91239 The World Bank in the Russian Federation RUSSIA ECONOMIC REPORT 32 | September 2014 Policy Uncertainty Clouds Medium-Term Prospects Russia Economic Report Policy Uncertainty Clouds Medium-Term Prospects I. Recent Economic Developments II. Economic Outlook III. In Focus: Paths to Diversified Development in Russia This report is produced twice a year by World Bank economists of the Macroeconomics and Fiscal Management Global Practice. The team was led by Birgit Hansl (Lead Economist and Program Leader for Macroeconomics and Fiscal Management, Governance and Social Policy in Russia, bhansl@worldbank.org) and consisted of the following members: Sergei Ulatov (Senior Economist), Stepan Titov (Senior Economist), Olga Emelyanova (Research Analyst), Mikhail Matytsin (Consultant), Michael Ferrantino (Lead Economist), John Pollner (Lead Financial Officer), Lawrence Kay (Сonsultant), Mizuho Kida (Economist), Ekaterine Vashkmadze (Senior Economist), Damir Cosic (Economist), John Baffes (Senior Economist) and Irina Rostovtseva (Team Assistant). Donato de Rosa (Senior Economist), Elena Bondarenko (Consultant) and Ekaterina Ushakova (Program Assitant) produced the focus note on paths to diversified development for Russia. Peer reviewers were Souleymane Coulibaly (Lead Economist), Fritzi Koehler-Geib (Senior Economist) and Karlis Smits (Senior Economist). The report was edited by Christopher Pala (Сonsultant), and the graphic design was provided by Robert Waiharo (Сonsultant). We are grateful for advice from Michal Rutkowski (Country Director for Russia), Lada Strelkova (Country Program Coordinator for Russia), Ivailo Izvorski (Program Manager of the Macroeconomics and Fiscal Management Global Practice), Satu Kahkonen (Director of the Macroeconomics and Fiscal Management Global Practice), Norbert Wunner and Kaspar Richter from the European Commission and the IMF team for Russia, led by mission chief Antonio Spilimbergo. TABLE OF CONTENT Abbreviations and Acronyms ............................................................................................................................ i Executive Summary ............................................................................................................................................... iii I. Recent Economic Developments .................................................................................................................... 1 1.1 Growth - An Economy on the Threshold of Recession ....................................................................................... 2 1.2 Labor Market – Still In A Tight Spot .................................................................................................................... 7 1.3 Monetary Policy and the Financial Sector – The Elusive Inflation Target ........................................................... 9 1.4 Balance of Payments – The Big Flight ................................................................................................................. 12 1.5 The Government Budget – Currency Depreciation and Oil Windfall Mask Medium-Term Challenges .............. 17 II. Outlook ................................................................................................................................................................. 21 2.1 Growth Outlook – Stagnation In The Face of Policy Uncertainty ........................................................................ 22 Baseline Scenario Projections .......................................................................................................................... 23 Alternative Scenario Projections ...................................................................................................................... 27 2.2 Development and Policy Challenges .................................................................................................................. 30 Poverty and Shared Prosperity Risks ............................................................................................................... 30 Policy Risks ...................................................................................................................................................... 31 III. Paths to Diversified Development in Russia ........................................................................................... 37 3.1 Introduction ........................................................................................................................................................ 38 3.2 Increasing Potential Output ............................................................................................................................... 40 3.3 Russia’s Current Asset Base: Abundant Natural Resources, Good Human Capital, Improving Infrastructure, But Weak Institutions ......................................................................................................................................... 42 Natural Resources ........................................................................................................................................... 42 Physical Capital ................................................................................................................................................ 43 Human Capital ................................................................................................................................................ 44 Institutions: Three essential functions of government .................................................................................... 46 3.4 Rebalancing Russia’s Asset Portfolio With Transparent Rules, Better Public Investment And Competition ....... 50 3.5 References .......................................................................................................................................................... 53 ANNEX: Main indicators ............................................................................................................................................... 54 List of Figures Figure 1: Global GDP growth, y-o-y, percent ............................................................................................................. 2 Figure 2: Composition of GDP growth, y-o-y and q-o-q sa, percent .......................................................................... 2 Figure 3: GDP growth, y-o-y and q-o-q sa, percent ................................................................................................... 3 Figure 4: Global industrial production and trade growth ......................................................................................... 4 Figure 5: Bond spreads ............................................................................................................................................. 4 Figure 6: Oil prices and OECD inventories ................................................................................................................. 4 Figure 7: Crude oil output shares, 2000 and 2013, mb/d ......................................................................................... 4 Figure 8: Stock market prices and trade volumes ..................................................................................................... 5 Figure 9: Exchange rate dynamics, Euro-Dollar basket ............................................................................................. 5 Figure 10: Non-tradable sector growth, y-o-y ............................................................................................................. 6 Figure 11: Tradable sector growth, y-o-y .................................................................................................................... 6 Figure 12: Beveridge curve ......................................................................................................................................... 7 Figure 13: Number of employed and economically active population, million people .............................................. 7 Figure 14: Productivity per worker by sectors, 2008Q1 = 100 percent ....................................................................... 8 Figure 15: Gap between real wages and productivity growth by sectors, 2008Q1 = 100 percent ............................. 8 Figure 16: Contribution to real income growth (all population), y-o-y, percent ......................................................... 8 Figure 17: Households’ real wages dynamics, y-o-y, growth, percent ........................................................................ 8 Figure 18: CBR’s key policy rate .................................................................................................................................. 9 Figure 19: CPI inflation by components, y-o-y ............................................................................................................ 9 Figure 20: The Ruble exchange rate and its bilateral band ......................................................................................... 10 Figure 21: NPLs as a share of total credit, y-o-y, percent ............................................................................................ 12 Figure 22: Credit growth, y-o-y, percent ..................................................................................................................... 12 Figure 23: Current account balance, percent of GDP .................................................................................................. 13 Figure 24: Trade and services balances and oil prices ................................................................................................ 13 Figure 25: Annual FDI flows in percent of GDP, net of round-tripping ....................................................................... 14 Figure 26: Russian inbound FDI from Cyprus, Bermuda and the Caribbean ............................................................... 14 Figure 27: Russia CDS spreads for 5 year bonds, basis points ..................................................................................... 15 Figure 28: Federal Budget Revenue and Balance in 2007-2014, percent of GDP ........................................................ 17 Figure 29: Russia’s growth outlook, y-o-y, percent ...................................................................................................... 23 Figure 30: Expected oil production growth until 2019, mb/d ...................................................................................... 24 Figure 31: Growth of global oil demand, y-o-y, mb/d .................................................................................................. 24 Figure 32: The rate of capacity utilization in manufacturing (percent), four quarter moving average ........................ 25 Figure 33: Unit labor cost in Russia, 2005 = 100, four quarter moving average .......................................................... 25 Figure 34: Poverty and inequality in Russia ................................................................................................................. 30 Figure 35: Income distribution: share of population with per capita income in US$ PPP per day, percent ................ 31 Figure 36: Real income growth, y-o-y, percent ............................................................................................................ 32 Figure 37: Poverty rates in 2013, percent .................................................................................................................... 33 Figure 38: Reserve and National Welfare Funds in 2008-2017, percent of GDP ......................................................... 34 Figure 39: Three ways to integrate and grow: export product share, by factor intensity ............................................ 38 Figure 40: Total factor productivity growth, percent ................................................................................................... 40 Figure 41: Russia’s potential growth, percent .............................................................................................................. 40 Figure 42: Newly registered firms (LLC) per 1000 working age population ................................................................. 41 Figure 43: Distribution of wealth by assets in 2005, percent ...................................................................................... 42 Figure 44: Subsoil natural resource wealth per capita in 2005, constant 2005 US$ .................................................... 42 Figure 45: Resource revenue as share of total fiscal revenue, 2006-2010 .................................................................. 43 Figure 46: Revenue of energy producing minerals across regions, percent of GDP .................................................... 43 Figure 47: Gross capital formation, percent of GDP .................................................................................................... 44 Figure 48: Quality of infrastructure, Global Competitiveness Index ............................................................................ 44 Figure 49: Fixed (wired-) broadband subscriptions per 100 inhabitants, 2012 ........................................................... 44 Figure 50: The quality of human capital is higher than predicted by income per capita ............................................. 45 Figure 51: Quality of education, Global Competitiveness Index .................................................................................. 46 Figure 52: Quality of on-the-job training, Global Competitiveness Index ................................................................... 46 Figure 53: Restrictiveness in competition, OECD Product Market Regulation Index ................................................... 49 List of Tables Table 1: Contribution to growth by demand components, percentage points ........................................................... 3 Table 2: Balance of Payments, 2008–2014, US$ billions ............................................................................................. 15 Table 3: Net capital flows, 2008–2014, US$ billions ................................................................................................... 16 Table 4: Russia’s external debt, 2011-2014, US$ billion .............................................................................................. 16 Table 5: Projected debt payments in 2014 – 2015, principal plus interest, US$ million ............................................. 16 Table 6: Federal budget, 2012-2014, percent of GDP ................................................................................................. 18 Table 7: Consolidated government finances, percent of GDP ..................................................................................... 19 Table 8: Main economic indicators: baseline scenario ................................................................................................ 23 Table 9: Global real GDP growth, percent ................................................................................................................... 24 Table 10: Government budget medium-term framework for 2014-2017, percent of GDP .......................................... 27 Table 11: Main economic indicators: optimistic scenario ............................................................................................. 28 Table 12: Main economic indicators: pessimistic scenario ........................................................................................... 29 Table 13: Poverty rates in Russia, percent .................................................................................................................... 31 Table 14: Length of transport networks, km, thousands .............................................................................................. 44 Table 15: Quality of education, OECD PISA scores, 2009 .............................................................................................. 45 Table 16: Quality of institutions, World Governance Indicators, 1996-2012 ................................................................ 47 List of Boxes Box 1: Recent global trends ...................................................................................................................................... 4 Box 2: Sanctions and their impact on markets and the economy ............................................................................ 5 Box 3: Output growth by sectors in first half of 2014 .............................................................................................. 6 Box 4: Recent productivity trends ............................................................................................................................ 8 Box 5: CBR continued its transition to a floating exchange rate .............................................................................. 10 Box 6: The link between capital flight and FDI ......................................................................................................... 14 Box 7: Amendments to the 2014-2016 Federal Budget Law .................................................................................... 18 Box 8: Global outlook ............................................................................................................................................... 24 Box 9: The potential impact of import substitution ................................................................................................. 25 Box 10: Government’s medium-term budget framework for 2015-2017 .................................................................. 27 Box 11: Recent poverty and inequality trends ........................................................................................................... 31 Box 12: Russia and the World Trade Organization ..................................................................................................... 35 ABBREVIATIONS AND ACRONYMS ANS Adjusted Net Savings APEC Asia-Pacific Economic Cooperation CA Current Account CBR Central Bank of Russia CDS Credit Default Swaps CIS Commonwealth of Independent States CPI Consumer Price Index DSB Dispute Settlement Body ECA Europe and Central Asia EU European Union FDI Foreign Direct Investment GDP Gross Domestic Product HDI Human Development Index HHI Herfindahl-Hirschman Index IEA International Energy Agency NPL Non-Performing Loan NWF National Welfare Fund OECD Organisation for Economic Cooperation and Development OPEC Organization of the Petroleum Exporting Countries RDIF Russian Direct Investment Fund SOE State-Owned Enterprise SPS Sanitary and Phytosanitary Standards TBT Technical Barriers to Trade PPP Purchasing Power Parity VAT Value-added Tax VTB Vneshtorbank WTO World Trade Organization Russia Economic Report | Edition No. 32 i EXECUTIVE SUMMARY R ussia’s economy is stagnating. Seasonally adjusted growth for the first two quarters of 2014 was near zero. Consumer and business starting with the second half of 2014. A small positive effect appears to be coming from import substitution. An expansion of sanctions related to sentiments were already weak in 2013 due to the Russia-Ukraine tensions could send business lingering structural problems and contributed and consumer confidence into another downward to the wait-and-see attitudes of households and spiral, further reducing domestic demand. companies. Heightened market volatility and policy uncertainty due to geopolitical tensions There are substantial risks to Russia’s medium- during the first half of this year exacerbated this term outlook. Inertia on structural reform policies confidence crisis. The Russian economy needed to combined with high policy uncertainty―related to internalize several rounds of sanctions, counter- geopolitical tensions and the overall direction of sanctions and measures to stabilize the economy; the economy―remain the deciding factors for our this environment of higher risk lowered domestic outlook. Global demand is projected to be broadly demand. While the macroeconomic stabilization stable, and oil prices are expected to remain around measures were timely and successful, medium- US$100/bbl, according to World Bank projections. term policy objectives are still being defined. This Our baseline projection is one of near stagnation continued policy uncertainty about the economic with growth of 0.5 percent in 2014, 0.3 percent course of the country is casting a shadow on in 2015, and 0.4 percent in 2016. This baseline Russia’s medium-term prospects. assumes no further escalation of geopolitical tensions and no additional sanctions. Geopolitical Increasing uncertainty impacted investor and tensions would continue to impact the economy consumer decisions. Consumption growth through the already observed transmission continued to slow, but it was deteriorating channels. An alternative optimistic scenario investment that became the main reason for the projects a small recovery, facilitated by an end to weak growth outturn in the first half of 2014. The geopolitical tensions and the lifting of all sanctions first rounds of sanctions against Russia limited by the end of 2014. Growth would improve from the country’s access to international capital 0.5 percent in 2014 to 0.9 percent in 2015 and 1.3 markets and increased the cost of borrowing percent in 2016. A pessimistic scenario envisions for households and firms. High uncertainty also an increase in geopolitical tensions and additional triggered massive capital outflows, and together sanctions. As a result, the economy would slip into with increased currency volatility and borrowing a recession with output contracting by 0.9 percent costs, it curtailed the willingness of businesses to in 2015 and 0.4 percent in 2016. invest through the first eight months of 2014. For consumers, higher borrowing costs meant that an Economic recovery will need a predictable policy increasing share of household income was used environment and a new model of diversified for paying off debts. Consumers also adjusted development. Since the beginning of geopolitical to the volatile environment with lower demand tensions, economic policy has been dominated by as renewed pressure on the Ruble and counter- measures to maintain macroeconomic stability. sanctions restricting food imports in August This important policy effort should go hand in hand translated into higher inflation. The impact of the with renewed focus on improving the economy’s latest rounds of sanctions and counter-sanctions structural fundamentals. However, some measures will be more clearly reflected in outcomes and economic policies under discussion have the Russia Economic Report | Edition No. 32 iii Executive Summary potential to alter how the economy operates and that there are strong competition regimes to and might turn out to be detrimental to its encourage private enterprise and