have failed to form a joint front with respect to the division of powers and advocacy of their stand before the federal center.

4) The need for promoting nationwide reforms and solving nationwide challenges (for instance, repayment of a huge external debt or the need to consolidate the society in the light of the terrorist threat) has helped form the value of the integrity of the political and economic space in the eyes of the society.

5) The correlation between the today's level of decentralization and the state of the respective institutions in the past45. In retrospective, all Russia's institutions and the society on the whole was closely associated with the planned economy and the hypercentralized administrative-and-command decision-making system, which to a significant extent has affected redistribution of the power and financial resources in favor of the federal center.

Thus, Russia has witnessed a gradual rise of a country-specific model of federalism. It displays a unique combination of fundamentals of cooperation and competition with the federal center's administrative control. On the one hand, regions compete with each other for placement in their territories of the most profitable enterprises, as well as for financial aid from the center and public investment resources. But, on the other hand, the federal center has concentrated in its hands

45 Path dependence - Arzaghi M., Henderson J. Why countries are fiscally decentralizing// Journal of Public Economics. Vol. 89, No. 7, 2005 - P. 1186-1188. 116

key powers and financial resources, and it sets a uniform legislation on all the critical matters and enforces the uniformity of the tax system across the Federation. These are characteristic features of the cooperative federalism of the German type. However, in Germany, subnational governments can maintain a significant influence on the federal center's policies by means of the party system and the Bundesrath. In Russia, the nascent party system challenged the federal center with a complex mission of ensuring efficacy of the regional governance by means of administrative methods. Hence, as noted above, the federal center is compelled to regard regions as branches of a single corporation, to formulate strategic objectives for them and evaluate the regional authorities' performance.

2.4.2. Main Trends of Development of Relationships between Budgets of Different Levels

To analyze main trends of 2006 in the area of relationship between budgets of different tiers, let us consider the revenue and expenditure structure of the RF consolidated budget and its evolution over several recent years. Table 22 below contains data that characterize the proportion of tax revenues and expenditures of budgets of the RF Subjects in the nation's consolidated budget.

Table 22

The Proportion of Some Indicators of Budgets of Subjects of the Federation in the Respective Indices of the Consolidated Budget of the Russian Federation in 1992-2006 (as %)

CN CO LO (O 00 O) o M CO LO (O

O) O) O) O) O) O) O) O) o o o o o o o

O) O) O) O) O) O) O) O) o o o o o o o

M M M CN CN CN CN

Tax revenues 44.2 53.1 53.4 47.6 49.5 53.1 56.6 49.2 43.5 37.4 35.1 39.6 36.1 30.9 31.8

Expenditures 34.0 40.3 37.7 43.4 45.4 48.1 54.1 51.9 54.4 54.2 49.3 50.0 50.8 49.5 43.4

Source: the RF Ministry of Finance, the authors' calculation.

The data in the Table 22 evidence that the trend to centralization of taxes in the federal budget, which had started in 1999, has been somewhat modified in 2006. While between 1999 and 2005 the share of tax revenues to budgets of the RF Subjects in Russia's consolidated budget revenues slid from 56.6% in 1998 to 30.9% in 2005, a year later, in 2006, it posted a 31.8% growth. Meanwhile, the proportion of expenditures of budgets of the RF Subjects in expenditures of the nation's consolidated budget plunged from 49.5% to 43.4%. Such a decline was caused by a faster increase in the federal budget expenditures. Whilst considering the state of tax revenues to consolidated regional budgets in 2005, one can note that, as before, it is revenues from two taxes, that is, personal income tax and corporate profit tax, that account for over a half of the tax revenues (34% and 42% of tax revenues to regional budgets, respectively). In 2006, the share of revenues from these two taxes in tax revenues to regional budgets slightly slid vis-à-vis 2005 - from 80% to 77%, which can be attributed to a slight decline in the share of corporate profit tax. It should be noted that revenues from personal income tax to consolidated budgets of the RF Subjects rose up to 3.5% of GDP (in 2005 - 3.3.%

of GDP), while revenues from corporate profit tax slid to 4.35% of GDP (4.41% in 2005). Excise taxes continued their decline to 0.6% of GDP (vs. 07% in 2005), while revenues from payments for the use of natural resources remained on the same level (0.26% of GDP). Small businesses have now found themselves taxed at a greater level (0.36% of GDP vs. 0.33% reported last year), while revenues form property taxes in the shares-of-GDP equivalent remained stable and accounted for 1.17% of GDP.

Given the above, an analysis of the indicator of tax revenues to consolidated budgets of the RF Subjects in per capita terms shows that in 2006 the cross-regional unevenness of this indicator continued to decline. Thus, the respective value of Jini coefficient fell over the year and accounted for 0.48 (vs. 0.57 in 2004 and 0.51 in 2005). The last year's decline in the cross-regional unevenness of per capita tax revenues to consolidated budgets of the RF Subjects occurred mostly because of the fall in the proportion of an unevenly distributed corporate profit tax in the said budgets. Yet another reason behind the fall in the unevenness of this indicator became integration of the data on execution of budgets of Krasnoyarsk krai, Taymyr and Evenk autonomous okrugs. It is also possible to suggest a hypothesis, according to which in the aftermath of an economic crisis the renewal of economic activity starts in a small number of regions (in Russia, those are oil-producing regions and the largest economic centers). As a result, regions began to diverge from each other in terms of various indicators and those of tax revenues in particular. Such a trend was noted in Russia between 1999 and 2004. Expanding across new regions, economic growth leads to a lower unevenness in distribution of tax revenues. Time will show whether the hypothesis is accurate. Presently, it seems too premature to judge its accuracy basing solely on the tax revenue data, as the 2005 reduction in the cross-regional differentiation of per capita tax revenues to consolidated budgets of the RF Subjects was caused mostly by the centralization in the federal budget of unevenly distributed taxes, namely, the mineral tax (9.4% of it in the part of oil and gas condensate) and corporate profit tax (1.5%).

Revenues to the consolidated budgets of the RF Subjects grew by 18% in real terms, with just 7 Subjects reporting their decline in real terms46. It should be noted that Novgorod oblast and the Republic of Sakha (Yakutia) have experienced just an insignificant fall in their budget revenues - at 0.66 and 0.67%, accordingly. In most cases, underlying a decline in regional budget revenues is the "abandonment" of a large corporate taxpayer, followed by a fall in revenues from corporate profit tax. Thus, the 2006 revenues from this particular tax slid in real terms vs. the respective indices of 2005 in the following regions: Chukotka AO - at 86%, Republic of Mordovia - 68%, Khanty-Mansy AO - 62%, Omsk oblast - 51%. Interestingly, in 2005 the proportion of corporate profit tax in the budgets of these regions was consid-

46 Novgorod oblast, Republic of Mordovia, Republic of Tatarstan, Khanty-Mansy AO, Omsk oblast, the Republic of Sakha (Yakutia), Chukotka AO. 118

erably greater than the respective average indices reported across the country. As these regions appear so dependent on revenues from corporate profit tax, an "abandonment" of a large taxpayer obviously could not help but trigger a fall in their budgetary revenues.

The maximum increments in tax revenues in absolute terms were reported by the city of Moscow, Saint Petersburg and Krasnoyarsk krai. These regions have displayed a great level of budget sufficiency and reported a great share of corporate profit tax in their 2006 tax revenues structure. For reference, the respective index has slid nationwide from the average 32% in 2005 to 31% in 2006, while the said regions, on the contrary, reported a growth of this index: the city of Moscow: from 44 to 47%, Krasnoyarsk krai - from 35 to 43%, and Saint Petersburg - from 22 to 32% (1.4 times!). However, it was Aginsky Buryatsky AO that posted a record-breaking increment in budgetary receipts per capita in real terms (7.48 times vs. the 2005 level). Such a breathtaking rise in budgetary revenues was caused by the registration in the region of a large corporate taxpayer (in 2006, the local budgetary revenues from corporate profit tax were reported to soar 17.8 times).

As regional budgets appear greatly dependent on corporate profit tax revenues, the situation result in an intensification of the race between regional authorities for getting large corporate taxpayers registered in the respective regions. In this competition regions are not anxious to improve a local investment climate. Rather, they are keen to attract a taxpayer by means of administrative resource or "bribing" him with budgetary subsidies on projects whose implementation is profitable for specific companies.

The problem can be remedied in two ways: first, by curbing the "mobility" of corporate profit tax; second, by getting the budgetary system adapted to prompt and sizeable "migrations" of tax bases.

The former option seems to be the most attractive one, but hard to implement. While Art. 288 of the Tax Code of RF (below referred to as TC of RF) reads that "the organization is bound to deduct a part of its profit to regions where it carries out its operations according to the formula 0.5 (a+b), where a is the proportion of the residual value of the organization's capital assets in a given region, while b is the proportion of salaries and wages or the number of its employees in the region", because of drawbacks of Art. 40 and 20 of TC of RF, "formally independent corporations" not only can conceal a part of corporate profit tax, but even easily "move" their profit from one region to another. But today, from the perspective of tax administration, it appears impossible to solve the problem of transfer pricing.

It is therefore appropriate to once again consider the problem of introduction to the RF tax law of the concepts of consolidated taxpayer and corporate profit tax, which suggests identification of the tax base of this particular tax on the whole by all the taxpayers that form a holding, with a consequent redistribution of tax revenues between budgets of the RF Subjects in the territories wherein the said taxpayers operate. But in all likelihood such a consolidation of legal entities for the sake of payment of corporate profit tax will be voluntary. Hence, the institution of "consoli-

dated taxpayer" will unlikely to fully solve the problem of "migration" of the tax in question.

The other option is to abolish the 4% regional benefit by corporate profit tax. This would bridle the businesses' eagerness to declare profit in certain regions, thus affecting the other ones. But as noted above, today regions mostly "entice" large taxpayers employing administrative means, rather than tax benefits.

Numerous corporations (such as, for instance, Gasprom and Transneft) account a great deal of their assets (pipelines) in the balance sheet of their head companies headquartered in the capital cities. Accordingly, once their corporate profit tax payments are distributed, the regions wherein the said assets are actually located, loose considerable revenues. Thus, it seems fair to distribute corporate profit tax not only between regions where just separate divisions of such organizations reside, but to include regions where their assets are located. This should help make the tax in question less mobile, especially in such sectors as oil and gas transportation. However, again, from the perspective of tax administration, this option also appears hard to implement.

Thus, in the short run it appears unlikely that one would be able to modify the tax law in such a manner, so that to radically "lower" the mobility of corporate profit tax. Hence, it is imperative to have the budgetary system adapted to prompt and considerable migrations of the tax bases. The only rational way to damp sharp fluctuations in regional budgetary revenues is to create regional stabilization funds, as most instruments the federal center so far has employed to this effect have been less efficient47.

The year of 2006 has become the third straight year of an aggregate surplus of consolidated budgets of the Federation's Subjects. In 2006, the surplus accounted for 0.52% of GDP, while the rise in the surplus of consolidated budgets of the RF Subjects accounted for 0.26 p.p. of GDP vs. the 2005 index.

The analysis of quantitative characteristics of the financial aid from the federal budget to the RF Subjects' ones (Table 23) evidences that the volume of the federal financial resources transferred gratis in favor of the subnational budgets dropped insignificantly (at 0.08 p.p, or 3.6% of GDP, vis-a-vis 2005).

Once compared with the recent situation, the 2006 federal budgetary expenditures on provision of financial aid to the RF Subjects and municipalities have undergone certain modifications. Thus, the tendency towards cuts in funding from the Fund for Financial Support of Regions, which had started in 2003, was reversed -the subsidies earmarked from FFSR grew from 0.88% of GDP in 2005 up to 0.94% of GDP in 2006. But, because of the procedure of the annual adjustment of FFSR with account of CPI, it can be forecasted that in the future the tendency should be renewed. Under the same share of public expenditures in GDP, economic growth in real terms should result in a rise of public expenditures at a pace greater than that

47 Nazarov V.S. Nuzhny li regionalnye stabilizatsionnye fondy. - M.: Bankovskoye delo. No. 26, 2007. - P. 40-45 120

of CPI. Furthermore, one can project a rise in public expenditures at a pace advancing that of the economy's growth. It is also possible to suggest that interbudgetary transfers would grow, at least, at a pace equal to that of the federal budget expenditures. Accordingly, the FFSR growth rates should be lagging far behind the growth rates of other interbudgetary transfers. The 2007 federal budget law, which will be considered in a greater detail below, proves the accuracy of the above assumptions: it is envisaged that the overall volume of interbudgetary transfers should grow from 2.17% of GDP in 2006 up to 2.51% of GDP in 2007, while the volume of FFSR should slid from 0.94% of GDP to 0.83% of GDP.

In conjunction with the division of powers between the levels of the budgetary system and the federal center's eagerness to fund its mandates in full, the volume of funds allocated from the Compensations Fund has grown dramatically - from 0.17% of GDP in 2005 up to 0.3% of GDP in 2006. After a rapid growth of the Fund for Co-Financing of Social Expenditures (from 0.04% of GDP in 2004 up to 0.12% of GDP in 2005), which is explained by the monetization of benefits (with subsidies for a partial compensation for the costs of implementation of measures of social support to veterans and other individual categories of citizens), in 2006, the volume of subsidies from the Fund declined insignificantly, to the level of 0.11% of GDP. Plus, subsidies on ensuring measures on maintenance of balanced regional budgets likewise slid only slightly- from 0.24% of GDP in 2005 to 0.16% of GDP in 2006. As a year before, a vigorous employment of this mechanism of financing has aggravated the problem of soft budgetary constraints. The volume of financing from the Fund for Development of Regions and the Fund for the Regional Finance Reform have remained unchanged, each accounting roughly for as much as 0.01% of GDP. Among negative results of the 2006 development of interbudgetary relations one should note a considerable rise in mutual settlements, which forms one of the most non-transparent instruments of interbudgetary relations: they grew from 0.01% of GDP in 2005 up to 0.05% of GDP in 2006.

The period between 2004 and 2005 saw some attempts to ensure a greater transparency in the interbudgetary relations area. Thus, it was 2005 when for the first time ever the FFSR and FC resources were distributed according to the methodology approved by the RF Government's Resolution. The formation and use of the Fund for Co-Financing of Social Expenditures, the Fund for the Regional Finance Reform and a part of subsidies on support of measures on ensuring balanced budgets of the RF Subjects were exercised on a formalized basis. Despite the reform attempts, distinguishing features of this particular kind of the federal budget expenditures still remain considerable amounts of funds distributed according to interbudgetary regulation procedures, without any methodological and financial, and economic justification. The proportion of the 2006 financial aid assigned on a formalized basis in the total volume of transferred resources accounted for less than 60%.

A characteristic feature of the period between 2003 and 2006 became the revision of the budget law and an increase of the originally allocated amounts of fi-

nancial aid to regions (in 2006 alone, at RUR 32 bn.). Notwithstanding that the volume of the additional, i.e. not provided for at the beginning of the financial year, aid to regions was reduced more than twice vis-a-vis its 2005 volume, the mere fact of the existence of a significant source of soft budget constraints compels one to question the efficiency of the completed reform of distribution of financial aid between regions.

To exemplify the current procedures and fundamentals of distribution of additional financial aid, suffice it to note that:

- subsidies to ensure balanced regional budgets were increased from RUR 25 bn to 40 bn, or at 62% over 2006;

- subsidies to budgets of the RF Subjects on diesel fuel consumed to complete seasonal agricultural works were increased from RUR 5 bn up to 12.5 bn (2.5 times);

- subsidies to budgets of the RF Subjects on compensation for teachers' out-of-class activities in the designated by the RF Government types of public and municipal educational institutions were raised from RUR 7.7 bn up to 11.7 bn (1.5 times);

- subsidies to budgets of the RF Subjects on monetary compensations to medical staff at local medical attendant's and obstetric offices, doctors, medical attendants and nurses employed in the ambulance service were raised from RUR 4.7 bn up to 5.1 bn (at 10%).

The above witnesses that launched in 1997-98 process of the interbudgetary relations reform, has recently displayed clear signs of deceleration. As the most recent practices show, the reform of fundamentals of distribution of the federal financial aid is still remains in the government's ordre de jour, as the current system remains insufficiently transparent. It does not therefore allows any conclusions on its efficiency and suggests it may contribute to the rise of negative incentives for regional, as well as local, administrations' budgetary policies. Below we are going to consider changes in characteristics of interbudgetary relations triggered by the 2006decisions in the fiscal federalism and subnational finance areas.

Table 23

Financial Aid out of the Federal Budget to Consolidated Budgets of the Subjects of the Federation in 1992-2006 (as % of GDP)

CN CO LO (0 00 0) o 1- CN CO LO (0

O) O) O) O) 0) 0) 0) 0) o o o o o O O

O) O) O) 0) 0) 0) 0) 0) o o o o o O O

CN CN CN CN CN CN CN

1_2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

1. Financial aid to 1.8 2.3 2.5 1.6 1.18 1.43 1.79 2.2 1.94 1.7 1.65 1.52 1.64 budget of

other tiers

0.05 0.15 0.27

1_2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

1.1. Federal targeted programs, as well as subsidies to the RF Subjects on support of agriculture, water economy measures, support of small businesses, and measures on children's recovery

1.2.Fund for co-financing of social expenditures

1.3. Fund for finan-

0.15 0.11 0.04 0.12 0.11 0.11

0.06 0.08 0.08 0.07

cialsup- 0 0 0.36 1.17 1.04 1.22 1.12 0.99 0.96 1.14 1.36 1.3 1.05 0.88 port of

regions, including: Subsidies on equalization of 0 0 0.36 0.86 0.68 0.86 1 0.99 0.96 1.14 1.36 1.3 1.05 0.88 budget sufficiency State support of the "Northern Supply" Transfers at the

0 0 0 0.31 0.36 0.36 0.12 ------expense

of VAT

1.4. Subsidies and

subven- 0 0.02 0.09 0.06 0.09 0.13 0.1 0.06 0.15 0.54 0.28 0.29 0.27 0.36 tions, including: Subsidies to budgets on support of

measures 0.11 0.24

on securing balanced budgets

1.5.Resou rces of the Fund for reforming regional finance

1.6. Other gratis and irrevocable transfers (subsidies and subventions)

0.94 0.83

0.94 0.83

0.00

0.00

0.21 0.25

0.16 0.16

0 0.01 0.01 0.01 0 0.01 0.01

0.01 0.01 0.01 0.01 0.08 0.13

1_2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

1.7. Fund for financ-

lng re- 0.03 0.05 0.1 0.1 0.15 0.01** 0.01 0.02

gional

development

1.8.Funds transferred

under 0.61 1.95 2.54 0.42 0.81 0.43 0.36 0.14 0.28 0.05 0.2 0.14 0.12 0.01 0.05 0.00

mutual settlements

1.9.Loans and budgetary credits, less loan

repay- 0.09 0.03 0.02 0.04 0.23 0.64 -0.03 -0.1 -0.08 0.02 0.09 -0.01 -0.02 -0.03 -0.04 0.00

ments to other levels of government**

2. Fund

for com- 0.37 0.38 0.36 0.34 0.17 0.30 0.49

pensations

3. Other

!nte,r" 0.18 0.11 0.4 0.45 0.54 0.35 0.33 0.34 0.38

budgetary

transfers Funds earmarked to

biudgets 1.49 2.7 3.4 1.8 2.3 2.5 1.6 1.36 1.54 2.56 3.03 2.84 2.39 2.25 2.17 2.51 of other

levels of government

* By the 2007 budget act.

** Since 2005 - budgetary loans only.

2.4.3. The 2007 Federal Budget in the Part of Allocation of Interbudgetary Transfers to Other Levels of the Budgetary System

The overall amount of funds planned for allocation in favor of regional and local budgets in 2007 accounts for some RUR 784 bn, or 1.3 times more than the respective index of the prior year. It is particularly notable, as the general federal budget expenditures are going to rise 1.23 times. Accordingly, because of a faster rise in interbudgetary transfers to other levels of the budgetary system, their proportion in the federal budget expenditures should grow from 13.5% reported in 2006 up to 14.2%.

The main channel of financial aid to regional authorities is subsidies on equalization of budget sufficiency from the Fund for Financial Support of Regions. Their volume should grow at 14.1% and reach RUR 260.4 bn. It should be noted that 2007 should see the renewal of the tendency to contraction in the proportion of the Fund in interbudgetary transfers to 33.2% (vs. 43.1% in early-2006 as per the 2006 federal budget law and 38.2%, as per the same law as of late-2006).

1999 2000 2001 2002 2003 2004 2005 2006 2007

— The share ofFFSR in ititcrbudgctary transfers

Fig. 10. The share of subsidies from FFSR in the overall volume of interbudgetary transfers to other levels of the budgetary system in 1999-2007

As evidenced by the data presented in Fig. 10, the share of subsidies from FFSR in interbudgetary transfers plunged from 73% in 1999 to 34% in 2007. Given that the methodology of formation of the Fund is among the most non-transparent ones, this tendency is unlikely to be positive. Another associated with the Fund negative novelty of 2007 should become a modification of the methodology of its distribution. While the 2007 Methodology of distribution of subsidies from FFSR displays certain progress vis-à-vis the current one, it should be remembered that the core feature of provision of interbudgetary transfers is predictability and stability over time. If modified once in a year or two, the respective methodology does not contribute much to the stability of the budgetary system. In our view, it is appropriate to revise the existing methodology in the medium term, but its modification, even providing insignificant alterations, should take place, at least, once in 35 years. In the longer run it would be appropriate to raise the proportion of FFSR in the overall volume of interbudgetary transfers, mostly by concentrating in it subsidies to the lower-tier budgets, which are allocated to support measures on ensuring their balances, as well as other transfers whose distribution is conducted without following strict and formalized methodologies.

Since 2005 the Fund for Compensations (below referred to as FC) has been integrating resources allocated for financing all the federal expenditure mandates stipulated in the federal law. The 2007 federal budget law provides for a considerable increase in the volume of FC from RUR 73.9 bn in 2006 up to 153.1 bn (2.08 times). The Federation's interests in regions begin gradually prevailing over the regions' ones, for, as noted above, the principal mission of FC is to finance federal mandates. The main explanation to this is the reform process of the system of so-

125

cial support and assignment to the regional level of significant expenditure obligations. In 2007, subventions from the Fund for Compensations will be spent mostly on the following:

a) subventions to regional budgets on payments for housing and public utilities services delivered to certain categories of citizens totaling RUR 81.7 bn, or 53% of the volume of the Fund (1.39 times more than in 2006);

b) subventions to regional budgets on exercising powers with regard to pursuance of the state population employment policy, including the costs of their administering: RUR 33 bn, or 21% of the FC's pool;

c) subventions to regional budgets on increases of money allowances and wages rises to the personnel of subdivisions of the territorial police, as well that of fire brigades, whose operations are covered from budgets of the RF Subjects and local budgets: RUR 15 bn, or 9.8% of FC.

On the one hand, the federal center's eagerness to finance expenditure mandates is a positive factor for the budgetary system as a whole. On the other hand, given a significant vertical budgetary imbalances and differences in regions' needs, it is equally imperative to boost at the same rate the non-targeted funding provided to regional authorities. Besides, in addition to the aforementioned huge subventions, which are significant to budgets of the RF Subjects, the last federal budget provides for a great number of "small-scale subventions", with the overall volume of financing by eight avenues accounting for less than RUR 1 bn. It should be noted that individual Subjects of the Federation often receive under one of these avenues less than RUR 1 m48. To cite a particular example, in 2007, the Altay Republic should receive RUR 176,000 to back-up powers on compiling (modifying, amending) lists of candidates for juries under the federal courts of law of general jurisdiction delegated to the executive and administrative bodies of municipal entities. The administrative costs associated with the subventions in question (planning and supervision of the respective spending) may exceed the volume of these subventions. We believe it is imperative to revise in the medium term principles of delegation of the

48 1 ) Subventions to budgets to ensure funding of delegated to the executive and administrative bodies of municipal entities powers on compiling (modifying, amending) lists of candidates for juries under the federal courts of law of general jurisdiction in the Russian Federation (RUR 144 mln); 2) subventions to budgets on exercise of powers in the area of organization, regulation and protection of water biological resources (RUR 46 mln); 3) subventions to budgets on exercise of powers in the area of protection nd use of the objects of fauna related to the category of hunting (RUR 31 mln); 4) subventions to budgets on payment of public one-time allowances under any form of placing children deprived of parental care to a family (RUR 677 mln); 5) subventions to budgets on exercise of powers on payment public one-time allowances and monthly compensations to citizens in the event of the rise of post- vaccinal complications (RUR 5 mln); 6) subventions to budgets on exercise of powers on payment to disabled insurance premiums under contracts of compulsory insurance of civil liability of vehicles owners (RUR 34 mln); 7) subventions to budgets on exercise measures associated with transportation between the RF Subjects and within territories of states that hold membership in CIS of minors that without permission have left families, orphanages, boarding schools, special education and rehabilitation centers and other institutions (RUR 34 mln); 8) subventions to the budget of the city of Saint Petersburg on exercise of the supreme executive body of state power in Saint Petersburg of the federal property management powers (RUR 19 mln). 126

powers, for the current procedures of their funding does not ensure a full coverage of regional expenditures on their exercise (for example, the costs incurred by regions on their administration are not taken into account). As well, there is no strict economic justification for efficiency of the delegation of powers, hence, the efficiency of standardization of the process of their delegation can be questioned, as in some regions it can be efficient, but fruitless in others. It is appropriate to examine the efficiency of the current division of powers and, if necessary:

a) to drop the practice of delegating to regions a series of federal powers and to switch to their funding directly from the federal budget;

b) to assign a number of federal mandates to the Federation's Subjects in a full volume, along with the respective increase in the volume of non-targeted transfers and those implying flexible conditions of consumption of thus received funds and/or expansion of the regional budgets' own receipts;

c) to consider a possibility for delegation/centralization of some powers on the contractual basis, with strict and legally stipulated conditions of such contracts. It must be noted that Russia has accumulated a significant negative experience of the contract-based division of powers, while foreign experiences often witness efficiency of this particular mechanism. That is why it would be appropriate to resume consideration of this problem in the long run, which requires an in-depth legal and economic examination.

The 2007 volume of the Fund for Co-Financing of Social Expenditures should grow at a more moderate (1.36 times) pace than that of FC, and it should ultimately account for RUR 35.4 bn This modification was mostly caused by an increase in subsidies to budgets on children's aliment in a trustee's family, as well as on wages payable to adoptive parents.

Besides, it should be noted that in 2007 there should happen drastic cuts in costs of the federal targeted programs on development of the Republic of Tatar-stan and the Republic of Bashkortostan. The costs in question have been fairly huge, as they had been approved to compensate for the termination of the effect of special tax and budgetary arrangements under agreements on division of powers between these regions and the federal center. Recently as much as RUR 20 bn.-plus has been allocated for this purpose, while in 2005-2006 the volume of the respective funding was some RUR 11 bn. In 2007, there exists the only program, that is the federal targeted program "Socio-Economic Development of the Republic of Bashkortostan", which is worth a total of a. RUR 3 bn.

