This report is produced twice a year by World Bank economists in the Macroeconomics, Trade and Investment (MTI) Global Practice. The team that prepared this edition was led by Apurva Sanghi (Lead Economist for the Russian Federation, asanghi@worldbank.org) and consisted of Olga Emelyanova (Economist, GMTE2), Mikhail Matytsin (Research Analyst, GPV03), Irina Rostovtseva (Research Analyst, GMTE2), Katerina Levitanskaya (Senior Financial Sector Specialist, GFCE1), Eva Gutierrez (Lead Financial Sector Specialist, GFCEE), Yoki Okawa (Economist, DECPG), Peter Stephen Oliver Nagle (Economist, DECPG), Christopher David Miller (Program Leader, ECCRU), Tigran Shmis (Senior Education Specialist, EDU), Maria Ustinova (Consultant, EDU). Peer reviewers included Yaroslav Baklazhansky (Advisor, Macroeconomic Policy Department, Eurasian Economic Commission) and Kevin Carey (Practice Manager, MTI). The report was edited by Christopher Pala (Consultant), and the graphic designer was Robert Waiharo (Consultant). The team would like to thank Andras Horvai (Country Director for Russia), Sandeep Mahajan (Practice Manager, MTI Global Practice), Donato De Rosa (Lead Economist, GMTE1), and Sergei Ulatov (Director for coordination, Eurasian Development Bank) for their advice and support. The team also would like to express their gratitude to the Department for Research and Forecasting of the Central Bank, Department for Macroeconomic Forecasting of the Ministry of Economic Development, Department for the budget policy and strategic planning of the Ministry of Finance and the IMF for the collaboration. This report went to press on December 4, 2018. TABLE OF CONTENTS ACRONYMS AND ABBREVIATIONS . ............................................................................................................................. i EXECUTIVE SUMMARY................................................................................................................................................... iii I. RECENT ECONOMIC DEVELOPMENTS .................................................................................................................... 1 1.1 Global growth: weighed by weakening recovery in trade and manufacturing................................................ 2 1.2 Russia: growth momentum slowed down in the third quarter. ...................................................................... 6 1.3 Balance of payments: current account surplus widened, capital outflows increased.................................... 10 1.4 Labor market and poverty trends: unemployment declines and wages are recovering................................. 12 1.5 Monetary policy: after a prolonged period of loosening, the Central Bank hiked the policy rate in September in the face of elevated inflationary risks....................................................................................... 14 1.6 The banking sector: largely stable despite remaining weaknesses and increasing concentration.................. 17 1.7 Fiscal policy: reforms are planned to support the ambitious goals set in the President’s May Decree........... 20 II. GROWTH CONTINUES, BUT RISKS ARE ELEVATED........................................................................................... 29 III. POTENTIAL GROWTH: OUTLOOK AND OPTIONS FOR RUSSIA ....................................................................... 35 3.1 Evolution and drivers of potential growth in the short- and long- term: productivity, capital, and labor ...... 36 3.2 Russia’s potential growth: outlook................................................................................................................... 38 3.3 Boosting potential growth: role of pensions, migration, investment and productivity................................... 39 3.4 Can Russian potential growth match global growth?...................................................................................... 40 LIST OF FIGURES Figure 1: Global growth is broadly stable ...................................................................................................................... 2 Figure 2: Trade Policy uncertainty is rising..................................................................................................................... 3 Figure 3: Capital flows to EMDEs are declining.............................................................................................................. 3 Figure 4: Crude oil prices have averaged USD 70 / bbl in 2018 so far............................................................................ 4 Figure 5: Production by Russia and Saudi Arabia significantly increased this year, in response to concerns about a shortfall in supply............................................................................................................................... 4 Figure 6: Metals and agricultural prices declined in the third quarter of 2018.............................................................. 4 Figure 7: Growth continued in 2018............................................................................................................................... 6 Figure 8: Within tradeable sectors, manufacturing was the main engine of growth in the first half of 2018 . ............. 