entrepreneurship. competitiveness. A return to higher growth in Stabilization, transparent rules, better quality of Russia will depend on solid private investment and public investment, and competition should be the a lift in consumer sentiment, which will require reform priorities for the next decade. a predictable policy environment and continued structural reforms. Developing a more balanced Prospects for further poverty reduction and portfolio of national assets, namely, natural shared prosperity are limited. In the past, rising resources, capital and economic institutions, will wages and pension transfers allowed Russia to help overcome structural constraints to growth. reduce poverty significantly and to expand the Russia is abundant with natural resources and ranks of the middle-class. Unless structural reforms institutional weaknesses are now the main to expand the economy’s potential are pursued, stumbling block on the road to greater economic low investment makes it less likely that plentiful efficiency and higher growth rates. Structural well-paying jobs will be created. High inflation, reforms would need to focus on improving moreover, will slow real income growth and hurt economic institutions to ensure that public finances consumption growth, dimming the likelihood for are stable and economic volatility well-managed; further poverty reduction and limiting the ability of that there are improvements in education and the bottom 40 percent of the population to share infrastructure to make workers more productive; in prosperity. iv Russia Economic Report | Edition No. 32 PART I Recent Economic Developments S tructural impediments slowed economic expansion to near stagnation even before the impact of increased policy uncertainty amid heightened geopolitical tensions took hold. GDP growth was just 0.8 percent in the first half of 2014 compared to 0.9 percent in the first half of 2013. The reasons for Russia’s slowdown remain on balance of structural nature, with the economy operating at close to its potential output level. Although Russia’s growth was not dissimilar to that of the Euro Zone, it dipped under that of other country comparator groups, such as emerging and high-income economies. Due to Russia’s integration into the world economy with the exports of resource-intensive products to high- income countries, their growth paths remain closely entwined. Current geopolitical tensions are adversely impacting these trade relationships. I. Recent Economic Developments 1.1 Growth - An Economy on the Threshold of Recession Russia’s growth stagnated in the first half of the year and lingers near the threshold of a recession. Growth is negatively impacted by low business and consumer confidence in an environment in which heightened geopolitical tensions and sanctions generate increased policy uncertainty. R ussia’s low-level growth is not that dissimilar to that in the Euro zone, but it contrasts with the cautiously firming growth in other high- Our special focus note explores more closely the nature of those structural constraints and proposes potential remedies. income and emerging economies (Box 1). Russia’s economy grew more slowly than emerging The increased uncertainty brought about by the economies outside the EU in recent years and over Russia-Ukraine tensions and related sanctions the last couple of quarters its pace of expansion impacted investor and consumer decisions. First, dipped even below that of emerging economies equity and currency markets entered a prolonged in the EU (Figure 1). This downturn came largely period of high volatility as they needed to as a result of structural constraints. With the internalize this high uncertainty (Box 2). Second, economy operating close to its potential, growth the impact of Western sanctions on Russia’s is constrained by inefficient factor allocation, non- growth performance in the first half of 2014 was competitive markets, and a dearth of innovation. channeled through adjustments in financial flows. Our special focus note explores more closely Third, it exacerbated the confidence crisis the the nature of those structural constraints and economy had entered in 2012-2013, weighing proposes potential remedies. Those constraints heavily on consumption and investment. Statistics led to a slowdown in growth starting from 2012 on output dynamics by economic sectors for the which was based on decelerating investment and second quarter (immediately following the start consumption growth (Figure 2). That slowdown of the geopolitical tensions) indicate that the is now exacerbated by geopolitical tensions. economy remains sluggish but with a small positive Figure 2: Composition of GDP growth, y-o-y and Figure 1: Global GDP growth, y-o-y, percent q-o-q sa, percent 12 17 8 9 4 1 0 -7 -4 -15 -8 -12 -23 Q1-08 Q2-08 Q3-08 Q4-08 Q1-09 Q2-09 Q3-09 Q4-09 Q1-10 Q2-10 Q3-10 Q4-10 Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13 Q1-14 Q2-14 8 Q1 08 9 Q1-09 0 Q1-10 1 Q1-11 2 Q1-12 3 Q1-13 4 -0 -0 -1 -1 -1 -1 -1 - Q1 Q4 Q4 Q4 Q4 Q4 Q4 Consumption GFCF Change in stock GDP growth Russia OECD HI EU Emerging Other Emerging Export Import Discrepancy Source: OECD. Source: Rosstat and World Bank staff estimates. Note: Emerging EU economies include the six central European Note: All data is from Rosstat, except the Q2 2014 GDP composition countries that are member both of the EU and the OECD: Czech which is a World Bank staff estimate (Table 1). Republic, Estonia, Hungary, Poland, Slovak Republic, and Slovenia. Other emerging economies include seven countries: Brazil, China, India, Indonesia, Mexico, South Africa and Turkey. 2 Russia Economic Report | Edition No. 32 I. Recent Economic Developments Figure 3: GDP growth, y-o-y and q-o-q sa, percent in the first half of 2013. Already in 2013, 6 economic activity in Russia was hamstrung by lingering structural problems and a wait-and- 5 see attitude on the part of both businesses 4 and consumers. 3 Consumption was negatively impacted by 2 1.4 1.0 the geopolitical tensions through the sharp 1 0.8 0.7 0.4 0.2 1.3 0.4 0.0 depreciation of the Ruble and related inflation 1.0 0 0.3 0.3 0.4 0.1 pressures. Consumption growth slowed and its -1 contribution to growth fell to about 2 percentage points in the first quarter of 2014 from 3 1 1 1 2 2 2 2 3 3 3 3 4 4 4 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 Q1 Q2 Q3 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q3 Q1 Q2 GDP growth, y-o-y GDP growth, q-o-q, sa percentage points in the first quarter of 2013 Source: Rosstat. (Table 1). Nevertheless, despite this reduction, consumption remained the main growth engine. impulse coming from some import substitution Other factors driving the consumption pattern (Box 3). Overall, the gradual implementation of in the first half of the year included increased trade sanctions started in late July and will likely household debt burdens and lower real income show their full impact only in the second half of growth. Consumption growth is currently 2014 and next year. An expansion of sectoral or moderating to a new and lower growth trajectory. trade sanctions related to the Russia-Ukraine Geopolitical tensions are weighing down further tensions could send business and consumer on consumption growth in an environment of confidence into another downward spiral, further subdued consumer sentiments. reducing domestic demand. Investment activities contracted due to a Near-zero quarterly growth in seasonally more uncertain business environment and the adjusted terms implies a continued slowdown increasing restrictiveness of credit conditions as of Russia’s economy from 2.0 percent in the last a result of sanctions. Decelerating investment was quarter of 2013 to 0.9 percent growth in the the main cause for the weak growth outturn in the first quarter 2014. Real GDP grew year-on- first half of 2014. In the first quarter, investment year (y-o-y) 0.8 percent in the second quarter demand deteriorated sharply, with fixed investment (Figure 3). Growth in the first half of 2014 contracting 7 percent after weakening 0.5 percent reached 0.8 percent compared to 0.9 percent a year earlier. Dwindling profit margins, slowing Table 1: Contribution to growth by demand components, percentage points Q1 Q2 Q3 Q4 Q1 Q2 2010 2011 2012 2013 2013 2013 2013 2013 2014 2014e GDP growth, percent 4.5 4.3 3.4 1.3 0.8 1.0 1.3 2.0 0.9 0.8 Consumption 2.6 3.7 4.7 2.4 3.0 2.3 2.4 2.1 2.0 1.8 Households 3.0 3.5 3.8 2.3 2.9 2.2 2.4 2.0 2.0 - Government -0.3 0.3 0.8 0.1 0.1 0.1 0.1 0.1 0.0 - Gross capital formation 5.4 4.7 0.4 -1.5 -0.9 -1.6 -1.9 -1.5 -2.3 -2.4 Fixed capital investment 1.3 2.0 1.4 0.0 -0.1 -0.3 0.0 0.2 -1.0 - Change in stocks 4.1 2.8 -1.0 -1.5 -0.8 -1.3 -1.9 -1.7 -1.3 - Export 2.0 0.1 0.4 1.2 0.0 1.1 2.1 1.6 0.5 0.3 Import -5.3 -4.3 -1.9 -0.8 -1.5 -0.8 -1.2 0.0 0.9 1.1 Source: Rosstat and World Bank staff calculation. Russia Economic Report | Edition No. 32 3 I. Recent Economic Developments Box 1 Recent global trends Global growth and trade picked up in the second quarter of 2014 after a weak start of the year (Figure 4). The second quarter rebound was largely driven by strengthening growth in the US, where the economy grew faster than expected, accelerating to 4.2 percent (q-o-q, saar) after a weather-related 2.1 percent contraction in the first quarter. In the Euro area, second quarter GDP growth disappointed at 0.2 percent (after 1.1 percent in quarter one) and saw Germany contracting 0.2 percent from 0.8 percent growth in the first quarter. In Japan, GDP growth contracted by 6.8 percent in the second quarter, as a result of the 3-percentage-point sales tax hike in April, offsetting 6.1 percent first quarter growth. In Japan, GDP growth contracted by 6.8 percent in the second quarter, as a result of the 3-percentage-point sales tax hike in April, offsetting strong first quarter growth (6.1 percent). Accommodative monetary policies and firming import demand in high-income countries have supported growth and capital inflows in developing countries. China’s second-quarter GDP growth was steady at 7.5 percent (y-o-y) supported by a rebound in exports and earlier stimulus measures. Global trade reported a healthy pick-up in the first half of 2014: in the three months to June it increased by 4.2 percent. Gross capital flows to developing countries have remained strong since March, notwithstanding the ongoing US Fed tapering. Additional easing by the European Central Bank, combined with prospects of modest growth and stable inflation in the United States, helped depress bond yields and volatility worldwide (Figure 5). Despite geopolitical concerns in Israel, Syria, Ukraine and Iraq, spreads on emerging market bonds have narrowed more than 100 basis points since early February. The escalation of tensions in Ukraine and the payment default of Argentina pushed up Credit Default Swaps spreads for sovereign bonds of these countries, but the impact on other emerging economies has so far been muted. Oil prices were remarkably stable through mid-year despite rising geopolitical tensions (Figure 6). Prices exceeded US$108/ bbl in June due to geopolitical concerns in Iraq, but retreated to a 12-month low under US$100/bbl in August and September. Apart from the June surge, oil prices have been stable and the rising geopolitical tensions seem to have not affected the global oil markets significantly. Oil production from Iraq’s Kurdistan autonomous region doubled in August and is expected to increase further by the end of 2014. OECD inventories rebounded from the past decade’s lowest level in December 2013, reaching 2,685 million bbl in June. According to the International Energy Agency (IEA), Russia will remain the world’s largest crude oil supplier, with production expected to be marginally up from 10.88 mb/d in 2013 (Figure 7). However, Russia is advancing its strategy of recent years to divert its crude oil exports to Asian markets. During January-July 2014, those exports were up 27 percent compared to a year ago while deliveries to Europe declined by 10 percent during this period. Figure 4: Global industrial production and trade growth Figure 5: Bond spreads % change, 3m/3m saar Bond spreads basis points 30 550 25 500 20 450 15 400 10 350 5 0 300 -5 250 -10 200 -15 150 -20 13 13 13 13 13 13 13 13 13 13 13 13 14 14 14 14 14 14 14 n- b- r- r- y- n- l- g- p- t- v- c- b- r- r- y- n- ul- g- 14 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Ja Fe Ma Ap Ma Ju Ju Au Se Oc No D e Fe M a A p M a J u J A u n- Ja Developing Industrial Production Developing Country Exports High Income Industrial Production High Income Imports Asia East Europe Latin America 326 Middle East Source: Datastream and World Bank Prospects. Source: Bloomberg. Figure 6: Oil prices and OECD inventories Figure 7: Crude oil output shares, 2000 and 2013, mb/d $US per bbl Million bbl Russian Fed. 140 Oil Price, World Bank average (left axis) 2850 U.S.A. 2800 S. Arabia 120 2750 China Canada 100 2700 Iraq 2650 Mexico 80 2600 UAE 60 2550 Iran OECD oil inventories (right axis) Kuwait 2500 Venezuela 40 2450 Brazil 20 2400 Nigeria 7 8 9 0 1 2 3 4 -0 -0 -0 -1 -1 -1 -1 14 -1 0 2 4 6 8 10 12 14 n n n n n n n n- g Ja Ja Ja Ja Ja Ja Ja Ja Au 2013 2000 Source: Datastream and World Bank Prospects. Source: IEA. 4 Russia Economic Report | Edition No. 32 I. Recent Economic Developments Box 2 Sanctions and their impact on markets and the economy Since the start of the Russia-Ukraine tensions, and up to September 17 when this report went to press, Russia has been subject to several rounds of sanctions from developed economies. First, there were sanctions introduced by the US, EU, and other countries aimed at specific individuals, groups and companies. They prohibit the entry of the sanctioned individuals, freeze their assets and ban business operations with these individuals and companies. Such sanctions were introduced by the US, EU, Canada, Australia, Albania, Iceland, Liechtenstein, Moldova, Norway, New Zealand, Ukraine, Switzerland, Montenegro, and Japan. Second, sanctions aiming at Russia’s military, energy and financial sectors were introduced. In the financial sector, access of the Russian six major state banks to the EU and US financial markets was severely limited. Since September 12, these companies can only apply for loans and issue debt not exceeding 30 days maturity. In the defense sector, the US and the EU cut access to financing exceeding 30 days maturity for Russia’s major companies and introduced an export ban for dual-use goods and technology for 14 mixed-defense companies. Sanctions on cooperation with Russia in the military sector were introduced by Great Britain, Israel, Switzerland, and Sweden. In the energy sector, the US and the EU limited access to finance for Russian major oil and gas companies. Also the EU and the US prohibited export of goods, services (not including financial services), or technology in support of exploration or production for Russian deep-water, Arctic offshore, or shale projects. Norway, Canada, and Australia largely joined sanctions introduced by the EU. Sanctions were also introduced against Crimea and Sevastopol, including a ban on investment projects and mineral extraction and a trade ban on a wide range of goods (by the EU and Norway). On August 7, Russia banned the import of meat, fish, seafood, vegetables, fruit, milk, dairy products, and a wide range of processed foods from the US, the EU, Australia, Canada, and Norway for a year in response to their sanctions. Sanctions and counter sanctions hit the economy through three channels. First, they led to increased volatility on the foreign exchange market and a significant depreciation of the national currency (Figure 8 and Figure 9). Massive capital outflows triggered by the tensions led to a deterioration of the capital and financial account balance and a decrease in net international reserves. Yet, despite the depreciation, non-oil exports did not increase much, and although there was a small impulse to import substitution, its potential appear to be limited, given that there is little spare capacity due to structural constraints. Depreciation also exerted additional pressure on inflation. In response to high inflation pressures, the Central Bank significantly tightened monetary conditions. The policy appears consistent with its long-term inflation target, yet it increased domestic borrowing rates and further restricted access to domestic credit for investors and consumers. Second, the tensions also limited Russia’s access to international financial markets, with markets pricing Russia’s higher risk into the cost of credit and sending sovereign Credit Default Swap spreads for Russia soaring. Foreign borrowing decreased in the first half of 2014. These tighter domestic and external credit conditions are likely to have negatively affected investment and consumption decisions, leading to a delay or a scaling back of respective plans. Finally,already low domestic business and consumer confidence in future growth prospects continued to diminish and reduce consumption and investment activities. We expect that these trends will worsen during the second half of 2014 and throughout 2015, when the impact of the additional sanctions will be felt, leading to a period of stagnation. We expect that these trends will worsen during the second half of 2014 and throughout 2015, when the impact of the additional sanctions will be felt, leading to a period of stagnation (see section 2). Figure 8: Stock market prices and trade volumes Figure 9: Exchange rate dynamics, Euro-Dollar basket 1500 3,500 0.0265 1450 3,000 0.026 1400 0.0255 1350 2,500 1300 0.025 2,000 1250 0.0245 1200 1,500 0.024 1150 1,000 1100 0.0235 500 1050 0.023 1000 - 6-Jan-14 3-Mar-14 2-Jun-14 17-Sep-14 0.0225 Trade volume, mln USD (right axis) RTS index 1-Jan-14 1-Mar-14 1-Jun-14 1-Aug-14 17-Sep-14 Source: MICEX. Source: CBR. Russia Economic Report | Edition No. 32 5 I. Recent Economic Developments consumption, and a weak growth outlook led the reflected in the high capacity utilization―nearing continued reduction in inventories, subtracting historical highs―together with limited prospects 1.3 percentage points from growth (Table 1). for additional increases in productive capacity The Russia-Ukraine tensions negatively impacted (Box 9 in the outlook section). already low business confidence in the economy and further depressed investor sentiment. More Demand for Russian exports was robust. The restricted access for Russian companies and banks contribution of exports to GDP increased to 0.5 to external financing is likely to have affected percentage points in the first quarter of 2014 from investment decisions, leading to a delay or a scaling nil a year earlier (Table 1). On the other hand, back of investment programs. We expect that this imports decreased due to the depreciation of trend will worsen during the second half of 2014 the Ruble and weak domestic demand. Owing and throughout 2015, when the impact of the to import contraction and stable export growth, additional sanctions will be felt and may lead to a the contribution of net exports to GDP growth period of near stagnation (see section 2). Despite increased to 1.4 percentage points in the first some import substitution potential (see Box 3), we quarter of 2014. However, if the Russia-Ukraine believe that private investors will remain hesitant tensions would lead the West to introduce more to invest as they continue to face increased sanctions against Russia, beyond the ones in policy uncertainty and structural and institutional place as of September 17 when this report went constraints to business expansion (see section to press, the impact on Russia’s economy could 3). The weak growth potential of the economy is be profound. Box 3 Output growth by sectors in first half of 2014 Growth in the non-tradable sector―the main growth driver in recent years―moderated to a lower level (Figure 10). Consumer demand for non-tradable market services is increasingly constrained by slowing income growth, high inflation and rising household debt burden, which was in particular reflected in the slowdown in retail and wholesale trade. Negative investment growth is reflected in continued contraction in the construction sector. However, in the tradable sector, the Ruble depreciation appears to have helped to revive economic activities in the manufacturing sector, which reported an acceleration of output (Figure 11). Activities in other tradable sectors such as agriculture and mineral extraction improved marginally in the second quarter relative to the first quarter of 2014. There was some positive impulse to a few manufacturing sub-sectors from import substitution, which appears to be carried over into the third quarter. As a result, the rate of capacity utilization increased back to 2012 levels when the recent economic slowdown began. With capacity utilization approaching historical highs and a continuously tight labor market (see section 1.2) the positive effect of import substitution might be short-lived and limited by structural constraints (Box 9 in part 2). Figure 10: Non-tradable sector growth, y-o-y Figure 11: Tradable sector growth, y-o-y 14 4 12 3.5 10 3 8 2.5 6 2 4 1.5 2 1 0 0.5 -2 0 -4 2013 Q1 2014 Q2 2014 -0.5 -6 2013 Q1 2014 Q2 2014 Electricity, gas, and water Construction Retail trade -1 Transport Financial services Real estate Agriculture Mineral extraction Manufacturing Source: Rosstat. Source: Rosstat. 6 Russia Economic Report | Edition No. 32 I. Recent Economic Developments 1.2 Labor Market – Still In A Tight Spot The economic stagnation has been accompanied by employment at near maximum historical levels and low unemployment. Some increase in labor mobility between sectors helped reallocate scarce labor resources. Growth in wage and transfers slowed during the first half of 2014 and negatively impacting real disposable-income growth. S table, low unemployment reflects continued tightness in the labor market. Despite slower growth, the demand for labor as measured by overall trends, decreasing to 4.8 percent in the first half of 2014 from 5.2 percent in the same period of 2013. Regional unemployment dynamics the vacancy rate1 remained little changed (Figure continue to be very unequal and indicate that 12). The number of employed also changed geographically there remain strong limitations to little. We saw that an increase in the number of labor mobility. Historically, the poorest regions employed in expanding sectors (such as financial tend to have high unemployment, including the services and real estate) compensated for a Northern Caucasus federal district of Ingushetia decline in the number of employed in contracting (36.1 percent), Chechnya (22.4 percent), and the sectors, suggesting some labor mobility between Tuva Republic (22.0 percent). At the same time, sectors. Although labor supply―measured by the large metropolitan areas remain the regions the economically active population―remains with the lowest unemployment rates: Moscow- near its historical maximum, it is slowly declining, city (1.2 percent), St. Petersburg (1.5 percent), and reflecting long-term demographic changes (Figure the greater Moscow region (2.6 percent). 