However, the 2007 budget law contains decisions that are aimed at a considerable increase in discretionary interbudgetary transfers. The volume and procedures of such transfers may vary substantially, due to the federal center's discretion. In 2007, there should occur a drastic rise in sectoral subsidies, as well as in the federal targeted programs on support to individual regions:

- subsidies to regional budgets on support to the agricultural sector - RUR 27.6 bn ( 1.6 times more than in 2006;

- subsidies to regional budgets on construction and modernization of territorial and municipal roads, including those in settlements, and road construction in

new areas of mass low-rise and apartments blocs construction, which will be worth a total of USD 35 bn (no such subsidies existed in 2006);

- subsidies on the monthly cash compensations for out-of-class activities at public and municipal schools of general education, worth a total of RUR 11.7 bn (1.5 times more than the respective amount provided for the start of the 2006 financial year);

- the federal targeted program "The social development of the rural areas through 2010", worth a total of RUR 5.5 bn;

- RUR 2 bn to fund establishment of technoparks operating in the high-tech areas;

- the federal targeted program "Restoration of the economy and social sphere in the Chechen Republic (in 2002 and subsequent years)" - RUR 11.9 bn (a 17fold increase vs. the respective volume of 2006);

- RUR 4.9 bn to fund the federal targeted program "The South of Russia" (a 2-fold increase vs. 2006);

- RUR 4.5 bn to fund the federal targeted program "The economic and social development of the Far East and Transbaikalia in 1996-2005 and through 2010" (1.6 times more than the 2006 level).

The subsidies allocated to the RF Subjects on support of measures on securing their budget balances should grow 1.24 times vs. 200649.

A drastic increase of discretionary transfers that displays no strict binding with the regions' budget sufficiency or funding of federal mandates can introduce distortions to the subnational authorities' fiscal behavior. For instance, a region that enjoys a greater level of budget sufficiency prior to the receipt of interbudgetary transfers may loose its advantages upon receiving financial resources from the federal center. That will diminish its appetite for an independent embarkation on measures aimed at boosting its fiscal capacity, i.e. economic growth rates.

2.4.4. Concept and Methodology of Advancement of Interbudgetary Relations in the Russian Federation and its Subjects in 2006 and in the Medium Run

With its Resolution of April 3, 2006, No. 467-p, the RF Government approved the Concept of increasing efficiency of interbudgetary relations and quality of supervision of public and municipal finance in RF in 2006-08 (below referred to as Concept) and an action plan on its implementation.

The Concept addresses the following challenges:

1. Solidification of financial independence of the RF Subjects;

2. Creation of incentives for boosting revenues to budgets of the RF Subjects and local budgets;

3. Creation of incentives for improvement of the quality of control over public and municipal finance;

4. Enhancement of transparency of regional and municipal finance;

49 On negative influence of this kind of interbudgetary transfers on the subnational authorities' fiscal behavior see the IET 2004 and 2005 annual issues "Russian Economy: Trends and Outlooks". 128

5. Provision of methodological and consultancy assistance to the RF Subjects for the purpose of enhancement of efficiency and quality of control over public and municipal finance, as well as for the purpose of implementation of the local self-governance reform.

Below, we will consider in a greater detail main measures suggested by the Concept and their possible impact on the state of interbudgetary relations in Russia.

Solidifying financial independence of the Subjects of Russian Federation

To tackle this task, the Concept suggests provision of stability of the tax law and interbudgetary relations in Russia for the sake of trustworthy and objective budget planning in the medium term. It is suggested to exclude a possibility of introduction of modifications on the federal level to the budget and tax legislation in the part of taxes and levies collected to budgets of the RF Subjects and local budgets that may result in a contraction of the tax base, as well as modifications of expenditure obligations of the regional budgets without adequate compensation from the federal budget. It should be noted that with all the indisputable accuracy of such a decision, the bulk of amendments to the budget and tax legislation in the part of taxes and levies collected to the noted budgets that result in the contraction of the tax base has been already passed (abolition of turnover taxes, sales tax, centralization of the mineral tax, and abolition of a number of minor regional taxes and charges, etc.). With that completed, the approach suggested by the Concept (that is, a full compensation payable from the federal budget to regions for their losses resulting from implementation of such measures) recently has not always prevailed. But with account of the imperfection of the national tax system, the priority of the tax reform relative to the need for securing the stability of interbudgetary relations has not been questioned.

Plus, most tax bases appear overlapped, and a change of procedures of calculation of a given tax may entail changes in other tax bases. The federal center can amend the tax law in the part of taxes and levies collectable to the federal budget, which may result in a contraction of the tax base in the part of taxes and levies subject to collection to regional and local budgets. For example, an increase of import duties that are collected exclusively to the federal budget may result in a contraction of the corporate profit tax base, a considerable proportion of which is collected to budgets of the Federation's Subjects. According to the Concept, such a contraction of the tax base does not require any compensation from the federal budget, albeit its effects on the consolidated budget of a given Subject of the Federation to a significant extent appear analogous to the direct centralization of corporate profit tax in the federal budget. Thus, the suggested by the Concept way of securing stability of the tax law and interbudgetary relations in RF appears formally correct, however, in reality it faces fairly rigid constraints. This calls for calculation in the medium run of the vertical budgetary imbalance with account of revenue sources, their instability, and expenditure obligations of all the levels of government. With account of thus calculated value of the vertical budgetary imbalance,

that should ensure a match between revenue sources and expenditure obligations of all the tiers of government.

To enable regions to efficiently exercise the medium-term budget planning, the Concept provides for timelines with regard to enactment of federal acts on introducing amendments to the RF law on taxes and charges effective since the start of next financial year. Such federal acts should be promulgated no later than in a month prior to the date of submission to the State Duma of the Federal Assembly of RF of the bill on the federal budget for next financial year.

To the same effect, the Concept suggests to specify the composition of the budget classification by completing the transition to the legislative approval of uniform (to all the budgets of the national budgetary system) groups and subgroups of the classification of expenditures, groups and items of operations of the public administration sector, as well as to introduce an ultimate timeline for introduction of amendments to the budget classification.

An important novelty suggested by the Concept became new procedures of the annual indexation of the volume of resources of the Federal Fund for Financial Support - in the event the actual level of inflation (CPI) in the reported year has proved to be greater than the projected one, it is necessary to increase the volume of resources of the Federal Fund for Financial Support of the RF Subjects by the difference between a volume of FFSR resources approved for the reported financial year and an estimated volume of its resources, proceeding from the actual inflation rate multiplied by inflation rates projected for the current and next financial years. These procedures of indexing the FFSR volume compensate for a greater inflation rate vis-a-vis the projected one, bit with a one-year lag. If, for instance, in 2007 inflation is higher than planned, the 2007 FFSR volume should remain unchanged, while that for 2008 should be increased. It has to be noted that such a lag is likely to form a permanent defect, the significance of which would be reduced to minimum under a far lower inflation rate and/or a better quality of projecting of the consumer prices dynamic. Thus, these particular procedures of indexing the FFSR volume can be indisputably perceived as positive ones.

The Concept also specify another critical avenue of addressing the objective of solidification of the RF Subjects' financial independence, namely, improvement of the structure of interbudgetary transfers allocated from the federal budget. In addition to main forms of provision of interbudgetary transfers (FFSR, FC, the Fund for Reforming Regional and Municipal Finance, the Federal Fund for Co-Financing of Social Expenditures, the Federal Fund for Regional Development, and budgetary loans), whose formation and distribution has been mostly formalized, under the evolving tax system and assignment of expenditure obligations from one level of the budgetary system to another, there occurred a rise in the employment of other interbudgetary transfers in the form of subsidies and subventions. They are allocated beyond the formalized system framework, without linking them to the current financial aid delivered in the frame of the main forms of interbudgetary transfers and without account of the regions' level of budget sufficiency. That substantially diminishes effects from provision of interbudgetary transfers on the whole. The Concept declares the necessity of systematization of the allocated interbudgetary

transfers, including a strict observance with the principle, according to which the financial aid should be allocated with account of the level of budget sufficiency of a given Subject of the Federation.

The Concept pays a particular attention to improvement of mechanisms of distribution of investment financial aid the federal budget allocates to the Subjects of RF. Given the promulgation of the federal acts on division of powers between the federal bodies of the state power, government bodies of the RF Subjects and local self-governance bodies, it is proposed to distinguish the financing of investment measures that result in the growth of the federal property from those which entail the rise in the regional property.

The Concept also suggests to design and introduce mechanisms of monitoring and evaluation by the federal bodies of executive power of efficiency of exercise of powers the federal center assigns to the government bodies of the RF Subjects and local self-governance bodies, and to increase responsibility for exercise of the delegated powers. Basing on the 2005 data on consumption of subventions from the Federal Fund for Compensations, it is proposed to introduce modifications to the procedures of submission by the RF Subjects of reports on execution of the assigned powers, to introduce to the practice of the federal bodies of executive power a preparation of annual reports, which will evaluate the efficiency with which the RF Subjects exercise the delegated powers. The monitoring system in question is likely to induce two different effects, that is, on the one hand, such a system may help promptly identify defects of the delivery of public goods and improve its quality. On the other hand, provided a great deal of public goods delivered by regional administrations falls on "the federal mandates", it will help the federal center to tighten its control over regional authorities. That would lead to a degradation of competitive features of the Russian federalism in favor of corporative ones. The federal center would be increasingly perceiving its regional counterparts as branches of the same corporation, which will inevitably result in a serious unification of most expenditure programs and, consequently, in an equally inevitable fall in their utility function for many Russian regions.

Creating incentives to boosting revenues to budgets of the RF Subjects and local budgets

The Concept suggests a dual policy in the area of creation of incentives that should help boost revenues to budgets of the RF Subjects. On the one hand, the policy implied a tighter control over the so-called "subsidized regions", while offering incentives to regions that have managed to expand their tax bases on their own, on the other.

Overall, the approach appears rational, however, specific ways of its implementation can be questioned.

First, in order to create incentives to the RF Subjects and local authorities to boost revenues to their respective budgets, the Concept proposes to legally introduce conditions of execution of budgeting for the RF Subjects depending on the extent to which they are subsidized. On the basis of proportions of interbudgetary transfers allocated from the federal budget over the past 2 of 3 reported years (except for funds assigned for the sake of exercising the delegated powers) in the vol-

ume of their own budget revenues, the RF Subjects are split into three groups, each being subject to different requirements.

So far as the RF Subjects in whose budgets the share of financial aid from the federal budget does not exceed 20% of the volume of their own revenues, are concerned, the Concept suggests application of general measures set by RF the budget law in the part of compliance with caps on the ultimate size of an RF Subject's public debt and budget deficit.

As concerns the RF Subjects in whose budgets the proportion of financial aid from the federal budget accounts for between 20 and 60% of their own revenue volume, the Concept suggests introducing additional caps on expenditures on maintenance of government agencies and labor compensations to public servants of an RF Subject, as well as introducing observance with ultimate sizes of wage rises payable to budget employees.

In addition, the Concept suggests introducing for such RF Subjects a provision regarding compulsory compliance with the RF Ministry of Finance's regulations with regard to budgetary matters, which are primarily aimed at elimination of problems in the part of accounts payable that arise in the course of the budget execution.

For the RF Subjects, in whose budgets the proportion of financial aid from the federal budget accounts for over 60% of their own revenues, it is imperative to set the following requirements with regard to control over efficiency of their consumption of budgetary funds:

- introduction of additional caps on the volume of their public debt and budget deficit;

- compulsory conclusion of agreements with the RF Ministry of Finance on measures on increasing efficiency of consumption of budgetary funds and tax and non-tax revenues to the budget of a RF Subject;

- imposition of a ban on financing out of budgets of the RF Subjects of measures that, according the RF Constitution and law, do not fall under jurisdiction of government bodies of the RF Subjects;

- conduct of an annual examination of the execution of the budget of a RF Subject by the Accounting Chamber of RF or the Federal Service for the Financial and Budget Supervision.

It is proposed to introduce similar requirements to relationship between the RF Subjects and municipal entities.

Such an approach appears methodologically incorrect.

First, the Concept and the Budget Code contain rather vague formulations of some requirements to the "subsidized regions" in. The Budget Code presently sets a number of restrictions with regard to the RF Subjects' budgetary policies, however, the failure to formally comply with restrictions approved by the Budget Code often appears related to imperfection in the formulations of the requirements in question. Thus, in compliance with the Budget Code, one of the conditions of eligibility for subsidies from FFSR is observance with the correlation between the size of labor compensations due to civil servants of the RF Subjects and the respective categories of the federal civil servants. The realization of this condition as a direct-

acting provision entails contradictions, as the mission of the territorial bodies of the federal government differs from that exercised by bodies of regional administrations. Their functions, an organizational structure and competence likewise differ from each other. Government bodies of the RF Subjects can practice their own approaches to improvement efficiency of the government and municipal service in a region, which can suggest greater labor compensations vis-a-vis those due to the staff of the territorial subdivisions of the federal bodies of the executive power. A correct comparison between the respective levels of labor compensations is inhibited by the lack of a formalized methodology of the comparison between sizes of labor compensations between the two groups concerned (which would otherwise take into account the above factors).

At the same time, in compliance with the budget law, in a municipal entity, to which subsidies are granted from the budget of the RF Subject, the sizes of labor compensations to local legislature, members of the elected local self-governance administration who exercise their powers on the permanent basis, and municipal staff are set at a level not greater than capped values set by the Subject's local law, which suggests setting amounts of labor compensations by each position and kinds of additional compensations. This suggests not only a detailed regulation of operations of local self-governance bodies in the part of the staff policy and list of members of staff, but requires considerable time and efforts on the part of the staff of the RF Subject. As well, it conflicts with provisions of Federal Act of Oct. 6, 2003, No. 131-FZ "On general fundamentals of organization of local self-governance in the Russian Federation".

The above necessitates respective amendments to the RF law, which should specify both requirements themselves and measures on enforcement of compliance with them, designing detailed procedures, which should introduce a methodology of evaluation of compliance with the requirements of the budget law and regulations of sanctions against those RF Subjects that breach the law, including economic and administrative mechanisms.

Secondly, so far as solidification of the regional authorities' financial independence is concerned, it appears inappropriate to give preference to the measures that per se imply introduction of various sanctions against the regions that receive great volumes of financial aid from the federal budget. There are, at least, two reasons for such an assertion.

First, a possibility for imposition of restrictions for the regions due to reasons not associated with a violation of the budget law or an inefficient spending of budgetary funds, may give a rise to incentives to distort the respective statistical data and a lower transparency of the budgeting, rather than a boost to the taxbase, which clearly conflicts with other provisions of the draft Concept.

Secondly, it is appropriate to introduce restrictions to the budgetary policy, as well as the external financial management, in the event of exposure of facts of an inefficient public finance management, which entailed the rise of excessive obligations of the public sector and outstanding debts. But such measures exercised by superior authorities, as a rule, are coupled with a provision of additional financial resources.

Meanwhile, given Russia's federative structure, a great proportion of financial aid in the conditions of existence of an interbudgetary equalization program (which in Russia is de facto represented by subsidies on equalization of the RF Subjects' budget sufficiency) does not a priori mean inefficiency in the public finance management area, as well as the situation of financial crisis in a given Subject of the Federation. Given that, such an indicator as the proportion of funds received from the federal budget in the form of interbudgetary transfers in the regional budget revenues can be determined by various factors, of which worth noting are the structure of the methodology of distribution of interbudgetary transfers, an overall amount of funds the federal authorities allocate for the sake of interbudgetary equalization, as well as other factors that do not depend on the regional authorities' decisions. In other words, a great proportion of financial aid in the regions' own budgetary revenues does not mean inefficiency in the public finance management area, but this phenomenon can be spotted even in those Subjects of the Federation that pursue a sound budgetary policy.

At the same time it should be noted that the bulk of financial aid from the federal budget is formed by non-targeted transfers, i.e. administrations of the RF Subjects are not bound with any conditions that would otherwise dictate areas, on which the federal resources should be spent (accordingly, even a greater volume of financial resources granted to them from the federal budget in the form of subsidies on equalization of their minimum budget sufficiency does not mean the necessity to control the targeted consumption of the funds in question).

As a result, the suggested remedy to the problem of creation of incentives to regional budgets to boost up their revenues may lead to punitive measures against the RF Subjects to whom such penalties do not pose a real threat. Meanwhile, it is equally undesirable to create a situation in which in the short run all the federal and regional authorities' attention and efforts would be centered on introduction of the aforementioned capping into highly subsidized regions and municipal entities, as problems of rehabilitation of regional and municipal budgets, creation of incentives for development of their tax bases, increase in the efficiency of financial management and, in particular, introduction to the national practice of the institution of external financial management, will per se be left beyond the framework of the discussion.

Thus, it is appropriate to introduce caps and restrictions into the budgetary policy, as well as the external financial management, upon exposing facts of an inefficient public finance management that has entailed a rise in excessive obligations of the public sector and outstanding indebtedness.

To ensure rehabilitation of regional finance, it is appropriate to apply certain measures to regions in a crisis situation, which differ form measures applied to regions that meet insolvency criteria. While contributing to the World Bank project entitled "Improvement of legislation on interbudgetary relations and subnational finance", the IET experts have already suggested a series of measures to prevent financial crises in Russian regions and create incentives for a sound public finance management on the regional level. In the most general form, they are as follows:

1. Regions in the situation of the financial crisis.

We propose to formulate the concept of a region (municipality) in the state of financial crisis as follows:

"A Subject of RF (municipal entity) in the state of financial crisis is the Subject of the Federation (municipal entity) whose volume of payments on servicing and repayment of its public (municipal) debt due in the current or regular financial year is in excess of 20% (or, optional, 30%) of the total volume of its revenues projected for the respective year, with account of non-targeted financial aid from the highertier budgets".

Once given this status, the region has a chance to receive an additional financial aid in the form of a long-term budgetary loan from the federal budget, providing it fulfills a regional finance rehabilitation program approved by the federal Ministry of Finance and legitimized by an agreement with the RF Government.

The main characteristics of the region in the state of financial crisis are:

- voluntary (by application) nature of granting the status;

- position of the region that has applied for such a status matches certain criteria;

- possibility to receive additional financial aid from the federal budget upon receiving the status in question;

- entering in the respective agreement with the RF Government, which should contain, as its inseparable part, a regional finance rehabilitation program and obligations assumed by the RF Subject with respect to observance with the program.

It is also necessary to consider a possibility for adjusting the respective provisions of the Budget Code of RF associated with the introduction of the new status, as follows:

1) to consider the possibility for provision to the RF Subjects, which have been granted the status of the region in the state of financial crisis, of long-term budgetary loans for the purpose of implementation of a regional finance rehabilitation program. That said, it appears appropriate to split the amount of the loan into several parts and introduce conditions of transferring each of them against completion by the region of the respective part of the program or its demonstration of some progress in implementation of individual measures. This should form a key precondition that would help enforce implementation of such an agreement;

2) to modify requirements of the Budget Code with regard to caps on the volume of the public debt of an RF Subject, costs of its servicing and an ultimate size of the budget deficit, so that the federal center could be able to disburse a budgetary loan to the region in the state of crisis.

2. Regions that meet the insolvency criteria.

By contrast to the "crisis" regions, where the failure to fulfill public obligations appears possible, the regions that meet the insolvency criteria are those wherein the failure has already occurred. The federal center, therefore, has to impose direct enforcement measures on such regions to ensure improvement of their finance.

The main instrument with which the federal center can exercise influence on regional authorities' budgetary policies is interbudgetary transfers. Should the regional legislature refuse to include in the local budget law measures provided for by

a given rehabilitation program, the upright effect of such a move shall be deprivation of the region of some kinds of interbudgetary transfers. This is where the difference between the status of the region (municipality) that meets insolvency criteria from the status of the region in crisis lies.

But, whereas a discontinuation of provision of the federal financial aid and collection to regional budgets of revenues from the federal taxes form very strong enforcement instruments, which practically excludes the possibility to oppose to the Federation's requirements, their application should imply certain legal constraints.

A bill on measures on regulation of debts accumulated by the RF Subjects and municipalities that meet the insolvency criteria should enumerate a closed list of measures that can be included in a budget rehabilitation program. The set of the measures should vary, depending on a concrete volume of the debt due to the restructuring, the extent to which a given region is subsidized, the structure and volume of its minimum budget expenditures, and other significant factors. Such a bill should specify bounds for differentiation of measures on rehabilitation of an insolvent regional (municipal) budget.

The Concept also offers stimulatory measures to regions that have increased their tax base on their own: it is envisaged to introduce amendments to the methodology of allocations of subsidies from FFSR, which will ensure creation of a mechanism of encouragement of government bodies of the RF Subjects to develop their own tax bases. The stimulatory effect will be ensured by specifying procedures of calculation of the said subsidies, which should not provide for their contraction, once an RF Subject displays socio-economic development indices greater than the average nationwide ones.

From the economic perspective, this measure raises questions, but it appears justified from the political perspective. Theoretically, in the frame of the 2006 methodology of allocation of subsidies from FFSR there existed an inverse relation between the volume of subsidies from FFSR and GDP growth rates, i.e. from the perspective of the formal cause-and-effect relation, there was no direct stimulation to GDP growth with the use of the FFSR subsidies. Regional authorities often criticized this particular aspect of allocation of subsidies from FFSR, but it is worthwhile noting that to a significant extent their criticism was steered by political reasons. First, it will be only a few years later when an accelerated growth in GDP could have a negative effect on the volume of the FFSR subsidies. Secondly, the regional authorities practically could not foretell a decline in GRP and growth in subsidies from FFSR, nor they could benefit from the phenomena, i.e. the 2006 methodology did not create negative fiscal incentives for them. Thirdly, there is no country in the world where subsidies on equalization of the level of budget sufficiency are aimed at stimulation of economic growth. Rather, they are aimed at ensuring a country's balanced budgetary system. Despite lax economic arguments against the 2006 methodology of distribution of FFSR and particularly its negative effect on the regions' fondness of economic growth, the RF Ministry of Finance has preferred to opt for an insignificant modification of the subsidies distribution formula, so that to ensure a positive political effect. The modification appeared absolutely justified from the perspective of the real economic policy, for upon an insignificant modifi-

cation of the methodology of distribution of the FFSR subsidies, which is one of the most transparent and economically rational methodologies of allocation of interbudgetary transfers in Russia, the ranks of its critics should thin out. Time will show whether, from the perspective of a real stimulation of economic growth and budgetary and tax discipline in the regions, such a modification of the FFSR methodology is efficient. Meanwhile, the modification in question appears fairly disputable from the methodological perspective. Every single government regulation instrument must first of all address a certain challenge, without affecting remedies to other problems. Thus, subsidies on equalization of the level of budget sufficiency must first of all secure the possibility of provision of an equal level under equal tax efforts in all the regions, but without disincentives to regions keen to boost their budget sufficiency on their own. But an efficient encouragement of regions to do so is most likely to happen once other government regulation instruments are applied.

Creating incentives to improvement of the quality of public and municipal finance management

The reform of division of powers has legitimized a considerable part of powers with regard to subjects of joint jurisdiction of the Federation and its Subjects by assigning such powers to the latter. Accordingly, the level of efficiency of the use of regional finance will have quite a strong cumulative impact on efficiency of the public sector on the whole.

To intensify incentives for improvement of the quality of public and municipal finance management, the Concept provides for the following:

- increase in the number of the RF Subjects and municipal entities selected to grant them subsidies according to results of the evaluation of regional and municipal finance reform programs;

- improvement of the current selection mechanisms by assigning a greater part to indices that determine the quality of the regional and municipal finance management;

- introduction of a system of the annual rating-based evaluation of performance by government bodies of the RF Subjects with regard to finance management, primarily their use of new fundamentals of result-oriented budgeting and medium-term budget planning. Creation of a system of financial rewards available to Subjects of the Federation that have been earned greater scores;

- revision of principles of provision of financial aid granted on terms of co-financing, to secure implementation of powers of government bodies of the RF Subjects that form priority powers for the Russian Federation. It is suggested to concentrate funds for provision of the said aid in a specially created Federal Fund for Co-financing of Expenditures. While identifying the level of co-financing from the federal budget of certain powers funded from budgets of the RF Subjects and/or local budgets, it is suggested to employ a mechanism of differentiated identification of volumes of the provision of subsidies, with account of the finance management quality indices. For example, should an RF Subject fail to fulfill set by its law obligations by accumulating a growing volume of the respective accounts payable, it is envisaged to reduce the amount of federal subsidies due to the region. Quite logically, should there be no debt or its amount is on the decline, the

region should be awarded with a greater volume of financial aid. That should allow development of incentives for the RF Subjects to enhance the quality of implementation of their own powers and avoid the rise of debts.

The measures on creation of incentives for improvement of the quality of the public and municipal finance management, especially in the part of intensification of the co-financing of the priority social expenditures from the federal budget, appear fairly justified. The urgency of intensification of the role played by the co-financing of the social expenditures is caused by a considerable vertical imbalance in favor of the federal budget, on the one hand, and the federal center's opting for its own expenditure obligations as a means of the vertical equalization. A notable increase in the federal budget expenditures and the national projects in progress prove the assumption. But with all its administrative and political attractiveness, this option suffers a number of defects. First, it took much time and a lot of efforts to complete the division of expenditure powers - with the promulgation of federal acts No. 122-FZ and 199-FZ, the health care, education and the housing and public utilities sectors now mostly falls under the regional authorities' jurisdiction50. Today, the national projects have de-facto revised the division in question. Secondly, one of the major pluses of federalism is delegation of expenditure powers to subnational authorities, aka the regional expenditure autonomy. It is possible to single out two major advantages of the assignment of implementation of social programs to the regional level:

- it is much easier to local authorities to take into consideration the local residents' preferences (as the federal center cannot fully account them - while one region displays the necessity of a wage rise for physicians, another one may be in a greater need for specialist doctors or medical centers);

- there exists room for innovations in the course of implementation of government programs by different regions (the federal center will always favor unification - a perfect illustration is payment by the federal center of an equal rise in wages to all the physicians nationwide, without regard to regional peculiarities).

The only advantage of a federal expenditure program is that it guarantees an equal accessibility to public goods to all the citizens of a country.

Thus, the best way to regulate the vertical budgetary imbalance in Russia is to employ the mechanism of co-financing of the priority social expenditures (to create

50 See 1) Art.11.1 of Federal Act of Aug. 22, 2004, No. 122-FZ "On introducing amendments to legal acts of the Russian Federation and recognition invalidity of some legislative acts of the Russian Federation due to the enactment of the federal acts "On introducing amendments to the Federal Act " On fundamentals of organization of legislative (representative) and executive bodies of state power of Subjects of the Russian Federation" and "On fundamentals of organization of local self-governance in Russian Federation".

2) Chapter 3 of Federal Act of Oct 6, 2003, No. 131-FZ "On fundamentals of organization of local self-governance in Russian Federation".

3) Art. 26.3 pp. 13 and 21 of Federal Act of Oct. 6, 1999, No. 184-FZ "On fundamentals of organization of legislative (representative) and executive bodies of the state power of Subjects of the Russian Federation".

4) Federal Act of Dec. 31, 2005, No. 199-FZ "On introducing amendments to individual legislative acts of the Russian Federation due to the improvement of division of powers".

5) Art. 29 of Federal Act of July 10, 1992, No. 12-FZ "On education". 138

a national analogue to CHST51), that is, a block transfer to the regions, which is aimed at the financing of the national priorities. It is the Federation that sets the volume of such a transfer and secures an equal access to the public goods for all the citizens. The volume of the transfer should be comparable with volumes of financing provided by the national projects program. The block transfer should grow in the course of completion of the national projects - after 2008 it is desirable to accomplish the transition towards financing the national priorities in the health care, education and housing areas (including the housing and public utilities sector) by means of the transfer. Meanwhile, the federal budget will have to allocate funds solely on interregional projects of national significance. Notwithstanding that proposed in the Concept measures on the co-financing of the priority social expenditures from the federal budget so far have not implied creation of such a block transfer, it can be asserted they form steps in the right direction.