6 Figure 9: Contribution to growth from retail and wholesale trade, transportation, and hotels and restaurants increased in the second quarter in view of the FIFA World Football Cup . ..................................................... 7 Figure 10: Net exports became main growth driver in the second half of 2018.............................................................. 7 Figure 11: Share of oil/gas products totaled about 59 percent in export of goods in 2017............................................. 7 Figure 12: Russia has made some progress in export diversification (2013 - 2017)......................................................... 8 Figure 13: In Russia and Kazakhstan export diversification happened mainly through active (as opposed to new) lines of products.............................................................................................................................................. 8 Figure 14: Azerbaijan succeeded best in introducing new export lines, Russia least ...................................................... 9 Figure 15: Russia’s progress in integration into the global economy through global value chains was limited............... 9 Figure 16: Employment in manufacturing decreased...................................................................................................... 9 Figure 17: FDI in oil and gas sector outperformed FDI in manufacturing in 2014-2017. .................................................. 9 Figure 18: The current account surplus widened............................................................................................................. 10 Figure 19: Non-oil/gas export volume growth was robust in the first half of 2018 . ....................................................... 10 Figure 20: Import growth decelerated in 2018................................................................................................................ 11 Figure 21: Labor force and employment (mln people) . .................................................................................................. 12 Figure 22: Unemployment rate........................................................................................................................................ 12 Figure 23: Real incomes dynamics . ................................................................................................................................. 13 Figure 24: Real wages growth by sector........................................................................................................................... 13 Figure 25: The CBR hiked its key policy rate by 25 bp in September ............................................................................... 15 Figure 26: Inflation rose but remained below the CBR’s target . ..................................................................................... 15 Figure 27: Inflation expectations are high........................................................................................................................ 16 Figure 28: Non-food products influence the headline inflation ...................................................................................... 16 Figure 29: Ruble depreciation since the beginning of 2018............................................................................................. 16 Figure 30: Overall financial sector indicators remained broadly stable . ......................................................................... 17 Figure 31: Credit growth is higher in the retail segment.................................................................................................. 17 Figure 32: Budget balance improved at all levels of the budget system.......................................................................... 21 Figure 33: The growth forecast for Russia suggests benign growth ................................................................................ 31 Figure 34: Slower potential growth was driven by TFP growth slowdown and decline in labor force............................. 37 Figure 35: Russia’s Investment-to-GDP ratio stopped increasing, and its capital-to-GDP ratio remains low................... 37 Figure 36: Russia’s potential growth is expected to decline slowly due to declining productivity growth . .................... 38 Figure 37: The simulated effects of pension reform in Russia ......................................................................................... 39 Figure 38: Comprehensive reforms can raise potential growth to the global growth...................................................... 41 LIST OF TABLES Table 1: Balance of payments, 2015 – 2018..................................................................................................................... 11 Table 2: Poverty................................................................................................................................................................ 13 Table 3: Budget system balances...................................................................................................................................... 22 Table 4: Global growth is broadly stable . ........................................................................................................................ 