13). The seasonally adjusted unemployment rate eased to 5.3 percent in the first half of 2014 from Growth in real disposable income slowed to nil in 5.6 percent a year earlier. Female employment the first eight months of 2014 from 4.3 percent a remains below male employment levels, but the year ago (Figure 16). Real wage growth weakened female unemployment rate moved in line with in all sectors, but especially for public employees. Figure 13: Number of employed and economically Figure 12: Beveridge curve active population, million people 77 76 3.1 3Q 13 4Q 13 75 2Q 14 2Q 13 3.1 74 3.2 3.04 3.0 1Q 14 73 4Q 12 1Q 13 72 Vacancy rate, % 3.0 2Q 12 71 2.7 5.1 5.2 5.3 5.4 5.5 5.6 4Q 11 70 2.2 4Q 104Q 09 69 68 1.7 67 5.0 6.0 7.0 8.0 9.0 2009 2010 2011 2012 2013 2014 Unemployment rate, % Employment Activity, SA Activity Employment, SA Source: Rosstat and World Bank staff estimates. Source: Rosstat and World Bank staff estimates. 1 Number of vacancies as a share of total number of jobs. Russia Economic Report | Edition No. 32 7 I. Recent Economic Developments Box 4 Recent productivity trends Real wages grew in line with productivity for the economy as a whole. In the first half of 2014, productivity growth was higher in the tradable sector than in non-tradable sectors (Figure 14). Nonetheless, favorable wage dynamics in the private non-tradable sector led to some improvement in the productivity gap (Figure 15). Developments in the manufacturing sector were more volatile than in other industries however, with productivity growth lagging wage growth in the first quarter before a sharp reversal in the second. Figure 14: Productivity per worker by sectors, Figure 15: Gap between real wages and productivity growth 2008Q1 = 100 percent by sectors, 2008Q1 = 100 percent 135 105 130 100 125 95 120 115 90 110 85 105 80 100 95 75 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 2009 2010 2011 2012 2013 2014 2009 2010 2011 2012 2013 2014 Total Tradables Non-Tradables Non-Market Manufacturing Total Tradables Non-Tradables Non-Market Manufacturing Source: Rosstat, Haver and World Bank staff estimates. Source: Rosstat, Haver and World Bank staff estimates. The contribution of the public or non-market 6.5 percent in February and by 1.7 percent in sector to wage growth is still the largest, but less April, both indexed to the headline CPI. Already so than it was in 2013 (Figure 17). Public wages and increasing household debt burden, combined with transfers contributed negatively to income growth lesser opportunity to rollover short-term debt due in the first half of 2014. Pension growth weakened to higher loan costs and tighter credit conditions, is in real terms despite two nominal increases in further reducing household’s disposable income. the first half of 2014. Pensions were raised by Figure 16: Contribution to real income growth Figure 17: Households’ real wages dynamics, (all population), y-o-y, percent y-o-y, growth, percent 12 15 10 8 10 6 4 5 2 0 -2 0 -4 -6 -5 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 2009 2010 2011 2012 2013 2014 -10 2009 2010 2011 2012 2013 2014 Others Business and property Public wages and transfers Market wages Total Non-Market Non-Tradables Tradables Total Source: Rosstat and World Bank staff estimates. Source: Rosstat and World Bank staff estimates. 8 Russia Economic Report | Edition No. 32 I. Recent Economic Developments 1.3 Monetary Policy and The Financial Sector – The Elusive Inflation Target The geopolitical tensions led to increased volatility on the foreign exchange market and a significant depreciation of the Ruble. In response to persistently high inflation pressures, the CBR significantly tightened monetary policy. The financial sector is becoming increasingly affected by the geopolitical tensions and related sanctions, which is eroding the depositors’ base and limiting access to credit. D uring the first half of 2014, the exchange rate went through three episodes of high volatility, leading the Central Bank to scale up basis points to 7.0 percent, while purchases for the Reserve Fund were immediately put on hold (Figure 18). In addition, the CBR strengthened its its interventions significantly. First, pressure on intervention rule.2 Although some confidence into the Ruble increased in January 2014 as a result the Ruble was restored, the CBR had to continue of uncertainty around the impact of the US Fed intervening and spent close to US$25 billion in tapering of its quantitative easing policies and March alone to support the Ruble. Pressure on the speculation around CBR’s move to a more flexible Ruble decreased substantially in April and May, exchange rate regime. To support the Ruble, the reflecting the temporary easing of geopolitical Central Bank more than doubled the amount tensions. Consequently, the CBR discontinued of intervention to US$8.6 billion compared to interventions on May 12 and relaxed the rules December 2013, and it continued intervening for its foreign exchange interventions in late in February (US$6.4 billion). On March 3, the May and again in June.3,4 However, at the end of exchange rate entered a second period of increased July, the exchange rate entered its third round of volatility due to the start of the Russia-Ukraine high volatility this year on the back of renewed tensions. CBR hiked its main policy rates by 150 Russia-Ukraine tensions. Yet, CBR refrained from Figure 18: CBR’s key policy rate Figure 19: CPI inflation by components, y-o-y 8.5 12 8 10 7.5 7 8 6.5 6 6 5.5 4 5 2 4.5 4 0 May-13 Mar-14 May-14 Feb-11 Mar-11 Apr-11 May-11 Aug-11 Mar-12 May-12 Mar-13 Jun-11 Oct-11 Nov-11 Feb-12 Apr-12 Aug-12 Nov-12 Nov-13 Sep-14 Sep-11 Jan-12 Jun-12 Sep-12 Oct-12 Dec-12 Jan-13 Feb-13 Apr-13 Aug-13 Sep-13 Jan-14 Jun-13 Jul-13 Oct-13 Feb-14 Apr-14 Jul-14 Aug-14 Jun-14 Jul-11 Jul-12 2011 2012 2013 2014 Food Non-Food Services CPI Source: CBR. Source: Rosstat and World Bank staff estimates. 2 On March 3, CBR raised the amount of cumulative interventions sufficient for moving the foreign exchange corridor by 5 kopecks from US$350 million to US$1.5 billion, moving the currency corridor up by 35 kopecks, and intervened in the amount of US$11.3 billion which is close to the historical maximum of US$15 billion on January 19, 2009. CBR officially announced these changes to its exchange rate policy as temporary and confirmed their intention to move to a flexible exchange rate regime by 2015. 3 On May 22, the CBR changed the rules of its foreign exchange interventions: the amount of its interventions was lowered from US$200 million to US$100 million when the Ruble is traded in the range of 1.5–2.5 Rubles from the center of the CBR band. In addition, it lowered the amount of its support from US$400 million to US$300 million when the Ruble is traded 0.95 Ruble apart from the edges of the CBR band. CBR kept its temporary March measure of moving the foreign exchange corridor by 5 kopecks for cumulative interventions of US$1.5 billion. The regulator only conducted purchases of currency for replenishment of the Reserve Fund (US$1.5 billion in June). Purchases were suspended on June 24, when the total amount of purchases for the Reserve Fund this year reached US$5.7 billion, close to the initially planned amount of about US$6.1 billion. 4 On June 17, CBR moved the operational band that does not require its interference from 3.1 to 5.1 rubles, reducing the amount of interventions in the zone 0.95 Ruble apart from the edges of the Ruble band from US$300 million to US$200 million. Also, CBR lowered the cumulative amount of interventions required for shifting of the Ruble band by 5 kopecks to US$1.0 billion from US$1.5 billion. Russia Economic Report | Edition No. 32 9 I. Recent Economic Developments interventions on the market and further relaxed percent in August, year-on-year) continued to intervention rules in mid-August (Box 5). In the push inflation up despite seasonal declines in first half of 2014, the Ruble depreciated compared fruit and vegetable prices in July and August. By to end-December levels by 9.2 percent versus the end of August, 12-month inflation rose to 7.6 the US Dollar and 9.6 percent versus the Euro- percent and core inflation to 8 percent (Figure 19). Dollar currency basket, despite interventions in Central bank reverted to further tightening at the the amount of US$40 billion for which CBR had to end of July in an attempt to rein in persistently draw on its foreign reserves, which fell by US$26 high inflation. This was the third hike of key policy billion from US$509 billion at the end of 2013. rates this year, bringing the cumulative increase The Ruble/US$ exchange rate broke its historical to 250 basis points. This time, the CBR expressed maximums on September 17, reaching 38.71. particular concerns regarding new risks to While the recent policy moves suggest that CBR inflation arising from potential changes in tax and remains fully committed to finalizing its move to tariff rates, increased geopolitical tension (with inflation targeting by the end of 2014, it might increasing sanctions and the latest food ban) and became challenging to operate in an environment its potential impact on the Ruble exchange rate that has now both high inflation and low growth dynamics. Those factors could become the source risks (see section 2). of elevated inflation expectation and pressures. Climbing headline inflation and an accelerating Inflation remained high and prompted the core inflation will make it difficult for the Central Central Bank to tighten policy further in mid- Bank to achieve its 2014 inflation target of 3.5-6.5 year. The geopolitical tensions that began in percent. The CBR had announced at mid-year that March destabilized the foreign exchange market inflation is likely to come out at the upper end, and led to a sharp depreciation of the Ruble. As around 6.0-6.5 percent. In September, it revised a result, demand for money fell sharply, adding its projection saying that inflation might exceed 7 to already high inflation pressures. Furthermore, percent by the end of the year. higher-than-expected prices for food (10.3 Box 5 CBR continued its transition to a floating exchange rate On August 18, 2014, the Central Bank of Russia announced Figure 20: The Ruble exchange rate and its bilateral band a significant easing of its foreign exchange management policy, leading to more exchange rate flexibility. The 51 following measures were introduced: 48 (1) The corridor for the bilateral currency basket was expanded from RUB7 to RUB9, the first expansion 45 since mid-2012. The new corridor was set in the 42 range of RUB35.40-44.40; 39 (2) The CBR will no longer conduct interventions when 36 the exchange rate is within the corridor; (3) Interventions will be conducted only at the bounds 33 of the corridor, and the amount of accumulated 30 interventions required to make a 5 kopek shift in the 27 corridor was lowered from US$1 billion to US$350 2011 2012 2013 2014 million, back to the amount at the beginning of the Rb/USD Rb/Eur Basket Lower bound Upper bound year, before the geopolitical tensions. Source: CBR and World Bank staff estimates. 10 Russia Economic Report | Edition No. 32 I. Recent Economic Developments Russian banks are increasingly impacted by the banks’ liquidity and put additional strains on the geopolitical tensions and related sanctions. With money market, which is already squeezed by CBR’s aloan-to-deposit ratio of 120 percent, a substantial tightening and by restricted access to international part of Russian banking is financed by borrowing funding. The cleaning up of the banking system is a abroad or at home. Financial sector sanctions welcome initiative and helps safeguard against the are likely to lead to a further increase of funding risk of maintaining adequate quality of the credit cost for banks.5 Already by mid-year, the rates for portfolio. In the first eight months of 2014, the CBR interbank lending increased by 0.7-2.2 percentage revoked the licenses of 49 banks(compared to 32 points from the end of 2013, depending on the banks in 2013) on account of money laundering, maturity. With the eroding depositors’ base inappropriate party lending, fraudulent reporting, and growing funding cost, Russian banks seek inability to pay creditors, overvalued assets, and increasingly additional liquidity from the CBR. By asset-quality issues. Most banks were small, end-July, the total amount of loans from the CBR participated in the deposit insurance scheme and to the banking sector reached RUB5.6 billion or 9 their closure did not significantly affect household percent of total liabilities, compared to 7.7 percent borrowing. The insurance payment to depositors at the end of 2013. In effect, the CBR remains a was organized in due manner and through the lender of last resort. Non-financial corporations bank-agents determined by the CBR and the are also increasingly suffering from liquidity Deposit Insurance Fund. constraints due to curtailed access to international capital markets as a result of sanctions. In this Credit growth slowed in the first seven months environment, they will have to resort to domestic of 2014 on the back of an eroding depositors’ financing, which could create additional pressure base and higher cost of credit. The slowdown on the money market and lead to further increased was largely driven by credit to households, whose cost of credit for the private sector. pace of expansion fell to 19.7 percent in the year through June from 32.6 percent in December Prudential indicators for the banking system 2013 (Figure 22). An increasing level of household remain stable and the Central Bank continued indebtedness (the debt/income ratio rose to 22.9 with the closing of financially non-viable banks percent in the first quarter of 2014 from 19.8 to reduce risks. The ratio of non-performing percent in the first quarter of 2013), slowing loans (NPLs) to total loans outstanding remained income growth and a growing number of bad stable during the first half of 2014 at 6.1 percent loans increasingly restricted the ability of banks to (Figure 21). Disaggregated statistics, however, extend credits. The latter and the increased cost indicate some deteriorating trends. Among loans of funding curbed growth in lending to companies to households, the share of NPLs rose to 8.2 to 16.0 percent in July; this was up, nonetheless, percent in June from 6.5 percent at the end of from 14.3 percent at end-2013. All in all, the total 2013 as households found it increasingly difficult credit stock rose to 52.7 percent of GDP by June to service debt due to slowing income growth, from 50.5 percent a year before. Deposit growth rising levels of indebtedness, combined with also slowed in July to just 8.3 percent (y-o-y), lesser opportunity to rollover short-term debt due compared to 21.0 percent in December 2013 to higher loan costs and tighter credit conditions. and 21.9 percent in July 2013. This was partly the Banks continued to report adequate levels of effect of the rising geopolitical uncertainty and a provisioning and capitalization and the sector- weaker national currency, which resulted in large wide ratio of provisions to NPLs rose slightly. withdrawals, especially during March (a reduction The increased need for provisioning weighed on of 2 percent). But depositors returned to the banks 5 Sanctions include the six large commercial banks (Sberbank, VTB, VTB24, Gazprombank, Rosselhozbank, and Bank of Moscow) with a combined market share of around 57 percent. Russia Economic Report | Edition No. 32 11 I. Recent Economic Developments during April-July (with a cumulative increase of 3.4 ongoing process of sanitizing the banking system). percent relative to March level) before the latest In order to reverse this trend, banks may start round of geopolitical tensions started. The erosion increasing interest rates on individual deposits, of the depositors’ base was also influenced yet this might have negative implications for the by slowing income growth and perhaps some cost of credit if banks pass this additional funding wavering trust in the banking sector (due to the cost on. Figure 21: NPLs as a share of total credit, y-o-y, percent Figure 22: Credit growth, y-o-y, percent 60 10 50 9 40 30 8 20 7 10 6 0 -10 5 2010 2011 2012 2013 2014 -20 Apr-12 Oct-12 Jan-13 Apr-13 Oct-13 Jan-14 Apr-14 Jul-14 Apr-11 Oct-11 Jan-12 Jul-12 Jul-13 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Jul-11 Non-performing Loans: Total Loans Loan Loss Provisions: Total Loans Non-performing HH Loans: Total HH Loans Nonfinancial Organisations Households Source: CBR. Source: CBR. 1.4 Balance of Payments – The Big Flight Balance of payments dynamics reflected the geopolitical tensions, dominated by heightened uncertainty and a depreciating Ruble. While the current account received a strong boost from weaker imports, the financial account deteriorated as net capital outflows surged. R ussia’s current account strengthened significantly in the first half of 2014. The current account (CA) surplus nearly doubled in the and the Ruble depreciation. For example, the value of imported machines, equipment and transport vehicles fell by 5.5 percent in the first half of 2014 first half of 2014 to US$44.2 billion (4.6 percent of from a year earlier. As for energy exports, gas GDP) from US$26.8 billion (2.7 percent of GDP) a export volume grew by 7 percent in real terms in year ago (Figure 23 and Table 2). This reflected two the first half of 2014 (y-o-y) after little change in main trends. First, import demand weakened as the first half of 2013, dominated by an increase the economy grew at a slower pace and uncertainty to CIS countries. Exports of non-energy goods, increased in the wake of the rising geopolitical meanwhile, do not appear to have benefitted tensions. This helped reduce the non-oil current substantially from the depreciation of the Ruble, account deficit from US$144.1 billion (14.6 percent raising questions about the competitiveness of of GDP) in the first half of 2013 to US$131.3 billion Russia’s non-energy economy. The impact of the (13.6 percent of GDP) in the first half of 2014. sanctions that the West started to introduce since Second, exports of oil products and gas increased. late July and the import ban on food products by Overall, consumer and investor demand for Russia in early August will be only observed in the imports was negatively affected by the uncertainty second half of 2014. 12 Russia Economic Report | Edition No. 32 I. Recent Economic Developments Figure 23: Current account balance, percent of GDP Figure 24: Trade and services balances and oil prices 140 60 11 130 50 9 120 7 40 110 5 100 30 3 90 20 1 80 10 -1 70 -3 0 60 -5 -10 50 -7 2008 2009 2010 2011 2012 2013 H1-2013 H1-2014 40 -20 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Q2-14 Goods Services Current account balance Investment income Crude oil, Brent, $/b (left axis) Trade balance, bln USD (right axis) Transfers Compensation of employees Services balance, bln USD (right axis) -3 -4 -5 -5 Source: CBR and World Bank staff estimates. Source: CBR, Bloomberg and World Bank staff estimates. Massive capital outflows triggered by the Russia- purchases spiked at the onset of the geopolitical Ukraine tensions led to a deterioration of the tensions in March. Massive capital outflow created capital and financial account balance and a substantial pressure on the Ruble and led to CBR decrease in net international reserves. Russia’s intervention of US$37.7 billion in the first half of capital and financial accounts balance worsened 2014 compared to US$22.1 billion for the whole to a deficit of US$75.3 billion (7.8 percent of GDP) of 2013. in the first half of 2014 compared to a deficit of US$21.2 billion (2.1 percent of GDP) in the first Foreign borrowing decreased in the first half half of 2013. High geopolitical uncertainty led to of 2014. Heightened geopolitical tensions, a more than doubling of net capital outflows from expectations of sanctions and a worsened medium- the private sector to US$74.4 billion in the first term outlook increased the cost of borrowing for half of 2014 from US$33.5 billion in the first half all sectors of the Russian economy and limited of 2013 when adjusted for currency swaps and their access to international financial markets.6 correspondent accounts of resident banks in the After hovering at the level of 160 bps at the CBR. They exceeded annual net capital outflows beginning of the year, Credit Default Swap (CDS) from the private sector of US$61 billion in 2013 spreads on 5-year bonds spiked in March to 278 (Table 3). However, it is likely that some of those bps and stayed close to this level after a second capital outflows will return to Russia in the form spike at the beginning of August (Figure 27). of FDI, as reflected in the historically high amount Compared to other global bond spreads, Russia’s of so-called round-tripping FDI (Box 6) that CDS spreads were more volatile in the first half of originates from Russian individuals and companies 2014, especially in March-April and in July-August seeking to avoid adverse features of the Russian at the heights of geopolitical tensions (Figure investment climate or that constitutes offshoring 4). Reduced new borrowing and debt rollover is to obtain undue tax advantages. Households’ reflected in the decrease in Russia’s external debt net purchases of foreign currency constituted an to US$707.7 billion (48.5 percent of goods and important part of the net capital outflows in the non-factor services exports) in the first half of 2014 first half of 2014 and amounted to US$12.1 billion, from US$720.9 billion (48.9 percent of goods and compared to US$3.9 net sales of foreign currency non-factor services exports) at the end of 2013 in the first half of 2013. Those foreign currency (Table 4). External government debt decreased 6 As geopolitical risks for Russia increased, Moody’s and Fitch rating agencies changed outlook for Russian rating to negative. S&P cut Russia’s external debt rating to lowest investment grade. Russia Economic Report | Edition No. 32 13 I. Recent Economic Developments Box 6 The link between capital flight and FDI FDI performance in Russia was in the past closely intertwined with capital outflows. Historically, investors sought to avoid adverse features of the Russian investment climate by relocating investments offshore and engaging in round-tripping (Fabry and Zeghini, 2002), but off-shoring for tax reasons is also likely. Russia’s FDI contains a large share of inbound FDI reported as originating from Cyprus and other countries, which is likely to be round-tripping FDI of Russian origin or, in other words,repatriated capital which was previously observed as capital outflows from Russia. However, round-tripping FDI of domestic firms that might earn additional rents from the fact that they are able to obtain tax advantages is less likely to carry with it benefits of growth-enhancing effects, such as technology and other productivity improving practices, as compared to genuinely foreign FDI. After removing FDI with a reported origin from likely tax havens, the ratio of Russia’s FDI inflows over 2007-2013 is around 1.8 percent, comparable to that for India and South Africa (Figure 25). This comparison may understate the amount of round-tripping in Russia’s inbound FDI since it may involve also other reported sources. Non-tax haven FDI declined precipitously in 2013, but was partly replaced by FDI from tax havens (Figure 26). FDI from sources other than tax havens dropped in the first quarter of 2014 to US$6.6 from a record high of US$29.9 billion in the first quarter of 2013. FDI from tax havens has been highly volatile lately, but ticked up to US$5.5 billion in the first quarter of 2014. Thus, an increasing percentage of total FDI inflows are from tax havens: 45 percent in the first quarter of 2014 as compared to 14 percent in 2012 and 25 percent in 2013. This suggests that substantial parts of the capital outflows in early 2014 may have returned to the country disguised as FDI. Certain sectors are more attractive for round-tripping FDI. For example, 89 percent of the Russian FDI stock in basic metals and metal products originates in the countries of Cyprus, Bermuda and the Caribbean. Close to half of FDI in the services sectors and in construction is of the round-tripping type, with particularly high percentages in financial intermediation and real estate. By contrast, FDI in mining and quarrying and in most lines of manufacturing (other than iron and steel) is more likely to be high-quality FDI, proxied by the share of FDI that does not come from an obvious tax haven. Recent large cross-border mergers and acquisitions of Russian companies were carried out through such countries. Six of the nine largest transactions since 2008 have included either Cyprus or the Jersey Islands as a buyer or seller or as part of the chain of ownership. Figure 25: Annual FDI flows in percent of GDP, Figure 26: Russian inbound FDI from Cyprus, net of round-tripping Bermuda and the Caribbean 4.0 14000 3.5 12000 10000 3.0 8000 2.5 6000 2.0 4000 1.5 2000 1.0 0 -2000 0.5 2008 2009 2010 2011 2012 2013 -4000 8 8 9 9 0 0 1 1 2 2 3 3 4 -0 -0 -0 -0 -1 -1 -1 -1 -1 -1 -1 -1 -1 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Brazil (2.3) China (1.2) India (2.0) Russia (1.8) South Africa (1.9) FDI 4 periods moving average Source: CBR. Period average in parentheses. Source: CBR. Note: Round-tripping sources of FDI are defined as Bermuda and the Caribbean, plus (for Russia) Cyprus, and (for China) 40 percent of FDI of Hong Kong origin (midpoint of range in Geng Xiao, 2004). Round- tripping for 2013 is estimated based on 2007-2012 average. 