Enhancing transparency of the regional and municipal finance

The Concept pays a particular attention to the fact that presently there is no complete picture of modus operandi of the public finance sectors at the regional and municipal levels, nor there is a uniform methodological basis for collection, processing and provision of such information. The problem appears particularly pressing at the municipal level, with data on municipal entities both of settlement and district types being fairly poor.

To have municipal entities efficiently exercise their powers on formation and distribution of interbudgetary transfers, the Concept suggests expanding possibilities for the use of tax reports and enhancing their quality and comprehensiveness by forming them by each municipal entity. Proceeding from that, the RF Ministry of Finance is going to design procedures of formation, running and dissemination of a single data base, which would characterize the state and quality of management of budgets of the RF Subjects and local budgets, and to ensure a free access to the base on the Internet. In addition, it is planned to develop uniform principles of compilation of statistical data on all the levels of government to compile the regional and municipal socio-economic performance indicators using a uniform methodology and to ensure their harmony with the respective federal-level indices.

The Concept emphasizes the need for introduction into practice of public annual accounts of government bodies of the RF Subjects and local self-governance bodies and for development of recommendations on their drafting and performance indicators in particular. Such public accounts should include reports on the government bodies' performance over the past period and plans to improve efficiency of the regional and municipal finance management in the forthcoming period.

The Concept assigns a special role in implementation of the budgetary reform and shift of focus in budgeting from "budgetary resources (costs) management" to "results management" to a non-partisan evaluation of government bodies of the RF

51 CHST (Canadian Health and Social Transfer) is the Canadian transfer on medical services and social insurance formed by subventions calculated proceeding from needs of a given province. Despite thus allocated funds are targeted, the Federation does not produce detailed conditions of their spending, which results in a great diversity of medical programs across Canadian provinces. - see Harvey Lazar. Money, politics and health care. The Institute for Research on Public Policy, 2004 .

Subjects and local self-governance bodies' performance. It is proposed to exercise the function not only with the help of accounting and control chambers, but by hiring independent audit companies, which is fully consistent with the best international practices.

Providing methodological and consulting assistance to the RF Subjects for the purpose of increase of the efficiency and quality of public municipal finance management and implementation of the local self-governance reform

The Concept suggests the following solutions to the problem:

- to continue developing model legal acts of the regional and municipal levels, and methodological recommendations;

- to improve the system of regional and municipal statistics that provide the necessary informational base of socio-economic performance indicators of different territories;

- to carry out training and retraining of the respective specialists on the level of the RF Subjects and municipal entities, publication of textbooks and methodological manuals, and creation of a single data base on the progress with the municipal reform, which will integrate and make available to the public at large necessary auxiliary materials and the best public and municipal finance management practices.

To implement the last of the aforementioned avenues, it is planned in the upcoming three years to complete training programs of the municipal staff, primarily the federal cadres, which will be done particularly in the framework of the federal targeted program of state support of development of municipal entities and creation of conditions of implementation of the constitutional powers of local self-governance.

In the transitional period of the reform implementation the RF Ministry of Finance will organize the work on sharing experiences between the RF Subjects in order to select an optimal way of the reform implementation.

To deliver the methodological assistance to the RF Subjects on increasing the manageability of the public and municipal finance, the RF Ministry of Finance will develop recommendations to the RF Subjects and municipal entities on the following guidelines of the budgeting reform:

- increase of effectiveness of budgetary expenditures;

- improvement of the medium-term financial planning;

- improvement of the system of the regional and municipal debt management;

- implementation of measures on preclusion from the rise of facts of the RF Subjects' insolvency.

2.4.5. New Methodology of Allocation of Subsidies on Equalization of Budget sufficiency of Subjects of the Federation

With its Resolution of September 18, 2006, No. 580 the RF Government introduced substantial modifications to the methodology of distribution of the FFSR subsidies. Accordingly, the 2007 subsidies from FFSR have been computed using

the new methodology. One can single out the following novelties in the 2007 procedures vis-à-vis the earlier ones:

1. While identifying a region's tax capacity, the procedures of calculation of value-added have been modified. If the growth rate of the value of value-added across the region is superior to the respective index averaged nationwide, the value of the value-added by the given Subject of RF is calculated proceeding from the average nationwide level. This provision allows additional benefits for the most vigorously advancing regions, as the initially designed level of their tax capacity proves to be lower than the actual one.

Two modifications below mirror a gradual transition to 100% payment by the population for housing and public utilities services in the frame of the respective reform currently in progress in the country. As well, they reflect the eagerness of the RF Ministry of Finance to encourage regions to pursue the reform.

2. Specific weights employed to identify the budgetary expenditures index (BEI) have been modified. The proportion of expenditures on labor compensations (including charges on labor compensations and other expenditures influenced by the level of labor compensations) in BEI remained unchanged and accounts for 0.55, while the specific weight of other expenditures has grown from 0.2 to 0.35, because of a fall in the proportion of expenditures on the housing and public utilities (and other costs whose formation is influenced by costs of the housing and public utilities services) from 0.25 to 0.10.

3. While calculating the coefficient of costs of the housing and public utilities services (which forms a part of the budgetary expenditures index) the marginal costs of the services in questions (including capital refurbishment costs) are substituted by costs computed on the basis of economically justified tariffs (still with account of the capital refurbishment costs). At this point, it should be noted that in the event the Federal Service for Tariffs introduces marginal indices of a maximum possible modification of the HPU tariffs, it is the very indices that should be used for computations.

4. Because of the aforementioned modifications in the methodology and in order to compensate for the regions' respective losses, since 2007 there has been established the second, additional part of FFSR. The Fund now includes resources needed to bring the 2007 volume of subsidies from the Fund to its 2006 level. This particular part of FFSR is also allocated in two stages. At the first stage, one calculates the volume of subsidies due to the regions whose designed volume of subsidies from the Fund for 2007 is lower than the 2006 volume of subsidies. At the second stage, the rest of the funds available after calculating additional subsidies is distributed between those Subjects of RF whose growth rates in subsidies from FFSR for 2007 are greater than in 2006, but lower than the average nationwide level computed without regard to the additional subsidy (of the first stage). It should be noted that, while computing additional subsidies from the second part of FFSR, one employs an adjusting index of fulfillment of measures on lowering accounts payable and boosting revenues to the RF Subject's budget. This index comprises three components that take into consideration the dynamic of the change in the following parameters: the proportional weight of accounts payable in the Subject's budget

revenues; the overall volume of accounts payable in the regional budget; and the total volume of budget revenues. The new methodology also contains the following provision: the overall volume of the 2007 subsidy to an RF Subject, with account of the additional subsidy earmarked at the first stage, may not exceed the volume of subsidies from the Fund provided for by the Federal Act "On the 2006 federal budget". Given that, with account of an additional subsidy assigned at the second stage, the overall volume of the subsidy may not exceed the volume of the subsidy from the Fund provided for by the Federal Act "On the 2006 federal budget" increased by the average nationwide level of growth of FFSR (without regard to the additional subsidy).

The regulations of distribution of the second part of FFSR entail breaching the "principle of monotonousness", i.e. an RF Subject that enjoyed a greater level of budget sufficiency prior to the equalization does not retain its rank afterwards52. The group of losers has been formed by 31 regions53, while the one of victors -by16 ones54. The breach of the principle in question forms a substantial drawback of the new methodology, but one should bear in mind that observance with the principle poses a problem even in the frame of the existing budgetary system, while it becomes hardly doable in the event of the transition to a three-year budgeting.

Overall, one should note the ambiguity of the 2007 novelties in the methodology of allocation of the FFSR resources: on the one hand, most of them pursue the goal of creation of incentives to improve efficiency of the regional finance management, with a parallel compensation for whatever probable losses that may arise due to changes in the methodology, while, on the other hand, subsidies from the second part of the Fund break the principle of monotonousness in their allocation. Plus, as already noted above, subsidies on equalization of the budget sufficiency level should first of all ensure the possibility for the provision of an equal level of budgetary services vis-à-vis equal tax efforts by all the regions, providing there is no discouragement of regions' attempt to boost the level of their budget sufficiency on their own. But an efficient stimulation of regions to boost their tax capacity is most likely to become possible under employment of other government regulation mechanisms.

There also are other novelties associated with FFSR in 2007. More specifically, there will be 68 regions that will receive subsidies from FFSR, or at 3 regions more than in 2006. Underlying this change are the following causes:

52 The IET computations on the basis of the data of the RF Ministry of Finance.

53 Volgograd oblast, Arkhangel oblast, Tula oblast, Krasnodar krai, Republic of Karelia, Orel oblast, Kursk oblast, Khabarovsk krai, Kaluga oblast, Tver oblast, Vladimir oblast, Voronezh oblast, Kostroma oblast, Amur oblast, Stavropol krai, Kirov oblast, Magadan oblast, Pskov oblast, Chita oblast, Republic of Chuvashia, Republic of Mordovia, Kurgan oblast, Altay krai, Bryansk oblast, Republic of Buryatia, Chukotka AO, Republic of Kalmykia, Kabardino-Balkar Republic, Republic of Dagestan, Taymyr (Dolgano-Nenetsky) AO, Republic of Tyva.

54 Novosibirsk oblast, Novgorod oblast, Saratov oblast, Primorsky krai, Ulyanovsk oblast, Republic of Yakutia, Tambov oblast, Penza oblast, Republic of Mary-El, Ivanovo oblast, Koryaksky AO, Jewish AO, Republic of North Ossetia-Alania, Karachaevo-Cherkess Republic, Evenk AO, Republic of Altay. 142

1. The Republic of Bashkortostan has begun receiving the subsidies, as its budget sufficiency level had plunged below the average nationwide one;

2. Ust-Ordynsky and Koryaksky AOs once again became eligible for the subsidies separately from the respective oblasts.

In 2007, the volume of FFSR in real terms (with account of CPI) posted a 6.1% growth vs. the respective index of 2006. Meanwhile, this year 26 regions should receive lesser volumes of subsidies from FFSR in real terms than in 2006 (when this group comprised 16 regions)55. As well, there also exists some correlation between the change in the volume of subsidies from FFSR in real terms and the level of budget sufficiency of the RF Subjects (Table 24).

Table 24

Correlation between Changes in the Volume of Subsidies from FFSR in Real Terms in 2007 vs. 2006 from the Level of Budget Sufficiency

of the Region

Budget sufficiency level The number of regions that received subsidies from FFSR in real terms in 2007 Lesser amount than in 2006 Greater amount than in 2006

Under 60% 10 34

60-80% 12 5

Over 80% 4 3

The data of the Table 24 evidence that some 77% of regions with the level of budget sufficiency below 60% will receive greater amounts of subsidies (in real terms), while the respective rate for regions with the budget sufficiency rate between 60 and 80% is just 29%. Last year, the respective proportions were 86% and 55%, accordingly. The situation in the group of regions with the budget sufficiency rate over 80% has not undergone any drastic changes. It should be noted that the above data may witness some rise in progressiveness of allocation of subsidies from FFSR.

It should also be noted that the minimum budget sufficiency of an RF Subject (after equalization) still remains very low, and in 2007 it accounts just for 62% of the average nationwide one. The respective index tends to fall vs. the period between 2005 and 2006 (at the time, it was 64%). It can be argued that, according to Rawls56, the allocation of the FFSR subsidies is still unjust. The dynamic of the change in the regions' minimum budget sufficiency rate after equalization is presented in Fig. 11.

55 Belgorod oblast, Kursk oblast, Moscow oblast, Ryazan oblast, Smolensk oblast, Arkhangel oblast, Murmansk oblast, Novgorod oblast, Karachaevo-Cherkess Republic, Volgograd oblast, Republic of Mary-El, Saratov oblast, Ulyanovsk oblast, Republic of Khakassia, Irkutsk oblast, Kemerovo oblast, Novosibirsk oblast, Omsk oblast, Taymyr (Dolgano-Nenetsky) AO, Evenk AO, Republic of Sakha (Yakutia), Primorsky krai, Amur oblast, Kamchatka oblast, Sakhalin oblast, Jewish autonomous oblast.

56 See Rawls, John. A Theory of Justice. Harvard University Press. 1999 [originally published 1971].

♦ Minimum budget sufficiency

Fig. 11. Dynamic of Minimum Budget Sufficiency of the RF Subjects

between 2001 and 2007

The analysis of the structure of FFSR allows the following observations: its newly established second part accounts for a meager 3.5% of its 2007 overall volume. The first part of FFSR is broken by stages as follows: 50% (of the total volume of FFSR) falls on the first stage, while 46.5 - on the second one. In 2006, the situation was opposite (44.3% - on the first stage and 55.7% - on the second). The change in the proportions has resulted in the following situation: the resources of the first part of the Fund remained after the allocation of subsidies at the first stage allowed allocation in 2007 of just 18.2% of the volume of budgetary subsidies needed to get the level of budget sufficiency of the regions of the second group to the average nationwide one (in 2006, this index made up 24.2%). As a result, the RF Subjects with a greater level of budget sufficiency (over 60% of the average nationwide one) ended up loosing, as they became eligible to a smaller fraction of FFSR.

In conclusion, it is worthwhile noting that the insufficient volume of FFSR and a low level of equalization of the budget sufficiency level indirectly entail the necessity of employment of subsidies on support of measures on getting the RF Subjects' budgets balanced, soft budget constraints, and the whole complex of associated with these phenomena effects on the subnational authorities' fiscal behavior.

2.5. Russian Financial Markets

2.5.1. Internal Debt Market

In 2006, the internal debt of the Russian Federation in securities grew in volume by nearly 20.8 per cent, from RUR 851.15 bln to 1,028.04 bln (in terms of GDP, the national debt has somewhat reduced from 3.94 per cent to 3.86 per cent of GDP).

Table 25

The RF Internal Debt Structure (RUR, billion)

Type of securities As of 01.01.2006 As of 01.01.2007

GKO 0,02 0,00

OFZ-PK 0,001 0,00

OFZ-PD 123,64 205,62

OFZ-FK 131,13 94,83

OFZ-AD 596,33 675,16

GSP-PPS 0,00 0,42

GSO-FPS 0,00 52,00

Total 851,15 1028,04

Source : the RF Ministry of Finance

Over the period of the first three quarters of 2006, the external debt of the Russian Federation (government authorities and monetary-credit control bodies) reduced from USD 82.3 go 54.7 bln (according to the data of the Central Bank of Russia). Thus, the absolute value of external debt of the Russian Federation reduced by 33.5 per cent. At the same time, the private sector (banks and other institutions) increased its debt to non-residents from USD 175.1 billion to USD 214.0 billion ( +22.2 per cent ) over the same period. Thus, the external debt of the Russian Federation grew from USD 257.4 to 268.6 billion in total within nine months of 2006.

Domestic Debt

In 2006, there was no such a substantial reduction in average weighted yield of the traded issues, that was noted in the ruble government debt market year ago. Thus, according to the data at closing on December 29, 2006, the average weighted yield has been reduced to 6.39 per cent per annum as opposed to 6.42 per cent p.a. at the beginning of 2006 .(See Fig. 12). Herewith, up to July the situation in the market remained quite stable, but in the second half of the year volatility was growing to a certain extent. Before July average weighted yield was kept up within the range of 6.24 per cent to 6.79 per cent per annum, while it changed to 5.36 per cent-6.57 per cent per annum in the second half of the year. A special emphasis should be placed on the fact that in 2006 the parameters of investment activity has somewhat decreased as compared with the data of preceding year of

2005. The total trading volume of GKO/ OFZ bonds in 2006 made RUR 333.04 bln against RUR 355.07 bln in 2005.

Herewith, at the background of some decrease in the total trading volume in

2006, the average weekly parameters were also getting down and made RUR 6.5 bln as apposed to RUR 6.9 bln in 2005. The maximum weekly trading volume in

2006 reached nearly RUR 32.36 billion in 2005 ( as opposed to nearly RUR 24.2 bln in 2005),while the minimum was nearly RUR 993.8 bln (about RUR 993.8 bln in 2005). Thus, in the year of 2006, the maximum trading volume parameter has somewhat decreased as compared with the minimal weekly trading volume parameter in the market of government bonds denominated in rubles, despite the growth of maximum trading volume.

I I Volume of trades on GKO/OFZ (mln. rubles) —«—Weighted-average return (annual rate) - right axis

35 000 30 000 25 000 20 000 15 000 10 000 5 000

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Source : Finmarket Asset Management Company, estimates made by the authors.

Fig. 12. Market Dynamics for GKO/ OFZ bonds in 2006

In analyzing the annual market dynamics, it should be noted that market quotations periodically moved up and down throughout the year. Thus, upon a short period of decrease to 6 per cent per annum at the beginning of the year, the average weighted yield of GKO-OFZ was gradually growing up to July and then got stabilized at the level of 6.5 - 7 per cent per annum. The process was continued till mid-July, when a moderately negative trend in the dynamics of shot-term up and down fluctuations was formed at the market. Let us consider in detail the monthly dynamics in liquidity in the market of government bonds, denominated in rubles.

Thus, within the first month of 2006, there were observed periods, when quotations would go up or down, which resulted in insignificant average weighted monthly indicators. Liquidity situation was quite favorable, and only one auction was held at the primary market. Also in January the government has approved the Program of National Debt for the year of 2006, according to which the total OFZ volume was planned in the amount of RUR 186 bln, whereas in 2005 the total amount of domestic debt was planned within RUR 258.9 bln, and actually bonds were placed for RUR 182.3 bln. A session of market participants, arranged by the RF Ministry if Finance, MICEX and National Fund Association, involved in the above situation, where the Ministry of Finance has confirmed the sustainability of the pol-

icy domestic debt with OFZ issues 3, 5, 10 and 15. It was also declared that Ministry of Finance is prepared to stop the extra liquidity on placed securities, which might become even lower than planed in the federal budget. The need of the Ministry of Finance in internal debt is decreased, and there is no necessity in extra yield of placed securities.

A month later the major part of investors' activities was moved to the primary market, where the demand was several times higher than securities offer. Inconsistency of the demand and offer in terms of price was noted in a number of issues, and hence, placement of some securities was incomplete. At the same time, insignificant volatility of quotations was observed in the secondary market, prices varied within a narrow range. In general, the market was supported by the stable RUR rate with some trend to its strengthening against USD, as well as sufficient liquidity level in the bank sector. As opposed to that, prices were affected by inflation expectations, since within the first two months consumer prices have grown by 4.1 per cent, much higher than the level of official estimates. Economic situation in general has been aggravated, what was confirmed by lower indicators of GDP, industrial production, investment and trading activities within the first month of preceding year as compared with December 2005..

In March inflation estimates made a stronger negative impact on the market, as the inflation within the first three months of the year reached about 5 per cent, whereas according to the estimates, that level should have been in the limits of 78.5 per cent by the end of the year. In this context, the Ministry of Economy and Trade has to make adjustments to the target estimates up to 8-9 per cent, wile the Ministry of Finance admits that consumer prices can be increased by 10 per cent as of 2006 results. Apparently, all the above was taken into regard in the bonds yield estimates and resulted in the market quotations. Liquidity problems in the bank sector made an additional pressure on prices. Alongside with that, one of counter-inflation measures, taken by the RF Central Bank, is effective strengthening of RUR in nominal terms. However, that factor provides an adverse effect, supporting RUR liquidity, and the gross yield of securities has somewhat grown as compared with February indicators.

Further aggravation of the situation with monetary liquidity and high inflation expectations have made a stronger effect over the government bonds denominated in rubles, than strengthening of RUR against USD. The government proposed a series of counter-inflation measures to be taken in the economy to restrain the greater prices growth rates, than planned ones. Some downward trend in yield was observed in May. The dominating factors were monetary liquidity, which has considerably raised as compared with other periods; stronger RUR against USD, as well as lower inflation expectations due to slower rates of consumer prices growth (in May it made only 0.5 per cent against 1.4 per cent in May 2005). The situation in the primary market was also rather favorable and the auctions on government bonds placements were successful.

In June there were no expressed changes in prices of traded securities. While there was observed a negative trend in quotations in the market at the beginning of

the month, prices have been adjusted by the end of June. The market was supported by the information on complete recovery of the RF debt to Paris Club of Creditors, what allowed to save about USD 7.7 of interest payments. Inflation was getting down; consumer prices went up by 0.3 per cent against 0.5 per cent in May. One more stabilizing factor in the market of government bonds denominated in rubles was liberalization of the RF foreign currency legislation, planned for July 1, 2006, which could be taken into regard by the investors in their considerations on the structure of investment portfolios.

Quotations were growing till the end of July, and at that background the average weighted yield of GKO-OFZ has decreased below 6 per cent for the first time since January and made 5.8 per cent per annum. Herewith, as can be observed in Fig. 12, the yield decrease was accompanied by the growth of trades. The basic factors of favorable dynamics were stabilization of external debt market, high liquidity, RUR strengthening, liberalization of the RF foreign currency legislation. Rather favorable situation was also observed in August-September, despite the fact that the yield came back to the level of 6 per cent per annum. Meanwhile, the volume of secondary trades has reached its peak as compared with preceding months of 2006. Among other standard factors of yield growth, the RF raised rating played an important role as well.

Some yield growth of the most liquid bonds was observed in October, though there were no vast-scale trades. Comments of some authorized officials on excessive RUR strengthening negative impact on the RF economy made some effect over the demand-offer balance. For instance, the RF Minister of Finance has mentioned, that further RUR strengthening will provide negative effect on the Russian economy and can result in RUR devaluation after 2009. Lower liquidity in the bank sector has added to the yield growth. Only noticeable RUR strengthening against USD contributed to the situation of the end of November, when the yield of the government bonds denominated in rubles has considerably grown, regardless some liquidity problems. That growth was continued till the end of the year, and has resulted in decrease of the most liquid ruble bonds. The basic supporting economic factors were the expected in 2006 high rates of economic growth and lower inflation. However, rather high volume of primary offer in the market of corporate bonds, characterized by high yield, and some aggravation of the situation in the sector of the Russian government foreign currency debt, prevented the bonds from reaching the level of potential, formed by the end of the year.

In 2006 the RF Ministry of Finance has successfully held 34 auctions on placement of GKO-OFZ for the total amount of about RUR 208.1 bln (against 20 auctions for the amount of RUR 165.7 bln in 2005). The actual placement volume amounted to RUR 188.6 bln. The yield at the average weighted price varied from 6.08 per cent to 7.06 per cent per annum (in 2005 the range of average weighted price varied from 6.22 per cent to 8.85 per cent per annum). Therefore, an expressed growth of government debt was observed in domestic market, accompanied by significant yield reduction, as compared with the preceding year. As of December 28, 2006, the volume of GKO/ OFZ bonds market amounted to RUR 875.6

bln billion at par value and RUR 879.3 bln at market value. Duration of the GKO/ OFZ market portfolio was 5.46 years.

External Debt

As of 2006 results, there was an upward trend for some bonds denominated in foreign currency (Figs 2 and 3). Thus, as of the end of December, 2006, the yield of the fifth tranche of MinFin Bonds amounted to 5.47 per cent per annum (as opposed to 5.14 per cent early in the year), the seventh tranche of MinFin Bonds -5.48 per cent per annum (as opposed to 5.24 per cent) eight tranche of MinFin Bonds - 5.57 per cent per annum (against 4.76 per cent at the beginning of trades as of May 2006). The yield of RUS-30 varied within the year from 5.42 per cent to 5.5 per cent and RUS-28 bonds stayed at the level of the beginning of the year, 5.96 per cent; the yield to maturity of RU-07 varied insignificantly and was established at the level of 5.05 per cent versus 5,03 per cent early in the year, and RUS-18 bonds were traded at prices corresponding to the yield of 5.64 per cent per annum ( as opposed to 5.5 per cent early in the year ).

Several most significant factors regarding the movement in the Eurobonds market can be highlighted. The first one is extremely favorable conditions in the world oil and metal markets, as well as stable macroeconomic situation in the country. The second factor is the early repayment of a share of the RF sovereign debt to the Paris Club of Creditors. The third factor: it is essential that Standard & Poor's upgraded the Russia's credit rating in foreign currency from BBB up to BBB+, and rating in national currency from A- to BBB, as well as Fitch upgraded the RF sovereign credit from BBB to BBB+. The key adverse factor for the market throughout the year was the movement of the yield of the US Treasury Bonds, which was influenced by periodical increases of the discount rate by the US Federal Reserve System, as well as the growth in inflationary processes in the US economy.

In the analysis of Russian bonds quotations dynamics several periods should be highlighted, when the market situation was variable. Thus, quotations were steadily growing up to mid July with occasional corrections. During the second period, from mid July to early October quotations were decreasing, partially winning back the growth of the beginning of the year. Throughout the third period, in October-December the yield was variable within a certain range. Let us consider the basic factors, which have influenced the dynamics of prices in the market of Russian Eurobonds. In January-February favorable information on the US economy were published in the USA, what has reduced the expectations of the slow-down in the economic growth rates, but supported inflation growth, especially in view of the forthcoming meeting of Committee on open markets of USA FRS. As a result, investors were selling US government bonds, what provoked trades in the Russian market as well, which nevertheless did not reach a vast scale, since the Russian bonds were substantially supported by high oil prices, demonstrated an expressed growth within January. In late January investors' expectations came true, the basic rate in US was raised by 0.25 p.a. and reached 4.5 per cent per annum. The investors were also influenced by several developments, in particular, by the statement

of B. Bernake, the new head of the US Federal Reserve System, though there was no new information in his words. He has mentioned, that the mechanism of the basic interest rate adjustment will be further applied as a balance instrument against inflation pressure. As a result of the month, quotations of the Russian bonds, denominated in foreign currency, have been decreased.

7.0%

6.5%

6.0%

5.5%

5.0%

4.5%

4.0%

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C^C^G^G^C^C^G^C^C^G^G^C^C^G^G^G^C^C^G^C^C^G^G^C^C^G^C^C^C^Í:^.——Hi—Hi———Hi———Hi—H ■—ii—iCNOi—iCNOi—iCNfli—ii—iCNOi—iCNOi—iCNr^ji—'—iCNOi—iCNr^iOi—iCNOi—'—iCNOi—iCNOi—CN

Source: Finmarket Asset Management Company.

Fig. 13. MinFin Bonds Yield to Maturity in 2006

Similar trends were prevailing in the market up to July. The interest rate in USA went up several times (up to go 4.75 per cent per annum in March, to 5 per cent per annum in May). A greater portion of US economic statistics stated a steady economic growth rate, whereas the upsurge of the world prices for energy sources created additional grounds for stronger inflation development and as a result, for further growth of interest rates. Comments of financial authorities in Europe also pointed to their intentions to raise the interest rates. In this situation one could most likely expect a downward trend in the sector of the Russian Eurobonds, what has actually happened in the market.

In July the upward trend of the Russian Eurobonds yield was replaced by an adverse tendency. The basic factor in the dynamics of the market situation was a reduced probability of further tightening of US Federal Reserve System monetary and credit policy, which effected both, the markets of the US government bonds and consequently, Eurobond markets of other countries. Moreover, statistical data, published in USA, reflected some slow-down in economy and inflation stabilization. In that situation investors were planning a decrease of interest rates in their forecasts, what also inspired price upswing. Their forecasts came true in October, when FRS made a pause in the series upgrades of interest rates. To the contrary, 1 50

the Central bank of Europe has increased the interest rate by 0.25 p.p. up to 3.25 per cent per annum, but commented on low likelihood of further growth. In November and December there was no expressed dynamics in the market of Russian Eurobonds as well. Herewith, while in the US market the bonds were downgrading in December due to contradictory publications on macroeconomic data, provoked one more review of expectations in regard to the US Federal Reserve System policy, the Russian debt market demonstrated high resistance to that factor, though there was observed some yield upgrading in some bonds.