30 Table 5: Projected growth rates are modest.................................................................................................................... 31 Table 6: The moderate poverty rate is expected to continue to decline in 2018 and throughout 2020.......................... 32 LIST OF BOXES Box 1: Recent development in major economies.......................................................................................................... 3 Box 2: The Russian oil and gas sector: record levels of production............................................................................... 4 Box 3: Halving Poverty in Russia by 2024: What will it take?........................................................................................ 14 Box 4: Stock of household debt is at maximum levels. .................................................................................................. 18 Box 5: Russian Government and Central Bank propose measures to expand access to finance for SMEs . ................. 19 Box 6: The proposed VAT rate increase would have a relatively neutral effect on the overall income distribution ..... 23 Box 7: Russia’s new Pension Law................................................................................................................................... 24 Box 8: Russia performs well and achieves a lot in terms of ensuring the equal access and quality of education for students, yet there are some problematic areas that need to be tackled.......................................................... 26 Box 9: Competition conditions in Russia have not improved as rapidly as broader investment climate conditions yet there are some problematic areas that need to be tackled . ....................................................................... 33 Box 10: Russia continued its efforts to enhance the regulatory environment for small and medium enterprises carrying out four reforms in the past year.......................................................................................................... 34 ACRONYMS AND ABBREVIATIONS AE Advanced Economy APR Annual Percentage Rate Bbl Oil Barrel BRICS Brazil, Russia, India, China, and South Africa (emerging economies) BP British Petroleum BSCF Banking Sector Consolidation Fund CBR Central Bank of the Russian Federation CPS Collaborative Problem Solving CPI Consumer Price Index EAEU Eurasian Economic Union EM Emerging Markets EMDEs Emerging Markets and Developing Economies EU European Union FAS Federal Antimonopoly Service FDI Foreign Direct Investment FIFA Fédération Internationale de Football Association FX Foreign Exchange GDP Gross Domestic Product GNFS General Number Field Sieve HBS Household Budget Survey HSE Higher School of Economics HSI Human Capital Index ILO International Labor Organization IMF International Monetary Fund LNG Liquified Natural Gas NPL Non-Performing Loan OECD Organization for Economic Co-operation and Development OFZ Federal Loan Bonds OPEC Organization of the Petroleum Exporting Countries PIRLS Progress in International Reading Literacy Study PISA Program for International Student Assessment PP Percentage point PPP Public–Private Partnership REER Real Effective Exchange Rate RLMS Russia Longitudinal Monitoring Survey Rosstat Russian Federal State Statistics Service SAR Special Administrative Region SMEs Small and Medium-Sized Enterprises SOE State Owned Enterprise TFP Total Factor Productivity TIMSS Trends in Mathematics and Science Study VAT Value-Added Tax WB The World Bank WITS World Integrated Trade Solution WTI West Texas Intermediate WTO World Trade Organization y-o-y Year-on-year i Russia Economic Report | Edition No. 40 EXECUTIVE SUMMARY I. The Global economy and oil prices Figure 1a: Global growth is broadly stable G lobal growth is broadly stable but downside risks from rising trade tensions are increasing. A weakening recovery in trade and manufacturing (Percent) 5.0 4.3 4.3 4.5 4.7 4.7 4.5 activities is weighing down global growth (Figure 4.0 3.7 3.7 1a). Global goods trade has decelerated more 3.5 3.1 3.1 3.0 2.9 3.0 2.8 2.8 rapidly than expected. U.S. tariffs and the retaliatory 2.5 2.3 2.4 2.3 2.2 1.9 2.0 responses of its trading partners have affected 2.0 1.7 1.7 2.5 percent of global goods imports. Surveys of 1.5 1.0 companies in the U.S., China and Japan suggest 0.5 that the risks of a trade war have not yet fully 0.0 2014 2015 2016 2017 2018f 2019f 2020f materialized. While the Eurasian Union (excluding World Advanced economies EMDEs Russia) posted strong growth in 2018, Russia’s main trading partners – the Euro area and China – ons). Source: World Bank (current working assumpti experienced a growth slowdown (Box 1). Figure 2a: Capital flow to EMDEs is declining (US$, billions) Financial conditions for Emerging Markets and 60 Developing Economies (EMDEs) are tightening. Divergent monetary policies and growth prospects 40 among the U.S. and other major economies contributed to a significant appreciation of the 20 U.S. dollar in 2018. This, together with intensifying 0 trade tensions, deteriorating growth prospects and renewed attention to external vulnerabilities -20 has contributed to significant depreciations and -40 capital outflows