14 Russia Economic Report | Edition No. 32 I. Recent Economic Developments market by non-residents also contributed to Figure 27: Russia CDS spreads for 5 year bonds, basis points this decrease. The external exposure of banks 300 decreased by US$7.8 billion in the first half of 280 2014 from US$214.3 billion at the end of 2013 due 260 to banks’ inability to rollover debt. Non-banking sector debt increased by US$6.9 billion in the first 240 half of 2014, with credits coming mainly from 220 foreign direct investors. Principal and interest 200 payments due on the external debt of Russian 180 banks and companies amounts to US$99.4 billion in the second half of 2014 (a significant part 160 of these are Rosneft’s debt payments) (Table 140 Jan-14 May-14 Jul-14 5). Financial sector sanctions since late July targeted selected Russian banks and companies, Source: Bloomberg. limiting their access to parts of the international by US$7.1 billion in the first half of 2014 from financial markets. The CBR has announced that it US$61.7 billion in the end of 2013 as government would provide support to banks and companies cancelled its initial plan to borrow US$7.2 billion hit by sanctions and in the medium term, there in 2014 on the international markets because of is still space for such maneuver as CBR’s foreign unfavorable market conditions. A significant sell- reserves stand at US$465.2 billion (or 12 months off of government securities at the secondary of import coverage) as of the end of August 2014. Table 2: Balance of Payments, 2008–2014, US$ billions Q1 Q2 Q3 Q4 Q1 Q2 2008 2009 2010 2011 2012 2013 2013 2013 2013 2013 2014* 2014* Current account balance 103.9 50.4 67.5 97.3 71.3 34.1 25.0 1.8 -0.7 8.0 27.1 17.1 Trade balance 177.6 113.2 147.0 196.9 191.7 181.9 48.6 42.8 43.7 46.8 50.7 54.5 Non-oil current -206.2 -140.3 -186.6 -244.5 -275.5 -316.1 -61.9 -82.2 -88.2 -83.9 -57.0 -74.2 account balance Capital and financial -139.8 -40.6 -21.6 -76.0 -30.9 -45.4 -13.3 -7.9 -4.7 -19.4 -48.8 -26.6 account Errors and omissions -3.1 -6.4 -9.1 -8.7 -10.4 -10.8 -6.8 1.6 -1.9 -3.8 -5.7 -0.9 Change in reserves 38.9 -3.4 -36.8 -12.6 -30.0 22.1 -4.9 4.4 7.4 15.2 27.4 10.3 (- = increase) Memo: average oil price 96.9 61.5 79.7 111.1 112.0 108.9 112.9 103.0 110.1 109.4 107.9 109.8 (Brent, US$/barrel) Source: CBR. Note: *Preliminary estimates. Russia Economic Report | Edition No. 32 15 16 Table 3: Net capital flows, 2008–2014, US$ billions Q1 Q2 Q3 Q4 Q1 Q2 2008 2009 2010 2011 2012 2013 2013 2013 2013 2013 2014* 2014* Total net capital inflows to the private sector -133.6 -57.5 -30.8 -81.4 -53.9 -61.0 -28.2 -5.5 -10.4 -16.9 -48.8 -25.8 Net capital inflows to the banking sector -55.2 -32.2 15.9 -23.9 18.5 -7.5 -17.4 -4.4 10.9 3.4 -21.2 -17.1 Net capital inflows to the non-banking sector -78.3 -25.3 -46.7 -57.4 -72.4 -53.5 -10.9 -1.1 -21.3 -20.3 -27.6 -8.8 Source: CBR. Russia Economic Report | Edition No. 32 Note: *Preliminary estimates. Table 4: Russia’s external debt, 2011-2014, US$ billion Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Total debt 538.9 557.5 570.6 598.9 636.4 691.7 707.8 716.3 728.9 715.8 720.9 Corporate 492.6 509.1 517.1 538.8 566.4 614.6 632.9 636.0 651.2 646.9 650.2 Banks 162.8 169.2 175.4 189.9 201.6 205.9 211.9 207.1 214.4 211.9 207.1 of which Private Banks 89.5 90.6 78.7 84.1 86.2 81.1 82.4 79.4 81.4 76.3 n/a Non-financial corporations 329.8 339.8 341.7 348.9 364.8 408.8 420.9 428.9 436.8 432.8 443.7 of which Private Non-fin. Corporations 227.8 236.0 234.2 237.7 251.3 255.5 259.5 265.3 271.6 264.3 n/a Source: CBR. Note: End of the month data. Table 5: Projected debt payments in 2014 – 2015, principal plus interest, US$ million Q2 2014 Q3 2014 Q4 2014 2015 Government 2,512 1,852 1,170 6,603 Banks 26,529 14,508 15,711 35,867 Other sectors 21,885 28,386 37,804 69,822 Total 50,926 44,746 54,685 112,292 Source: CBR. I. Recent Economic Developments I. Recent Economic Developments 1.5 The Government Budget – Currency Depreciation and Oil Windfall Mask Medium-Term Challenges The budget balance improved in the first half of 2014 thanks to the depreciating Ruble, higher oil prices than assumed in the budget, and prudent expenditure management. However, key medium- term challenges persist. First, the non-oil deficit remains stubbornly high above 10 percent of GDP. Second, weakness in subnational finances continues with debt levels on the rise. Russia’s fiscal buffers remain below their levels before the global economic and financial crisis, yet investment rules for the National Welfare Fund were recently loosened significantly. T he federal budget balance for the first seven months of 2014 exceeded expectations because of the currency depreciation and higher- These trends resulted in a federal budget surplus of 1.7 percent of GDP in January-July, three times as large a year earlier. These numbers compare than-projected oil prices, but a high non-oil with a budget surplus of 0.5 percent of GDP under deficit persists (Figure 28). Larger oil-related the original budget and 0.4 percent under the revenues helped boost federal budget revenues to revised one (Box 7). However, given the weaker- 10.7 percent of GDP in January-July 2014 from 9.8 than-expected non-oil revenue performance, percent a year earlier (Table 6). In line with global the non-oil deficit is likely to remain persistently oil prices, the average oil price during January- high―above 10 percent of GDP―despite the July (US$107/bbl) remained above the $101/bbl government’s short- and medium-term goal of assumed in the original 2014-2016 Budget Law reducing it significantly. In fact, non-oil deficit and the $104/bbl in the budget revision. The targets of recent years were persistently revised Federal government also tightly controlled budget upwards. In addition, given the commitment of spending during the first seven months of 2014: large parts of Russia’s fiscal buffers to growth- expenditures amounted to 18.8 percent of GDP, stimulation and other measures, Russia’s fiscal a ¼ percent lower than a year earlier. Federal position is becoming even more tightly linked to expenditures for defense, administration, and oil revenues and global oil price trends. intergovernmental fiscal transfers rose from a year earlier, but fell for social policy, health and Russia’s fiscal buffers in the National Welfare Fund education. and the Reserve Fund are increasingly committed Figure 28: Federal Budget Revenue and Balance to providing resources for off-budget stimuli. in 2007-2014, percent of GDP Recently, claims on National Welfare Fund (NWF) 25 10 resources have been rising and there was talk of relaxing the fiscal rule, which largely determines 5 20 the replenishment level of the Reserve Fund. 15 0 In August, the Reserve Fund was replenished by more than US$6 billion, reaching US$91.7 billion 10 -5 or 4.7 percent of GDP (as of September 1, 2014). The replenishment represents oil revenue accrued 5 -10 to the federal budget in 2013 that is higher than 0 -15 originally budgeted. The NWF currently holds 2007 2008 2009 2010 2011 2012 2013 2014 reserves equivalent to about 4.4 percent of GDP. Non-oil revenues, percent of GDP Total balance, percent of GDP Nevertheless, both funds remain well below the Oil revenues, percent of GDP Non-oil balance, percent of GDP pre-crisis 2008 levels of 9.8 percent of GDP and Source: Ministry of Finance. Russia Economic Report | Edition No. 32 17 I. Recent Economic Developments 6.3 percent of GDP respectively. In June, the Following the recent economic sanctions, further government decided to raise the limit on NWF discretion in the investment decisions of NWF resources that can be used to finance domestic resources was introduced. A new Government infrastructure projects to 60 percent from 40 resolution of August 22, 2014 allows the NWF to percent. Of those 60 percent, 40 percent (or invest in privileged stock of two sanctioned Russian RUB1.16 trillion as of January 1, 2014) can now banks: Vneshtorbank (VTB) and Rosselkhozbank in be used to implement projects through the the amount of RUB239 billion, a mutual settlement state-owned Vnesheconombank, ten percent (or for subordinated loans given to those banks RUB290 billion) for projects implemented with and their affiliates during 2009 crisis. There are the participation of the Russian Direct Investment discussions to expand NWF investment into the Fund (RDIF)7 and another ten percent (or RUB290 stock to several other banks such as Gazprombank billion) for projects implemented by the state that received subordinated loans back in 2009 and corporation Rosatom.8 Already about RUB900 that currently suffer from sanctions. Companies billion of the NWF have been committed to on the sanctions list such as Rosneft, Russia’s state purchase domestic stock and bonds associated oil company, presented applications for support with priority infrastructure projects.9 from the NWF (in the amount of RUB1.5 trillion, Box 7 Amendments to the 2014-2016 Federal Budget Law In June, the amendments to the 2014-2016 Federal Budget Law were signed into law. Based on revised macroeconomic assumptions, including real GDP growth of 0.5 percent in 2014 instead of 3 percent and an uptick in the Urals oil price from US$101 to US$104 per barrel, oil revenue is projected to be 1.6 percent of GDP higher than originally budgeted and non-oil revenue is forecast to drop by 0.1 percent of GDP. Without changes on the expenditure side, the original budget deficit of 0.5 percent of GDP is projected to turn into a budget surplus of 0.4 percent, while the non-oil deficit would rise from the previously projected 9.4 percent of GDP again over the 10 percent mark to 10.1 percent of GDP (Table 6). Table 6: Federal budget, 2012-2014, percent of GDP 2012 2013 2013, Jan - Jul 2014, Jan - Jul 2014 2014 Amended Execution Execution Execution Execution Budget Law Budget Law Expenditures 20.6 20.0 19.1 18.8 19.0 19.5 Revenues 20.5 19.5 19.8 20.4 18.5 19.9 Balance -0.1 -0.5 0.6 1.7 -0.5 0.4 Oil Revenues 10.3 9.8 9.8 10.7 8.9 10.5 Non-Oil Revenues 10.2 9.7 10.0 9.7 9.6 9.4 Non-Oil Balance -10.4 -10.3 -9.2 -9.0 -9.4 -10.1 Urals oil price, 110.4 106.4 106.8 107.0 101.0 104.0 US$/barrel Source: Ministry of Finance, Economic Expert Group and World Bank staff calculations. 7 The RDIF was established in June 2011 at the initiative of the President and Prime Minister to attract foreign investment into leading sectors of the Russian economy. 8 Rosatom is the State Corporation established to develop a variety of nuclear energy projects in civil and military sectors, including nuclear energy production, nuclear research, design and construction of nuclear power stations, extraction and enrichment of uranium, etc. 9 These projects include the construction of high-speed train tracks between Moscow and Kazan, a new Central Ring Road in Moscow, upgrades to the Trans-Siberian railway and to Moscow’s airports, and other projects to improve energy efficiency and internet connectivity. 18 Russia Economic Report | Edition No. 32 I. Recent Economic Developments claiming almost half of NWF), and it is understood to 37.5 percent in the first half of 2014. The that more firms are lobbying for NWF resources. improvement in revenue was driven by a higher In order to allow the Reserve Fund and NWF to collection rate of export duties and VAT, increasing continue playing important roles as fiscal buffers by 0.6 percent of GDP and 0.3 percent respectively. and long-term investment vehicles, prudence on This revenue increase in the consolidated budget decisions how to use them in the most efficient was also accompanied by a moderate drop in way is advisable. execution of consolidated expenditure by 0.4 percent of GDP. Increasing fiscal pressure on As part of the consolidated budget,10 subnational the consolidated budget is continuing to come finances weakened, resulting in an increase in from weaker subnational budget performance: subnational debt stock. The consolidated budget over the previous years, an acceleration in the was in surplus (3.2 percent of GDP) at half-year accumulation of public debt was observed here, point, yet is expected to turn again into a deficit of given lower-than-projected revenues (due to the 1.0 percent of GDP for 2014 as a whole (Table 7). This economic slowdown) and higher-than-expected is due to the expected acceleration in subnational outlays (due to commitments for higher wages in expenditure execution during the second half of the social sector of the economy at subnational 2014, following historical performance trends level in the President’s decrees of May 2012). and patterns. These expenditure dynamics on the There was a steady increase of debt stock from subnational budgets are also expected to override 2.1 percent of GDP in 2012 to 2.6 percent in the large increase in consolidated budget revenue 2013, and to 2.4 percent of GDP in the first half from 36.4 percent of GDP in the first half of 2013 of 2014 (Table 7). Table 7: Consolidated government finances, percent of GDP 2012 2013 2012 H1 2013 H1 2014 H1 2014 Execution Execution Execution Execution Execution Forecast Consolidated Budget Expenditures 36.6 37.4 34.6 34.7 34.3 37.8 Revenues 37.0 36.1 38.5 36.4 37.5 36.9 Balance 0.4 -1.3 4.0 1.7 3.2 -1.0 Consolidated Subnational Budget Expenditures 13.3 13.2 12.1 11.8 11.7 13.0 Revenues 12.9 12.2 13.5 11.8 12.0 11.8 Balance -0.4 -1.0 1.4 0.0 0.3 -1.2 Subnational Debt 2.1 2.6 1.8 2.0 2.4 NA Source: Ministry of Finance and World Bank staff calculations. 10 The consolidated budget includes the federal budget, the subnational budgets and extra-budgetary funds, e.g. pension and social security. Russia Economic Report | Edition No. 32 19 PART II Economic Outlook O ver the medium term, growth will continue to be determined by slow progress in structural reforms and policy uncertainty emanating from geopolitical tensions. To account for the heightened geopolitical risk the report presents a baseline scenario and two alternative scenarios. The challenges for Russia’s outlook are twofold: consumption growth is likely to weaken even further than projected in the March version of the Russia Economic Report,11 and recovery in investment demand will be slower than previously expected. The effects of weak growth for a second consecutive year, an increasing household debt burden, and continued high inflation expectations, are likely to depress consumer demand further, slowing this main engine of growth in Russia. These effects are expected to persist for the next two years. With no major structural reforms planned, and microeconomic fundamentals unchanged, investment will remain subdued and there will be only a limited positive effect from import substitution. Similarly, the multiplier effect from the planned increase in public and quasi-public investment expenditures is likely to be modest. 11 See World Bank Russia Economic Report №31: Confidence Crisis Exposes Economic Weakness. II. Economic Outlook 2.1 Global Outlook - Stagnation In The Face of Policy Uncertainty The report presents three scenarios, the baseline, an optimistic one, and a pessimistic one. Our baseline outlook is one of near stagnation, given the most likely path of continuing Russia-Ukraine tensions and the persistence of related sanctions in an environment of stalling structural reforms. The optimistic scenario projects a small recovery, facilitated by an end to geopolitical tensions and the lifting of all sanctions by the end of 2014. The pessimistic scenario envisions an increasing intensity in geopolitical tensions and further sanctions leading the economy into a low-level recession. T here are substantial risks to Russia’s medium- term growth prospects. Based on recent developments, we see a large degree of stability alter how the economy operates and might turn out detrimental to its competitiveness. A return to higher growth in Russia will depend on solid in the economy despite the geopolitical tensions. private investment growth and a lift in consumer Macroeconomic stability prevailed and Russia sentiment, which will require a predictable policy remains in possession of large buffers to uphold environment and addressing the unresolved stability in the near future―as long as its access to structural reform agenda (see section 3). oil and gas markets is not restricted permanently. The less good news is that we still see little The key parameters for our outlook framework movement on the structural reform agenda that evolved from our March projections. Initially could boost Russia’s growth potential in the the geopolitical tensions brought with it much medium-term. These observations together, result uncertainty about how this shock would impact in our most likely baseline scenario of a positive the economy. After observing how the geopolitical but low-growth outlook of near stagnation in 2015 uncertainty played out in the first half of 2014, and 2016. we expect to see continued strong but short- lived market responses if tensions increase, with Structural reform inertia, combined with high a quick pricing-in of additional risks. However, policy uncertainty related to political decisions overall there was a fast adjustment to a relatively around the geopolitical tensions, remains the stable but slightly lower trajectory. This is also deciding factors for our outlook. It is now policy the essence of our revised scenarios. We regress uncertainty about the economic course the from our previous model of a one-time deep country will take that is casting the longest shadow shock and project now a more drawn-out impact on Russia’s medium-term prospects. Since the of the geopolitical tensions. Nevertheless, in our beginning of the geopolitical tensions, economic view, much geopolitical uncertainty prevails. To policy has been dominated by measures to acknowledge this risk environment, the World maintain macroeconomic stability and safeguard Bank kept for its outlook a growth spectrum the economy from the impact of these tensions. with two alternative scenarios straddling Russia’s This important policy effort should go hand baseline scenario (Figure 29). in hand with renewed focus on improving the economy’s microeconomic fundamentals to allow The core assumptions of our forecast scenarios for more efficient markets. While macroeconomic are connected to an environment of heightened stabilization measures were timely and successful, geopolitical risks and policy uncertainty. While medium-term policy objectives are still being global demand is projected to be broadly stable and redefined. However, some measures and economic oil prices are expected to remain around US$100/ policies under discussion have the potential to bbl (Box 8), we acknowledge the following main 22 Russia Economic Report | Edition No. 32 II. Economic Outlook Figure 29: Russia’s growth outlook, y-o-y, percent multiplier effect of the planned increase in public and quasi-public expenditure to foster investment. 3 This is reflected in the projection of a slower and 2 more drawn-out recovery in investment demand compared to our previous estimates. 