Source : Finmarket Asset Management Company.

Fig. 14. Russian Eurobonds Yield to Maturity due 2030, 2018 and 2007, in 2006

2.5.2. The market for Municipal and Subfederal Borrowings

The dynamic of market development

By the results of the year 2006, the consolidated regional budget was drawn with a surplus of 139.8 bn roubles (0.53 % of GDP). The budgets of subjects of the Federation were drawn with a surplus of nearly 133.8 bn roubles, the budgets of city okrugs and the intracity municipal formations of the cities of Moscow and St. Petersburg - with a surplus of 0.3 bn roubles, the budgets of municipal raions -with a surplus of 9.8 bn roubles, the budgets of urban and rural settlements - with a surplus of 2.2 bn roubles57.

57 For five subjects of the Russian Federation (Moscow Oblast, the Republic of Ingushetia, the Chechen Republic, Koriak AO, and Chulotka AO), the budget statistics on municipal formations is cited without

151

In 2005, the consolidated regional budget was drawn with a surplus of 57.1 bn roubles, or 0.26% of GDP. The budgets of subjects of the Federation were drawn with a surplus of nearly 53.8 bn roubles, the budgets of municipal formations - with a deficit of 9.4 bn roubles (Tables 26 and 27).

Thus, in one year the surplus of the consolidated regional budget against GDP increased more than twofold - by 0.27 p.p. of GDP.

Table 26

Ratio of the surplus (or deficit) of territorial budgets to budget

expenditure (in %)

Consolidated regional budget Regional budgets Municipal budgets1

2002 -2.7 -3.0 -2.8

2003 -2.6 -2.3 -3.2

2004 1.1 1.6 0.2

2005 1.6 2.3 -0.8

2006 3.7 4.4

Source: the lET's estimates, based on the data of the Federal Treasury.

Table 27

Ratio of the surplus (or deficit) of territorial budgets to budget expenditure in 2006 (in %)

The budgets of city okrugs and intracity municipal formations of Moscow and St. Petersburg Budgets of municipal raions Budgets of urban and rural settlements Local budgets of five subjects of Russian Federation (Moscow Oblast, Republic of Ingushetia, Chechen Republic, Koriak AO, Chukotka AO)1

0.04 1.63 2.52 -2.07

As of 1 January 2007, the consolidated budget was drawn with a surplus in 54 subjects of the Federation (as compared to 33 in 2005). The aggregate volume of budget surplus in those regions amounted to 190.6 bn roubles, or 6.9% of the total revenue of their budgets (in 2005 - 5.4%). The average budget surplus amounted to 2.5% of budget revenue budget.

The highest surplus to revenue ratio in the consolidated budget was achieved in Agin-Buriat AO - 22.9%, in St. Petersburg and Nenets AO - 14.7% each, in Chechen Republic - 13.4%, Koriak AO - 12.0%, in Cheliabinsk Oblast - 11.7%, in the republic of Bashkortostan - 10.3%, in Krasnoyarsk Krai - 10.2%, in Pskov Oblast -9.3%, in the city of Moscow - 8.8%, in Tumen Oblast - 8.5%. Nearly 2/3 (or 64.2%) of the aggregate surplus of the consolidated regional budget was achieved by four subjects of the Federation: the city of Moscow - 35.0%, or 66.6 bn roubles, the city of St. Petersburg - 16.8%, or 32.0 bn roubles, Tumen Oblast - 7.1%, or 13,5 bn roubles, and Krasnoyarsk Krai - 5.4%, or 10.2 bn roubles.

The substantial budget surplus in two autonomous okrugs was produces by additional budget funding in connection with the approaching merging of Agin-Buriat AO and Chita Oblast, as well as Koriak AO and Kamchatka Oblast. The high surplus in

breaking it into the categories of "city okrugs", "municipal raions", and "urban and rural settlements" The budgets of the municipal formations in these regions were drawn with the deficit of 2.2 bn roubles. 152

the budgets of Moscow, St. Petersburg, Tumen Oblast and Bashkortostan is associated primarily with the high growth of export prices of energy carriers.

In 2006, rthe consolidated budget was drawn with a deficit in 33 RF subjects (in 2005 - in 54 regions)58, its aggregate volume amounting to 50.7 bn roubles, or 4.9 % of their budget revenue (in 2005 - 48.0 bn roubles).

The average level of budget deficit amounted to 2.7% of budget revenue. The highest deficit to budget revenue ratio was observed in the Republic of Mordovia -13.1%, in Magadan Oblast - 9.9%, and in the Republic of Sakha (Yakutia) and Khanty-Mansi AO - 8,4% both.

More than a half, or 54.4%, of the aggregate deficit was produced by 5 subjects of the Federation: the Khanty-Mansi AO had an aggregate deficit of 20.0 %, or 10.1 bn roubles, Moscow Oblast - 12.4%, or 6.3 bn roubles, the Republic of Sakha (Yakutia) - 9.3%, or 4.7 bn roubles, Omsk Oblast - 6.6%, or 3.3 bn roubles, Samara Oblast - 6.2%, or 3.1 bn roubles (Table 30).

Changes in the structure of accumulated debt

The amount of accumulated debt in the consolidated regional budget increased in 2006 to 54,777.75 mln roubles, or 0.21 % of GDP. The increased debt resulted from the growth of domestic debt (that is, rouble-denominated debt). The external debt in the regional consolidated budgets decreased by 496.2 mln roubles, while domestic debt grew by 54,981.5 mln roubles (Table 28). As in the previous years, the combination of the surplus of the consolidated regional budget and the growing volume of accumulated debt can be explained by the general increase of the amount of residuals on the budget accounts and the growth of the other assets owned by the territorial authorities.

Table 28

Net borrowings regional and local budgets (in % of GDP)

1999 2000 2001 2002 2003 2004 2005 2006

Borrowings of subfederal and local authorities Including: 0.15 -0.29 -0.04 0.47 0.37 0.26 0.09 0.21

Reimbursable loans from budgets of other levels -0.11 -0.03 0.04 0.12 -0.1 -0.02 -0.03 -0.04

Subfederal

(municipal) -0.05 -0.27 -0.07 0.16 0.31 0.29 0.09 0.14

bonds

Other borrowings 0.31 0.01 -0.02 0.19 0.6 0.03 0.11

Decreasing residuals on budget accounts -0.19 -0.30 -0.05 -0.04 -0.18 -0.62 -0.48

Financing of deficit from borrowings and decreasing residuals on budget accounts -0.04 -0.59 -0.09 0.38 0.19 -0.36 -0.38

Source: the lET's estimates, based on the data of the RF Ministry of Finance and the Federal Treasury.

58 In the reports published by the RF Ministry of Finance (or the Federal Treasury) on the execution of the budgets of subjects of the Russian Federation in 2005 and 2006, the data on Evenk AO and Taimyr (Dolgano-Nenets) AO are not shown separately.

The structure of borrowings

The total volume of borrowings in the regional consolidated budget in 2006 amounted to 264,166.1 mln roubles, of which external borrowings constituted 14,964.1 mln roubles. As in 2005, the sole recipients of external loans were Moscow city (13.7 bn roubles) and the Republic of Bashkortostan ( 1.2 bn roubles), which were refinancing the previously received external loans.

The aggregate volume of internal borrowings received by regions and municipalities amounted to 249,202.0 mln roubles. The biggest borrowers on the domestic market were as follows: Moscow Oblast - 48.1 bn roubles, Moscow city - 17.9 bn roubles, Omsk Oblast - 14.7 bn roubles, and Novosibirsk Oblast - 11.7 bn roubles. By comparison with 2005, the volume of domestic borrowings in nominal terms increased by 23.5 bn roubles, or by 10.6%, which is nearly equal to the rate of inflation.

Within the total volume of domestic borrowings of the consolidated regional budget, the issue of securities amounted to 29.4%, the loans from the federal budget - to 4.4%, and other types of borrowings (primarily bank loans) - to 66.2%.

In a situation of an absolute reduction in the volume of the issue of securities, the level of securitization of borrowings made by regions and municipalities went down from 36.0 % in 2005 to 29.4% in 2006 (Table. 29).

Table 29

The structure of domestic borrowings in the subnational budgets (in %)

2006 2005 2004

Regional consolidated budget Regional Municipal Regional consoli- Regional Municipal budgets Regional consoli- Regional Municipal

budgets budgets dated budget budgets dated budget budgets budgets

Issue of securities 29.4 37.1 9.7 36.0 45.5 10.2 32.5 41.0 4.0

Budget loans 4.4 6.0 0.3 1.2 1.6 0.03 3.0 4.0 46.4

Other types of borrowings 66.2 56.9 90.1 62.9 52.9 89.8 64.5 55.1 49.6

Source: the lET's estimates, based on the data of the RF Ministry of Finance and the Federal Treasury.

The highest ratio of net borrowings to budget revenue was demonstrated by Moscow Oblast - 16.5%, Astrakhan Oblast - 12.8%, Kostroma Oblast - 9.4%, Kaluga Oblast - 8.8%, Yaroslavl Oblast - 7.9% (Table 30).

The biggest net borrowers were as follows: Moscow Oblast - 28.9 bn roubles, Moscow - 8.9 bn roubles, Samara Oblast - 3.6 bn roubles, Irkutsk Oblast - 2.6 bn roubles, Yaroslavl Oblast - 2.1 bn roubles, Astrakhan Oblast and Saratov Oblast -2.0 bn roubles each.

The greatest reduction in the amount of accumulated debt was observed in Krasnoyarsk Krai - by 4.9 bn roubles, in Nizhnii Novgorod Oblast - by 2.1 bn roubles, in St. Petersburg - by 1.6 bn roubles, in Leningrad Oblast - by 1.5 bn roubles.

Table 30

The execution of the consolidated budgets of subjects of the Russian Federation in 2006

Budget revenue, thousand roubles.

Budget surplus

(deficit), thousand roubles.

Ratio of Attracted surplus borrowed (deficit) resources to reve- to revenue, in % nue, in %

Net borrowings to revenue, in %

Cost of debt redemption to revenue, in %

Net borrowings to budget surplus (defi-city), in %

1 2 3 4 5 6 7 8

Central Federal Okrug

Belgorod Oblast 29 484 991.76 -1 615 443.06 -5.48 3.84 3.05 0.80 -55.59

Briansk Oblast 17 602 562.54 -195 708.94 -1.11 14.08 1.81 12.27 -162.74

Vladimir Oblast 21 514 145.62 491 021.71 2.28 0.05 -0.79 0.84 -34.41

Voronezh Oblast 30 435 574.02 453 109.44 1.49 7.50 1.44 6.06 96.51

Ivanovo Oblast 17 598 473.14 130 194.82 0.74 1.71 0.30 1.40 41.14

Tver Oblast 24 276 982.69 162 631.36 0.67 4.28 -3.28 7.55 -489.11

Kaluga Oblast 17 428 075.24 -1 402 107.61 -8.05 14.00 8.79 5.21 -109.24

Kostroma Oblast 10 239 314.04 -679 101.85 -6.63 22.62 9.37 13.26 -141.22

Kursk Oblast 16 707 865.59 301 239.29 1.80 0.66 -0.34 1.00 -18.85

Lipetsk Oblast 27 935 248.32 646 410.12 2.31 6.44 6.26 0.18 270.73

Moscow Oblast 175 166 922.03 -6 299 496.49 -3.60 27.49 16.48 11.01 -458.24

Orel Oblast 11 181 582.93 251 151.27 2.25 1.43 0.89 0.53 39.65

Riazan Oblast 17 727 957.73 -323 485.86 -1.82 8.22 2.37 5.85 -129.75

Smolensk Oblast 13 619 936.64 327 285.37 2.40 3.42 -1.71 5.12 -71.08

Tambov Oblast 15 203 434.33 294 919.40 1.94 3.42 1.32 2.10 67.83

Tula Oblast 23 789 184.02 -1 401 707.76 -5.89 34.53 6.36 28.17 -107.91

Yaroslavl Oblast 26 447 297.54 -1 890 399.90 -7.15 16.37 7.94 8.43 -111.05

Moscow city 757 936 696.98 66 606 909.18 8.79 4.18 1.18 3.01 13.45

Total 1 254 296 245.15 55 857 420.50 4.45 8.68 3.74 4.96 83.88

North-Western Federal Okrug

Republic of Karelia 15 158 667.26 -1 057 344.49 -6.98 13.69 6.13 7.56 -87.88

Republic of Komi 30 071 168.79 670 319.23 2.23 1.12 0.03 1.09 1.37

Arkhangelsk Oblast 27 470 667.82 337 842.82 1.23 4.45 0.28 4.17 22.41

Vologda Oblast 32 684 358.61 506 973.59 1.55 1.67 -0.63 2.29 -40.33

Kaliningrad Oblast 20 782 886.55 -156 177.57 -0.75 8.62 1.02 7.60 -135.20

Leningrad Oblast 37 096 265.98 2 488 579.26 6.71 1.69 -4.10 5.79 -61.05

Murmansk Oblast 29 151 834.53 141 683.50 0.49 6.88 0.87 6.01 178.47

Novgorod Oblast 12 054 297.59 -286 838.19 -2.38 0.12 -0.97 1.10 40.82

Pskov Oblast 11 107 536.40 1 035 094.49 9.32 1.09 -6.31 7.40 -67.69

St. Petersburg city 218 096 278.88 31 961 300.62 14.65 1.86 -0.74 2.60 -5.06

Nenets AO 7 650 921.80 1 126 908.51 14.73 0.00 0.00 0.00 0.00

Total 441 324 884.22 36 768 341.77 8.33 2.90 -0.61 3.51 -7.29

Southern Federal Okrug

Republic of Dagestan 27 095 641.55 545 436.04 2.01 0.00 0.00 0.00 0.00

Republic of Kabardino-Bal karia 11 079 032.31 526 164.44 4.75 8.67 -2.27 10.94 -47.85

Republic of Kalmykia 4 665 809.76 -68 007.66 -1.46 7.72 1.30 6.42 -89.52

Republic of North Osetia - Alania 11 418 024.51 104 126.89 0.91 9.63 1.89 7.75 206.74

1 2 3 4 5 6 7 8

Republic of Ingushetia 6 438 992.64 -16 956.75 -0.26 0.00 0.00 0.00 0.00

Krasnodar Krai 81 032 699.06 5 133 373.90 6.33 1.00 0.51 0.49 8.12

Stavropol Krai 35 720 169.22 1 237 746.31 3.47 3.90 0.88 3.02 25.34

Astrakhan Oblast 15 644 980.75 -1 222 172.57 -7.81 49.83 12.84 36.99 -164.36

Volgograd Oblast 39 839 761.98 -690 523.52 -1.73 10.52 2.37 8.15 -136.72

Rostov Oblast 59 641 367.30 1 510 089.89 2.53 0.18 0.00 0.18 0.15

Republic of Adygeya 5 708 000.36 162 094.83 2.84 0.35 -2.75 3.10 -96.71

Republic of Kara-chaevo - Cherkessia 6 248 318.64 -77 117.17 -1.23 26.32 3.48 22.84 -282.16

Chechen Republic 31 624 049.42 4 247 709.56 13.43 0.00 0.00 0.00 0.00

Total 336 156 847.50 11 391 964.21 3.39 5.47 1.12 4.35 33.10

Volga Federal Okrug

Republic of Bashkortostan 83 565 631.02 8 635 577.68 10.33 3.28 1.57 1.90 15.21

Republic of Marii El 10 464 294.32 -143 259.12 -1.37 7.16 2.06 5.10 -150.37

Republic of Mordovia 14 356 730.25 -1 885 905.16 -13.14 0.00 -0.74 0.74 5.66

Republic of Tatarstan 88 326 860.15 2 064 567.36 2.34 8.73 -0.11 8.85 -4.88

Republic of Udmurtia 25 339 742.02 -1 102 825.24 -4.35 4.07 0.05 4.02 -1.22

Republic of Chuvashia 19 171 874.22 -499 010.92 -2.60 6.21 4.84 1.38 -185.76

Nizhnii - Novgorod Oblast 59 242 672.46 4 295 302.71 7.25 7.52 -3.54 11.06 -48.83

Kirov Oblast 21 649 798.63 -336 218.93 -1.55 8.67 4.62 4.06 -297.40

Samara Oblast 67 696 875.17 -3 142 590.83 -4.64 8.39 5.35 3.04 -115.21

Orenburg Oblast 35 793 475.32 193 883.83 0.54 0.39 -1.03 1.42 -190.76

Penza Oblast 19 743 330.90 55 462.64 0.28 10.58 0.91 9.68 322.76

Perm Oblast 56 572 339.83 2 334 274.74 4.13 1.13 0.56 0.57 13.59

Saratov Oblast 32 904 692.51 -823 946.95 -2.50 13.82 5.98 7.84 -238.93

Ulianovsk Oblast 20 419 309.01 1 212 795.80 5.94 0.11 -4.28 4.39 -72.02

Komi-Permiak AO 3 393 009.86 21 986.75 0.65 0.07 -0.71 0.78 -109.46

Total 558 640 635.67 10 880 094.37 1.95 5.89 1.07 4.84 54.98

Ural Federal Okrug

Kurgan Oblast 13 448 299.19 -256 332.85 -1.91 5.41 2.56 2.84 -134.36

Sverdlovsk Oblast 97 882 319.84 6 771 737.58 6.92 0.41 -0.18 0.59 -2.62

Tumen Oblast 159 368 409.34 13 509 541.07 8.48 0.01 -0.23 0.24 -2.74

Cheliabinsk Oblast 66 866 623.62 7 792 056.19 11.65 0.86 -0.45 1.31 -3.90

Khanty-Mansi AO 121 064 671.80 -10 119 699.34 -8.36 0.65 0.18 0.47 -2.12

Yamal-Nenets AO 64 621 447.15 347 585.97 0.54 3.17 0.74 2.43 137.43

Total 523 251 770.94 18 044 888.63 3.45 0.87 0.04 0.84 1.03

Siberian Federal Okrug

Republic of Buriatia 21 361 222.34 191 613.66 0.90 9.03 0.95 8.08 105.82

Republic of Tyva 7 540 373.50 -42 924.79 -0.57 0.00 -0.48 0.48 84.24

Altay Krai 35 892 424.96 900 063.30 2.51 4.55 -3.64 8.19 -145.02

Krasnoyarsk Krai 99 687 940.60 10 201 968.87 10.23 6.43 -4.99 11.42 -48.75

Irkutsk Oblast 50 372 002.51 -1 854 726.60 -3.68 17.04 5.19 11.85 -141.09

Kemerovo Oblast 63 420 573.99 -2 604 559.91 -4.11 2.55 0.92 1.63 -22.47

Novosibirsk Oblast 51 633 127.34 1 580 010.03 3.06 22.66 -1.81 24.47 -59.26

Omsk Oblast 41 626 420.45 -3 340 427.34 -8.02 35.33 3.00 32.33 -37.39

Tomsk Oblast 25 897 683.36 373 069.88 1.44 26.73 0.63 26.10 43.81

Chita Oblast 22 299 648.60 512 741.13 2.30 2.38 -1.04 3.42 -45.22

1 2 3 4 5 6 7 8

Republic of Altay 7 343 323.21 87 769.43 1.20 4.00 -0.39 4.39 -32.73

Republic of Khakassia 8 906 297.63 43 408.69 0.49 0.42 -0.32 0.74 -66.04

Agin-Buriat AO 17 391 010.92 3 988 694.54 22.94 0.04 0.04 0.00 0.19

Ust-Ordyn Buriat AO 2 886 066.00 88 044.54 3.05 -1.88 -1.88 0.00 -61.63

Total 456 258 115.42 10 124 745.42 2.22 11.91 -0.61 12.51 -27.36

Far Eastern Federal Okrug

Republic of Sakha (Yakutia) 56 028 624.58 -4 713 991.13 -8.41 14.02 3.29 10.73 -39.10

Primorskii Krai 42 170 346.62 1 155 056.55 2.74 1.59 -0.59 2.17 -21.49

Khabarovsk Krai 38 940 124.46 1 401 150.66 3.60 20.26 -0.06 20.32 -1.64

Amur Oblast 20 781 029.01 -490 177.97 -2.36 10.43 4.55 5.88 -192.69

Kamchatka Oblast 15 810 492.39 -958 415.24 -6.06 33.16 5.87 27.29 -96.77

Magadan Oblast 10 294 903.30 -1 021 789.99 -9.93 8.95 6.98 1.97 -70.37

Sakhalin Oblast 24 269 286.14 393 427.53 1.62 9.47 -0.52 9.98 -31.98

Jewish AO 4 646 637.75 182 989.03 3.94 0.54 -0.51 1.04 -12.87

Koriak AO 5 864 167.60 703 846.64 12.00 33.42 -6.28 39.70 -52.30

Chukotka AO 9 590 995.91 138 037.89 1.44 34.62 -2.15 36.77 -149.39

Total 228 396 607.75 -3 209 866.04 -1.41 14.16 1.51 12.66 -107.14

Total, federal okrugs 3 800 391 881.18 139 793 189.73 3.68 6.95 1.44 5.52 39.18

Source: the lET's estimates, based on the data of the Federal Treasury.

Domestic bond loans

In 2006, the prospectuses of bond loans issued by 27 subjects of the Federation and 16 municipal formations were registered (as compared to 25 regional and 13 municipal loans in 2005). The total volume of bonds to be placed in 2006 amounted to 73.3 bn roubles, against 81.2 bn roubles in 2005 (decrease in nominal terms by 7.9 bn roubles), having gone down in one year from 0.37% to 0.28% of GDP (Table 31).

Although the volume of debt securities issued by regions and municipalities decreased by comparison with the previous year, in 2006 the volume of the market for subfederal bonds increased, in real terms, by 8.1% - from 161.1 bn roubles in 2005 to 189.8 bn roubles. This was explained by the increasing duration of debt securities: the issue volume, as before, remained higher than that of the bonds redeemable during the year.

Table 31

Volume of issue of subfederal and municipal securities (in % of GDP)

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Issue 0.63 0.77 0.47 0.31 0.19 0.17 0.27 0.46 0.47 0.37 0.28

Redemption 0.47 0.56 0.48 0.36 0.46 0.23 0.10 0.15 0.19 0.28 0.14

Net financing 0.16 0.22 -0.01 -0.05 -0.27 -0.07 0.16 0.31 0.29 0.09 0.14

Source: the lET's estimates, based on the data of the RF Ministry of Finance and the Federal Treasury.

The following entities registered their issue prospectuses at the RF Ministry of Finance in 2006: the Republic of Chuvashia, the Republic of Komi, the Republic of Sakha (Yakutia), the Republic of Bashkortostan, the Republic of Karelia, the Re-

public of Marii El, Krasnoyarsk Krai, Volgograd Oblast, Tomsk Oblast, Irkutsk Oblast, Moscow Oblast, Yaroslavl Oblast, Lipetsk Oblast, Nizhnii Novgorod Oblast, Voronezh Oblast, Belgorod Oblast, Tver Oblast, Samara Oblast, Kirov Oblast, Kaluga Oblast, Tambov Oblast, Irkutsk Oblast, Kurgan Oblast, Penza Oblast and Tula Oblast, the cities of Moscow, St. Petersburg, Ekaterinburg, Novosibirsk, Volgograd, Kazan, Tomsk, Astrakhan, Blagoveshchensk, Briansk, Voronezh, Lipetsk, Magadan, Yaroslavl and Orekhovo-Zuevo, as well as Klin raion, Odintsovo raion, and Noginsk raion of Moscow Oblast.

The biggest issuers of debt securities were as follows: Moscow Oblast, whose aggregate issue amounted to 18.7 bn roubles, or to 25.6% of the aggregate volume of territorial issues; Moscow city - 17.4 bn roubles, or 23.8%; Samara Oblast -4.5 bn roubles, or 6.1%; Irkutsk Oblast - 4.2 bn roubles, or 5.7%, and St. Petersburg - 4.1 bn roubles, or 5.5%. Thus, the five biggest issuers produced 61.2% of the total volume of placed regional and municipal bonds.

Besides, big issues were placed by the following entities: the Republic of Sakha (Yakutia) - 2.5 bn roubles, Yaroslavl Oblast - 2.4 bn roubles, the Republic of Tatarstan - 2.3 bn roubles, Nizhnii Novgorod Oblast - 2.0 bn roubles, and the Republic of Bashkortostan - 1.5 bn roubles (Table 32).

Table 32

Placement of subfederal and municipal securities

in 2006

Issue volume, Issuer's share in total Ratio of issue vol-

Federation's subject thousand rou- issue volume, in ume to domestic

bles % borrowings, in %

1 2 3 4

Central Federal Okrug

Belgorod Oblast 1 020 000.0 1.4 90.0

Briansk Oblast 300 000.0 0.4 12.1

Voronezh Oblast 500 000.0 0.7 21.9

Kaluga Oblast 1 300 000.0 1.8 53.3

Lipetsk Oblast 1 800 000.0 2.5 100.0

Moscow Oblast 18 740 516.5 25.6 38.9

Tambov Oblast 100 000.0 0.1 19.2

Tula Oblast 1 500 000.0 2.0 18.3

Yaroslavl Oblast 2 411 027.5 3.3 55.7

Moscow 17 433 218.9 23.8 97.3

North-Western Federal Okrug

The Republic of Karelia 500 000.0 0.7 24.1

St. Petersburg 4 058 466.3 5.5 100.0

Southern Federal Okrug

Astrakhan Oblast 500 000.0 0.7 6.4

Volgograd Oblast 1 236 454.8 1.7 29.5

Volga Federal Okrug

Republic of Bashkortostan 1 519 600.0 2.1 100.0

Republic of Marii El 499 136.2 0.7 66.6

Republic of Tatarstan 2 300 000.0 3.1 29.8

1 2 3 4

Republic of Chuvashia 1 000 000.0 1.4 83.9

Nizhnii - Novgorod Oblast 2 000 000.0 2.7 44.9

Kirov Oblast 600 000.0 0.8 32.0

Samara Oblast 4 500 000.0 6.1 79.2

Penza Oblast 800 000.0 1.1 38.3

Ural Federal Okrug

Kurgan Oblast 500 000.0 0.7 68.8

Sverdlovsk Oblast 172 800.4 0.2 43.0

Khanty - Mansi AO 507 000.0 0.7 64.5

Siberian Federal Okrug

Irkutsk Oblast 4 150 230.0 5.7 48.4

Novosibirsk Oblast 300 000.0 0.4 2.6

Tomsk Oblast 68 962.1 0.1 1.0

Far Eastern Federal Okrug

Republic of Sakha (Yakutia) 2 500 000.0 3.4 31.8

Amur Oblast 75 500.0 0.1 3.5

Magadan Oblast 450 000.0 0.6 48.8

Source: the lET's estimates, based on the data of the Federal Treasury.

So far, a high level of securitization has been observed predominantly in respect of biggest issuers: Moscow - 99.2% and St. Petersburg - 100%. Borrowings exclusively in the form of issue of securities were made by Lipetsk Oblast. The level of securitization of borrowings in Belgorod Oblast amounted to 92.4%, in the republic of Komi - to 87.7%.

