* IMF sees 2014 GDP growth 0.2 pct vs government's 0.5 pct
* Says sanctions have "chilling effect" on investment
* Urges central bank rate rise to meet 2015 inflation goal
By Lidia Kelly
ST PETERSBURG, Russia, July 1 (Reuters) - Sanctions imposed on Russia over Ukraine have brought growth to a standstill, had a "chilling effect" on investment and could force Moscow into economic isolation, the International Monetary Fund said on Tuesday.
The Fund kept its forecast for gross domestic product (GDP) to grow 0.2 percent this year, but said in a report that there were risks. Russia's Economy Ministry said recently growth could come in above the official forecast of 0.5 pct and closer to 1 percent.
"Even without the escalation (of the Ukrainian crisis), prolonged uncertainty and the resulting deterioration of confidence could lead to lower consumption, weaker investment, and greater exchange rate pressure and capital outflows than assumed under the baseline," the IMF said in a report.
"Moreover, this risks derailing the reform agenda and a shift toward more emphasis on economic self-reliance rather than integration with the rest of the world."
After annexing Ukraine's Crimea in March, Russia has been punished by sanctions imposed by the European Union, the United States and other Western countries.
The punitive measures, including asset freezes and visa bans on officials, sent the rouble spiralling and prompted capital flight of $80 billion in the first five months of the year.
Russian government and central bank officials have called the impact on growth "negligible" and the rouble has since recovered much of its losses. But former Finance Minister Alexei Kudrin said sanctions could mean Russia loses between 1 and 1.5 percentage point in GDP growth.
"Concern about a possible escalation of sanctions has increased the uncertainty of doing business in Russia and is having a chilling effect on investment, while bond issuance has declined sharply," the IMF said.
"This comes at a crucial moment when the old growth model based on energy and use of spare capacity has been exhausted and moving to a new growth model based on diversification requires new investment, including foreign technology."
Capital investment by firms in their tangible assets, such as building and infrastructure, has been falling month after month, down 2.6 in April. The IMF estimates that capital outflows could reach $100 billion this year, in line with the Russian government's estimates.
The Fund said budget reserves, of around 0.3 percent of GDP last year, would cushion the overall balance from Crimea-related spending on infrastructure. The finance ministry expects a 0.5 percent budget surplus this year.
"Under the baseline scenario, general government debt is expected to remain sustainable and low," the IMF said.
Russia's sovereign debt to GDP ratio stood at around 12 percent last year, while many developed countries, such as Italy or Japan, carry a burden of 100 percent or more.
The IMF urged the finance ministry, however, to remain prudent in spending and when assuming the base oil price for budgetary purposes.
The energy sector accounts for one-fifth of Russia's gross domestic product, two-thirds of exports and around one-third of general government revenues.
"Additional fiscal measures, if needed, should be temporary and of high quality and be set in a medium-term framework that ensures sustainability," the IMF said. "But additional fiscal consolidation in outer years is needed to rebuild buffers."
The finance ministry manages two sovereign funds, the Reserve Fund and the National Wealth Fund, which stand at $87 billion each. The Reserve Fund, which is to cover budget shortcomings, is meant to reach ultimately 7 percent of GDP.
Last year, it stood at 4.3 percent.
"With the Reserve Fund below its target, the authorities risk pro-cyclical fiscal adjustments in the event of large and lasting oil price decline," the IMF said.
"This risk is heightened given the already high level of oil prices. Staff argued for more prudent oil-price assumption during the budget process to generate more savings."
TIGHTER MONETARY POLICY
Capital outflow from Russia in the first months of the year cost the rouble 10 percent of its value against the dollar and drove up inflation.
The Russian currency has rebounded since, to trade at early-year levels against the dollar, but inflation proved a longer-lasting shock. The IMF expects consumer price inflation to come in at 6.5 percent by the end of the year, above central bank estimates of around 6 percent and well above the central bank's general target of 4.5 percent.
"The Central Bank should raise further its policy rates over the next year to ensure that its 4.5 percent inflation target in 2015 is met, in order to anchor inflation expectations in the transition to a full-fledged inflation targeting framework," it said.
"Higher rates would also help reduce capital outflows that have emerged amid geopolitical tensions, global liquidity tightening and rate hikes by major emerging markets' central banks." (Reporting by Lidia Kelly, editing by Elizabeth Piper and Ruth Pitchford)