1 0 Baseline Scenario Projections -1 -2 T he World Bank baseline scenario is one of near-stagnation due to the continuation of the geopolitical tensions and related sanctions, 2012 2013 2014 2015 2016 Pessimistic scenario Optimistic scenario paired with a lack of structural reforms to Low risk scenario (March 2014) Baseline scenario High risk scenario (March 2014) increase the economy’s output potential. The baseline scenario takes into account the status Source: World Bank staff estimates. quo of geopolitical tensions and international challenges. First, we believe that high uncertainty, sanctions as of September 17 when this report combined with the effects of weak growth for a went to press (see Box 2 in section 1). It assumes second year in a row, increasing household debt no significant reform effort that would improve burden, and high inflation expectations, are likely Russia’s growth potential over the projection to depress consumer demand profoundly, slowing period. The main features of this scenario are this main engine of growth for Russia for the next that the already observed transmission channels two years. As a result, consumption growth is of the geopolitical tensions would continue to likely to weaken even further than we projected impact the Russian economy and that consumer previously, even in our optimistic scenario. and investor confidence would recover only very Second, as we cannot foresee major changes to gradually. As a result of weakening domestic the microeconomic fundamentals in which the demand, growth is projected to moderate from economy operates―with no major structural 0.5 percent in 2014 to 0.3 percent in 2015, before reforms being initiated―we project a limited it will slightly tick-up again in 2016 (Table 8). impact of import substitution and a relatively small Table 8: Main economic indicators: baseline scenario 2012 2013 2014 2015 2016 GDP growth (%) 3.4 1.3 0.5 0.3 0.4 Consumption growth, percent 6.8 3.5 2.1 0.5 0.6 Gross capital formation growth, percent 0.6 -6.0 -8.1 0.3 1.0 General government balance (percent of GDP) 0.4 -1.3 -1.1 -2.1 -1.0 Current account (US$ billions) 71.3 34.1 62.8 57.9 54.3 percent of GDP 3.6 1.6 3.1 2.8 2.5 Capital account (US$ billions)* -32.3 -62.2 -113.0 -60.1 -55.6 percent of GDP -1.6 -3.0 -5.6 -2.9 -2.6 Oil price assumption (US$ per barrel) 105.0 104.0 102.9 99.5 100.1 Consumer price inflation 5.1 6.8 8.0 7.0 5.0 Source: World Bank staff estimates. Note: *Current account minus change in reserves. Russia Economic Report | Edition No. 32 23 II. Economic Outlook Box 8 Global outlook Global growth is to remain subdued in 2014. Global growth estimates for 2014 have been revised further down, following signs of persistent stagnation in the Euro Area, Japan, parts of Latin America and emerging Europe. Conditions are gradually improving, but repeated forecast downgrades lead to a cautious assessment of the underlying strength of the recovery going forward. The world economy is forecast to grow at 2.6 percent in 2014, up from 2.4 percent in 2013. Gradually improving labor markets, accommodative monetary policy, and easing fiscal consolidation are expected to support growth in high- income countries, which in turn will benefit activity in developing countries through stronger trade, investment, and capital flows. From 2015, growth in both high-income and developing countries is expected to accelerate, reaching 2.4 percent and 5.3 percent. Table 9: Global real GDP growth, percent 2009 2010 2011 2012 2013 2014f 2015f 2016f World -1.9 4.3 3.1 2.5 2.4 2.6 3.2 3.4 High Income -3.6 3.0 1.8 1.5 1.2 1.8 2.4 2.5 Developing Countries 3.0 7.8 6.3 4.8 4.8 4.5 5.0 5.3 Euro Area -4.4 1.9 1.6 -0.6 -0.4 0.9 1.4 1.8 Russia -7.8 4.5 4.3 3.4 1.3 0.5 0.3 0.4 Source: World Bank Global Economic Prospects Group and World Bank Russia team. World demand for crude oil is expected to moderately increase, offset by good supply prospects from non-conventional sources. In 2014, global oil demand is expected to increase by 1.1 million barrel per day (mb/d) to reach 92.7 mb/d in 2014 and 94.0 mb/din 2015. As in the recent past, all of the demand growth will originate in non-OECD countries. In fact, demand by OECD economies contracted during the first two quarters of 2014 (by 0.09 mb/d and 0.63 mb/d respectively).China is expected to be a key contributor to demand growth: during the past decade China has increased its consumption at almost 0.5 mb/da year. On the supply side, increase in crude output is expected for Iraq and Libya. Libya could boost its production to 1 mb/d by the end of September, up from 0.5 mb/d during the summer. Iraq is expected to account for 60 percent of OPEC’s additional capacity during the next five years (Figure 30). In the United States the Energy Information Agency forecasts US crude oil output to reach 9.28 mb/d day next year, the highest annual average since 1972. In fact, the crude oil shortfalls in various OPEC countries of the past few years have been counterbalanced almost barrel for barrel by rapid expansion of unconventional oil production in North America (shale oil in the US and tar sands in Canada). Figure 30: Expected oil production growth until 2019, mb/d Figure 31: Growth of global oil demand, y-o-y, mb/d Iraq 4 UAE 3 Angola 2 Venezuela Ecuador 1 Saudi Arabia 0 Iran Qatar -1 Libya -2 Nigeria -3 Algeria Kuwait -4 Q1-07 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Q1-14 -0.4 0 0.4 0.8 1.2 OECD China Non-OECD, ex China Source: IEA. Source: IEA and World Bank staff calculations. We expect the continuation of recent trends at the oil market and project an average oil price of 103/bbl in 2014 and of $100/bbl in 2015. Over the longer term, oil prices are expected to recede slightly in real terms due to growing supplies of unconventional oil, combined with efficiency gains and (to a lesser extent) substitution away from oil. The assumption behind such projections reflect the high cost of developing additional oil capacity, notably from the oil sands in Canada, which is currently assessed by the industry at about US$90/bbl in 2014 constant terms. OPEC, which usually limits supplies in order to sustain prices, may actually slightly increase supplies not to let prices rise too high for fear of inducing technological innovations that eventually could reduce oil demand. Removal of fuel subsidies, especially in Asia, is gaining momentum and will likely dampen further oil demand, especially in the longer term—fossil-fuel consumption subsidies worldwide accounted for US$544 billion in 2012, half of which goes to oil products. 24 Russia Economic Report | Edition No. 32 II. Economic Outlook Investment and consumption activities will remain activity is projected to remain depressed despite depressed in 2014 and marginally recover in the some import substitution in the absence of following years. In 2015, higher public investment other reforms that would fundamentally change within the existing fiscal rule and with the use of the business environment (Box 9). Gross fixed off-budget resources through the National Welfare investment dynamics will come almost exclusively Fund are expected to increase investment, lifting from government infrastructure projects. We gross capital formation marginally by 0.3 percent in assume that construction of some of the priority 2015 and by 1 percent in 2016. Private investment infrastructure projects will commence towards the Box 9 The potential impact of import substitution Manufacturing industries took advantage of the sharp Ruble depreciation and import contraction in the first half of 2014. The Ruble real effective exchange rate lost 6.4 percent in the first half of the year relative to the same period a year ago, which resulted in a contraction of imports. It appears that manufacturing industries reacted positively to changes in relative prices, reporting an acceleration of economic activities in the second quarter. Capacity utilization rates inched up (Figure 32). The positive impulse to manufacturing production from import substitution appeared to have been carried over into the third quarter. The seasonally adjusted HSBC Russia Manufacturing PMI remained above the 50 threshold in July-August 2014 indicating cautious expansion, despite overall slowing consumer demand. The introduction of restrictions to food imports by Russia in August 2014 added to the potential positive impact of import substitution on economic activities. However, the impact of import substitution could be short-lived and limited by structural constraints. In the third quarter of 2014, the Ruble stabilized around its medium-term equilibrium and the rate of depreciation slowed. This could close the depreciation window, through which manufacturing industries received some competitive advantage,by the end of 2014. Manufacturing firms might also again face capacity constraints. Although the nominal capacity utilization rate appears low (Figure 32), major tradable sectors were already at comparable levels of production capacity in 2013 as in 2007, when growth was approaching 8 percent. A further increase in the capacity utilization rate may be constrained and require capital investment. Firms also continue facing a tight labor market, which is reflected by steady growth in unit labor cost (Figure 33). As a result, import substituting firms will continue facing increasing cost pressures. Given constrained capacity, they may choose to increase prices rather than production. Agriculture―in areas with relatively low capital intensity and shorter production cycles―could benefit from the import ban on food throughout 2015. Overall, the positive impact of import substitution will likely taper off in the second half of 2015, unless investments in capacity expansion are carried out. Figure 32: The rate of capacity utilization in manufacturing Figure 33: Unit labor cost in Russia, (percent), four quarter moving average 2005 = 100, four quarter moving average 70 300 280 65 260 60 240 220 55 200 50 180 45 160 140 40 120 Q4-06 Q1-07 Q2-07 Q3-07 Q4-07 Q1-08 Q2-08 Q3-08 Q4-08 Q1-09 Q2-09 Q3-09 Q4-09 Q1-10 Q2-10 Q3-10 Q4-10 Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13 100 Electronic & Optical Equip Food Transport Vehicles Machinery & Equip Textile & Clothing Manufacturing Source: Haver Analytics. Source: Haver Analytics. Russia Economic Report | Edition No. 32 25 II. Economic Outlook end of 2014, picking up somewhat in 2015. Without intact. Expenditures are projected in line with the structural reforms, the economy is projected to revised parameters of the medium-term budget essentially stagnate throughout 2014-16,despite (Box 10). In addition, no changes to the tax regime some fiscal and quasi-fiscal stimulus and robust will be introduced that could significantly affect external demand. Consumption is projected to the revenue structure. Provided that government be constrained by lower income growth than in has limited capacity to scale up expenditure due previous periods, especially due to non-changing to the fiscal rule, the consolidated fiscal position is public wages―reflecting reprioritization of projected to remain relatively stable with a deficit public expenditure to investment―despite some of 1.1 percent in 2014 cushioned by the flexible increasing public consumption during 2015. We exchange rate and favorable oil prices. In 2015, estimate that consumption growth slows from the deficit is projected to increase to 2.1 percent about two percent in 2014 to 0.5 percent in 2015. due to some expenditure expansion and slightly Import demand will decrease on the back of lower lower projected oil prices than in 2014. income growth and continued import restrictions. As a result, the contribution of net exports to Our baseline projections for external balances growth will become slightly negative. assume relief will come in the second half of 2015 from a lifting of sanctions. The impact on trade Our baseline scenario has the following flows of the already introduced sanctions and assumptions in regard to monetary and fiscal Russia’s import ban is projected to be relatively policy. The CBR completes its move to inflation- limited in 2014. We assume stable capital flows targeting by 2015 and refrains from interventions in the last four months of 2014, with the capital on the exchange rate market, allowing a free float account deteriorating to an estimated US$113 of the Ruble from January 2015. For the remainder billion (mostly due to larger outflows in the first of 2014, we assume that the CBR will not intervene three quarters of the year). Banks and corporation in the foreign exchange market and the exchange will be able to rollover their external liability even rate for the bilateral currency basket stays within with the current restricted access to international the targeted band. In such an environment, capital markets. As a result, the CA will improve Russia’s foreign reserves should stay largely intact in 2014 to US$62.8 billion, taking advantage of and will depend on the movement in US$/Euro import contraction and improved income balances. exchange rate. Inflation pressure will persist in the Given sluggish growth due to weakening domestic remaining four months of 2014 assuming a slightly demand and the continuation of current sanctions weakening Ruble and the impact of Russia’s ban in the first half of 2015, the CA will marginally on food imports. We estimate that inflation will deteriorate in 2015 to a surplus of US$57.9 billion. increase to around 8.0 percent by year-end, above As CBR completes its transition to a flexible CBR’s upper bounds of the inflation target range exchange rate management, improvement in of 6.0-6.5 percent for 2014. Inflation pressure the capital account should generally reflect the is expected to subside somewhat in 2015 with projected deterioration of the CA, with net capital a smaller Ruble depreciation, but assuming a flows decreasing as geopolitical tension subsides. potentially accelerated indexation of utility prices. Restricted access to capital markets will continue As a result, we project inflation to moderate to 6-7 for some time and will have a negative impact percent in 2015 before moving closer to the CBR’s on the debt-rollover profile of Russian banks and target range by 2016. Our fiscal projections for corporations. This will result in a deficit of US$60.1 the baseline assume that the fiscal rule remains billion in the capital account. 26 Russia Economic Report | Edition No. 32 II. Economic Outlook Box 10 Government’s medium-term budget framework for 2015-2017 The government’s medium-term draft budget policy document Key directions of the budget policy for 2015 and for the planning period of 2016 and 2017 is currently discussed by the government and parliament. The draft contains a preliminary, medium-term budget forecast and some estimates for budget execution of 2014 budgets. Similar to the envisioned objectives of the medium-term framework documents of previous years, a gradual fiscal consolidation is planned. The key assumption is that the non-oil federal budget deficit will fall over time from 10.1 percent of GDP in 2014 to 9.0 percent of GDP in 2017. The consolidated budget deficit is expected to rise to an altogether higher level than projected in the current Budget Law of 2014-1016 to 2.4 percent of GDP in 2015, a 1.4 percent of GDP increase over 2014. At the same time, consolidated revenue and expenditure are projected to decline by 1.4 percent of GDP and 0.9 percent of GDP respectively (Table 10). This constitutes a noticeably worsened of projections for the consolidated budget parameters compared to the previous framework of 2014-2016 and reflect changes in the geopolitical environment. Table 10: Government budget medium-term framework for 2014-2017, percent of GDP Amended Current Budget Law Medium Term Budget Current of 2014-2016 Document of 2015-2017 Budget 2014 2015 2016 2014 2015 2016 2017 Consolidated Budget Expenditures 37.2 37.3 37.0 37.8 38.9 38.1 36.9 Revenues 36.4 36.4 36.8 36.9 36.5 36.3 35.5 Balance -0.8 -0.9 -0.2 -1.0 -2.4 -1.8 -1.4 Federal Budget Expenditures 19.0 19.3 18.9 19.5 20.0 19.5 18.9 Revenues 18.5 18.3 18.3 19.9 19.4 18.9 18.3 Balance -0.5 -1.0 -0.6 0.4 -0.6 -0.6 -0.6 Non-oil balance -9.4 -9.6 -8.4 -10.1 -10.3 -9.7 -9.0 Urals crude oil price, US$/barrel 101.0 100.0 100.0 104.0 100.0 100.0 100.0 Source: Ministry of Finance. The baseline scenario is accompanied by an 0.4 percent, while growth under the optimistic optimistic scenario and a pessimistic scenario scenario is projected to quicken to 1.3 percent and (Figure 29). Those two alternative scenarios update the contraction under the pessimistic scenario is the previous low-risk and high-risk scenarios from assumed to moderate to 0.4 percent. March.12 However, we narrowed significantly the projection continuum we developed at the Alternative Scenario Projections T beginning of the geopolitical tensions. For 2014, he optimistic scenario projects a small the baseline and the optimistic scenarios assume recovery following the full resolution of growth of 0.5 percent while the pessimistic one the geopolitical tensions and an end of all projects an expansion of 0.4 percent. In 2015, sanctions by the end of 2014. This assumes that the baseline expansion of 0.3 percent is straddled the tensions would be contained in a peaceful by an expansion of 0.9 percent in the optimistic fashion and an orderly resolution will ensue. This scenario and a contraction of 0.9 percent in the would restore access to international capital and pessimistic scenario. By 2016, baseline growth financial markets and confidence would start to is assumed to remain broadly unchanged at gradually improve during 2015, although some 12 See World Bank Russia Economic Report №31: Confidence Crisis Exposes Economic Weakness. Russia Economic Report | Edition No. 32 27 II. Economic Outlook impact of the tensions would linger. The result For the optimistic scenario, the baseline would be a slow recovery in private consumption assumptions about fiscal and monetary policy and private investment, supported also by some remain intact, while outcomes for external renewed focus on structural reforms in late 2015. balances are expected to be similar. However, Growth would improve from 0.5 percent in 2014 the optimistic scenario contains slightly more to 0.9 percent in 2015 and 1.3 percent in 2016. favorable projections on inflation dynamics and The growth outlook in this scenario has the same Russia’s external position. As in the baseline, expectations as the baseline scenario in regard inflation accelerates to around 8.0 percent by to the external conditions in 2014-1016. Only year-end of 2014, but inflation pressure would expectations regarding domestic demand differ subside somewhat faster in 2015 with the potential (Table 11). Consumption growth would initially elimination of the food import ban and a lesser decrease in this scenario from around two percent Ruble depreciation. Inflation would stand in 2015 in 2014 to 0.9 percent in 2015, negatively affected at around 6 percent and reach by 2016 a level close by slowing income growth in the preceding periods to CBR’s medium target. The 2014-2015 balance of and still elevated inflation levels. In 2016, it would payments outcomes under the optimistic scenario recover back to 1.5 percent as sentiment gradually are similar to the baseline, with differences improves and growth regains some momentum. In reflecting the extent of the Ruble depreciation and addition to the public investment boost assumed in capital flows. The removal of all sanctions by the end the baseline scenario, private investment growth of 2014 and a more vibrant economy could result would gradually recover towards the end of the in a faster shrinking of the CA surplus to US$42.9 projection period, given strengthening confidence billion. Given the assumed full transition to a in the face of subsiding policy uncertainty and flexible exchange rate management, improvements signals of a renewed focus on structural reform. in the capital account should reflect the projected Gross capital formation is projected to increase deterioration of the CA with net capital flows by 1.5 percent in 2015 and 2.5 percent in 2015. decreasing as geopolitical tension subsides. Banks Robust export demand and lower import demand and non-financial corporations would restore their due to weaker consumption will result in a slightly rollover capacity faster than in the baseline, which negative contribution of net exports to growth. would result in somewhat lower deficit on the capital account of US$45.0 billion. Table 11: Main economic indicators: optimistic scenario 2012 2013 2014 2015 2016 GDP growth (%) 3.4 1.3 0.5 0.9 1.3 Consumption growth, percent 6.8 3.5 2.2 0.9 1.5 Gross capital formation growth, percent 0.6 -6.0 -8.1 1.5 2.5 General government balance (percent of GDP) 0.4 -1.3 -1.1 -2.3 -1.2 Current account (US$ billions) 71.3 34.1 62.8 42.9 28.6 percent of GDP 3.6 1.6 3.1 2.0 1.3 Capital account (US$ billions)* -32.3 -62.2 -113.0 -45.0 -25.5 percent of GDP -1.6 -3.0 -5.6 -2.1 -1.1 Oil price assumption (US$ per barrel) 105.0 104.0 102.9 99.5 100.1 CPI inflation 5.1 6.8 8.0 6.0 5.0 Source: World Bank staff estimates. Note: *Current account minus change in reserves. 28 Russia Economic Report | Edition No. 32 II. Economic Outlook The pessimistic scenario projects an increasing Under the pessimistic scenario, the assumption intensity of geopolitical tensions, which would for fiscal policy differs from the baseline scenario, see the economy slipping into a protracted low- while the monetary policy assumption changes level recession. Access to the international capital little. However, in 2014 the Ruble will remain under market would become increasingly restricted for high pressure due to a return of large geopolitical Russian companies and banks, further increasing uncertainty. Given that the CBR has already lost borrowing costs and hampering investment about US$44 billion of its foreign exchange reserve activities. Additional sanctions (including short- from end-2013 until mid-September of this year, term gas trade limitations) over the projection the reserve position will further deteriorate by period would translate into heightened policy end-2014 as the CBR would revert to interventions uncertainty and capital flight, high exchange in the fourth quarter of 2014 to support the Ruble rate volatility and Ruble depreciation with a at the upper limit of the bilateral currency basket. detrimental impact on confidence and investment Continued rapid depreciation of the Ruble, coupled activities. Yet, this scenario assumes that the with non-monetary factors, will result in inflation international community would still refrain from accelerating to 10 percent in 2015, assuming no oil trade sanctions. The economy is projected further tightening of monetary conditions by the to contract by 0.9 percent in 2015 and by 0.4 CBR in the upcoming months. As in the other two percent in 2016 (Table 12). Domestic demand scenarios, the CBR completes its move to inflation- would stay depressed longer than we projected targeting by 2015. The fiscal position is expected in our baseline scenario, continuing to contract to deteriorate as the government relaxes its fiscal throughout 2016. Even an assumed relaxation rule in order to scale up expenditures to provide of the fiscal rule would not result in enough additional fiscal stimulus in 2015 in an attempt to public investment growth to compensate for the lift the economy out of recession. We anticipate contraction in private investment, leading to a that the cap on expenditure will be lifted by 1 continued decline in gross capital formation in percentage point of GDP, allowing the government 2016. Lower income growth, high inflation and to scale up the ongoing investment programs and higher consumer credit defaults, together with to increase the indexation of social transfers. depressed sentiment, would bring consumption However, such an additional fiscal stimulus is likely growth to a crawl, stalling the economy’s main to have only a marginal and short-lived effect on growth engine during the coming years. economic growth, given the low level of multiplier Table 12: Main economic indicators: pessimistic scenario 2012 2013 2014 2015 2016 GDP growth (%) 3.4 1.3 0.4 -0.9 -0.4 Consumption growth, percent 6.8 3.5 2.0 -0.3 -0.3 Gross capital formation growth, percent 0.6 -6.0 -8.5 -4.3 -1.2 General government balance (percent of GDP) 0.4 -1.3 -0.7 -2.8 -1.2 Current account (US$ billions) 71.3 34.1 69.3 82.2 80.8 percent of GDP 3.6 1.6 3.6 4.5 4.3 Capital account (US$ billions)* -32.3 -62.2 -128.0 -82.3 -80.0 percent of GDP -1.6 -3.0 -6.6 -4.5 -4.3 Oil price assumption (US$ per barrel) 105.0 104.0 102.9 99.5 100.1 CPI inflation 5.1 6.8 8.0 10.0 8.0 Source: World Bank staff estimates. Note: *Current account minus change in reserves. Russia Economic Report | Edition No. 32 29 II. Economic Outlook for government spending in Russia and lingering in 2014 and US$82.2 billion in 2015. With new structural constraints. The fiscal position is sanctions in place, Russian banks and corporation expected to deteriorate to a deficit of 2.8 percent will find it increasingly difficult to rollover their in 2015. external debt in 2015, which will also contribute to net capital outflows. Russia would also face an In the pessimistic scenario, external balances acceleration of net capital outflows due to further would be more profoundly altered as compared deterioration of market sentiment, reduced FDI to the baseline. Higher import contraction in both inflows and reallocation of assets away from 2014 and 2015 due to a continued depreciation Russia. As a result, the deficit on the capital of the Ruble and additional trade sanctions could account is projected to remain large at US$82.3 result in a larger CA balance of US$69.3 billion billion in 2015. 