The aggregate volume of net borrowings on the market of subfederal and municipal securities, earmarked to cover the deficit budget, and the refinancing of debt against bank credits amounted in 2006 to 36.5 bn roubles, having increased on 2005 (20.9 bn roubles) by more than 1.5 times (Table 33).

Table 33

Volume of net borrowings on the market of domestic subfederal and municipal securities, thousand roubles

Consolidated regional budget Regional budgets Municipal budgets

1 2 3 4

2006

Net borrowings 36 489 742 35 161 627 1 328 115

Attraction of resources 73 288 653 66 524 832 6 763 820

Redemption of debt proper 36 798 911 31 363 205 5 435 706

2005

Net borrowings 20 887 596 16 939 894 3 947 703

Attraction of resources 81 220 540 75 016 756 6 203 783

Redemption of debt proper 60 332 944 58 076 863 2256081

2004

Net borrowings 47 880 300 44 470 128 3410 172

Attraction of resources 79 436 708 74 995 965 4 440 743

Redemption of debt proper 31 556 408 30 525 837 1 030 571

2003

Net borrowings 41 908 199 40 043 511 1 864 688

Attraction of resources 61 712 635 59 012 901 2 699 734

Redemption of debt proper 19 804 436 18 969 390 835 046

2002

Net borrowings 17 696 530 17 153 760 542 770

1 2 3 4

Attraction of resources 29 141 777 28 169 158 972 619

Redemption of debt proper 11 445 247 11 015 398 429 849

2001

Net borrowings 6 601 447 6 667 592 -66 145

Attraction of resources 15 123 785 14 226 931 896 854

Redemption of debt proper 8 522 338 7 559 339 962 999

2000

Net borrowings -1 877 328 -2 286 175 408 847

Attraction of resources 13 042 220 10 090 208 2 952 012

Redemption of debt proper 14 919 548 12 376 383 2 543 165

Source: the RF Ministry of Finance and the Federal Treasury.

The majority of the regions regularly issuing debt securities were continuing this activity in 2006. Since 1999, bonds have been issued every year by Moscow, St. Petersburg, the Republic of Chuvashia, and Volgograd Oblast. Since 2000 - by Tomsk Oblast, the Republic of Komi, and Ekaterinburg. Since 2001 - by Irkutsk Oblast (Table 34).

Table 34

Registration of prospectuses for the issue of subfederal and municipal securities in 1999-2006

Issuer 1999 2000 2001 2002 2003 2004 2005 2006

1 2 3 4 5 6 7 8 9

Moscow * * * * * * * *

St. Petersburg * * * * * * * *

Republic of Chuvashia * * * * * * * *

Volgograd Oblast * * * * * * * *

Tomsk Oblast * * * * * * *

Republic of Komi * * * * * * *

Irkutsk Oblast * * * * * *

Moscow Oblast * * * * *

Republic of Sakha (Yakutia) * * * * *

Yaroslavl Oblast * * * *

Krasnoyarsk Krai * * * *

Republic of Bashkortostan * * * * *

Republic of Karelia * * *

Lipetsk Oblast * * *

Nizhnii Novgorod Oblast * * *

Voronezh Oblast * * *

Belgorod Oblast * * * *

Tver Oblast * * * *

Samara Oblast * * *

Kirov Oblast * *

Republic of Marii El * * * *

Kaluga Oblast * *

Tambov Oblast * *

Irkutsk Oblast *

Kurgan Oblast *

Penza Oblast *

Tula Oblast *

Khabarovsk Krai * * * *

Novosibirsk Oblast * * * *

Kostroma Oblast * * *

Republic of Kabardino- * *

Balkaria

Republic of Udmurtia *

Leningrad Oblast * * * *

Yamal - Nenets AO * *

Krasnodar Krai *

Briansk Oblast *

Khanty-Mansi AO * *

Murmansk Oblast * *

Republic of Mordovia *

1

Sakhalin Oblast Kursk Oblast Stavropol Krai Primorskii Krai Municipalities Ekaterinburg Novosibirsk Volgograd Kazan

Klin raion, Moscow Oblast Odintsovo raion, Moscow Oblast Tomsk

Noginsk raion, Moscow

Oblast

Astrakhan

Blagoveshchensk

Briansk

Voronezh

Lipetsk

Magadan

Orekhovo-Zuevo,

Moscow Oblast

Tomsk

Yaroslavl

Yuzhno-Sakhalinsk

Krasnoyarsk

Novocheboksarsk

Cheboksary

Angarsk

Vurnarsk raion, Republic of Chuvashia Shumerlia, Republic of Chuvashia Ufa

Barnaul Perm

Nizhnii Novgorod Kostroma Arkhangelsk Dzerzhinskii

Source: the RF Ministry of Finance.

2

3

4

5

6

7

8

9

*

*

*

*

*

*

*

*

*

*

*

*

*

*

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The credit potential of territorial authorities

Credit rating

The substantial fall in the ratio of accumulated sovereign debt to GDP (associated with high rate of economic growth in Russia, early redemption of foreign debts by the federal government, and the stregthnening, in real terms, of the rouble's exchange rate), as well as the growing volume of the Stabilization Fund and the gold and foreign currency reserves in recent years, have all accounted for Russia's growing credit rating among other countries. At the same time, the credit rating of territorial authorities has also been growing. In 2006, Moscow's international credit rating went up, alongside the sovereign rating of the Russian Federation, to the level "BBB+", as estimated by Standard&Poor's and Fitch, and since November of last year has stayed at the level "Baa2", as estimated by Moody's.

Besides, Moody's estimated as being at the level of sovereign credit rating the credit rating of the city of St. Petersburg. Standard&Poor's and Fitch estimated the rating of St. Petersburg as being two grades below the sovereign level, or "BBB-", which, however, also placed it in the category of "investment level". The other Russian regions and municipal formations did not manage to meet the investment-level credit rating of either of the rating agencies (Table 35).

Table 35

Standard&Poor's international credit rating as of early 2007

Issuer In foreign currency / Forecast In national currency / F

Sovereign Ratings

Russian Federation "BBB+"/Stable Ratings of regional and local authorities "BBB+"/Stable

Balashikha raion "B"/Stable "B"/Stable

Bashkortostan "BB"/Stable "BB"/Stable

Bratsk "B"/Stable

Volgograd Oblast "B+"/Stable "B+"/Stable

Vologda Oblast "B+"/Stable

Irkutsk Oblast "B+"/Stable

Klin raion "B-»/Positive "B-"/Positive

Krasnodar Krai "BB-"/Stable "BB-"/Stable

Leningrad Oblast "B+"/Positive --/--/--

Moscow "BBB+"/Stable --/--/--

Moscow Oblast "BB"/Positive "BB"/Positive

Nizhnii Novgorod "BB-"/Stable "BB-"/Stable

Novosibirsk "B "/Positive --/--/--

Omsk "B"/Stable --/--/--

Samara Oblast "BB-"/Positive --/--/--

St. Petersburg "BBB-"/Stable "BBB-"/Stable

Sverdlovsk Oblast "BB"/Stable "BB"/Stable

Stavropol Krai "B"/Positive "B"/Positive

Surgut "BB-"/Stable --/--/--

Tatarstan "BB-"/Stable "BB-"/Stable

Ufa "B+"/Stable "B+"/Stable

Khanty-Mansi AO autonomous Okrug "BB+"/Positive --/--/--

Yamal-Nenets Autonomous Okrug "BB+"/Stable/ --/--/--

Source: Standard&Poor's.

The regulation of state debt in regional budgets

Against the backdrop of an improving budgeting situation in the majority of subjects of the Russian Federation, the process of stale debt regulation became more intensive. According to the data published by the RF Ministry of Finance, the volume of stale (non-regulated) debt against the liabilities of regions as of October 2006 had gone down, by comparison with October 2005, more than twice - by 7.2 bn roubles in nominal terms, or from 14.2 to 7.0 bn roubles. By comparison with 162

October 2004 (29.0 bn roubles), stale debt decreased by more than four times, amounting to only 0.22% of the budget revenue of the Federation's subjects, or less than 0.03% of GDP.

The most serious situation in respect of non-regulated debt against debt liabilities was observed in the following regions: in Tumen Oblast - 2.6 bn roubles, or 1.8% of budget revenue, in Samara Oblast - 1.3 bn roubles, or 2.5% of budget revenue, in Irkutsk Oblast - 1.1 bn roubles, or 2.9% of budget revenue.

Besides, the arrears of receivables in regional budgets continued to decrease at a high rate, having been reduced in 2006 by 23.1 bn roubles, and amounted, as of the year's end, to 57.9 bn roubles. One in one-tenth of all the regions the volume of debt increased - by the aggregate value of 2.2 bn roubles.

Table 36

Stale (non-regulated) debt against liabilities of subjects of the Federation

Volume of stale (non-regulated debt)* Ratio of stale (non-regulated) debt to budget revenue, %**

Central Federal Okrug

Belgorod Oblast 137 867 0.59

Briansk Oblast 39

Kostroma Oblast 105322 1.32

Kursk Oblast 77 982 0.57

Moscow Oblast 9 280 0.01

Tver Oblast 151.4 0.00

Yaroslavl Oblast 709 612 3.91

North-Western Federal Okrug

Kaliningrad Oblast 7 187 0.05

Novgorod Oblast 33 549 0.35

Pskov Oblast 414

Southern Federal Okrug

The Republic of Adygeya 35 700 0.75

Volgograd Oblast 36 154 0.13

Volga Federal Okrug

The Republic of Bashkortostan 31 311 0.04

The Republic of Chuvashia 14 450 0.09

Nizhnii Novgorod Oblast 2 190 0.01

Orenburg Oblast 367 528 1.32

Samara Oblast 1 341 794 2.52

Saratov Oblast 1 170

Ural Federal Okrug

Kurgan Oblast 84 781 0.77

Tumen Oblast 2 571 397 1.82

Siberian Federal Okrug

Irkutsk Oblast 1 050 000 2.89

Novosibirsk Oblast 3 120 0.01

Far Eastern Federal Okrug

Primorskii Krai 377 750 1.17

* Data as of 1 October 2006.

** The relation of stale (unregulated) debt as of 1 October 2006 to a regional (non-consolidated) budget's revenue of the year 2006.

Source: the lET's estimates, based on the data of the RF Ministry of Finance.

2.5.3. Stock Market

According to the results of the year, the Russian Stock Market in 2006 grew significantly, like in preceding year. Such a rapid growth of the Russian Stock Market was caused by several key factors, namely fairly favorable conditions in the world markets of oil and metals, which allowed the revenues of the budget system of the Russian Federation to significantly exceed the estimates, the same is true with regard to the Stabilization Fund of the Russian Federation. Moreover, in summer of 2006 the RF has completely recovered its debt to the Paris Club of Creditors. All those factors contributed to upgrading of the sovereign rating of Russia with the leading rating agencies; thus, Standard & Poor's and Fitch have upgraded its rating by one point to the level of BBB+ within the year. The macroeconomic situation was also favorable, combating with the inflation was successful and consumer prices did not go beyond the forecasted range. In July 2006, the Russian government has taken actions on further liberalization of foreign currency legislation, what has also contributed to the market dynamics, since the last barriers for capital movement were removed.

Internal corporate news played a significant role as well. According to the outcomes of the first two-three quarters of 2006, financial performance results of most companies involved in the raw materials, telecommunication and some other sectors were considerably beyond the indicators of 2005, which made such companies more attractive in terms of investment. In addition, developments in electric power and telecommunication sectors (like "Svyazinvest" privatization) contributed to the upward movement of that sector securities. Liberalization of Gazprom and IPO Rosneft shares, actively traded for population, became a significant factor for the market.

In the past 2006, the Russian RTS Stock Market grew by 731.58 points from 1190.34 to 1921.92 points, which accounts for 61.46 per cent of the index value at closing on January 10,

2006 (against 85.26 per cent in 2005). Thus, in 2006, the stock market again demonstrated a fairly impressive growth as opposed to the preceding year. The minimum growth of RTS index in 2006 - 1190.34 - was recorded in the first trading session of the last year, while the historical maximum - 1921.92 points - was attained on December 29. Regarding investment activity in 2006, it grew as opposed to the previous year of 2005. In particular, the trading turnover in the classic stock market in the RTS amounted in 2006 to nearly USD 16.5 bln with an average daily turnover of USD 65 mln, which was far beyond the corresponding figure of 2005 (nearly USD 7.65 bln with an average daily turnover at the level of USD 30.86 mln). Hence, the trading volume has been nearly doubled in 2006 as opposed to the corresponding indicator of 2005.

Several distinctive periods can be highlighted in the market movement. In the period between January -February the market grew from 1190.34 ao 1516.99

points under the RTS index, which was followed by a short-term correction in the mid March, when the RTS index rolled back to reach 135126 points. As illustrated in Fig. 15, despite the short period of correction, the movement of the RTS index was accompanied by rather high trading volume during that period. The next period was accompanied by a steady growth of RTX index growth, which reached its historical peak on May 6 (1765.35 points). Herewith, before early May, the market was growing at the background of higher trading volumes than in the second half year, when the market was recovering from deep correction. Thus, in the period between January-May the average monthly turnover in the classic stock market in the RTS amounted to nearly USD 1469.5 bln, while throughout the rest of the year it remained at the level of USD 875 bln. That period was followed by a deep correction, continued till mid June and accompanied by downgrading of RTS index to the minimum level in the year (1234.82 points).

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Source : the RTS Stock Exchange.

Fig. 15. The RTS Stock Exchange and Trading Volume in 2006

Then, the rest of the year of 2006 can be split in two sub-periods. The first one includes the market recovery up to the level of 1650 points of RTS index, followed by a decrease and then - by further growth till the end of the year, when RTS index has again reached its historical peak of the level of May 2006 (1853.24 points).

Making an analysis of monthly dynamics of the Russian stock market, one should note that despite long vacations in January, the investors' activity in the stock market was rather high, which allowed the basic stock indicators to reach historical peak values. Sberbank of Russia, LUKOIL, and RAO UES of Russia with their

prominent stock indices were in high demand. An extremely important event for the Russian stock market in terms of its liquidity, attractiveness to investors and further growth prospects became Gazprom open trades of its shares in MISEX, which became the leaders in trade volume since the first days of trades without any restrictions. External macroeconomic factors were also favorable: US index ratings, world oil prices and ADR prices for Russian bonds were growing by steady high rates.

In February the impact of those factors, accompanied by increased liquidity in the bank sector, contributed to high rates of Russian securities prices growth. A significant effect on the market dynamics in general was provided by the RAO UES of Russian shares, the upward movement of which took place due to positive news on reforms in energy sector. Thus, in his comments on the reform, the President of Russia has supported the idea to attract investments in the sector, both, domestic and external ones. Rostelecom shares have also demonstrated an expressed growth upon M. Fradkov's signature of Regulations on utilization of the RF consolidated telecommunication network resources to support the functioning of special nets as a necessary provision for privatization of Svyazinvest. Among external conditions, further growth of oil prices should be highlighted as a primary factor.

The first correction in the stock market happened in early March. Reduction of oil prices in the international market, strengthened expectations of interest rates in USA, as well as a number of technical factors (relative overestimation of some Russian companies) provoked a decline in the domestic stock market. However, the period of decline did not last long and from the middle of the month the quotations started to move upwards under the impact of positive news in the RF (LUKOIL statement on acquisition of a part of its own shares , a discussion, held in Moscow by "Big Eight" country-members on the issues of global telecom safety, a notification on a tentative date for Rosneft IPO), as well as external market news (expansion of basic stock markets).

Steady market growth was continued in April, when the market has reached its historical peak. An outstanding impact on the stock the market was provided by Gazprom, which has made an application to the US Committee on Securities to get a registration in ADR program of the first level, as well as Nordnickel shares, which positive dynamics was supported by analytics' recommendations, based on the upward trend of nickel prices in the international market. Moreover, Gazprom got an upgraded rating in MSCI index, which is used by a lot of prominent foreign market participants as a reference point for formation of their portfolios in developing markets. The stock market was also extremely sensitive to external macroeco-nomic factors. Thus, in the tensed situation, created by Iran nuclear program, the world oil prices have come up close to the level of USD 70 per barrel, and the Russian Urals brand - to USD 65 per barrel. In that background, the markets of highly industrialized countries demonstrated variable dynamics, contributing to minimization of unfavorable factors effect in the domestic market.

After May 6, when RTS index has reached its peak of 1765.35 points throughout the period under review, the upward trend has been replaced with a decline, followed by a large-scale correction. Within nine trading sessions RTS index has got down from the maximum peak level of 1318.5 points, what makes about 33.9

per cent in relative terms. Basically it was caused by the outflow of assets of external investors from all «emerging» markets, including Russia, due to upgrading of the US interest rate up to 5 per cent per annum and statements on the prospect of tightening of FRS policy. Moreover, the growth of quotations of the majority of Russian securities, observed for quite a long period, could not last forever. The decline in the world oil market ("black gold" price in New York has decreased from USD 75 to USD 70 per barrel) and non-ferrous metals can be also considered as the grounds for vast-scale sales of shares. By late May prices have won back some of the downfall in the background of improved situation in the world markets and information on prospective merging of Severstal and Arcelor companies.

Further market dynamics was characterized by high volatility. While in the first half of June correction was continued and the market moved close to the minimum level during the year, in the second part of June quotations started to move upwards again. The downfall of early June was caused by rather high interest rate risks, coming from USA, due to which the net capital outflow from emerging markets within mid May to mid June accounted to USD 13.4 bln, or 5.1 per cent of total amount. Recovery of the market at the end of the month was based on extremely high oil prices, raised to the level of USD 74 per barrel and favorable macroeco-nomic indicators of the RF.

In July there were no expressed dynamics in the stock market. Quotations of the most liquid securities were variable, but throughout July some growth was observed. Lower market volatility was caused by reduced negative expectations of investors in regard to further US FRS policy, based on the published report, informing on completion of the period of increased interest rates, expected shortly due to some slow-down of economic growth in USA in the background of stable prices. In line with that, some strengthening of geopolitical factor was observed in the world stock market dynamics: expanding military conflict in Middle East discouraged the growth of quotations of industrial countries. On the other hand, that factor has boosted up oil prices, bringing them up to the historical peak again, which is traditionally favorable to the Russian market. Among the significant internal factors there should be highlighted Fitch's upgrading of the Russia's sovereign rating and IPO of Rosneft, which became the largest primary placement among the Russian companies, and the gains accounted to USD 10.4 bln. It should be noted that the company was the first in Russia to give an access to its shares for the population.

In August trading activity in the Russian stock market was restored after the summer stagnation. However, the greatest demand was focused on blue chips of (Gazpom and Sberbank of Russia). In one of scheduled meetings of FRS the interest rate was maintained at the level of 5.25 per cent per annum, which has positively effected both, the US and RF stock markets. Nevertheless, a noticeable downgrading of world oil prices started in August and continued in September (Brent price has declined from USD 75 to USD 60 per barrel, Urals - from USD 70 to USD 55 per barrel), which negatively effected quotations of oil companies. In September the market was supported by positive dynamics in US and other stock markets and a number of positive corporate news on electric power industry re-

form, upgrading of several Russian companies' international ratings, including telecom companies. As a result, in late September the market decline has stopped and gradual growth of prices has begun.

On the one hand, declined oil prices were still providing some pressure on the prices. On the other hand, in the background of a number of positive factors, such as stable interest rate in USA and its expected decrease, upgrading of the world stock indices, the market became more resistant to the "oil factor" than it was in August-September. Among domestic factors, that made an impact on the market, there should be noted IPO of some Russian companies (TMK, OGK-5), where the demand for securities was much higher than the offer, demonstrating a high attractiveness of Russian companies to the investors.

In November the growth was continued and its rates have increased. Due to that fact, RTS index has again reached historical maximum of 1853.24 on December 15 (same level as in May). The grounds for such expressed growth were prepared by improved situation in the international oil market, where the "black gold" prices has growth again to the level of USD 63-65 per barrel in view of OPEC decision to reduce oil extraction volume and increased demand for fuel in cold season in USA. Securities of telecommunication and electric power companies were in high demand of the investors due to positive results of discussions of energy sector reform in President's Administration.

December of preceding year was not an exception; there was a traditional "pre-New Year rally" in the stock market. Bonds were growing due to improved situation in the oil market, in the international stock markets, as well as positive news background. Herewith, securities of companies that do not belong to primary commodity market were in high demand among investors: Sberbank of Russia, RAO UES of Russia, Rostelecom.

In 2006, like a year before, most liquid Russian shares grew significantly in value (Fig. 16). Last year, for example, returns on investments in OAO Rostelecom were most favorable, with the yield being 223.47 per cent (as opposed to 28.18 per cent in 2005).. Such high growth rates were caused mainly by expectations of investors for Svyazinvest prospective privatization. Some lower profitability was demonstrated by shares of OAO Sberbank of Russia, which gained 165.38 per cent (against 156.92 per cent in 2005). Next to OAO Sberbank were shares of GMK Norilsk Nickel, which gained in value 161.7 per cent (versus 12.36 per cent in 2005). Rather high returns on investments were demonstrated by RAO UES of Russia, which gained 154.72 per cent (against 53.07 per cent in 2005). As concerns other leading companies, their shares gained less: OAO LUKOIL- 47.82 per cent (100.34 per cent in 2005), Surgutneftegaz - 40.37 per cent (49.23 per cent in 2005), Tatneft - 40.06 per cent (127.87 per cent in 2005), Mosenergo - 36.43 per cent (-4.76per cent in 2005), Gazprom - 36.26 per cent and Rosneft - 23.98 per cent. The lowest growth rates among the "blue chips" were noted on shares of Gazprom Neft (former Sibneft), the value of which has grown in 2006 only by 16.69 per cent.

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Fig. 16. Blue Chips Price Dynamics in 2006

In 2006, among the "second echelon" companies whose shares gained maximum values, were OAO Chelyabinsk (447.95 per cent), ОАО TKZ "Krasny Ko-telschik (439.1 per cent), ОАО Pskovenergo (423.53 per cent) respectively. However, trading activity of the above listed companies remained low. For example, 22 transactions were made on the shares of OAO Chelyabinsk, 26 transactions on the shares of ОАО TKZ "Krasny Kotelschik, and 34 transactions on the shares of Pskovenergo

RAO Gazprom was the leader by trading turnover to account for 39.8 per cent of the total trading volume in the RTS in 2006. Apparently, such an upswing can be explained by open trading of Gazprom shares. The leader is followed by RAO UES of Russia, accounting for 16.7 per cent against 25.86 per cent in 2005. The next company is OAO LUKOIL , to account for 13.9 per cent (29.55 per cent in 2005). The shares of Norilsk Nickel and Sberbank were ranked accordingly as number three and four to account for 5.9 per cent (9.7 per cent in 2005) and 4.8 per cent (5.6 per cent in 2005) of the total trading volume in the RTS in 2006. Hence, in 2006, transactions on the shares of the five abovementioned issuers accounted to nearly 80.8 per cent of the total trading volume in the RTS, which significantly exceeded the relevant indicator of 2005 (71.28 per cent).

According to the data as of December 29, 2006, the top five list of companies by capitalization was as follows: Gazprom - USD 272.25 bln, Rosneft - SD 83.19 bln, LUKOIL - USD 74.18 bln (against USD 50,5 bln in 2005), Sberbank of Russia -USD 65.6 bln (USD 24.89 bln in 2005), Surgutneftegaz - USD 54.7 bln (USD 38.5

bln in 2005).There were no expressed changes in the companies' rating in terms of capitalization as compared with 2005. It should be noted that the four most capitalized companies of Russia belonged to the oil and gas sector against three companies in the previous year, which is explained by extremely favorable conditions in the primary commodity markets in 2006. Sberbank of Russia had the highest capitalization among the companies that do not belong the primary commodity market, like in the previous year.

Futures Contracts Market

Every year FORTS market (Futures and Options on the RTS) is steadily growing, and celebrated, and the year of 2006 was not an exception. For example, the turnover of futures and options contracts in the futures market totaled nearly RUR 2 708.5 bln in the previous year, as opposed to RUR 711.54 bln in 2005. In other words, the turnover of the futures contracts (FORTS) market in 2006 has grown nearly three-fold as compared with the corresponding figures of the previous year. Participants of the market entered into nearly 5 million transactions to amount to 89.6 million contracts (nearly 1.96 million transactions and 54.87 million contracts in 2005). The average daily volume of open positions on standard contracts was RUR 64.6 bln, 2.24 million contracts, to grow 2.6 times in rubles and by 37.2 per cent in contracts as compared with 2005. During 2006 the volume of open positions reached maximum level to the amount of RUR 147.8 billion (on December 12) and 4.19 million contracts (as of the same date). A share of futures transactions was the largest in the segment of futures contracts in 2006 to account to nearly 88 per cent of the total trading volume or RUR 2 397 bln (RUR 630.53 bln in 2005), while the value of option transactions amounted to only RUR 311.4 billion (as opposed to RUR 81.01 billion in 2005). Hence, a share of options transactions by trading volume remained in the last year at the same level as compared with 2005.

Some dynamics was observed in the ratings of trading volumes of a number of contracts. Thus, upon placement in the market of RTS index futures in 2005, it became most attractive for investors in 2006. Its share in the total trading volume made 27.7 per cent. It was followed by futures contracts on market value of the shares of Gazprom and RAO UES of Russia, whose shares in the total trading volume made 27.74 per cent and 20.79 per cent accordingly (21.62 per cent and 27.37 per cent in 2005). The next in the list is LUKOIL (significantly lagging behind the leaders), with the share in the total trading volume of 7.77 per cent (against 17.59 per cent in 2005). Among the options, those ones for futures of Gazprom shares were in highest demand (3.95 per cent in the total trading volume of the market of futures).

In 2006, some new instruments emerged in the market. On February 14 futures contract on Moscow ten-year bonds was launched, which is currently the sole long-term interest rate derivative. On February 20 futures contract for the RF Eurobonds with maturity term in 2030 was launched. Hence, there emerged a new market instrument for risk hedging and the investors have an opportunity for arbitration between Eurobonds 30 and US Treasuries at minimum expense. Futures contract for Moscow Inter - Bank Offered Rate was launched on May 30, which became the

first market instrument for risk hedging of short-term rates. Futures contracts for Urals oil and gold were launched on June 8, opening a new stage in FORTS market development. Further expansion of the number of commodities contracts can continued with oil and gold options, as well as futures for oil. Finally, futures contract for common shares of OAO Rosneft and options for futures contract for common shares of OAO GMK Norilsk Nickel were launched on October 16. With appearance of the new instruments, a full set of derivatives was formed for all blue chips of the Russian stock market. Hence, for the time being, FORTS participants can enter into transactions on 16 futures and 7 option contracts.

Corporate Bonds Market

In 2006, the market of corporate and regional bonds was stable in general. However, the corporate bonds market did not demonstrate any expressed dynamics in 2006 as compared with the stock market. This is evidenced by the movement of corporate bonds indices assessed by Zenit Bank on the basis of market prices of bonds traded in the MICEX41 (Moscow Interbank Currency Exchange). In 2006, the ZETBI-Corp index grew by 0.43 points (-0.39 per cent) from 111.52 to 111.09 points. However, the ZETBI-Corp10 index, which is assessed on the basis of quotations of most liquid corporate bonds, grew from 118.2 to 119.11 points in 2006.