2.2 Development And Policy Challenges Poverty And Shared Prosperity Risks under the pessimistic scenario). However, in 2015 B and 2016, the differences between the scenarios ased on recent trends, our poverty would become more significant. As income is forecast projects little potential for further assumed to stagnate under the baseline scenario, improvement in the near term (Box 11). This we project a further minor uptick of the poverty forecast is driven by the core assumptions of high rate under the baseline scenario to 11.5 percent food and service inflation―outpacing headline in 2015 and some correction to 11.2 percent in inflation―and stagnating or declining real incomes. 2016. In the optimistic scenario, we expect the In our three growth forecast scenarios (Figure 34), poverty rate to stagnate in 2015 and then revert we expect the poverty rate to increase slightly in back to historically low levels of around 10.6 2014 (up to 11.3 percent under the baseline and percent in 2016. In the pessimistic scenario, while the optimistic scenarios and up to 11.4 percent income is expected to decelerate, the poverty Figure 34: Poverty and inequality in Russia line will continue to grow fast in a high-inflation environment. This would result in an increase of 16 0.424 the poverty rate to 12.3 percent in 2015 and 12.6 15 0.422 percent in 2016. 0.420 14 0.418 Another challenge will be to further increase 13 shared prosperity. In recent years, the shared 0.416 12 prosperity indicator―as measured by the average 0.414 income growth of people in the bottom 40 percent 11 0.412 of the income distribution relative to the average 10 0.410 growth rate of income―worsened in Russia. 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Consistent with the trends described above, real Poverty rate, % Pessimistic scenario Baseline scenario Gini (rhs) Optimistic scenario income growth of the bottom 40 percent of the population significantly decelerated in 2012-2013 Source: Rosstat and World Bank staff estimates. to 3 percent from almost 10 percent in 2005-2011 13 The shape of distribution is assumed to be stable. Changes in poverty are driven by the average income and poverty line dynamics. 30 Russia Economic Report | Edition No. 32 II. Economic Outlook Box 11 Recent poverty and inequality trends Low income growth resulted in less positive poverty dynamics during the first half of 2014. There was a small increase in the absolute number of poor since 2013. We estimate that the seasonally adjusted poverty rate for first quarter of 2014 was the same as a year ago, 10.6 percent (Table 13). The total poverty rate for Russia is low compared to other countries in the Europe and Central Asia region, yet the variation across Russia’s regions remains significant (Figure 37). Among the regions with the lowest poverty rate are the resource-rich Yamal-Nenets Autonomous Area (6.9 percent) and the Tatarstan Republic (7.2 percent), along with the Belgorod oblast (7.6) and Moscow oblast (7.7). The highest poverty rates are in the Tuva and Kalmyk republics (35.1 and 35.4 percent). Due to the strong seasonality in poverty and income dynamics, annual data is the more reliable indicator: the yearly poverty rate was almost flat at 11.0 percent in 2013 compared to 10.7 percent in 2012. The average income growth was offset by faster growth in prices for goods in the poverty-line basket. Table 13: Poverty rates in Russia, percent 1Q 2Q 3Q 4Q 1Q 2Q Period (cumulative) 2010 2011 2012 2013 2013 2013 2013 2013 2014 2014 Poverty rate, percent 12.5 12.7 10.7 11.0 13.8 13.0 12.6 11.0 13.8 13.1 Source: Rosstat and World Bank staff estimates. Inequality measures for Russia remain stable. The Gini coefficient remains at the level of 0.418 (Figure 34), in line with the average for 2007-2013 when it stood at 0.420. Unfortunately, this indicator is not very informative in recording the changes in the shape of the distribution, so we also looked at indicators for recent middle-class dynamics in Figure 35: Income distribution: share of population Russia. We defined the middle class as people with per with per capita income in US$ PPP per day, percent capita income exceeding US$ 10 PPP per day . In 2011, the 100 share of the population belonging to this group increased 90 slightly to 63.3 percent from 62.6 percent in 2010 (Figure 36). In 2012, this already high share increased further to 80 68.4 percent. Within the Europe and Central Asia region, 70 Russia is one of the best-performing countries when this 60 middle-class definition is applied. However, a closer look 50 to the distribution indicates that this growth was driven 40 by the expansion of the share of the relatively better-off 30 people within that group. The share of population with a per capita income of US$25-50/day increased from 11.9 20 percent in 2010 to 15.1 in 2012. The increase in the share 10 of the population with an income of US$50/day was even 0 steeper in relative terms―from 3.6 percent in 2010 to 5.7 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 percent in 2012. In contrast, the share of the population >50 25-50 10-25 5-10 <5 Total 10+ with an income of US$10-25/day stagnated at around 47 Source: World Bank staff estimates based on RLMS data. percent (47.1 in 2010 and 47.5 2012; see Figure 35). 14 These estimations were done on RLMS data in the comparable approach with the Focus note of the Russia Economic Report no. 31. However, all this estimation should be taken with caution as survey data is usually biased downward due to underreporting of incomes and expenditures and under-representativeness of people with high incomes. Russia Economic Report | Edition No. 32 31 Figure 36: Poverty rates in 2013, percent 32 1 Yaroslavl 7 Tula 13 Chuvashia 21 Volgograd 27 North Ossetia 2 Kaluga 8 Nizhniy Novgorod 14, 16 Tatarstan 22 Kalmykia 28 Chechnya 3 Vladimir 9 Ryazan 15 Penza 23 Adygea 29 Ingushethia 4 Ivanovo 10 Mari El 17 Ulyanovsk 24 Stavropol 5 Perm 11 Udmurtia 18 Saratov 25 Karachaevo-Cherkessia 6 Moscow-city 12 Mordovia 19, 20 Samara 26 Kabardino-Balkaria Russia Economic Report | Edition No. 32 II. Economic Outlook Source: Rosstat and World Bank staff estimates. II. Economic Outlook (Figure 37). That was lower than for the whole allow for more efficient markets. The special focus population, whose income growth was relatively section of this report will suggest structural reform stable at 4-5 percent a year, according to the priorities to unlock Russia’s growth potential Household Budget Survey. This deceleration of within the framework of finding a more diversified income growth for the bottom 40 percent already development path for the country. negatively affected poverty reduction and is likely to limit further the evolution of the shared Structural constraints in the economy also diminish the effectiveness of the Central Bank’s disinflation prosperity indicator in the future. policy. It appears that Russia’s output gap remains Figure 37: Real income growth, y-o-y, percent effectively closed, with the economy operating 16 near its capacity limits. A tight labor market, a high level of capacity utilization and depressed 14 investment activities make CBR’s disinflation policy 12 increasingly difficult. In the current environment 10 of heightened geopolitical tension and increased 8 uncertainty, a loosening of its monetary stance could lead to increased pressure on the Ruble and 6 accelerating capital outflows. This leaves the CBR 4 no option but to keep monetary conditions tight 2 if it is to achieve the longer-term inflation target of 4 percent. However, this inflation target might 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 underestimate the impact of structural constraints Average Bottom 40 on inflation dynamics. We see some stagflation Source: Rosstat and World Bank staff estimates. risk, unless the process of removing structural constraints to economic growth begins. Policy Risks In the current environment of elevated inflation E conomic recovery in 2015 and afterwards would depend on solid private investment growth and a lift in consumer sentiments. risk, it will be particularly important to adhere to fiscal prudency, given also that the economy operates near its production frontier. There is In addition to macroeconomic stability, this increasing pressure for higher fiscal expenditure would require a positive shift in business and and off-budget stimuli to the economy. Such consumer confidence based on a predictable stimuli might lead to some marginal and short-term policy environment. Without significant structural growth impulses, but it would likely come at the reforms directed towards strengthening regulatory cost of even higher inflation, thus not presenting a and market institutions and tackling inefficiencies credible alternative. Counterbalancing the effects in factor allocation across the economy, this is of structural constraints in the economy is beyond unlikely to happen and would subdue long-term best Central Bank policy or fiscal policy, and, in this growth prospects. The current stalling of structural case, a fiscal stimulus could not mask them for reforms represents a down-side risk to Russia’s long. However, adherence to a clear medium-term medium- and long-term outlook. While it will fiscal target, such as a non-oil deficit target or the remain important to pursue policies to maintain current fiscal rule, could prevent the temptation to macroeconomic stability and policies to safeguard expand counter-cyclical policy to a level that would the economy from the impact of the current jeopardize long-term fiscal sustainability. Difficult geopolitical tensions, this policy effort should go times test the credibility of policies, and now is the hand in hand with renewed focus on improving right moment to display policy commitment. the economy’s microeconomic fundamentals and Russia Economic Report | Edition No. 32 33 II. Economic Outlook In its medium-term fiscal outlook for 2015- Figure 38: Reserve and National Welfare Funds in 2008-2017, percent of GDP 2017, the government acknowledges the risks to fiscal stability and quantifies the parameters 18 of utilization of the Reserve Fund to finance 16 unforeseen budget deficits in case such risks 14 materialize. Key risks to the budget identified 12 and quantified by the Ministry of Finance are: 10 (1) lower oil and non-oil revenues, (2) lower 8 privatization proceeds, and (3) fewer domestic 6 and foreign borrowing options. Under the scenario 4 of materialization of all budget risks, the Reserve 2 Fund is projected to diminish to 2.9 percent of 0 GDP by end 2017. Otherwise, the Reserve Fund is 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 projected to increase to about 5.3 percent of GDP National Welfare Fund Reserve Fund (scenario 1) Reserve Fund (scenario2) by 2017. The NWF is forecasted to decline to about Source: Ministry of Finance and World Bank staff calculations. 3.7 percent of GDP by 2017 (Figure 38). substitution, an example being the ban of pork In the short-term, the positive impulse of import products at the beginning of this year (Box 12). substitution might increasingly be used to promote There is a risk that government will continue protectionist measures. Even before the current protectionist measures once import substitution geopolitical tensions started, government effects vanish. This could delay structural showed interest in supporting selected firms reforms which would help the Russian economy and sectors that would benefit from import to become globally more competitive. 34 Russia Economic Report | Edition No. 32 II. Economic Outlook Box 12 Russia and the World Trade Organization Russia formally joined the WTO on August 22, 2012, but its WTO commitments are designed to be implemented on a phased basis. They are laid out in a series of schedules included in the WTO Protocol of Accession. For example, tariffs are to be reduced gradually from the date of accession through 2019. Some liberalization in services is also on a phased-in basis, e.g. limitation of foreign equity for telecoms companies (2016) and market access for foreign insurance companies (2021). Russia has already joined the Information Technology Agreement. The country is obligated to join by 2016 the WTO Government Procurement Agreement. Questions remain whether Russia’s regulatory standards affecting imports fully comply with WTO norms. During its accession process, Russia declared to the WTO Working Party that its regulations in the areas of technical barriers to trade (TBT) and sanitary and phytosanitary standards (SPS) conform to the relevant provisions of the WTO TBT and SPS Agreements. However, many products that satisfy safety and health requirements in non-Russian markets appear not to satisfy Russia’s current regulatory standards.15 Russia’s standard-setting measures are based on a Soviet-era historical model, the GOST standards. The WTO Agreements require that national regulations shall be directed at legitimate objectives such as human health or safety; the health of animals, plants and the environment; national security requirements and the prevention of deceptive practices. It shall not be applied in a manner that would constitute a disguised restriction on international trade or create unnecessary obstacles to trade.16 There are concerns among Russia’s trading partners as to whether Russia’s current TBT and SPS practices conform to international standards, or provide the degree of market access envisioned by the relevant WTO agreements. These concerns give rise to potential challenges of such practices in the Dispute Settlement Mechanism. In January 2014, Russia excluded the import of live pigs, pork, and pork products from the European Union by its SPS policy. Altogether, these products amounted in 2013 to US$1.3 billion in imports. On April 18, 2014, the EU requested consultations with the WTO Dispute Settlement Body (DSB) with regard to the ban of pork products. The pork product ban followed the detection of four cases of African swine fever in wild boar in Lithuania and Poland. However, the ban applies to live pigs, pork, and pork products from throughout the European Union. One issue in the dispute involves localization requirements, which refer to attempts by a country or customs territory (such as the EU) to impose measures for control of diseased animals on part of its territory―such as quarantines―and to have the rest of the territory certified as disease- free. Russia maintains that EU localization measures are not sufficient, that additional information is required, and the EU has not provided it. The EU states that it has sought to provide relevant information and that measures that would ban pork from, for example, Spain, because of SPS issues in Lithuania and Poland, are not scientifically grounded. It further states that Russia does not appear to effectively control the disease on its own territory, citing nearly 1,000 cases of the same disease among Russian wild boar and domesticated animals since 2007. On July 22, 2014, the DSB established a panel for the dispute. The recent sanctions and countersanctions may pose additional challenges to the WTO. The Dispute Resolution Mechanism with appeal requires about 15 months to operate and, in practice, can take many years when there are strong disagreements between the parties. Moreover, parties have invoked national security concerns in connection to their sanctions. The WTO agreements contain a broad exception for countries to determine what national security measures they apply to trade (GATT 1947, Article XXI(b)(iii)17). Such claims have rarely been challenged historically, and there is little WTO jurisprudence on the potential contestability of national security measures. 15 The name GOST is derived from a Russian phrase meaning “state standard” (gosudarstvennyystandart in Romanized form, государственны йстандартгосударственныйin Cyrillic.) 16 This language is adapted from Article 2 of the SPS Agreement and Article 2 of the TBT Agreement. 17 Article XXI(b)(iii), with its chapeau, states: “Nothing in this Agreement shall be construed…to prevent any contracting party from taking any action which it considers necessary for the protection of its essential security interests...taken in time of war or other emergency in international relations.” Russia Economic Report | Edition No. 32 35 PART III Paths to Diversified Development in Russia 18 W orld Bank research on resource-rich nations suggests that economic diversification is neither necessary nor sufficient for economic development. Interventions to diversify economies appear to work only when they are supported by policies to diversify their assets. There is a stronger correlation between diversified assets and greater efficiency. This means the government needs to worry less about the composition of exports and the profile of production, and more about the diversity of its national asset portfolio—the blend of natural resources, built capital, and economic institutions. This diversification approach implies a rich reform agenda for Russia, as its portfolio is heavy in tangible assets such as oil and gas, and even hard infrastructure such as schools, but it is still light in intangibles, such as institutions for managing volatile resource earnings, providing high-quality social services, and even-handedly regulating enterprises. It was investments in intangibles that allowed economies dominated by extractive industries to become innovative and successful. 18 This note is based on the recent World Bank Europe and Central Asia Regional Flagship Report: Diversified Development: Making the Most of Natural Resources in Eurasia. Washington, DC 2014. The authors of the report are Indermit Gill, IvailoIzvorski, Willem van Eeghen, and Donato De Rosa. This note was produced by Donato De Rosa, Elena Bondarenko and Ekaterina Ushakova. III. Paths to Diversified Development in Russia 3.1 Introduction H ow to make most of its natural resources is the main question for Russia, which integrated into the world economy by exporting Their deep and comprehensive integration with the policies and institutions of the European Union led to the largest inflows of foreign capital resource-intensive products. This question is one and Western know-how in history (Figure 39). of several on diversified development that are discussed in a recent World Bank report (2014) Natural resources allowed Russia to reach high- which seeks to contribute to the debate on what income status in less than a decade, but the governments must do to develop their countries. global economic crisis exposed the structural It also derives lessons from success stories of other weaknesses of the commodity-driven growth countries that integrated into the world economy model. After bottoming out in 1998, the economy with the export of resource-intensive products. grew until 2008 on the back of rising commodity Russia and several Eurasian countries are large prices and spare capacity, leading to large exporters of resource-intensive products. Their productivity gains and expanding the output growth path in the past two decades differed in frontier. GDP grew by 95 percent, incomes per that respect from other countries: Asia’s rapidly capita doubled in real terms, and poverty was growing economies integrated with labor- drastically reduced. The share of the population intensive products into the global markets. living on US$5 or less a day fell from more than Their growth path was dominated by importing 35 percent in 2001 to 10 percent in 2010. But capital and know-how and exporting goods and starting in 2008, Russia experienced an abrupt services that require a great deal of labor. Central end to its economic boom as a sudden reversal European economies entered the global economy of capital flows caused a credit crunch and a by exporting capital-intensive goods and services. sharp contraction in demand. In 2009, Russia’s Figure 39: Three ways to integrate and grow: export product share, by factor intensity Eurasia EU12 East Asia 2010−11 2000−01 1990−91 Resource Capital Labor intensive intensive intensive (72%) (59%) (48%) Source: World Bank staff calculations based on Comtrade. Note: Eurasia: Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, the Kyrgyz Republic, Moldova, the Russian Federation, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan. European Union-12: Bulgaria, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, the Slovak Republic, Slovenia and Croatia. - East Asia-12: Cambodia, China, Indonesia, the Republic of Korea, the Lao People’s Democratic Republic, Malaysia, Mongolia, Papua New Guinea, the Philippines, Singapore, Thailand, and Vietnam. - Factor intensity is measured with the export data classified by Standard International Trade Classification (SITC) Revision 1. The modified version of commodity classification by Krause (1987) is used. Resource intensive includes products related to hydrocarbon and minerals only. Goods related to agriculture are contained in labor intensive (unskilled labor intensive). Here, capital intensive is represented by both technology intensive and human capital intensive. 38 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia output contracted almost 8 percent. Between were created before the crisis, but dropped 2009 and 2013, economic growth averaged 1.1 from 14 percent of GDP in 2008 to 8.7 percent in percent per year, far lower than other large, 2013. The challenge will be to identify better emerging economies19 (5.1 percent) and other strategies to save some of the earnings from resource- rich countries20 (3.5 percent). Private the oil and gas for future generations or use investment plunged at the onset of the crisis by public resources to foster specific activities 9.2 percent in 2009 compared to the previous that are less extractive and more innovative. year. Today it remains low, with weak credit Only a broader approach to future growth growth to the private sector and falling business potential can help Russia’s economy become creation. Productivity growth slowed from an more innovative as well as extractive. average 4.1 percent in 1998-2008 to 1.6 percent in 2008-2012. This makes it likely that the recent This note looks at paths to diversified slowdown in Russia’s economic growth is largely development that would rebalance Russia’s due to structural rather than cyclical factors, portfolio of national assets: natural resources, implying that the economy as it is structured is capital and economic institutions. The paper reaching the limits of its potential output. discusses the observed slowdown in Russia’s potential growth, assesses strengths and Structural constraints to Russia’s potential weaknesses of its current asset portfolio, and output pose the key question how to increase suggests priorities to unlock Russia’s growth that potential, so that the economy can sustain potential. Russia’s growth path will remain high growth rates. Given the observed slowdown entwined with its resource endowment, which has in the Russian economy and its resource-based undoubtedly contributed to its previous success. growth model, the problem is: How should the But Russia is also rich in human capital: a highly government diversify exports and the economy educated population similar to Central Europe’s away from activities that depend on natural and great potential to increase its physical resources? The recent growth strategy based on capital base, notably infrastructure. The paper direct government presence and active industrial will explore what challenges and opportunities policies to diversify the economy did not open the those assets could hold for Russia. Moreover, door to higher potential output. Also, at present, the central issue for greater economic efficiency the margin for maneuver for expansionary fiscal and a higher growth potential for Russia might be policy appears to be small, limiting the scope for related to a more intangible asset: the quality of direct transfers for social objectives and direct its institutions, which manage resource revenues, interventions to help diversify production. Russia provide social services and regulate enterprises. was left after the 2008 crisis with a large non- Our main hypothesis is that investments in oil fiscal deficit of 14 percent in 2009 and 10 intangibles will make the difference between a percent in 2013. Large fiscal buffers―Russia’s more productive economy and a stagnating one. Reserve Fund and the National Welfare Fund― 19 BRICS countries – excluding Russia: Brazil, China, India, and South Africa. Resource-rich countries: Australia, Azerbaijan, Botswana, Canada, Chile, Kazakhstan, Malaysia, Nigeria, Norway, Ukraine, United States, 20 Uzbekistan, and Venezuela. Russia Economic Report | Edition No. 32 39 III. Paths to Diversified Development in Russia 3.2 Increasing Potential Output R ussia appears to have reached its potential output. Over 2000–2006, increases in Total Factor Productivity (TFP) were the dominant The quality of physical capital and a lack of competition are a drag on productivity. Firm- level data show that variables connected with driver of output expansion. The main force behind adequate public services (infrastructure and TFP growth during this period was efficiency gains education) and with the business environment from the transition process, with the reallocation (regulation and competition) explain up to 36 of excess capacity to more productive sectors of percent of aggregate log Total Factor Productivity the economy. Over time, capital accumulation (TFP).21 Distortion of competition, in particular, grew to account for a larger component of output has a strong adverse impact on productivity. expansion, while labor’s contribution became Firms facing domestic competition display an more limited. At the same time, TFP growth estimated 19 percent higher productivity and are slowed as productivity gains from first generation 8 percent more likely to export than firms that reforms wore off (Figure 40). Although hard to do not face such competition.22 Among other estimate, it is likely that much of the slowdown variables, innovation, labor skills, and exporting in Russia’s economic growth is due to structural, and importing activities are all associated with rather than cyclical, factors, implying that the higher TFP (World Bank, 2013). Russian economy may be reaching the limits of its potential output (Figure 41 and IMF 2014). Figure 40: Total factor productivity growth, percent Figure 41: Russia’s potential growth, percent 15 Potential GDP Growth, % 7 10 6 5 5 4 0 3 2 -5 1 -10 0 2009 2010 2011 2012 2013 -15 Russia BRICS Average EU11 Average (excluding Croatia, 19 3 94 19 5 19 6 19 7 19 8 99 20 0 01 20 2 03 20 4 20 5 20 6 20 7 20 8 09 20 0 11 12 (excluding Russia) Latvia and Luthuania) 9 9 9 93 9 0 0 0 0 0 0 0 1 19 19 20 20 20 20 20 Total Factor Productivity Capital Labor GDP Growth Resource Rich* Average Source: Conference Board and World Bank staff estimates. Source: OECD, IMF and World Bank data23. Note: Potential output for all countries is calculated using the production function approach. 21 Variables connected with public services and with the business environment were broadly termed as the “investment climate.” In addition to “investment climate” variables, other factors explaining aggregate log TFP included in the analysis were export propensity, foreign ownership, innovation, employment, industry/region/size effects, and the constant technical efficiency term (constant term of the TFP equation). 22 To evaluate how competition is related to the endogenous variables of the system, four variables approximating four measures of competition were defined: domestic, foreign, customer, and informal. 40 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia Product markets are often dominated by Figure 42: Distribution of wealth by assets 2005, percent incumbents. In 2001–07, the share of highly 6 concentrated markets increased from 43 percent 5 to 47 percent, which is high compared with most developed economies.23 Most markets are 4 dominated by a few incumbent players. Price-cost margins―an empirical measure of intensity of 3 competition―are higher in Russia than in Europe, 2 indicating less competition. Firms in sectors with higher price-cost margins tend to be older 1 and larger, have smaller export orientation and 0 R&D intensity, are more likely to operate in local 2004 2005 2006 2007 2008 2009 2010 2011 markets, and, in some sectors, are less likely to Russia BRICS Average (excluding China) EU11 Average Resource Rich* Average operate in a competitive market structure. Source: World Bank. Uncompetitive markets are the ultimate cause industrial policies to diversify the economy. of weak entrepreneurship. The diminished Economic diversification has been a key priority access to credit following the global economic for over a decade. Various tools were deployed to crisis is associated with a sharp decline in levels subsidize the non-extractive economy and jump- of entrepreneurship. It is, however, only one of start an innovation-based enterprise sector that the factors shaping the incentives to establish would reverse Russia’s “de-industrialization” and new firms. Levels of entrepreneurship in Russia almost exclusive reliance on commodity exports. were low (and declining) even before the crisis State aid, with direct transfers and preferential (Figure 42). Adjusted for the size of population, treatment of enterprises, was extensively used entrepreneurs register twice as many companies to protect incumbent firms from competition. At in Malaysia and three times as many in Chile the same time, a sustained attempt was made than in Russia. The ultimate reasons for low to create the basis for an innovation-driven entrepreneurship in Russia lie in an unfriendly knowledge economy, with massive initiatives regulatory environment, with rules that are often such as the Russian Venture Company, Rosnano arbitrarily enforced, and markets dominated by or Skolkovo. Whereas it may be early to evaluate incumbents. the results of these policies, it is time to focus the attention of policymakers on actions that can The slowdown in potential output calls into increase the economy’s growth potential. These question Russia’s recent growth strategy based should aim at diversifying and strengthening the on direct government presence and active economy’s asset base. 23 Concentration ratios are calculated using the Herfindahl-Hirschman Index (HHI) and CR3 methodologies. A highly concentrated industry is defined as one in which the HHI is greater than 2,000. See Conway et al. (2009). Russia Economic Report | Edition No. 32 41 III. Paths to Diversified Development in Russia 3.3 Russia’s Current Asset Base: Abundant Natural Resources, Good Human Capital, Improving Infrastructure, But Weak Institutions A ssets can be classified into three categories: natural resources, built capital, and national institutions. Natural resources in the form of differ in how productively they use their land or in how effectively they exploit their subsoil assets. The period over which resources generate minerals, arable land, and forests are largely profit depends on whether they are renewable endowed, but technological progress and better or exhaustible. Reserves of subsoil assets such management can radically alter their economic as oil, natural gas, and minerals are typically value. Built capital consists of both physical nonrenewable and exhaustible, whereas land, and human capital, in the form of adequate forests, and rivers can potentially last forever if infrastructure and a healthy and skilled labor managed well. The Changing Wealth of Nations force. Both such assets can be measured for any (World Bank 2011a) develops and applies a country, though in the case of built capital, with methodology that captures these dimensions. more difficulty and less precision than natural Each country’s estimated total natural capital resources. Finally, the most poorly measured is then divided by its 2005 population to and possibly the most important assets a country estimate per capita natural capital and its major has are national institutions: the regulations and components (subsoil capital and land capital) to mechanisms that a country has put in place to permit comparisons across countries, regions, manage resource rents, deliver public services and income groups. such as roads, security, health care, and education, and regulate private enterprise. Russia ranks 15th in the world in natural capital per capita and 13th in subsoil wealth. Russia Natural Resources has around 5 percent of the world’s proven N atural capital, similarly to physical capital, is the present discounted value of the profit stream that natural resources can generate far oil reserves and 25 percent of its proven gas reserves. In resource-rich Australia, Canada, Norway, and New Zealand, natural capital is 8–13 into the future. Countries with similar initial percent of overall wealth. The ratio in Russia is 43 quantities of land or subsoil assets may thus have percent (Figure 43 and Figure 44). Natural capital different levels of estimated natural capital if they per capita rose in Russia over 2000–10, driven Figure 44: Subsoil natural resource wealth per capita Figure 43: Distribution of wealth by assets in 2005, percent in 2005, constant 2005 US$ 100 United Arab Emirates (3) 118,111 Norway (4) 99,706 90 Saudi Arabia (6) 86,620 80 Turkmenistan (12) 32,468 Russian Federation (13) 24,238 70 Venezuela, RB (14) 24,090 60 Australia (15) 20,328 Kazakhstan (16) 20,268 50 Canada (19) 12,644 40 Malaysia (22) 10,102 Chile (23) 9,563 30 Azerbaijan (24) 9,194 20 Netherlands (26) 7,061 Uzbekistan (28) 5,365 10 Nigeria (30) 3,940 United States (33) 3,478 0 AUS AZE CAN KAZ MYS NLD NOR RUS SAU TKM UKR ARE USA UZB VEN Ukraine (44) 1,970 Natural capital Produced capital Intangibles Botswana (55) 982 Source: World Bank (2011a) and Sugawara (2012). Source: World Bank (2011a). 42 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia by a combination of growth in the production of depletion of natural resources and damage caused natural gas, the expansion in reserves, and, most by pollution. With positive ANS, Russia has importantly, higher world prices. Where Russia been adding more renewable capital―roads, has done less well is in exploiting its potential for railways, airports, telecommunication facilities, agriculture. schools, and hospitals―than the amounts of natural resources it has been extracting In addition to being resource abundant, Russia is and selling. Russia should maintain a positive dependent on its natural resources. As of 2012, ANS and continue avoiding reductions in total extractives (including oil, natural gas and minerals) economic endowments. One reason why ANS accounted for 17.5 percent of GDP (with oil and could turn negative is high energy subsidies. In gas at 16.2 percent). In 2013, energy exports 2012, these subsidies in Russia amounted to 2.3 represented about 67 percent of total exports (54 percent of GDP. percent oil and 13 percent gas) and oil revenues contributed to 30 percent of fiscal revenue Physical Capital A (Figure 45 and Figure 46). This dependence may fter declining until the early 2000s, physical result in excessive volatility of export receipts and capital stock has begun to increase. Gross government revenue, adding to overall economic fixed capital formation has been at just over 20 volatility, hurting savings, investment, and percent of GDP since 2007. This is still lower economic output, straining government finances, than comparators, especially large emerging and increasing uncertainty for households and economies (Figure 14). Public investment has firms. In 2013, the non-oil fiscal deficit amounted stagnated at about 3 percent of GDP since 2005. to 10 percent of GDP with an overall deficit of Overall, the stock of infrastructure capital is still 0.5 percent. The difference between the two is a comparatively low (Table 14). good measure of the government’s dependence on oil and gas. The quality of infrastructure appears to have improved since 2007. Inadequate maintenance Russia has sustained positive adjusted net and repairs had led to steep drops in infrastructure savings since 1998, reaching 10 percent of GDP quality since the end of the Soviet period. in 2008–10. Adjusted net savings (ANS) measures Infrastructure established in cold climates proved the true rate of savings in an economy after too expensive to maintain and was allowed to taking into account investment in human capital, degrade. Communal infrastructure similarly Figure 45: Resource revenue as share of total Figure 46: Revenue of energy producing minerals fiscal revenue, 2006-2010 across regions, percent of GDP 90 60 80 50 70 60 40 50 30 40 20 30 20 10 10 0 0 s t Sib y ia t l h as th- ti n ra as es al sk ut er ra ia No on us nt Ur uc or rE -W lzh So s de us Ce E ria a n ia ay ia ile Bo an ela an ia Ca N Fa rth an ivo UA sta ys ss b Fe R rw Ch ij ist ge ra zu ba tsw Ru ala Pr kh en iA No Ni ne er za M ud m Ve Az Revenue of Energy producing minerals as % of GDP Ka rk Sa Tu Revenue of Non-Energy producing minerals as % of GDP Source: text Source: text Russia Economic Report | Edition No. 32 43 III. Paths to Diversified Development in Russia Table 14: Length of transport networks, km, thousands The penetration of information and 1992 1990 2011 2010 communications technology (ICT) is at very low Russia US Russia US levels compared to high income countries and Highways 466 6187 903 6507 this may hamper business growth going forward. Railroad 88 240 86 204 In 2012, there were only 53 internet connections and only 14 fixed broadband internet subscribers Navigable channels 98 42 101 41 per 100 people, far less than in advanced countries Oil pipelines 66 - 65 293 (Figure 49). Given its rising role in the modern Gas pipeline 140 2032 167 2479 economy, low ICT penetration may become an Source: US Department of Transportation and Rosstat. increasing problem for doing business. suffered, as artificially low prices and heavy state Figure 49: Fixed (wired-) broadband subsidies led to persistent underinvestment and subscriptions per 100 inhabitants, 2012 less-frequent maintenance. The situation has 45 improved since 2007, as indicated by a rise in 40 35 perceived infrastructure quality (Figure 48). 30 25 Figure 47: Gross capital formation, percent of GDP 20 14 32 15 10 30 5 28 0 26 Malaysia Ukraine Saudi Arabia Venezuela, RB United Arab Emirates Kazakhstan Botswana Nigeria Uzbekistan Turkmenistan Netherlands Norway Canada United States Australia Azerbaijan Chile Russian Federation 24 22 20 18 16 14 Source: International Telecommunication Union. 12 Human Capital 89 91 93 95 97 99 01 03 05 07 09 11 13 19 19 19 19 19 19 20 20 20 20 20 20 20 H Russia BRICS Average EU11 Average Resource Rich* (excluding Russia) Average uman capital is a vital asset for economic Source: World Bank, WDI 2014. growth. It is the ultimate source of innovation and productivity and one of the key mechanisms Figure 48: Quality of infrastructure, for transferring wealth across generations. Its Global Competitiveness Index pace of growth depends on the quantity and 5.5 quality of education (in the classroom and in on- 5.0 the-job training), on the quality of health care, and on the broader social environment. Education 4.5 and training institutions play a key role in 4.0 enhancing the productivity of capital by supplying well-trained graduates and developing innovative 3.5 ideas that improve existing technologies. Workers 3.0 whose skills are aligned more closely with the demands of firms are typically more productive 2.5 and contribute more to the country’s economic 09 0 1 12 13 14 7 8 -1 -1 -0 -0 growth. In addition, they tend to command higher - - - - 08 09 10 11 12 13 06 07 20 20 20 20 20 20 20 20 Russia EU11 Average BRICS Average (excluding Russia) Resource Rich** Average wages and enjoy lower levels of unemployment. By Source: World Economic Forum, Executive Opinion Survey Base period contrast, workers whose skills are misaligned with 2012–13 weighted average. Score 1 (low) to 7 (high). employers’ needs are likely to be unemployed, underemployed, or paid less than others. 44 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia Figure 50: The quality of human capital is higher The quality of Russia’s human capital is high. The than predicted by income per capita Human Development Index (HDI), a composite HDI Value, 2012 statistic of life expectancy, education, and income, 1.00 AUS USA NOR shows that the spectacular increase in income NLD 0.90 CAN per capita experienced in recent years has been CHI UAE SAU accompanied by improvements in health and 0.80 UKR AZE RUS education (Figure 50). At 9.8 years, the average VENKAZ MYS UZB years of schooling are high for Russia’s income 0.70 TKM BWA level, a legacy of the Soviet system of universal 0.60 education. Russia stands out among Eurasian y = 7E-06x + 0.6294 NIG R? = 0.7405 countries for better education attainment— 0.50 quantity of schooling—at all levels but more 0.40 strikingly at the tertiary level. 0 10,000 20,000 30,000 40,000 50,000 GDP per capita, PPP (constant 2005 international $), 2012 Yet, there appears to be a mismatch between Source: World Bank, UNDP 2013 and Barro and Lee. education achievement and employers’ Notes: HDI = Human Development Index; PPP = purchasing power parity. perceptions. The OECD PISA assessment reveals how the quality of education in Russian schools, perceptions paint a different picture, with the especially in Moscow and Saint Petersburg, is high perceived quality of education being lower than by international standards (Table 15). Business for comparators (Figure 51). On-the-job training, Table 15: Quality of education, OECD PISA scores, 2009 On the overall On the On the science Average reading scale mathematics scale scale Hong Kong-China 533 555 549 546 Singapore 526 562 542 543 Korea 539 546 538 541 City of Moscow 529 541 541 537 Canada 524 527 529 527 Australia 515 514 527 519 City of Saint Petersburg 510 523 501 511 Tymen Region 503 504 501 503 OECD Average 493 496 501 497 United States 500 487 502 496 North-West FD 482 496 482 487 Urals FD 467 483 476 475 Central FD 466 479 470 472 Siberia FD 461 486 463 470 Russian Federation 459 468 478 468 Privolzhsky FD 453 471 460 461 South FD 450 462 455 456 Far East FD 432 455 455 447 Chile 449 421 447 439 North-Caucasus FD 410 455 448 438 Source: OECD. Russia Economic Report | Edition No. 32 45 III. Paths to Diversified Development in Russia albeit improving, is still perceived as inadequate Institutions: Three essential functions (Figure 52), even though it plays an important role of government I in building human capital (Heckman, Lochner, and nstitutions are a fundamental asset for Taber 1998). Employee training also affects wage long-term economic development and are growth of young or highly educated employees particularly important in resource-abundant and training employees allows them to attain countries. They set the rules and norms by which and maintain the competencies required to bring economies and societies operate, shaping the productivity in line with market wages of older incentives of governments, individuals and firms. and low-educated workers (OECD, 2004). In resource-abundant economies, institutions make the difference between success and failure Further investment in human capital is crucial in in the long run. Building a sound institutional light of the sharp decrease in the working-age framework will ensure that natural assets are population expected in the next two decades. exploited responsibly and productively and that Current employment rates of 60 percent and a governments, individuals and firms have an labor force participation rate of 73 percent for the incentive to invest in physical and human assets. 