As compared with the market of government bonds, corporate bonds market quotations demonstrated higher volatility throughout 2006. Three periods can be highlighted within the year, when the dynamics of prices were different. (Fig. 17). The first one lasted from January to June, when a downward trend was prevailing in the market. The second period - from July to September, when the market was growing in general, while the most liquid bonds have stopped at the maximum levels of 2006. Finally, during the third period the market indicators remained at the level of late October, despite significant downgrading in November and upgrading in December.

Making an analysis of monthly dynamics of quotations, we should mention, that long January vacations have provided a negative impact over investors' activity in the market of corporate and regional bonds. Nevertheless, in early January quotations of the most liquid bonds have somewhat grown. Making an analysis of external factors, we should note, that the dynamics of US bonds and Russian Eurobonds made for the decline of corporate bonds prices. As opposed to that, domestic economic factors supported the stock market: RUR was strengthening against USD, liquidity was maintained at a reasonable level. The situation in the primary market was rather quiet, whereas the volume of trade was quite low.

In February-March relatively positive dynamics was observed in the market. The impact of primary market factors grew stronger: a considerable volume of primary offer made for the outflow of assets from the secondary market. Moreover, foreign currency market, where some decline of RUR versus USD was observed, made an additional pressure on prices. Apparently, the market dynamics was dependant on expectations for further growth of interest rates in developed markets, whereas other factors did not contribute to the market downfall (Russian Euro-

bonds quotations remained stable, and by the end of the month RUR has restored its position against USD). One more reason for the market downgrading was an upgrading of interest rates by industrialized countries (USA, European countries, Japan), which demonstrated a lower attraction to investment value.

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Source : Zenit Bank.

Fig. 17. Corporate Bonds Price Index Dynamics in 2006 ( January 10, 2005 = 100per cent )

Within the next month investment activity in the market of corporate bonds has considerably grown, what however did not bring up a noticeable positive trend; quotations of the most liquid bonds were variable. The basic external factor that effected the situation, was uncertainty in regard to further priorities in the US FRS credit and monetary policy, which provided an immediate impact on activities of investors in emerging markets. Another upswing of oil prices in the international market and confrontation between Western countries and Iran also did not add to attraction of investors. An excessive pressure over the prices was made by interest rates growth in the inter-banking market. Even an expressed upgrading of RUR against USD could not contribute to the demand for securities.

May was characterized by moderate growth of quotations of the most liquid issues of corporate bonds against the background of relatively high activity in the market. The market was resistant to negative external factors. Apparently, it can be explained by the background of massive release of assets in the stock market and general aggravation of the situation in the international markets, when corporate bonds were regarded by investors as relatively attractive opportunity for invest-

ments. Moreover, the initial the structure of investments in the market of securities and corporate bonds was variable: investments in securities are made as a rule for a short-term for speculative purposes, while investments in corporate bonds are more conservative, and the investors, involved in such operations, are governed by the basic market indicators and are less affected by short-term trends. One should not ignore also the factor of liquidity, which is traditionally one of the most effective one for the RF debt market, as well as continued strengthening of national currency.

However, May growth did not last long and since June the market started to get down, which has affected a wide range of securities. Investment activity was still high, what confirmed both, technical and fundamental character of the decline. Uncertainty in the US FRS policy remained one of the basic fundamental factors, effecting financial markets in the majority of countries. Comments of the US financial authorities, that inflation is getting beyond a "comfortable margin", have confirmed a high probability of further upgrading of interest rates. Hence, in May that factor has mainly effected the bonds market, whereas in June it has naturally made an impact on the debt market. Like some months before, the major factors, supporting the market, were rather high liquidity level in the banking sector and RUR strengthening against USD.

July was a turning point in the trend of corporate debt market, as well as in other sectors of the Russian financial market. In many ways it happened due to general improvement of the situation in the world debt market in general and in the Russian Eurobond market in particular. High liquidity and lowered inflation in the RF contributed to additional support to quotations. Rather large volume of securities was traded in primary market and restrained quotations in a way. The growth of corporate bond price continued in August due to high liquidity (international stock market quotations made about 2-3 per cent per annum), upgraded RF rating a month ago, favorable situation in the external debt market and lower inflation expectations.

The growth, observed within two months, in August and September, was replaced by variable price dynamics, and as of monthly results, quotations were changed insignificantly. External factors had a negative effect. Thus, a probability of increased interest rate in the EU and stability of that factor in the US were restraining the growth of quotations of the bonds, denominated in foreign currency and in RUR. In line with that, one could note the upsurge of volatility of USD nominal exchange rate as opposed to its relatively stable rate against RUR. In the background of expressed decline in the world oil prices, the investors realized, that one could not expect any support from that factor, which has been observed for the greater part of 2006. External factors also restrained the growth: liquidity decline, large volumes of primary placements. Regardless the fact, that by late September the yield of the most liquid issues got down to the minimum level, expressed changes in the structure of basic factors provided a growing pressure on prices. Information on upgrading of the RF long-term credit ratings by S&P credit agencies made a positive impact on the market.

In late October there started a smooth decline in the market. In general, external background remained neutral. On the one hand, interest rates in US and Europe remained unchanged, what contributed to stabilization of quotations. On the other hand, a noticeable aggravation in natural resource markets provided an adverse effect on prices of corporate bonds. Reduction of prices (for Brent) beyond USD 60 per barrel fostered downgrading of Russian securities, and then -corporate bonds' prices. Domestic factors also made a negative effect: the volume of offer in primary market was large, the situation with liquidity was deteriorated at the end of the month (the yields reached 7-10 per cent per annum).

In November the market trends were variable, but as of results of the month, the majority of the issues demonstrated some growth. The basic factors, that hindered the upward trend, were aggravated situation with liquidity in the bank sector and large volume of primary placements. On the other side, significant RUR strengthening against USD highly contributed to attractiveness of the securities, denominated in RUR. In December the market situation has improved due to positive macroeconomic factors, as well as upgraded financial indicators of business companies and ratings of some of them. The most negative factor was massive placements in the primary market, distracting the assets form secondary market.

Total volume of placements of corporate and regional bonds in the primary market was RUR 515.4 bln (investments of banks and companies made RUR 464.4 bln), as compared with approximately RUR 311 bln in 2005. Hence, one may see a substantial increase in primary offering in the market of corporate and regional debt. In the background of general growth of issuers' activity in 2006, auctions were arranged more regularly throughout the year. For example, the maximum volume of placements of corporate and regional bonds in primary market was recorded in December (like a year ago) to amount to nearly RUR 85.8 bln (as opposed to nearly RUR bln in December of 2005), while the minimum one amounted to RUR 13.9 bln in May (as opposed to RUR 9.05 bln in May of 2005). Therefore, the maximum and minimum volumes of placements of corporate and regional bonds in primary market were recorded in 2005 in December and May accordingly.

Factors that Have an Effect on the Russian Stock

Market Dynamics

In 2006, the Russian Stock Market was governed by a series of factors, which conventionally can be broken down into the groups as follows :

• Internal political situation;

• Relations with international financial institutions and organizations;

• Situation in the international financial markets;

• Situation in the world raw material markets (especially oil);

• Corporate news.

Each of the above groups of factors had a different effect on developments in different segments of the Russian financial market during the year of 2006. In spite of the fact that most of these factors have already been mentioned in the analysis of different segments of the Russian financial market, it is appropriate to focus on

them in detail, and the situation in the world market of raw materials was considered in Secton.

Internal political situation. Throughout 2006 internal political situation in Russia remained quite favorable for financial markets. First of all, it should be noted that published statistical data indicated the growth of Russian economy. Certain problems were observed in the first half of the year, caused by accelerated inflation, exceeding estimated parameters. It effected inflation expectations, and as a result, made an impact on the yield of stock market instruments. However, in the second half of the year the inflation was taken under control and some officials of the government and Central Bank expressed a hope to restrain the inflation within the estimated limits.

Another significant factor of financial market dynamics was the growth of the world market oil prices. Like a year ago, that factor promoted not only further upgrading of the RF budget indicators, but higher deductions to Stabilization Fund as well, which were partially addressed to final redemption of the Russian debt to Paris Club of Creditors.

Moreover, during the year there was no news on tax claims to large Russian companies, like it happened in 2004-2005. Any claims of tax authorities to individual taxpayers were settled without conflicts. The government maintained its policy of control over some sectors of economy. Thus, at the end of the year audits were performed in TNK-BP company, participating in PSA projects. According to official information, the basic reason for close attention to that company was violation of ecological legislation. However, one can presume, that PSA projects are rather attractive assets, but initial provisions of those agreements, could be unacceptable to the present government of the country.

Finally, one should not ignore a number of decisions, adopted on structural reforms, implemented in the country. Thus, the President has informed on the need to create conditions for involvement of domestic and international investments in the national electric power section. In autumn a successful discussion of the reform implementation took place, which can also be regarded as one of the support factors to the domestic market. Moreover, some comments were occasionally made on the need for Svyazinvest privatization, which is expected by the market participants for a long while and is considered as a factor of growth of the shares of telecom companies.

Relations with international financial organizations. Relations between Russia and international financial organizations developed successfully enough throughout the entire year, which depended largely upon favorable macroeco-nomic situation in the country available over the last two years, and effective management of the Russian external debt.

For example, in July Fitch rating agency has upgraded the Russia's sovereign credit rating denominated in foreign currency from BBB to BBB+ , Outlook Stable. The Agency representatives have explained the upgrading by several reasons, one of them is prompt strengthening of Russia's macroeconomic and financial positions due to high prices in the markets of raw materials, as well as decreased risks

in government debt service. According to the Agency forecast, by the end of the year Russia will be an external net-creditor for government debt in the amount of USD 200 bln, what will ensure considerable reserve for cases of negative market dynamics. In September another rating agency, Standard&Poor's has upgraded the Russia's long-term credit rating, denominated in foreign currency, from BBB to BBB+, and that one in national currency from BBB+ to A-. The Outlook Stable. According to the Agency press release, that decision was based on the enlarged gold and foreign currency reserves of the RF, improved budget indicators of the enlarged government, as well as reasonable approach of the government to the problems of macroeconomic stability.

Another factor, confirming strengthening of the Russian companies' positions is inclusion of their shares in the global stock indices. Thus, in 2006 Morgan Stanley Capital International agency has not only included Gazprom securities into the listing of bonds traded under index MSCI Russia, but was also upgrading its rating in the index.

Upgrading of Russia's sovereign credit rating in 2006 was based to a great extent on successful policy in external debt management. Thus, in June the RF has completed negotiations on early redemption of the debt balance to Paris Club of Creditors in the amount of USD 22 bln. The transaction has been completed in August.

Situation in the international financial markets. The year of 2006 was characterized by a substantial improvement of the situation in the world stock markets. (See Table 37).

Table 37

Dynamics of International Stock Indices in 2006

Data on 29.12.2006 Value Variance, %

RTS (Russia) 1921,92 61,45%

Dow Jones Industrial Average (USA) 12463,15 14,90%

NASDAQ Composite (USA) 2415,29 7,65%

S&P 500(USA) 1418,30 11,78%

FTSE 100 (Great Britain) 6220,80 9,50%

DAX-30 (Germany) 6596,92 21,04%

CAC-40 (France) 5541,76 16,55%

Swiss Market (Switzerland) 8785,70 15,17%

Nikkei-225 (Japan) 17225,83 5,28%

Bovespa (Brazil) 44474,00 32,73%

IPC (Mexico) 26448,32 47,54%

IPSA (Chili) 2693,22 38,85%

Straits Times (Singapore) 2985,83 26,01%

Seoul Composite (South Korea) 1434,46 3,25%

ISE National-100 (Turkey) 39117,46 -1,69%

Morgan Stanley Emerging Markets Free Index 912,66 29,09%

In particular, the US stock market indices demonstrated a significant growth in 2006. For example, while the Dow Jones has grown by 12.87 points (14.90 per cent), the Nasdaq Composite gained 168,87 points (7.65 per cent) as of the year results. Two periods with different trends can be highlighted in the dynamics of US stock indicators (Fig. 18). Thus, while in the first half of the year there were variable trends in the market, in the second half a steady growth was observed.

Making an analysis of the basic factors of dynamics, we should note, that the major ones were tightening of the US FRS monetary and credit policy, macroeco-nomic news, dynamics of the world oil prices, corporate news, as well as geopolitical tension in the Middle East.

It should be mentioned, that the significance of the first factor has grown up in 2006. Within the first half of the year FRS has repeatedly raised the interest rate, which effected the quotations of the US securities. The decision on upgrading the interest rate was adopted on the basis of macroeconomic statistics, which reflected a stable economic growth, accompanied by accelerated inflation. An additional factor, provoking inflation, was a considerable increase of the world energy sources' prices, whereas the US economy is dependant on oil and its products supplies. At the beginning of the year a group of corporations has published negative estimates of their productive and financial indicators, what has affected the stock market quotations. Moreover, certain negative impact was provided by Iran nuclear program. Inability of USA and Iran governments to find a compromise increased the risk of economic sanctions on the part of US and other industrialized countries and even a probability of a military conflict. All those factors also affected the investors' behavior.

As opposed to that, starting from July, macroeconomic statistics reflected some decline in economy and hence, reduction of inflation risks. With regard to that information, FRS has decided to sustain the interest rate. In view of that decision, many investors have reviewed their estimates of the interest rate and moreover, expected some decrease in case the trends of the end of the year stay in effect.

As concerns the stock markets of other countries, they have also grown as of 2006 results. Thus, the European stock indices grew some more than the US rates. German aggregate stock market index DAX-30 gained 21.04 per cent within the year, French CAC-40 -16.55 per cent. Upgrading of EU CB interest rate was one more factor, effecting the dynamics of the stock market. The situation in developing countries was even better, here the stock markets' growth measured more than a dozen of per cent per annum in 2006. As a result, the Morgan Stanley's aggregate stock market index in developing countries grew by nearly 29.09 per cent.

In general, the markets of industrialized countries had a greater effect on the Russian stock market, when there was no essential domestic news or oil prices were stable. On the contrary, when there were some domestic news on both, business or public sectors, they had a greater effect than external markets' fluctuations. It is the policy of the US Federal Reserve System that was the sole factor considered by investors from any country, which could have a medium-term effect

on market liquidity in the markets due to an outflow of major US funds and other institutional investors.

220%

200%

180%

160%

140%

120%

100%

80%

Dow Jones Industrial Average NASDAQ Composite The RTS Index

Fig. 18. Dynamics of US aggregate stock market indices Dow Jones u NASDAQ

in 2006 (January 10, 2006 =100 %)

Corporate News

Upgraded credit ratings. Enhancement of some of Russian corporations' performance have been reflected in assigning long-term credit ratings or upgrading of existing ratings.

For example, late in March, Standard & Poor's, the international credit rating agency, decided to upgrade its long-term credit rating of OAO Rostelecom from B+ to BB-, Outlook Stable. Standard & Poor's reported that the upgrade reflected strengthened financial positions of the company, based on high performance and low arrears. Standard & Poor's has assessed OAO Rostelecom stable performance results, as well as efficient measures taken by its management in order to reduce company's costs and retain leading market positions. Further reduction of debt load, as well as increase of disposable cash flow contributed to high liquidity of the company. Moreover, in May the company has announced that Standard&Poor's has upgraded corporate management rating according to the national scale up to the level of RCM-6.2 and as per international scale to RCM-6. Total company rating is formed from the points, gained by separate components under 10-point scale. Thus, according to the year results, the points, gained on "property structure and shareholders' authority", have been slightly lower, from 5/5.3 to 5/5.2 (where the first figure reflects the points under international scale, the second one - according to the national scale), as well as the points, gained under "Authority of financially

involved entities and cooperation with them" from 7+/7.5 to 7/7.3 points. The points, gained for "Financial transparency and information disclosure" were confirmed at the level of 6+/6.9. However, due to upgrading of Rostelecom rating under component "Members and performance of the Board of Directors", S&P raised the company rating from 5+/5.7 to 5+/5.9. Standard & Poor's agency has positively evaluated the level of information transparency of the company, introduction of a new position of Corporate Secretary of the company, activities of Committees under the Board of Directors, in particular Audit Committee, implementation of fair bonus system for the company management. S&P has highly estimated commitment of the company management to upgrade the standards of corporate management in compliance with international standards.

In 2006 OAO LUKOIL rating was revised twice. On April 13, the company was assigned by Fitch, the international credit rating agency, the rating of issuer of securities, denominated in foreign and in national currency of BBB- level and F3 short-term rating; Outlook Stable. At the same time, the Agency has assigned BBB-rating to the issue of OAO LUKOIL shares for the amount of USD 350 mln, issued by LUKinter Finance BV. The Agency stated, that Outlook Stable id based on high financial stability of the company in future, ensured by sustained level of oil extraction and production, keeping up favorable price policy in the international oil market and gaining positions in the new markets, especially in the North America. On the other hand, adverse tax legislation, high export taxes and transportation costs as well as increased competition in the Russian market of oil products is a threat to the ratings.

On July 11 the rating agency Standard & Poor's has upgraded the long-term credit ratings of OAO LUKOIL from "BB" to "BB +". The outlook is Positive. At the same time, the rating according to national scale has been raised from "ruAA" to "ruAA +". Upgrading of the ratings reflects the continued growth of cost efficiency of the company within the first quarter of 2006 (net profit per barrel was USD 9, what is by 29 per cent higher than the relevant indicator of the first quarter of 2005). Standard & Poor's expects that in future the gains of LUKOIL Group and its resistance to oil prices decline will continue to grow due to rapidly increasing gas production.

Credit rating of GMK Norilsk Nickel in 2006 was also upgraded by two leading rating agencies. Thus, on August 8 the international rating agency Standard & Poor's has upgraded the ratings of OAO GMK Norilsk Nickel from "BB+" to "BBB-". This is the highest rating among private companies in Russia. The Outlook "Stable". At the same time, the rating according to the Russian national scale was confirmed at the level of "ruAA +". According to common ratings of other agencies (Fitch's, "BBB-", Moody's "Ba1" and Standard & Poor's - "BBB-") Norilsk Nickel is keeping the leading position among the highest ranking private Russian companies. According to the rating agencies, the ratings are based on the unique resource base, sound financial position, successful performance of the company managers, as well as leading positions of GMK Norilsk Nickel in the world market of nickel, palladium, platinum, copper.

On October 9, the international rating agency Moody's Investors Service upgraded the corporate rating of OAO GMK Norilsk Nickel to "Baa2" "from" Ba1 ", i.e. by two points, bringing it to the investment level. Rating of unsecured bonds was upgraded by 3 points from "Ba2" to "Baa2" according to the national scale; as per Moody's Interfax - from "Aa1.ru". to "Aaa.ru" The Agency stated, that upgraded rating is based on strong basic performance indicators of the company. The Outlook is Stable. According to consolidated ratings (Fitch, "VVB-", Moody's, "Vaa2" and Standard & Poor's, "BBB"), Norilsk Nickel holds a leading position with the highest ranking private Russian companies. These ratings reflect the unique resource base and sound financial standing company, as well as leading positions of GMK Norilsk Nickel in the world market for nickel, palladium, platinum, copper.

Results of financial performance. In the period between August-December 2006, most companies published their financial performance statements for 2005. The following companies should be mentioned.

On December 5, 2006, RAO UES of Russia disclosed the results of its performance in the first half of 2006, prepared in accordance with international accounting standards (IAS). For example, its earnings from basic activity totaled RUR 453.3 bln in the first half of 2006, what is RUR 62.2 bln higher than in the relevant period of preceding year. Profit from basic activities of RAO UES of Russia for the first half-year of 2006 rose by RUR 6.6 bln (14 per cent) as compared with the first half of 2005 and amounted to RUR 53.4 bln. Profit before tax amounted to RUR 47.2 bln, having increased by RUR 8.5 bln. Net profit of RAO UES of Russia for January-June 2006 amounted to RUR 27.2 bln. As compared with the first half of

2005, there had been an increase in net income by RUR 5.3 billion (24 per cent), based on the increase in operating income by RUR 6.6 bln and cut down of expenses by RUR 1.6 bln.

On December 21 OAO Gazprom has disclosed unaudited consolidated interim financial statement for the first half of 2006, developed in accordance with International Accounting Standard 34 "Interim Financial Reporting" (IAS 34). Thus, within the six months of 2006 net proceeds from natural gas increased by RUR 225.929 bln, or 46 per cent, as compared to the corresponding period of 2005, and amounted to RUR 721.885 bln, what was mainly based on price growth for sales to Europe and former Soviet Union countries, as well as higher volumes of sales in natural terms. The profit of AOA Gazprom shareholders for the first half-year of 2006 amounted to RUR 321.491 bln, what is RUR 168.681 bln, or 110 per cent more than in the same period of 2005. Net debt was decreased by RUR 126.716 bln, or 16 per cent, from RUR 797.465 bln as of December 31, 2005 to RUR 670.749 bln as of June 30, 2006. The decrease was mainly explained by a net repayment of long-term debt due to an increase of monetary assets and raised proceeds from operational activities, as well as RUR exchange rate dynamics.

In early October, consolidated financial reporting for the first half of 2006 was disclosed by OAO Gazprom Neft, a daughter company of Gazprom. In accordance with the reporting, prepared in conformity of US GAAP, revenues for the first half of

2006, compared with the first half of 2005, increased by 77 per cent and amounted to USD 10.1 billion. Profit before tax, interest and depreciation (EBITDA) for the

first half of 2006 to compare with the same period the previous year increased by 35 per cent and amounted to USD 2.6 billion. Net profit of OAO Gazpromneft for the first half of 2006 amounted to USD 1.8 billion, which is 26per cent more than in the same period of preceding year.

On October 18 LUKOIL has also issued consolidated financial statements for the first half of 2006, prepared in accordance with generally accepted accounting principles the United States (US GAAP). According to the information provided, the net profit for the first half of 2006 amounted to USD 4 010 billion, an increase of 54.8 per cent as compared with the same period of preceding year. The EBITDA parameter grew by 50.4 per cent to USD 6 464 million. Sales revenue rose to USD 33,210 billion, or by 38.1 per cent. The increase in net profit was based on favorable price environment, increased production, processing and effective control over expenditures, as well as higher oil refining margins. However, the increase in profit was constrained by RUR strengthening against USD, as well as increased tax burden.

On November 2 Rostelecom has published unaudited results for the first nine months of 2006 in compliance with the Russian accounting legislation (RAS). According to the reporting, revenues for the first nine months of 2006 increased as compared with the relevant period of the preceding year by 47. per cent and amounted to RUR 43,757.1.1 million. The EBITDA parameter decreased against the same period of 2005 by 21.9 per cent, to RUR 9,069.4 million due to significant increase in costs, caused by changes in mutual settlements with Russian companies. Cost efficiency as per EBITDA amounted to 20.7 per cent. Net profit of Rostelecom for the first nine months of 2006 amounted to RUR 5,004.6 million, as compared with RUR 7,843.8 million in the first nine months of the previous year.

Mergers and acquisitions. In 2006, several Russian companies continued to purchase new assets, including foreign ones, as well as establish long-tem relations allowing them to expand and enhance efficiency of their businesses. In addition, some of these companies implemented business reorganization and restructuring.

For example, January, Norilsk Nickel has informed on creation of a joint venture with Rio Tinto, one of the world largest mining and metal companies, which will deal with exploration and development of mineral deposits in Russia. The companies signed a agreement on cooperation in the Ministry of Natural Resources of the Russian Federation. Based on the principles of the agreement, a contract will be signed, which will stipulate the provisions of the joint venture. The agreement implies establishment of a joint venture for exploration and development, 51 per cent of which would be owned by Norilsk Nickel and 49 per cent by Rio Tinto. Initially exploration works will be concentrated in the Siberian and Far Eastern Federal Regions of Russia.

LUKOIL Overseas, the operator of international upstream projects OAO LUKOIL, has signed an agreement on merging with the company Chaparral Resources, Inc., according to which LUKOIL Overseas acquires all Chaparral Resources shares, issued in circulation. The agreement was approved by a special

Committee of the Board of Directors of Chaparral Resources. Recommended purchase price is USD 5.80 per share, which includes a bonus of 12.3 per cent to an average price of the share over the past 30 days. The total cost of the package of shares of Chaparral Resources, not owned by LUKOIL, amounts to USD 88.6 million, what is equal to the value of acquired proven reserves of oil (USD 8.10 per barrel). Consolidation of Chaparral Resources assets is executed by LUKOIL for complete control over the company, as well as enhancement of management system.

Also in May LUKOIL, acting through its 100 per cent subsidiaries, and Marathon Oil Corporation reached an agreement, that LUKOIL will acquire extraction facilities of Marathon Oil Corporation in Khanty-Mansi Autonomous Region. Those assets include more than 95 per cent of OAO Hantymansiyskneftegazgeologiya, as well as 100 per cent of the shares of two other companies : OAO Paytyh Oil and OAO Nazymgeodobycha". The amount of the transaction is USD 787 million with regard to adjustment for circulating capital and other adjustments. Total oil productive capacity as of January 1, 2006 was 257 million tons of brand AVC1 + C2 (about 1.88 billion barrels).

On June 26 OAO Gazprom, represented by ZGG GmbH, signed with OOO LEVIT and SWGI GROWTN FUND (CYPRUS) LIMITED (main shareholders of OAO NOVATEK, a preliminary agreement on the acquisition (for market price) of their shares in the authorized capital of OAO NOVATEK in the amount of less than 20 per cent of outstanding stock of the company.

On November 20, 2006 GMK Norilsk Nickel has informed on the signature of a purchase agreement for nickel business of OM Group Inc. for USD 408 million for monetary assets, excluding financial indebtedness. The acquired Nickel business includes OMG nickel refinery, a unit OMG mining and refining of nickel ore, 20 per cent of the shares of MPI Nickel Pty. Ltd, a company that develops Black Swan nickel mines and Silver Swan, as well as up to 11.1 per cent in the form of ordinary shares and convertible debentures in Talvivaaran Kaivososakeyhtiq(project on concentrated bioleaching in the Kainuu Region in Finland). The transaction will allow GMK Norilsk Nickel to continue international expansion of its business activities, and to strengthen their position in the international mining and metal market.

Capital investment. In the preceding year the native companies have actively pursued the policy on investing additional volumes of assets, including those in foreign financial markets, ad well as in the world stock markets.

On March 2 OAO Mosenergo has placed the bond loan amounted to RUR billion, at the rate of 7.65 per cent from 1 to 12 coupon. The mature term is 10 years. OAO Mosenergo has placed the bond loan to refinance debt liabilities and optimize financial activity of the company. Placement purpose of the loan is ZAO Stock Exchange MICEX. Agency Standard and Poor's has assigned ruBBB + rating to the loan. Furthermore, on September 19 there was placed a ruble bond loan of OAO Mosenergo, in which the output made RUR 5 billion, at the rate of 7.54 per cent from 1 to 6 coupons with the term of maturity of 5 years. The next day after posting the bond loan, the rating agency Standard & Poor's has increased the international credit rating of Mosenergo from B- to B , the national rating was upgraded from ruBBB + to ruA-.

On April 18, 2006 OAO Gazprom has announced the entry into force of the program of depository receipts (DR) of the Society of the First Level, as well as of the simultaneous amendments to correlation of a number of ordinary shares of OAO Gazprom per one DR, from ten shares for one DR to four shares per DR. Gazprom DRs, available in circulation so far, were automatically converted at the effective rate (on the basis of existing restrictions). Depository receipts, issued under Program ADR of the first level will be freely circulating in the USA stock market, as well as in European stock markets. The maximum amount of ordinary shares, which may be the base asset for all ADRs of OAO Gazprom, will not exceed 35 per cent of the authorized capital of OAO Gazprom.

On 20 October OAO Sberbank of Russia has signed an agreement on a syndicated loan in the amount of USD 1.5 billion between Sberbank of Russia and foreign banks, including bank founders of ABN AMRO Bank N.V., Barclays Capital, J.P. Morgan plc and Sumitomo Mitsui Banking Corporation Europe Limited. Thirty banks with the widest geographical representation participated in the syndicate. The average prices for Syndicate has been much higher than in earlier syndicated borrowings of Russian borrowers. Syndicated loans held for a period of 3 years with a single payment at maturity. The borrowing was announced at the level of USD 1 billion. However, the proposals on the part of banks to participate in the loan amounted to about USD 1.7 billion, and in this regard, Sberbank of Russia has decided to increase the loan amount up to USD 1.5 billion The rate of borrowing was LIBOR+0.3 per cent per annum, while the margin is the lowest for a three-year syndicated loans to Russian borrowers. The loan will be used for general corporate purposes. The transaction is the largest unsecured syndicated loan, ever granted to the financial institutions of Russia and other CIS countries, as well as countries in Eastern Europe, Middle East and Africa. The syndicated loan of Sberbank of Russia in the amount of USD 1.5 billion is the third largest syndicated transaction, organized in 2006.

On October 27, the Board of Directors of RAO UES of Russia has approved the issuance of additional shares of OAO Mosenergo for a closed subscription in favor of the Gazprom Group. During the additional emission, OAO Mosenergo intends to attract at least USD 2.1 billion of investments. Monitoring of the implementation of investment projects will be implemented by a simple partnership, formed by RAO UES of Russia, Gazprom and OAO Mosenergo.

On November 2, OAO Gazprom posted ruble bonds, series A7 and A8, accounted to RUR 5 billion each, with a nominal value of RUR 1000 rubles, with the maturity term of 3 and 5 years respectively. The annual coupon rate bonds series A7 paid every 182 days, as per the auction results on the MICEX, was established in the amount of 6.79 per cent per annum. The investors have made applications amounting to RUR 9.6 billion. The annual coupon rate bonds series A8 paid every 182 days, to the auction on the MICEX, was determined at the rate of 7 per cent per annum. Investors have made applications amounting to RUR 7.4 billion. The loans were arranged by the investment group Renaissance Capital and Rosbank OAO

,with the Horizon investment company as a partner; the financial advisor was OAO Federal Stock Corporation.

On December 14, 2006 LUKOIL has placed two issues of non-documentary interest bonds of OAO LUKOIL payable to the bearer, when they keep Series 03 and 04, for the total amount of RUR 14 billion. The contest coupon rate bonds series 03 totals to the nominal value of RUR 8 billion for a period of 5 years, at the rate of 7,10 per cent per annum. The annual coupon rate on Series 04 bonds in the amount of 6 billion rubles and treatment for 7 years was 7.40 per cent per annum. Price placement of bonds Series 03 and Series 04 was set at 100 per cent of nominal value. Early repayment of bonds and preferred right for the bonds' acquisition is not provided. 152 applications were filed for acquisition of the bonds, worth over RUR 20 bln, which exceeds the emission nearly 2.5-fold. As a result, LULOIL has become the first Russian private company, which has successfully placed bonds with a continuous maturity of 7 years. The issuance was executed by ABN AMRO Bank, Dresdner Bank and IB Renaissance Capital.

On December 20 an extraordinary general meeting of shareholders of OAO Mosenergo has approved an increase in the authorized capital of the Company by issuing additional shares in favor of a strategic investor. Shareholders of Mosenergo have approved the limit of issued ordinary shares in the amount of 11 500 000 000 and relevant amendments to the Charter of the Company with respect to the number of declared shares and the deployment of issuance of additional shares in favor pf OAO Gazprom and/or other affiliated entities of OAO Gazprom. The price of shares will be determined as the weighted average value of RTS and MICEX trades within the six months, preceding the date of the meeting of shareholders of OAO Mosenergo, but not less than 5 rubles per share. OAO Mosenergo is intended to implement an investment program of the Company amounting at to USD 2,1 billion for the issuance of additional shares.

Dividend Policy. We know that one way of enhancing the attractiveness of the shares is efficient dividend policy.

In May, the Board of Directors of Sibneft decided to advise the annual general shareholders' meeting of the company to pay dividends as per results of 2005 fiscal year in the amount of RUR $ 7.90 per ordinary share. The deadline for payment of dividends, according to the Articles of the company is May 31, 2007

On June 24 Rostelecom decided to pay dividends in the amount of RUR 3.72 per preferred share and RUR 1.56 per ordinary share. Total dividend payment as of results of 2005 amounts to RUR 2,040.8 billion.

Finally, on June 22, 2006 shareholders of OAO Gazprom Neft "at the annual meeting has approved payment of dividends as per results of 2005 in the amount of RUR 7.9 per ordinary share. Thus, payment of dividends will make RUR 37,456 billion. Dividends will be paid before May 31, 2007

2.5.4. Investments of Pension Savings in the System of Mandatory Pension Insurance

The main bulk of the funded component of the mandatory pension system, as before, is accumulated by a government asset manager, whose functions are performed by the USSR Bank for Foreign Trade (Vneshekonombank). As of the beginning if 2006, the value of the pension savings invested by the government asset manager amounted to 176.5 bn roubles, while the total volume of pension savings administered by private asset managers (PAM) was 5.6 bn roubles (3%). Another 2 bn roubles (1%) were transferred by citizens to the Non-Government Pension Fund (NGPF).

Simultaneously, yet another 91.7 bn roubles was constituted by the insurance contributions to the funded component of labor pension collected by the Pension Fund of the Russian Federation (PFR) but not yet transferred into the trusteeship management of asset managers or the PFR. Out of this sum, more than 80 bn roubles was invested by the PFR in government securities. During the first half of 2006, another 40.7 bn roubles was received by the PFR as part of the funded component of labor pension. The share of funds invested by the PFR in government securities did not undergo any important changes59.

By late 2006, the value of the pension savings invested by the government asset manager (Vneshekonombank) had exceeded 267 bn roubles, having increased during that year by 90.8 bn roubles (51%). Most of it was represented by the funds transferred during the year from the PFR (83.5 bn roubles). The rate of return on investments declared by Vneshekonombank amounted in 2006 to 6% (against 12% by the results of the year 2005)60.

The reports published in the autumn of 2006 by the Federal Service for Financial Markets (FSFM) concerning the investment of pension savings in 2005 made it possible, for the first time, to observe the directions along which pension savings were being invested by private asset managers and the NGPF, and not only by the government asset manager61. The structure of investments of the Vneshekonombank and the aggregate investment portfolio of all private asset managers62 as of the end of 2004 and 2005, as well as of the end of Q HI 2006, is shown in Fig. 1925.

59 Federal Law "On the budget of the Pension Fund of the Russian Federation for the year 2007", Vestnik [Herald] of the PFR No 3 for 2006.

60 The data concerning asset managers and the NGPF have not been published yet. In the Federal Law "On the budget of the Pension Fund of the Russian Federation for the year 2007", the PFR made a preliminary estimation of the amount of pension savings as of the end of 2006 as being equal to 345.3 bn roubles, which constitutes slightly more than 1% of GDP. As of 1 January 2006, the corresponding index was 255.9 bn roubles.

61 For the data for the first three quarters of 2006, see the PFR's website: http://pfrf.ru.

62 For purposes of analysis, the data published by the Federal Service for Financial Markets in respect of each of asset managers, in disputable cases were checked with other sources of information, and then aggregated. The source of data for 2006 is the PFR's website: http://pfrf.ru

Fig. 19. The structure of the investment portfolio of the government asset manager

(Vneshekonombank), as of end of 2004

RF government securities,

denominated in foreign Monies of credit instil Lit ions,

currencies 10% ¡n foreign currencies 2%

Other 196

Fig. 20. The structure of the investment portfolio of the government asset manager

(Vneshekonombank), as of end of 2005

Monies of credit institutions, in foreign currencies 3%

Monies of credit institutions, in roubles 10%

RF government securities, denominated in foreign currencies 1%

RP government securities 77%

Fig. 21. The structure of the investment portfolio of the government asset manager (Vneshekonombank), as of end of Q III 2006

Monies of credit institutions.

Fig. 22. The structure of the investment portfolio of the government asset manager

(Vneshekonombank), as of end of 2006

Fig. 23. The structure of the aggregate investment portfolio of private asset

managers as of end of 2004

Fig. 24. The structure of the aggregate investment portfolio of private asset managers as of end of 2005

Source: calculated on the basis of information published by the Federal Service for Financial markets, the Pension Fund of the Russian Federation, Vneshekonombank.

Fig. 25. The structure of the aggregate investment portfolio of private asset

managers as of end of Q III 2006

As was found, the share of government securities of the Russian Federation in the investment portfolios of private asset managers varied between 0 and 96%, as of the end of 2004, and between 0 go 73% as of the end of 2005 constituting 17% in the aggregate portfolio in 2004, and 15% - in 2005. However, there were only two asset managers whose share of RF government securities as of the end of 2005 was more than 50% ("Dvortsovaia ploshchiad" and "KIT"), while 29 investment portfolios63 contained no such securities. As of the end of Q LU 2006, the highest share of RF government securities in the portfolios of PAMs decreased to 54%, while 28 investment portfolios contained no such securities, and their average share was 12.4%.

Thus, during one year and 9 months the share of federal government bonds decreased from 17% to 12%, which, no doubt, reflected the trend of diminishing rate of return on this instrument. At the same time, such an explanation can hardly be accepted as exhaustive, because the decrease of the rate of return was small, while the dynamics of the rate of return on subfederal and corporate bonds was displaying a similar trend. However, the share of these instruments in the aggregate investment portfolio of PAMs was growing, thus reflecting the diversification of the investments being made by asset managers, and in the case of corporate bonds - also the dynamic development of the market.

At the same time, in contrast to the government asset manager, private asset managers do not invest in RF government securities denominated in foreign currencies. As seen in Fig. 19-22, Vneshekonombank increased the share of Euro-

63 The number of asset managers engaged in the trust management of pension savings is not compatible with the number of investment portfolios listed under their management, because several asset managers have formed more than one investment portfolio.

bonds in its portfolio to 10% by the end of 2005, and afterwards it was fluctuating within the range of 7-10 %.

On the whole, fixed-income securities (federal, subfederal, municipal, corporate bonds) amounted, in the aggregate investment portfolio of private asset managers, as of the end of 2004, to 54 %, as of the end of 2005 - to 64%, and as of the end of Q H 2006 - 62%.

The percentage of shares in the aggregate investment portfolio of PAMs was fluctuating around 20%, while at the same time 11 asset managers had no shares in their investment portfolios as of the end of 2005 (Table 38). In 2004, there were 10 such asset managers, and as of the end of Q H 2006 - only 5. The actual average percentage of shares in the aggregate investment portfolio of private asset managers is much lower than the maximum indices permissible for this type of assets in accordance with Decree of the RF Government No. 37964.

Table 38

Private Asset Managers with no Shares in their Investment Portfolios as of the End of 2004 - Q W 2006

Asset manager (investment portfolio) End of 2004 End of 2005. End of Q III 2006

1 VI KA + +

2 3 4 5 6 Dvortsovaia ploshchiad Natsionalnaia upravliaushchiaia kompania [National Asset Manager] UNIVER Management TRINFIKO (for conservative preservation of capital) PIOGLOBAL Asset Management + + + + + + + + + +

7 PROMYSHLENNYE TRADITSII +

8 REGION Asset Management +

9 RN-trust + +

10 Rostov Trust Company +

11 YAMAL +

12 Alfa-Capital + +

13 Alians ROSNO (conservative) +

14 INTERFINANS +

15 Metropol +

16 Analytical Center +

17 FINAM MANAGEMENT +

18 NVKUK +

Note: + means absence of shares in investment portfolio as of corresponding date.

At the same time, it were shares that generated the highest rate of return during the period under study. In 2005-2006, the RTS index grew by 3.1 times (in USD denomination) and, no doubt, such a dynamics of the prices of shares was a factor of the high rate of return achieved by PAMs in 2005-2006. By the results of 2005, the highest rate of return on investments demonstrated by PAMs amounted to 52% (Troika-Dialog), in 2006 - to 39% (UNIVER Management).

64 The margin for 2004 was 40%, for 2005 - 45 %, and for 2006 - 55 %. 190

In Table 39, the structure of the investment portfolio of asset managers with the highest rate of return by the results of the first three quarters of 2006 is shown. It appears that judging by that structure, one cannot come to the conclusion that it was the investments in shares, which provided the highest rates of return on investment portfolios. Only RTK-INVEST had an investment portfolio where shares constituted approximately one half of all assets. Three asset managers with the rate of return of 26-29% had a rather similar percentage of shares (25-26 %) and a high percentage of subfederal bonds (31-36 %). As for the leader of 2006 - UNI-VER Management - its investment portfolio is negligible in absolute terms (its market value was only 2,3 mln roubles as of the end of Q LU 2006), which, evidently, was the reason for the deformity of its structure (more than a half of assets was accumulated at credit institutions in the form of residuals on the asset manager's accounts or the monies transferred to the professional participants of the securities market, which has nothing to do with instruments with high rates of return).

Table 39

Structure of the Investment Portfolio of Asset Managers with the Highest Rate of Return, by Results of the First Three Quarters of 2006

UNIVER RTK-INVEST AKKORD As- URALSIB - ASSET MANAGEMENT

Management set Management URALSIB

1 2 3 4 5 6

Rate of return, % PER ANNUM 44.4 29.8 29 28.5 25.7

Market value of portfolio, mln roubles. 2.3 20.1 34.1 15.9 533.7

Share in investment portfolio, %

RF government securities 6.4 26.0 4.8 4.8 4.6

Including in foreign currencies 0.0 0.0 0.0 0.0 0.0

Government securities of RF subjects 21.1 21.5 36.7 33.6 31.3

Bonds of municipal formations 8.6 0.0 0.0 8.2 7.6

Bonds of Russian economic societies 5.2 0.0 14.5 10.4 11.4

Shares of Russian issuers 2.5 44.3 24.9 25.7 26.1

Monies on accounts at credit institutions 26.7 0.3 0.0 0.0 0.0

Rouble - denominated deposits at credit institutions 0.0 0.0 0.0 0.0 0.0

Receivables 29.5 7.9 1 9.0 1 7.4 19.0

including

monies transferred to professional 28.7 7.4 17.9 16.2 1 7.8

participants of the securities market

receivables against interest income on securities 0.8 0.5 1.2 1.2 1.1

other receivables 0.0 0.0 0.0 0.0 0.0

The data published by the FSFM offer no exhaustive information concerning the amounts of money being placed by asset managers at credit institutions. The corresponding tables, compiled by asset managers, contain no information on bank deposits, which is available only for the system as a whole. Thus, a rather substantial percentage of assets has remained hidden. For some asset managers, this index is higher than 15%, although the total number of asset managers (or investment portfolios) decreased in 2005 from 28 to 15.

The statistics published by the PFR makes it possible to obtain a more complete picture concerning the use of bank deposits by asset managers . As of the end of Q H 2006, this instrument was represented in only 10 investment portfolios, while their share in the aggregate investment portfolio of PAMs was less than 6%. At the same time, the percentage of the monies being transferred by asset managers to brokers and/or exchange settlement systems for purposes of purchasing securities is still high. For the aggregate investment portfolio of PAMs this index amounted to 8%, while the total percentage of monies placed within the banking system was thus equal to 16%.

As for the pension savings in the NGPF, the data published by the Federal Service for Financial Markets make it possible to estimate the structure of the investment portfolios only at one date - as of the end of 2005. The data are arranged by the list of those funds, which participated in the mandatory pension insurance system.

As compared to the aggregate investment portfolio of the private asset managers administering the monies of the Pension Fund of the Russian Federation, the percentage of shares in the aggregate portfolio of the NGPF earmarked for mandatory pension insurance is lower (10% against 19%). As of the end of 2005, the highest percentage of investments in shares was 31% (by the NGPF "Volga - Kapital"), while 10 of 43 NGPFs had no shares in their investment portfolios earmarked for mandatory pension insurance. The percentage of RF government securities in the investment portfolios of the NGPF earmarked for mandatory pension insurance varies between 0% and 99% (the NGPF "StalFond"), amounting to 21% in the aggregate portfolio, which is by 6 p. p. higher than the average index of private asset managers as of the same date. On the whole, the instruments with fixed rate of return (federal, subfederal, municipal, corporate bonds) constituted 77% in the investment portfolio, which was also higher than the same index of private asset managers. The most popular type of assets among both private asset managers and the NGPFs were subfederal bonds: as of the end of 2005, the average percentage of subfederal bonds in the aggregate investment portfolio of private asset managers was 26%, that of NGPF - 33 %.

RF government wcurtlies 21%

Note: The bonds of other Russian issuers include corporate and municipal bonds.

Source: Calculated on the basis of the data published by the Federal Service for Financial Markets.

Fig. 26. The structure of the aggregate investment portfolio of non-government

pension funds as of end of 2005

The sum of assets being administered by private asset managers under agreements with the Pension Fund of the Russian Federation amounted, as of the end of 2005, to 5.6 bn roubles, while the sum of assets of NGPFs earmarked for mandatory pension insurance, as of the same date, - to 2 bn roubles. In their aggregate investment portfolio the percentage of subfederal bonds was 28%. However, among the total volume of subfederal bonds being circulated on the market, pension savings constituted only 1.5%65. An even less percentage of pension savings (0.4%) was on the corporate bond market. So far, the only segment where the presence of pension savings represents a significant factor has remained the market for rouble-denominated federal bonds (OFZ). Even without the investments made by the Pension Fund of the Russian Federation itself66, their share was, as of the end of 2005, equal to 18.1%, where Vneshekonombank accounted for 17.9%. The share of pension savings invested in the foreign-currency-denominated bonds of the Russian Federation is much smaller - about 2% of the total volume of RF eurobonds in face value.

Since the data concerning the structure of the investments of pension savings, formed by NGPFs in 2006 was not yet available by the moment of publication, the role of the institutes participating in the mandatory pension system within the corresponding segments as of later dates can be assessed only by the data on the asset managers investing the PFR's monies. Thus, the percentage of pension sav-

65 Estimation based on the date posted at www.rusbonds.ru concerning the volume of subfederal and municipal bonds in circulation, in face value.

66 If all the contributions to the funded component of labor pension invested by the PFR were placed in OFZ, then it accounted for another 11% of OFZ being circulated on the market.

ings invested by asset managers in rouble-denominated government securities increased, by the end of Q III 2006, to 22% of the total volume of marketed OFZ issues. At the same time, the share of pension savings on the corporate bonds markets and share markets remains negligible (0.2 and 0.01%, respectively). If one takes it into account that pension savings may be invested only in high-level listed securities the situation will change only slightly. The share of pension savings in the total volume of bonds listed as A1 at the Russian exchanges constituted only 2.2%, in the capitalization of shares included in those lists - 0.04%.

This situation provides grounds for placing the focus of attention once more on the urgent necessity to diversify the instruments and to liberalize the procedure for investing the pension savings formed for the benefit of those persons who have not made their investment choices67. The intention to this effect was declared by the RG Government as early as 2004, but so far it has not been practically implemented.

2.6. Municipal Reform: the First Year of Implementation

The year 2006 stands apart within the overall process of the implementation of municipal reform. According to the reform's initial concept, it is in this year that the full-scale implementation of Federal Law of 6 October 2003, No. 131-FZ, "On the general principles of the organization of local self-government in the Russian Federation", was to begin all over the country's territory. That Law envisaged certain fundamental transformation in the system of local self-government in the Russian Federation. The key ideas of reform was to establish in legislation, clearly and with a single interpretation, the structure and functions of municipal formations of various types, and on that basis to determine their spending powers and to consolidate to them, on a permanent basis, appropriate sources of revenue. The main directions of transformations were to be as follows:

- on the greater part of the country's territory, it was intended to establish a two-tier model of local self-government, with municipal formations being formed both at the level of settlements and at the level of raions; one-tier municipal formations - city okrugs - could be created in urban territories by decision of regional authorities;

- rigid lists of issues of local importance were established for each type of municipal formations - settlements, municipal raions, city okrugs; on the whole, the competence of bodies of local self-government was noticeably reduced by comparison with the pre-reform situation;

- a more precise regulation was established for the transfer, to the local level, of certain state powers and for their financial backing from the budgets of superior levels;

67 For more details, see L. V. Mikhailov, L. I. Sycheva "Predlozheniia po izmeneniiu poriadka investi-rovaniia sredstv pensionnykh nakoplenii zastrakhovannykh lits, ne vospol'zovavshikhsia pravom vy-bora investitsionnogo portfelia" [Proposals concerning changes to the procedure for investing the pension savings of those insured persons who have not made use of their right to choose an investment portfolio] // Ekonomiko-politicheskaia situatsiia v Rossii [The economic and political situation in Russia]. M., IET, 2005 (11). 194

- the legislatively consolidated requirements to bodies of local self-government were made more strict; in particular, it was envisaged that each municipality was to have a representative body, a head official and a local administration; the number of deputies to that representative body was subject to special regulation, etc.; at the same time, the opportunities for regional authorities to influence the organization and composition of the bodies of local self-government were expanded;

- the list of property that could be placed in municipal ownership was limited; those objects that fell beyond the legislatively established restrictions were to be used for other purposes or alienated;

- sources of revenue were consolidated to municipal formations on a permanent basis; the principles and mechanisms for the granting of financial assistance to municipalities were rigidly consolidated in federal legislation (including the possibility of negative transfers for municipal formations with the most favorable financial situation).

During the preparation for the implementation of reform, it became obvious that the suggested model of the organization of the system of local self-government was too rigid and not totally adequate, while at the same time the necessary prerequisites for its practical implementation in many regions were lacking. The crisis in the implementation of municipal reform developed in mid-2005, when a group of deputies submitted to the State Duma a draft amendment whereby the timelines for the transformations as envisaged in legislation were to be extended. In a somewhat softened version this amendment was adopted on 21 September 2005. The changes introduced into Law No. 131-FZ envisaged that a transition period was to be established until 1 January 2009, within the framework of which, as far as the newly created municipal formations were concerned, the Federation's subjects could on their own distribute issues of local importance and sources of revenue between municipal raions and settlements, and thus largely determine the rate of implementation and directions of municipal reform.

That amendment marked just one important step in the sequence of changes being introduced into Law No. 131-FZ, influenced both by the lobbyism on the part of regional authorities and by the pressure of objective circumstances, which necessitated that the Law's excessively rigid structure was to be adjusted to the demands of practicality. One characteristic feature of all those changes was that the Law's intrinsic ideology, aimed at a strict division of the spheres of competence between the bodies of local self-government of different types of municipal formations and at the introduction of financial equalization mechanisms, designed to endow municipal formations with appropriate financial resources, was becoming more and more vague under the influence of currently arising problems and short-term demands. In this connection, no acknowledgement was made of the fact that the viability of the conceptual approaches that laid the foundation of municipal reform had never been tested, nor that the existing situation had to be rethought comprehensively from the point of view of the strategic prospects for the development of the entire system of local self-government in Russia. The necessary pre-

requisite for such rethinking was an analysis of the real situation surrounding the implementation of municipal reform in different regions. From this point of view, the monitoring of reform as it was developing in 2006 is of especial interest. In a situation when regional authorities were given ample opportunities for determining the rate and directions for implementing municipal reform until 2009, more than a half of the regions declared that they were going to initiate full-scale reform of local self-government from 1 January 2006. This means that we now can make assessments not only of the preparatory measures, but the of transformations proper as they were envisaged in legislation.

2.6.1. Normative-Legal Regulation of the Ongoing Transformations

In contrast to the years 2004 and 2005, the changes introduced into legislation on local self-government in 2006 did not influence in any significant way the division of powers between municipal raions and settlements. Some serious amendments were made only to land legislation. By Federal Law of 17 April 2006, No. 53-FZ, "On making changes to the Land Code of the Russian Federation", Federal Law "On the enactment of the Land Code of the Russian Federation", Federal Law "On State registration of the rights to immovable property and the transactions therewith", and "On the recognition as null and void of some provisions of the legislative acts of the Russian Federation" it was determined that the disposal of the plots of land the State ownership of which has not been divided should be executed by the bodies of local self-government of municipal raions and city okrugs.

Such regulation cannot be recognized as logical, because the main powers in the sphere of the regulation of the use of land have been consolidated to the bodies of local self-government of settlements. Thereby, at the level of settlements, in respect of those lands the State ownership of which has not been divided, there should be established rules for the use of lands and their construction development, as well as construction permits should be issued, while the disposal of these lands (that is, the allocation of plots of land) is the prerogative of a municipal raion. Thus, there emerge additional grounds for conflict between two levels of authority within local self-government: the bodies of local self-government of settlements may refuse to issue construction permits in respect of a plot of land allotted by the raion, simple because they have taken no part in related decision-making. Besides, the costs being borne by the recipient of a plot of land become higher, because he has to effectuate coordination at two administrative levels instead of just one.

By the same normative act it was established that the plots of land in those settlements that are administrative centers or capitals of RF subjects should be disposed of by the bodies of local self-government of the said settlements, if by the laws of the corresponding RF subjects it is not established that the disposal of those plots of land should be carried out by the executive bodies of state authority of RF subjects. This provision appears to be rather bizarre, because the situation when a settlement and not a city okrug is the capital of a Federation's subject can be regarded as a rare exception. This can be observed only in a few autonomous city okrugs - in particular, Nenets AO, Agin Buriat AO, and Ust'-Ordynskii Buriatskii AO. In this connection it is unclear why it has become necessary to separately

regulate this specific instance. However, this is an illustration of the general trend that characterizes nearly every initiative aiming at introducing changes into the normative - legal regulation of local self-government in 2006 - namely, the intention to shift the balance of power between the bodies of local self-government located in regional capitals and the bodies of state authority of the Federation's subjects in favor of the latter.

More obviously this trend has revealed itself in the draft Federal Law "On making amendments to Article 26i of the Federal Law 'On the general principles of the organization of the legislative (representative) and executive bodies of state authority of subjects of the Russian Federation' and to Article 75 of the Federal Law 'On the general principles of the organization of local self-government in the Russian Federation'", submitted to the State Duma in late April 2006 by deputies V. S. Mokryi, V. A. Zhidkikh, and A. V. Ogon'kov. Under this draft law, it was intended that subjects of the Federation should be granted the right to temporarily execute some of the powers of the bodies of local self-government of those settlements and city okrugs that are administrative centers of the Federation's subjects, for purposes of ensuring the uniform functioning of their utilities and communications systems and other infrastructure. The draft contained no specific fundamental principles or conditions for temporary regulation of the "life support" systems in big cities at the level of the Federation's subjects. Up to ten key issues of local importance could be potentially withdrawn from the jurisdiction of big municipal formations, including the organization of the supply of heating, gas, electric power and water; the organization of removal and utilization of domestic and industrial waste; the construction and maintenance of motor roads and bridges; the organization of transport services to the population; the establishment of rules for the use of land and its construction development, and the control over the use of lands. It was suggested that the timelines for the temporary withdrawal of powers and the specific grounds for such actions should be established by laws of the Federation's subjects.