15-64 year old population are low by international standards. Russia’s working age population is Russia lags in most dimensions of governance. expected to decline by over 5 percent by 2030 Inconsistent enforcement of laws and regulations (Arias et al. 2014), implying that more (and better) are typical symptoms of weak governance, investment in human capital is needed to ensure its and Russia is behind high-income resource- adequate contribution to growth. Between 1999 rich comparators in all elements of governance and 2012, investments in education averaged 3.4 and transparency. The World Bank’s Worldwide percent of GDP (16 percent of total investment in Governance Indicators (WGI) indicate that 2012). Health expenditures averaged 3.5 percent rule of law, corruption, regulatory quality and of GDP in the same period (17 percent of total accountability remain problematic, ultimately investment in 2012). Whereas efficiency and undermining the effectiveness of government effectiveness of public expenditures should be policy (Table 16). of paramount concern, absolute levels are low in international comparisons. In 1999-2012, high- Three government functions are essential: (i) income OECD countries spent, on average, over 5 the package of fiscal, monetary and exchange- percent of GDP on education and over 6 percent rate policies that allow managing the volatility on health. deriving from a concentrated export basket; Figure 51: Quality of education, Figure 52: Quality of on-the-job training, Global Competitiveness Index Global Competitiveness Index 4.5 5.0 4.0 4.5 4.0 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 1 12 3 4 7 8 9 10 -0 0 -0 -1 -1 1 - - 3- 7- 7 08 9 0 1 2 13 4 06 08 09 10 11 12 -0 -0 -1 -1 -1 -1 1 0 7- - 06 08 09 10 11 12 13 20 20 20 20 20 20 20 20 0 20 20 20 20 20 20 20 20 Russia BRICS Average (excluding Russia) Russia BRICS Average EU11 Average Resource Rich* Average EU11 Average Resource Rich* Average (excluding Russia) Source: World Economic Forum, Executive Opinion Survey Base period Source: World Economic Forum, Executive Opinion Survey Base period 2012–13 weighted average. Score 1 (low) to 7 (high). 2012–13 weighted average. Score 1 (low) to 7 (high). 46 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia Table 16: Quality of institutions, World Governance Indicators, 1996-2012 Political Average of Government Control of Stability and Regulatory Voice and Governance Rule of Law Effectiveness Corruption Absence of Quality Accountability Indicators Violence Netherlands 1.71 1.89 2.15 1.11 1.79 1.75 1.58 Norway 1.71 1.92 2.12 1.29 1.39 1.91 1.6 Canada 1.62 1.87 2.04 1.01 1.59 1.73 1.5 Australia 1.59 1.75 1.98 0.98 1.63 1.75 1.45 United States 1.32 1.64 1.51 0.44 1.54 1.55 1.22 Chile 1.15 1.21 1.43 0.56 1.48 1.25 0.98 Botswana 0.7 0.54 0.89 0.97 0.61 0.61 0.58 United Arab Emirates 0.49 0.85 0.84 0.86 0.66 0.54 -0.81 Malaysia 0.36 1.06 0.27 0.2 0.53 0.5 -0.39 Saudi Arabia -0.36 -0.2 -0.23 -0.29 0.03 0.16 -1.62 Ukraine -0.58 -0.68 -0.92 -0.21 -0.53 -0.85 -0.27 Kazakhstan -0.63 -0.6 -0.98 0.16 -0.4 -0.89 -1.06 Russian Federation -0.73 -0.47 -0.93 -1.05 -0.33 -0.89 -0.7 Azerbaijan -0.88 -0.8 -1.08 -0.79 -0.59 -0.88 -1.13 Venezuela, RB -1.02 -0.98 -1.01 -1.12 -1.07 -1.33 -0.62 Nigeria -1.14 -1.02 -1.11 -1.73 -0.89 -1.24 -0.84 Turkmenistan -1.32 -1.47 -1.25 0.15 -1.99 -1.42 -1.94 Uzbekistan -1.34 -1 -1.07 -1.16 -1.66 -1.27 -1.91 Source: World Bank. (ii) the capacity of the public administration in export performance, ups and downs of GDP to effectively deliver public services, such as growth, budget revenues, public spending/ health, education and infrastructure; (iii) and the investment, employment, inflation and exchange- ability to effectively regulate private enterprise rate behavior. guaranteeing a competitive environment. These are especially necessary for countries that have to Russia has established an institutional manage sizable resource rents, where weaknesses framework to manage macroeconomic volatility. in accountability and corruption can become International experience shows that stabilization sources of instability. funds are useful to ensure fiscal discipline (Sugawara, 2014). In 2004, Russia created Managing Volatility a Stabilization Fund tasked with absorbing R esource-rich economies usually face the excessive liquidity, reducing inflationary pressure challenge of uncertainty and volatility and insulating the economy from volatility of associated with the price and/or demand raw material export earnings. In February 2008, fluctuations for natural resources. Given the the US$160 billion Stabilization Fund was split importance of the extractive sector for such into the Reserve Fund and the National Welfare economies, volatility of resource flows may impact Fund, the later with the longer term purpose of broader macroeconomic parameters and lead bolstering the national pension scheme. to larger policy challenges, such as fluctuations Russia Economic Report | Edition No. 32 47 III. Paths to Diversified Development in Russia Despite an excessively expansionary fiscal policy utilization could also be improved with better during the boom years, the Reserve Fund proved targeting (or reallocation) of existing resources to to be useful during the last financial crisis. priority areas. During the height of the oil-price boom after 2005, Russia’s fiscal policy became increasingly Regulating Enterprise T expansionary and the Stabilization Fund failed to he government’s function in regulating private prevent rapid growth of government spending, enterprise is essential. Apart from imposing allowing more of the oil revenue windfall to pass additional costs, regulation can be manipulated through to the economy. The boom in credit with the objective of creating unfair competitive and in domestic demand was fed only-partial advantages for some firms (not necessarily the sterilization of oil revenue, the high liquidity from most productive) with welfare losses for the rest large capital inflows reflecting accelerated foreign of the economy. In the long run, an economy borrowing by state-owned enterprises (SOEs) and where competition is restricted by cumbersome the banking sector’s negative real interest rates, or captured regulation or by other means will and a tightly managed exchange rate. However, be less productive because some of its firms will during the 2008 crisis, the Reserve Fund played face reduced incentives to be efficient and adopt a key role in smoothing out public spending. new technologies (Nicoletti and Scarpetta 2003; The financial sector was also stabilized when Conway et al. 2007). The consequences may be the National Welfare Fund injected about US$30 particularly severe for economies that are far billion into three state-owned banks. from the technological frontier, since the ability to adopt new technologies is essential to productivity Providing Public Services growth and convergence to the levels of more I nstitutional changes have been taking place in the delivery of public services (World Bank, 2011b and 2001c). Some steps have been taken developed economies (Acemoglu et al., 2006). Many spheres of corporate activity in Russia in the introduction of program budgeting and are dominated by less-productive incumbents. performance arrangements in the civil service. These firms are likely to have privileged access to The system of inter-budgetary relationships has natural resources, markets, credit, and licenses. also improved, in particular as a result of the 2005 More efficient enterprises, especially small and Budget Law, which led to a more clear assignment medium firms and start-ups, cannot compete with of fiscal spending and service provision public-sector entities and incumbent firms on an responsibilities across levels of government. equal footing, with the result that the best firms Ambitious national projects embracing education, do not emerge or do not survive small slumps health and other areas (e.g., provision of housing) while inefficient firms remain dominant and overall have been launched, and significant public funds productivity suffers. are spent through those programs. However, due to regional differences in the commitment and the Trade and competition policy have been used capacity to implement the reforms, the progress to protect incumbents and have contributed to has been quite uneven. market fragmentation. Tariffs have progressively replaced non-tariff barriers as the principal Russia still has much scope for efficiency- instrument for regulating foreign trade, but enhancing reforms. The allocation of resources average tariff rates and tariff dispersion were still can be improved by generating savings with sector higher in Russia than in all OECD countries in the reforms (for example, in health, education and mid-2000s, providing some degree of isolation transport) and strengthening the system of inter- from international competition. Isolation from budgetary transfers to better reflect priorities global markets may induce companies to choose and support efficiency-enhancing reforms in less-modern technology and operate at suboptimal the regions. The efficiency of public resource scale, thus reducing productivity. Around half of 48 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia Russia’s firms consider local markets their main Figure 53: Restrictiveness in competition, OECD Product Market Regulation Index sales destination—a large proportion, even relative to economies of comparable size and structure 4.5 such as Brazil, where the number is about 35 4 percent. Two factors could potentially explain 3.5 market fragmentation and uncompetitive markets: 3 high transport costs related to limited transport 2.5 infrastructure and long distances, and, in countries 2 1.52 with some degree of regional autonomy, additional 1.5 barriers created by interventions of regional 1 governments that hamper the entry of firms from 0.5 outside the region. Russian consumers and firms 0 face prices 20 percent higher than in comparable Product Market Regulation (PMR) State Control Barriers to Enterpreneurship Barriers to Trade and Investment economies, with regional price dispersion in key Russia 2008 OECD Average 2008 OECD Average 2013 sectors (pharmaceuticals, communication services, Source: OECD (2013), Economy-wide regulation, OECD Product and retail gasoline) exceeding what would be Market Regulation Statistics. explained by other factors that can be assumed to Note: *Index scale: 0-6, where 6 is more restrictive. OECD average does not include U.S., Turkey, Poland, Mexico, and Luxembourg. affect prices, such as distance to markets and level of economic activity (World Bank, 2013). 50 percent in gas, electricity, air transport, and telecommunications (World Bank, 2013). Russia’s product market policies are more restrictive of competition. The high degree of state The current state-aid regime can distort the control, as well as statutory and regulatory barriers market and stifle emergence and survival of to entrepreneurship and to trade and investment, more efficient players. Russia regulates the all contribute to stifling the development of a provision of state aid in its competition law and productive enterprise sector (Figure 53). allows exceptions for various forms of state aid to specific industries, firms, or regions. Incumbent State ownership in Russia is heavy by international firms receive preferential treatment from standards. Enterprises owned by federal or lower federal and regional authorities in various forms levels of government accounted for 19 percent including tax breaks (or arrears), investment of employment in 2009. SOEs occupy dominant credits, direct subsidies, guaranteed loans, market positions in their areas of activity, with access to state property, and the creation of scope for private participation, including that by special economic zones on the sites of specific foreign investors, tightly controlled.24 National enterprises. State support is often based on a and subnational governments controlled at least firm’s affiliation to business associations and ties one firm in 16 economic sectors, versus only nine dating from the Soviet era, to the detriment of in the typical OECD economy in the late 2000s new entrants. Asymmetric application of state (Conway et al. 2009). State ownership is markedly aid rules is particularly acute at the regional level pronounced in infrastructure/network industries. and is a source of regional variability in the broad The government has 100 percent market share in competition regime. rail transport and postal services and more than 24 The share of foreign participation in the average Russian company was 2.7 percent in 2007 compared with 7.5 percent in the EU’s new member states. Russia Economic Report | Edition No. 32 49 III. Paths to Diversified Development in Russia 3.4 Rebalancing Russia’s Asset Portfolio With Transparent Rules, Better Public Investment And Competition T o sustain long-run growth, Russia needs to leverage its abundant assets and build up its less abundant ones. The country is well endowed large outlays on explicit and implicit subsidies and transfers. Bhattacharyya et al. (2011) use the Hall and Jones (1999) institutions index to with natural resources and human capital. It proxy for “social infrastructure” and find that the has begun to rebuild its physical capital. The resource curse is experienced only by countries greatest weaknesses are in the institutions for the below a certain threshold. Improving the quality regulation of private enterprise. Relatively low of institutions is therefore essential for Russia and inefficient investments in physical capital, low to escape the trap of low public capital. Overall, labor force participation and weak productivity Russia does not have to increase spending by have shown the limitations of growth driven by much: increasing gross fixed capital formation to high commodity prices and utilization of spare about 25 percent of GDP, as recommended by the capacity. Russia can return to a sustainable growth Growth Commission, may be enough. No more path by leveraging the assets it has and by building than a third of this increase needs to be public up those that are more deficient. investment. The rest could be private, brought about simply by improving the investment climate. To achieve higher growth Russia needs to increase the contribution of labor and capital and More transparent rules for investors would remove constraints to economic efficiency. At just enhance the contribution of natural resources over 20 percent of GDP, Russia has relatively low to Russia’s growth. After 2004, the Russian investment. It also faces challenging demographic government increased taxes and intervened conditions: an aging population, low birth rates, more frequently in the oil industry. The growth in and imminent decreases in working-age cohorts, Russia’s oil production dropped from 7 percent in pointing to a limited contribution of labor to 2001–2005 to about 1.5 percent in 2006–2011. The future growth. The first key to future growth gas industry has remained a national monopoly, lies in improvements in the quality of physical probably limiting efficiency and reducing the scope and human capital. It will be equally important for the discovery and exploitation of untapped to remove structural constraints to total factor reserves. The potential for discovering additional productivity, the efficiency with which factors reserves of both oil and gas would be enhanced if of production are employed. More responsible more risk capital and better technology could be use of natural resources, more transparent rules deployed for more intensive exploration in more for investors, better planning and monitoring of difficult terrain (IEA 2011). public investment, and a stronger competition framework would appear to be the priorities for Better prioritization of expenditures and focus the next decade. on results will strengthen the quality of public service provision. Greater attention should be The ultimate reasons of low investment are paid to planning, monitoring and evaluation of institutional, rather than the proximate cause public investment expenditures in education, of limited fiscal space. Resource-rich countries health and infrastructure. Russia could follow require much stronger institutions and political the lead of advanced OECD countries and shift commitment than resource-poor economies. The to performance-oriented public sectors that pervasive nature of resource rents can result in emphasize efficiency and accountability. This lower-than-optimal government investment and requires systems to monitor results, including 50 Russia Economic Report | Edition No. 32 III. Paths to Diversified Development in Russia enlisting private companies, academic institutions, Effective competition policy will increase the and nongovernmental organizations to monitor productivity of the business sector. Entry and exit indicators of public-service delivery. The role of conditions need to allow firm churning, so that external performance audits will also become more productive firms survive and prosper and important in ascertaining that delivery units obsolete ones exit. This is what allows increases in comply with their delivery obligations, on the aggregate productivity. An effective competition basis of which they receive budget financing. policy framework would enforce antitrust rules This approach would require systematic reviews for private and state-owned firms, help reduce of public spending to identify the scope for wasteful state aid and ensure that the benefits service delivery improvements and to advance of competition are understood and appreciated institutional reforms (World Bank, 2011c). by policymakers, firms and consumers. Specific measures that would have tangible effects in Increased private participation could improve Russia could include broadening the mandate of the quantity and quality of the delivery of public the Federal Antimonopoly Service on state aid services. One option widely used at international regulation to diminish firm- and sector-specific level is to establish public-private partnerships state aid; creating an inventory of state aid; (PPPs) as an alternative to more traditional aligning state aid regulation with international arrangements. International experience shows best practices and eliminating preferential that different incentives, combined with an treatment to enterprises owned by states or adequate legal framework, have to be in place in municipalities (World Bank, 2013). Sector- order to ensure sustainability of PPPs, as well as to specific policies in key service industries such maximize and improve the use of resources. as transport, construction, and professional services would further increase competition and reduce prices for firms and households. Russia Economic Report | Edition No. 32 51 REFERENCES ▪ Acemoglu, Daron, Philippe Aghion and Fabrizio Zilibotti. 2006. “Distance to Frontier, Selection, and Economic Growth.” Journal of the European Economic Association, 4, 1, pp. 37-74. ▪ Arias, Omar S., Carolina Sánchez-Páramo, María E. Dávalos, Indhira Santos, Erwin R. Tiongson, Carola Grun, Natasha de Andrade Falcão, Gady Saiovici, and Cesar A. 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Russia Economic Report | Edition No. 32 53 Annex: Main indicators 54 2013 2014 Output Indicators 2013 2007 2008 2009 2010 2011 2012 Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug 1/ GDP, % change, y-o-y 8.5 5.2 -7.8 4.5 4.3 3.4 - 1.2 - - 1.3 1.3 - - 0.9 - - 0.8 - - Industrial production, % change, y-o-y 6.8 0.6 -10.7 7.3 5.0 3.4 -0.2 1.3 1.0 2.8 0.4 0.4 -0.2 2.1 1.4 2.4 2.8 0.4 1.5 0.0 Manufacturing, % change, y-o-y 10.5 0.5 -15.2 10.6 8.0 5.1 -0.7 1.1 0.6 4.8 1.7 0.5 0.0 3.4 3.5 3.9 4.4 0.3 2.4 -0.6 Extraction of mineral resources, % change, y-o-y 3.3 0.4 -2.8 3.8 1.8 1.0 1.0 1.9 1.7 1.8 2.0 1.1 0.9 0.8 0.6 1.1 0.9 0.8 0.2 0.8 Fixed capital investment, % change, y-o-y 23.8 9.5 -13.5 6.3 10.8 6.8 -1.8 -1.3 -0.1 0.4 0.6 -0.2 -7.0 -3.5 -4.3 -2.7 -2.6 0.5 -2.0 -2.7 Fiscal and Monetary Indicators Federal government balance, % GDP 1/ 5.4 4.5 -5.9 -4.1 0.8 -0.1 0.9 1.2 1.1 1.0 -0.5 -0.5 9.7 0.3 0.7 0.3 1.4 1.9 1.7 - Russia Economic Report | Edition No. 32 M2, % change, p-o-p 2/ 51.3 27.2 -3.5 30.6 23.3 17.9 0.2 -0.5 -0.3 2.2 7.7 15.4 -4.0 1.1 -2.2 1.2 0.3 0.6 0.3 - Inflation (CPI), % change, p-o-p 9.0 14.1 11.7 6.9 8.5 5.1 0.1 0.2 0.6 0.6 0.5 6.8 0.6 0.7 1.0 0.9 0.9 0.6 0.5 0.2 Producer price index (PPI), % change, p-o-p 25.1 -7.0 13.9 16.7 13.0 6.8 2.8 1.4 -1.2 -1.5 1.0 3.5 0.4 -0.4 2.3 0.7 0.4 0.8 1.6 Nominal exchange rate, average, Rb/USD 25.6 24.8 31.7 30.4 29.4 31.1 33.0 32.6 32.1 32.6 32.9 31.8 33.5 35.2 36.2 35.7 34.9 34.4 34.6 36.1 Reserve Fund, bln USD e-o-p - 137.1 60.5 25.4 25.2 62.1 85.4 86.4 87.2 86.9 87.4 87.4 87.1 87.5 87.5 87.9 87.1 87.3 86.6 91.7 National Wealth Fund, bln USD, e-o-p - 88.0 91.6 88.4 86.8 88.6 86.8 88.0 88.7 88.1 88.6 88.6 87.4 87.3 87.5 87.6 87.3 87.9 86.5 85.3 Reserves (including gold) billion $, end-o-p 478 427 439 479 499 538 510 523 524 516 510 510 499 493 486 472 467 478 469 465 Balance of Payment Indicators Trade Balance, billion $ (monthly) 123.4 177.6 113.2 147.0 196.9 191.7 14.0 15.9 12.7 16.6 15.8 181.9 18.7 12.4 19.6 19.8 18.3 14.0 17.1 - Current Account, billion $ 72.2 103.9 50.4 67.5 97.3 71.3 - -0.7 - - 8.0 34.1 - - 27.1 - - 17.1 - - Export of goods, billion $ 346.5 466.3 297.2 392.7 515.4 528.0 42.6 44.8 43.6 46.7 49.2 523.3 39.7 36.5 47.1 47.5 44.3 40.7 46.1 - Import of goods, billion $ 223.1 288.7 183.9 245.7 318.6 335.7 28.6 28.9 30.9 30.2 33.4 343.0 21.0 24.0 27.4 27.6 26.0 26.8 29.0 - Gross FDI, mln USD1/ 27,797 27,027 15,906 13,810 18,415 18,666 - 18,610 - - 26,118 26,118 - - n/a - - - - - Financial Market Indicators Average weighted lending rate for enterprises, %3/ 10.8 15.5 13.7 9.1 9.3 9.4 9.3 9.5 9.2 9.0 9.4 9.4 9.2 9.4 10.3 10.5 10.6 10.7 10.7 - CBR policy rate, %, end-o-p 10.0 9.5 6.0 5.0 5.3 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 7.0 7.5 7.5 7.5 8.0 8.0 Real average rate for Ruble loans, % (deflated by PPI) -3.4 -6.8 -0.1 -6.5 -3.2 3.9 4.5 7.5 7.1 7.3 5.5 5.5 4.3 6.0 5.0 3.1 1.6 1.7 1.6 - Stock market index (RTS, ruble term, eop) 2,291 632 1,445 1,770 1,382 1,527 1,291 1,422 1,480 1,403 1,443 1,443 1,301 1,267 1,226 1,156 1,296 1,366 1,219 1,190 Income, Poverty and Labor Market Real disposable income, (1999 = 100%) 245.6 251.5 259.3 272.5 274.7 286.2 288.9 277.3 292.3 301.6 425.0 295.7 204.4 273.1 262.2 304.9 276.6 291.0 291.8 301.5 Average dollar wage, US $ 532 697 588 698 806 859 885 899 938 928 1,205 942 838 812 882 923 929 1,003 910 854 1/ Share of people living below subsistence, % 13.3 13.4 13.0 12.5 12.7 10.7 - 12.6 - - 11.0 11.0 - - 13.8 - - 13.1 - - Unemployment (%, ILO definition) 6.1 7.8 8.2 7.2 6.1 5.1 5.2 5.3 5.5 5.4 5.6 5.6 5.6 5.6 5.4 5.3 4.9 4.9 4.9 - Source: Rosstat, CBR, EEG, IMF, staff estimates. 1/ Cumulative from the year beginning. 2/ Annual change is calculated for average annual M2. 3/ All terms up to 1 year. 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