The draft law stirred strong public response, and opinions in society became divided. The draft law's critics pointed to its lack of democracy and incompatibility with the RF Constitution and the European Charter of local self-government, and to local self-government becoming discredited in the eyes of the population as a result of its adoption. In this form, the draft law could not even find support among all the subjects of the Federation (thus, for example, the Legislative Assembly of Ulianovsk Oblast, in its resolution, declared that "the amendments violate the essence of local self-government, the RF Constitution and the European Charter of local self-government"). Under the pressure from the public, the State Duma adjourned the consideration of this amendment.

In its stead, however, and under the same number, in October 2006 by a similar group of deputies from the faction "United Russia" a somewhat different amendment to Law No 131-FZ was suggested. The draft law put forth by the deputies envisaged that in administrative centers and capitals of subjects of the Russian Federation local self-government may be executed either within the borders of an administrative center or the capitals of a subject of the Russian Federation as a

whole, or in inner urban territories68. In this connection, in both instances to regional capitals, in fact, the regulation was extended which was envisaged for the inner urban municipal formations of the two cities of federal importance - Moscow and St. Petersburg. In particular, it was suggested that legislation of the Federation's subject should regulate the following issues:

- with due regard to the opinions of the population, to establish and change the borders of inner urban municipal formations, and to effectuate their transformations;

- to determine lists of issues of local importance, sources of revenue for local budgets;

- to establish the powers of the bodies of local self-government to make decisions concerning the issues of local importance from the list established by federal legislation;

- to establish the composition of municipal property on the basis of the federal composition of property and the regional list of issues of local importance, determined for the corresponding municipal formations by laws of the Federation's subjects.

Besides, it was suggested that amendments should be made to the RF Budget Code to the effect that to the Federation's subjects should be consolidated the right to determine the sources of revenue for the budgets of those city okrugs and settlements that have the status of administrative centers, capitals of subjects of the Russian Federation, as well as of the inner urban municipal formations located on their territories, and the list of spending powers and the procedure for their execution.

The emergence of such suggestions is quite logical in terms of the structure of the vertical of power. Since it became clear that within the existing RF Constitution it would be impossible to introduce the mechanism of actual appointment of mayors similar to that being executed in respect to governors, another pathway was chosen - that of limiting the independence of elective bodies of local self-government in biggest regional centers, which in most cases have the powers to dispose of vast resources, - namely, regional capitals69.

At the same time it is obvious that such an initiative, which, similar to the previous one, being designed to dramatically shift the balance of powers in favor of the Federation's subjects and to actually restrict the protection of the rights of local self-government (ensured by federal legislation) in regional capitals, was met with indignant response of the municipal community. Negative opinions were voiced not only domestically, but also by international organizations. As a result, the amendment was not considered by the State Dume, and the ultimate fate of this initiative is still unclear.

68 Accordingly, it was suggested that legislation should reflect the definition of such an inner urban territory as part of the territory of an administrative center or the capitals of a subject of the Russian Federation, within the borders of which local self-government is executed by the population directly and (or) through elective bodies of local self-government.

69 Only in two regions - Vologda Oblast and Kemerovo Oblast - the regional capital is not the largest city in their respective territories.

The last among the significant legislative acts of 2006, which had to do with local self-government, was Federal Law of 29 December 2006, No. 258-FZ, "On making amendments to some legislative acts of the Russian Federation in connection with the improvement of the division of powers". The new law deals mainly with the division of powers between the Federation and subjects of the Federation, although it does, indeed, also touche upon the activity of bodies of local self-government. In respect to the latter, the changes introduced into legislation can be subdivided into two groups: some of them bring order and classification to the changes introduced earlier, while others actually touch upon the sphere of competence of bodies of local self-government.

These changes consolidate a rather complicated and controversial interpretation of the sphere of competence of bodies of local self-government, which incorporates the following:

- the settlement of issues of local importance;

- the execution of delegated state powers;

- the participation in the execution of other state powers, if this participation is envisaged by federal laws;

- the settlement of other issues, which are not placed within the sphere of competence of the bodies of local self-government of other municipal formations or bodies of state authority, or not withdrawn from the sphere of their competence by federal laws or laws of subjects of the Russian Federation.

At the same time, in respect to each type of municipal formations, a list of those issues is specified, which do not belong to the category of issues of local importance, but can be dealt with by bodies of local self-government. These issues are very versatile in their nature. Some of them can be treated as non-delegated state powers, in the execution of which bodies of local self-government may participate, which has become possible after the introduction of amendments into Law No. 131-FZ in late 2005. However, for example, the right to found local museums can hardly be fully compatible with this category, from the point of view of its essence. One gets the impression that, alongside the evolution of the division of powers, there also emerge the foundations for the subdivision of issues of local importance into compulsory and voluntary, which has already been practiced for a long time in foreign countries. However, the process itself if rather inconsistent and controversial.

It should be noted that the new classification of the spheres of competence of municipal formations is not quite compatible with their powers in the financial sphere (Article 86 of the RF Budget Code), because it is not defined precisely to which category of powers belong the rights of bodies of local self-government to deal with those issues that are not placed within the category of issues of local importance.

As for the specific set of issues of local importance, which are placed within the sphere of competence of bodies of local self-government but not on the established list, the recognition of the right of the bodies of local self-government of settlements to execute notarial actions in the event of absence of a notary in a settle-

ment is of utmost importance70, because otherwise in many instances the population's access this service would have become more difficult. In order to realize this right, in the Fundamental Legislation of the RF on the notariat some amendments were made, whereby the head of a local administration of a settlement and the specially empowered official of the local self-government of a settlement should have the right to execute the following notarial actions:

- to certify wills;

- to certify powers of attorney;

- to take appropriate measures for the protection of bequeathed property and, in an event of necessity, appropriate measures for its management;

- to attest to the correctness of copies and extracts from documents;

- to attest to the authenticity of a signature on a document.

By legislation of the Federation's subject, this list can be expanded.

At the same time, on accordance with the RF Budget Code, the State duty, as well as the fees for the execution of notarial actions by notaries working at state notary's offices and appropriately empowered by legislative acts of the Russian Federation and subjects of the Russian Federation, by government officials of bodies of executive authority, and by bodies of local self-government, are to be transferred to the budget of a municipal raion. Thus, there emerges a discrepancy between the execution of notarial actions at the level of settlements and the transfer of the corresponding revenues to the budgets of municipal raions

As for any changes to issues of local importance, the lawmakers have revived the trend of excluding social issues from the sphere of competence of bodies of local self-government71. From the list of issues of local importance of settlements such issues have been excluded as aid in establishing trusteeship and guardianship, as well as the computation of subsidies for the housing and utilities fees and the organization of the procedure for granting subsidies to those citizens who are entitled to them. This last issue was placed on the list of issues of local importance only a year ago. This inconsistence in the lawmakers' behavior does not make any easier the organization of the work of bodies of local self-government. As for municipal raions, the issue of trusteeship and guardianship has been withdrawn from the sphere of their competence. Accordingly, the whole bulk of these issues has also been withdrawn from the sphere of activity of city okrugs and placed within the sphere of competence of the Federation's subjects. In this connection, the participation in the activity relating to trusteeship and guardianship had been placed on the list of issues that are not classified as those issues of local importance that can be settled by the bodies of local self-government of all types of municipal formations72.

70 The provisions of Law No. 131-FZ concerning this right are to enter into force from 15 January 2008.

71 The corresponding items of Articles 14, 15, 16 of Law No. 131-FZ will become null and void from 1 January 2008.

72The corresponding provisions of Law No. 131-Fz concerning this right will enter into force from 15

January 2008.

Such changes can hardly be regarded as positive. It is highly doubtful that the distancing, from the grassroots, of certain social issues, especially issues like as trusteeship and guardianship, which are so delicate and require an in-depth knowledge of the situation (including the specific family situations), could indeed result in improved performance. As for the issue of the computation and granting of subsidies, its successful settlement also depends on the knowledge of local specificities and the opportunities provided by the resources of local budgets, which has also become impossible in the situation of the new division of powers.

To the list of issues of local importance assigned to settlements and city okrugs, that of creating appropriate conditions for the activity of voluntary population units for the protection of public order was added73, while to the list of issues of local importance assigned to all types of municipal formations - not only that of the replenishment of library holdings, but also of the ensuring of their adequate protection.

It should be noted that this legislative is not free of the imprecision that was characteristic of the previously adopted documents of a similar type. The new powers of the bodies of local self-government, assigned by the amendments to branch legislation, have not been fully reflected in the amendments introduced to Law 131-FZ and are poorly compatible with the issues of local importance consolidated by this Law to municipal formations. The most vivid example of this incompatibility are the amendments made to the Fundamental Principles of Legislation of the Russian Federation on the Protection of Citizens' Health.

2.6.2. The Implementation of Reform in Certain Regions: General Trends and Local Features

The amendments to Law No. 131-FZ adopted in 2005 enabled the regions to determine on their own the volume of powers to be executed and the sources of revenue applicable to the newly created settlements. In this connection, different subjects of the Federation provided different solutions to that issue: some of them declared that they were going to implement municipal reform full-scale in 2006, while others took advantage of the right granted to them by the newly adopted amendments to legislation and resorted to the evolutional variant of reform implementation. Thus, the first question to be answered by the monitoring of reform in 2006 is as follows: how great is the actual difference between the situation in those regions where municipal reform has been fully implemented and in those where the transformations planned at the municipal level were not in their entirety carried out in 2006.

The analysis of the situation as it exists in some regions74 has demonstrated that nowhere do the newly created municipal formations of the settlement level deal with all the issues of local importance envisaged in Law No. 131-FZ. From this

73 This amendment to Articles 14 and 16 of Law No. 131-FZ will enter into force from 1 January 2008.

74 In 2006, a detailed analysis of the situation with the implementation of municipal reform was conducted in Vologda Oblast, Cheliabinsk Oblast, Orenburg Oblast, Kaluga Oblast, Tver Oblast and the Republic of Chuvashia, while information on the other regions was sketchier.

point of view, those regions that have declared full-scale implementation of municipal reform do not in any significant way differ from those where the evolutional variant has been chosen. In this connection, in those regions where full-scale implementation of reform has been declared, the instrument of agreements as to the transfer of powers between the bodies of local self-government of settlements and municipal raions is applied, in order to limit the competence of the bodies of local self-government of settlements. As for those regions where reform has not yet been fully implemented, there the powers of settlements are limited both by regional legislation and by agreements on the transfer of powers. Nevertheless, we may point out certain differences between the regions where reform has been implemented full-scale from the rest of the subjects of the Federation. Thus, the share of the budgets of settlements in the consolidated budgets of municipal raions, as can be derived from the information relating to the first-half year 2006, in the former category of regions amounts to 16.6%, while in the other regions it is only 6.2%.

Of some interest also the question as to the ratios of competence of the bodies of local self-government of newly created and previously existing settlements. In all propability, the situation varies greatly between regions. For example, in Orenburg Oblast, where prior to the onset of reform there existed only 4 municipal formations of the settlement type, the differences between the powers granted to newly created and previously existing settlements are rather substantial. Thus, the competence of the bodies of local self-government of newly created settlements in 2006 was restricted by both regional legislation and by agreements on the transfer of powers, while the previously existing municipal formation "Chernorechenskii sel'sovet" was not only dealing with all the issues of local importance envisaged in Law No. 131-FZ, but was also continuing to finance from the local budget the objects of public education and public healthy care located in its territory. Quite a different situation developed in Cheliabinsk Oblast, where prior to the onset of reform the two-tier model of territorial organization had already been implemented. Here, in order to restrict the competence not only of the newly created, but also of the previously existing settlements the mechanism of transfer of powers is applied. Simultaneously, there is an obvious intention to bring the powers granted to the bodies of local self-government of settlements to that level which emerged in the pre-reform period.

It is evident that the main instrument for restricting the competence of the bodies of local self-government of settlements, applied in the regions where municipal reform has been implemented full-scale, as well as in the regions where the process of transformation has not been completed yet, is the agreement on the transfer of powers. And this instrument may be widely applied not only within the framework of the transition period, but also after 1 January 2009. Therefore, the character and peculiarities of the application of this instrument need to be analyzed in more detail.

The possibility of and the conditions for the conclusion of an agreement on the transfer of powers are envisaged in Law No. 131-FZ, and not in its transitory provisions, but in its text body (Article 15). By legislation it is thus envisaged that:

- the transfer of powers may be effectuated both from the bodies of local self-government of settlements to the raion level, and from the bodies of local self-government of municipal raions - to settlements;

- the agreements must provide for the financial backing of the powers being thus transferred from the subventions granted from the local budgets of those municipal formations that have transferred their powers; the procedure for determining the annual volume of subventions must be determined by the agreement;

- the agreements must envisage the transfer not of an issue of local importance as such, but a part of the powers assigned to the bodies of local self-government for the decision-making in respect to a certain issue of local importance;

- the agreements must be concluded for a certain period of time;

- the agreements must contain provisions establishing the grounds and procedure for their termination, including early termination;

- the agreements must envisage financial sanctions for the non-execution of the agreements.

In actual practice, in a vast majority of cases, the agreements are concluded with violations of existing legislation. The most typical violations are as follows.

1. The agreements are not voluntary in their essence (being an obligation instead of a right). A model agreement is adopted at the level of either a whole region, or one municipal raion. Thus, for example, the Administration of the President of the Republic of Chuvashia developed a model agreement containing a list of powers assigned to settlements, which the Republic's bodies of state authority recommend to be transferred from settlements to the level of raions. The corresponding agreement in most cases is signed, without any changes, by the bodies of local self-government of municipal raions with all the settlements on a uniform basis. In this connection, no regard is given to the specific potential of each settlement for dealing with issues of local importance, and from the instrument designed to adjust to the shortage of material resources and personnel in certain settlements the agreement is turned into a universal instrument for restricting their powers.

In some cases the individualization of agreements is allowed to previously existing settlements. Thus, in Maloyaroslavets raion of Kaluga Oblast, individual agreements were signed by only two previously existing settlements with the status of municipal formations: "Posiolok Detchino" and the town of Maloyaroslavets (in this latter case the volume of powers actually being transferred was minimal). At the same time, all the newly created settlements signed agreements in a single format determined by the administration of the municipal raion, despite their organizational potentials being entirely different. An attempt made by the largest of the newly created settlements with the population of approximately 4,000 to limit the volume of powers being transferred to the raion level resulted in a serious personnel reshuffle at the settlement level.

However, in some other regions the situation is less oppressive: there are some "rebel" municipal formations who are defending their right to execute a wide

range of powers than that envisaged by the standard approached. Nevertheless, in none of the surveyed regions the number of such settlements, according to representatives of local administrations, is more than 10%. And in only some regions the oblast administration does not impose the unification of the mechanism of transfer of powers and truly wants to take into account the local peculiarities. One such example is Tver Oblast.

2. Not the powers but the whole issues of local importance are transferred. As a result, the bodies of local self-government of settlements actually lose control over a certain issue of local importance. The transfer of issues of local importance generally, without any specification of the powers being transferred, results in a situation when the actual activity of the bodies of local self-government of the municipal raion in their dealing with a given issue may substantially differ from the settlement's expectations. Thus, in one of the rural settlements in Nizhnii-Novgorod Oblast the bodies of local self-government, as admitted by their representatives, when transferring to the raion level the issue of providing appropriate conditions for the development of mass-scale physical culture and sport in the settlement's territory, believed that rural children would thus obtain the opportunity to regularly visit the raion center in order to train at a local sports school, while the hockey field in the village would be repaired, and the sports organizer would be receiving methodological assistance from the raion. At the same time, the bodies of local self-government of the municipal raion were planning to receive additional funding for the upkeep of the administrative apparatus, for the participation of athletes in inter-raion and regional competitions, as well as for the upkeep of the sports school, although it was not planned that rural children would be brought to train at that school.

The transfer of issues of local importance in their full volume implies that the bodies of local self-government of settlements, in fact, will lose control over the decision-making in respect of a given issue of local importance, while remaining formally accountable for that issue to the population. Accordingly, the agreements envisage neither monitoring nor any control by the bodies of local self-government of settlements over the execution of the powers transferred to the municipal raion, or any accountability of the raion bodies of local self-government to settlements, etc. Thus, the provision concerning financial sanctions for the non-execution of an agreement cannot be realized in actual practice, either. At the same time, it should be noted that in those cases when powers are transferred from a municipal raion to settlements (which actually happens sometimes), the situation may become entirely different. This asymmetry can be observed in the agreements being made in Cheliabinsk Oblast. Thus, in Troitsk raion, in the agreement on the transfer of powers from settlements to the municipal raion there is neither a special section concerning the rights of a settlement nor any sanctions for the non-execution of the obligations undertaken by the raion. At the same time, sanctions are envisaged for settlements if they do not transfer in due time the subventions to cover the execution of the transferred powers (as a rule, it is a penalty in the amount of 1/300 of the rate of interest esytablished by the RF Central Bank for each day of delay). As for the agreements on the transfer of powers from the municipal raion to settlements

(this transfer of powers has taken place in the sphere of pre-school education), their structure is quite different. There exists a well-elaborated section in the agreement concerning the rights of the municipal raion in respect to the agreement's execution, including the conduct of checks and revisions, expert's assessment of pre-school educational establishments, the formation of an estimate of expenditure for each establishment, the establishment of the regime of operation for each establishment, the procedure for demanding explanations, the issue of instructions, etc.

3. Subventions for the financing of the powers being transferred are either not established altogether, or are determined on a purely formal basis in an amount clearly insufficient for the backing of the relating activity. The main bulk of expenditures to cover the transferred powers come from the budget of a municipal raion. It should be noted that no such participation in the financing of the powers transferred under an agreement is envisaged in legislation, in contrast to the transferred state powers that can be co-financed from local budgets. Thus, no references to the lack of financial resources in the budget of a settlement may be regarded as legitimate grounds for making an agreement. In actual practice, the bodies of local self-government are attempting to bypass these restrictions, entering into agreements of other types, instead of the agreements on the transfer of powers. For example, in Orenburg Oblast and in the Republic of Chuvashia they apply agreements on the interaction between the administration of a municipal raion and settlements in the decision-making with regard to issues of local importance. However, such approaches cannot be recognized as being fully compatible with the existing legal space.

4. The bodies of local self-government of settlements transfer to a municipal raion such powers, which by their very nature cannot be treated as transferable. Thus, for example, the powers for ownership, use and disposal of a settlement's property are transferred. In this connection it is not clear how, in absence of any opportunities for the execution of its property rights, a settlement can deal with issues of local importance. Evidently, the necessity of transferring appropriate powers in a certain specific sphere may follow from the transfer to the raion level of the powers to provide the population with some municipal services; however, no transfer of powers for the ownership, use and disposal of a settlement's property as a whole may be regarded as being lawful.

A similar situation arises when the transfer of powers may give rise to a conflict of interests. Thus, for example, it happens in a situation when to the bodies of local self-government of a municipal raion the right to represent the interests of a settlement in a court of justice is transferred. This right cannot be executed in an event of direct court proceeding between a municipal raion and a settlement and may give rise to a conflict of interests when, while representing the interests of a settlement, the municipal raion has its own related interest in a given case, which is different from the settlement's interests.

The procedure of the transfer of powers cannot always ensure the best possible division of rights and responsibilities between municipal raions and settlements,

either. For example, the surveying of this issue in one of the raions in Orenburg Oblast yielded the following picture. Although the oblast has declared that from 2007 it is implementing full-scale municipal reform, the actual volume of powers assigned to settlements has not increased by comparison with the year 2006. The text of the agreement elaborated by the raion administration for 2007 envisages the transfer to the raion level of 12 key issues of local importance, including in the sphere of utilities, constructioin and maintenance of motor roads, cultutal services, physical culture and sport, library services, the formation of a settlement's archival funds, the use of lands and construction thereon, civil defense, mobilization readiness, promotion of agricultural production and small businesses, children's and youth activities, and the calculation of housing and utilities subsidies and the provision of these subsidies.

All the settlements in a raion make agreements in a single format, in conditions of rigid administrative pressure. The decision concerning the transfer of powers is made by the representative bodies of settlements "orally", no materials in writing being distributed. The whole list is being voted on, and not each power separately. The raion administration submits no report as to how it has been executing the powers transferred to it for the previous period, or which funds have been spent in this connection. The division of objects of property does not correlate in any way with the division of powers: for example, the powers for utilities services are transferred to the bodies of local self-government of a municipal raion, while boiler stations are transferred into municipal ownership.

As a result, one may come to the conclusion that, although the list of issues of local importance to be actually dealt with by newly created settlements, as it has emerged under the influence of both regional legislation and the agreements being concluded, does, indeed, differ from region to region, most often the bodies of local self-government of settlements realize their powers in the following spheres:

- creation of adequate public recreation conditions for the residents of a settlement and the organization of adequate equipment of popular public recreation sites;

- organization of the collection and removal of domestic waste and litter;

- organization of the provision of all amenities and the planting of urban greenery on the territories of settlements;

- organization of street lighting and the setting-up of signs with names of streets and numbers of buildings;

- organization of funeral services and the maintenance of cemeteries.

In some instances, these issues are supplemented by the maintenance of roads, children's and youth activities, and the provision of cultural services to the residents. In a great majority of cases, the issues of the disposal of land resources are concentrated at the raion level. The treasury execution of the budgets of settlements also takes place at the level of municipal raions.

Although the large-scale transfer of powers is directed from the bodies of local self-government of settlements to those of municipal raions, there are also some instances of a reverse process - the transfer of powers from municipal raions to settlements. Most often, the organization of pre-school education is transferred

to settlements (which is quite understandable, this service being of a local nature), and sometimes also such issues as the organization of supplementary training, current upkeep of educational establishments, current upkeep of medical institutions, primarily first-aid and tocological stations (FATS). However, this process is better developed at previously existing settlements and reflects the aforesaid trend of bringing the competence of the bodies of local self-government of these settlements to its pre-reform level: while previously such issues were dealt with at the settlement level, now they are transferred to the same level by agreements.

Special problem is represented by the organization of financing procedures at the newly created municipal formations. Nearly all the regions have been faced with difficulties in that sphere. No adequate base has existed - either for forecasting the revenues of settlements, or for planning their budget expenditures.

Also, certain difficulties arose in connection with the land tax, for which the tax base from the year 2006 has been radically altered. According to the information from the regions, the forecasting of revenues from this tax has, nevertheless, been done "from the achieved level", on the basis of the data of previous years. This has resulted in serious errors, because the volumes of revenues from the land tax have changed significantly, being different in different regions and municipal formations. Thus, in the municipalities of Kaluga Oblast the revenues from this tax declined nearly by one order, while in some regions of Orenburg Oblast the land tax payments increased six-fold.

Different regions are practicing entirely different approaches to the granting of financial assistance to settlements - from covering the difference between the actual or standard expenditures and the revenues, to applying complicated mechanisms of computations, with the determination of the tax potential index and the spending needs index. However, the application of the methodological recommendations originating from the provisions of the Budget Code cannot by itself ensure any real financial equalization of settlements. Thus, in Orenburg oblast, where financial equalization represents a regional power delegated to the raion level, and financial assistance is being distributed on the basis of the equalization of budget sufficiency with due regard for the indices of tax potential and spending needs (that is, the existing system is fully compatible in this respect with federal legislation), the actual differences in the budget sufficiency of settlements in different raions are greater than by 10 times. The practice of granting dotations to settlements has also become quite widespread, which completely distorts the nature of this instrument.

As for the treasury execution of the budgets of settlements, such powers, with a few exceptions, have been transferred to the raion level.

2.6.3. The price of municipal reform is the cost of administration

While the preparations to the implementation of municipal reform were going on, there was no end to discussions as to what would be the result of transformations from the point of view of the efficiency of budget expenditure. This issue if of especial significance in terms of administrative costs. Here, two opposite standpoints have emerged. On the one hand, there existed the opinion that the approach

suggested in Law No. 131-FZ to the reforming of local self-government can substantially lower the level of performance in the administrative sphere and result in growing administrative costs. On the other, there were also some contrary arguments - since the total volume of powers assigned to the bodies of state authority and local self-government was not to be changed, and was only to be redistributed between different levels of authority, the associated administrative costs were not to become greater, either. Only an analysis of the actual administrative costs can provide an adequate answer to the question as to whether resulting from the creation of tens of thousands of new municipal formations at the settlement level there will be significant losses due to the insufficient scale of administrative activity, associated with increased costs.

Naturally, it is yet too early to draw any final conclusions. Nevertheless, the analysis of this issue on the basis the national budget statistics for the first half-year 2006, as well as surveys of the situations existing in some regions, has yielded the following results.

Firstly, the growth of administrative costs in municipal budgets in 2006, by comparison with 2005, was far ahead of the corresponding index of the previous years. This can be explained by different factors; at the same time, the conclusion that this has largely been produced by the implementation of municipal reform seems to be well-substantiated. Such a conclusion is confirmed by the fact that in those regions where full-scale implementation of reform from 2006 was declared, the corresponding growth was higher than in all other regions. At the same time, the highest growth was observed in those regions where municipal reform had been fully implemented, and the number of municipal formations had been accordingly greatly increased. While the costs of the upkeep of the bodies of local self-government grew in all regions, on the average, by 30.7% in real terms, in those regions where municipal reform had been fully implemented the growth was 32.8%, while in those where municipal reform had been fully implemented and the number of municipal formations increased more than twice - by 41.7%.

Secondly, during our study certain facts have been revealed, which are indicative of the existence of real losses due to the insufficient scale of activity at the level of settlements, this problem, not having been softened in the course of reform, has become even more acute. This conclusion can be substantiated by the following arguments:

- as shown by the results of the analysis of budgets in the first half-year 2006, the share of expenditures on the upkeep of the bodies of local self-government at the level of settlements amounts to more than 30%, while at the level of raions it is lower more than four-fold, and amounts to 7%; in some settlements, where the situation was analyzed during regional studies, - to more than 80%;

- the estimated numbers of residents of a settlement per one staff member of a local administration demonstrate a rather distinct inverse dependence on the number of residents in a settlement; in other words, the less residents there are in a settlement, the higher is the relative number of staff in the local administration;

- in some settlements, which existed prior to the onset of municipal reform, resulting from the reformed division of powers and the implementation of other provisions of Law No. 131-FZ, the share of administrative costs has become much higher; thus, for example, in Khomutinskii rural settlement in Cheliabinsk Oblast it has more than doubled.

Thirdly, the growth potential of administrative costs, associated with the implementation of municipal reform, have not yet been exhausted in either those regions where the evolutional approach to municipal reform has been chosen, or in those where its full-scale implementation has been declared. The increased administrative costs will be determined by several factors:

- the inevitable growth in the number of the administrative staff of settlements in many regions, and, accordingly, the associated growing costs of their upkeep (at present, the growth in the number of administrative staff is being restricted by administrative measures, thus preventing them from any real decisionmaking in respect to issues of local importance);

- the necessity to provide the local administrations with additional technical resources: computers, office equipment, service motor transport;

- the acute need for better qualification of the personnel.

Thus, any full-scale reform of local self-government will entail additional budget expenditures, and, as estimated, the costs will be comparable to those associated with the insufficient scale of administrative activity at the level of a settlement. Thus, the issue of the need to optimize such costs through a rational division of issues of local importance between municipal raions and settlements, as well as the organization of adequate cooperation between municipalities, will become of utmost importance. At the same time, it has become obvious that this growth in administrative costs is largely inevitable in view of the specific model of municipal reform that has been selected, and the attempts to restrict it by administrative measures, which are being made by regions, may result only in disorganization of the smooth operation of the bodies of local self-government of settlements.