in many EMDEs. EMDE currencies Jan-17 Mar-17 Apr-17 May-17 Feb-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Mar-18 Apr-18 May-18 Feb-18 Jun-18 Jul-18 Aug-18 fell – including the Russian ruble – and cumulative portfolio outflows from EMDEs surpassed those tute of Internati Source: Insti onal Finance and World Bank seen after the 2013 taper tantrum. Economies with external vulnerabilities, including Argentina, expected to average USD71/bbl over the next three Indonesia, and Turkey, experienced the sharpest years. They remain volatile, with the price of Brent, currency depreciations. While the spillover the international marker, ranging from USD59/ from those countries has been limited, the bbl to USD86/bbl in 2018. The announcement of intensification of turmoil could lead investors to U.S. sanctions on Iran and declining production reevaluate their exposure to EMDEs and to capital in Venezuela supported prices in September and outflows (Figure 2a). early October. However, prices fell sharply in early November after the U.S. announced it would grant Oil prices have risen this year and remain volatile waivers to its sanctions on Iran to eight countries, as Russia’s oil production reached an all-time high. including China, and India. This, combined with Oil prices have averaged USD70/bbl in 2018 so far an upward revision to production in the U.S., and (up 33 percent from their 2017 average) and are increased production by both OPEC members and iii Russia Economic Report | Edition No. 40 Executive Summary their non-OPEC allies, is causing concerns in the increased geopolitical tensions, exacerbated by markets that a supply shortfall might be followed higher risk perception for emerging economies, by an oversupply. Production in Russia reached an resulted in increased net capital outflows from 1.1 all-time high of 11.4 mb/d in October (Figure 3a). percent of GDP in January – September 2017 to about 3.4 percent of GDP in the same period this II. Russia’s economic performance in 2018 year. These outflows were mainly driven by the G sell-off of OFZ bonds and slump in incoming FDI rowth momentum in Russia increased in the first (reflecting reduced interest of foreign investors half of 2018, supported by robust global growth, in Russian assets). Driven largely by increasing rising oil prices and a macro policy framework that oil prices the current account surplus widened to has promoted stability. Real GDP growth totaled 1.3 about 6.3 percent of GDP in January – September percent y/y in the first quarter of 2018 and 1.9 percent 2018 (from 1.7 percent in the same period last y/y in the second. It was broad-based and in line with year). Overall, a sound macroeconomic framework the economy’s potential. Non-tradable sectors were with relatively high levels of international reserves the main growth drivers in the first half of 2018. In the (USD461 billion), low external debt levels (about 29 tradable sectors, manufacturing was the main driver. percent of GDP), and a comfortable import cover Growth in mineral-resource extraction was limited (15.9 months) positions Russia well to absorb until June 2018 by the OPEC+ agreement, supported external shocks. by Russia (Box 2). Monetary policy remained consistent with the However, preliminary estimates suggest that inflation-targeting regime. Since July, inflation has growth momentum appears to have weakened in been increasing, but stayed below the CBR’s target the third quarter of 2018. Third quarter growth is level of 4 percent in annual terms, with non-food expected to be 1.3 percent, y/y. This slowdown is on products contributing the most to headline inflation the back of a weaker harvest, sluggish performances (Figure 5a). After a prolonged period of monetary in manufacturing and construction, and the waning loosening, the Central Bank hiked the policy rate effects from the World Football Cup (Figure 4a). in September from 7.25 percent to 7.5 percent in the face of elevated inflationary risks (ruble Net capital outflows increased because of turbulence depreciation prompted by elevated geopolitical in emerging markets and elevated geopolitical tensions and turbulence in emerging markets and tensions. The recent expansion of sanctions and the planned hike in the VAT). Figure 3a: Russian production of hydrocarbons has Figure 4a: Growth momentum has slowed reached record highs (Mb/d) 12 6 130 5 120 10 4 110 3 100 U.S. Dollars 2 90 Percent 8 1 80 0 70 6 -1 60 -2 50 4 -3 40 -4 30 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2 2012 2013 2014 2015 2016 2017 2018 2006 2008 2010 2012 2014 2016 2018 GDP growth, percent, y/y GDP growth, percent, qoq, sa U.S. Russia Saudi Arabia Oil price, Brent, US/bbl (rhs) onal Energy Agency. Source: Internati Source: Rosstat. iv Russia Economic Report | Edition No. 40 Executive Summary Figure 5a: Inflation rose but remained below the Figure 6a: Overall financial sector indicators remained CBR’s target broadly stable (CPI index and its components, percent, y-o-y) (Key credit and performance indicators, percent) 25 16 14 20 12 10 15 8 10 6 4 5 2 0 0 Oct -15 Oct -16 Oct -17 Oct -18 Apr -15 Apr -16 Apr -17 Apr -18 Jul-15 Jul-16 Jul-17 Jul-18 Jan-15 Jan-16 Jan-17 Jan-18 -5 Ap 5 Ju 5 Oc 5 Ja 5 Ap 6 Ju 6 Oc 6 Ja 6 Ap 7 Ju 7 Oc 7 Ja 7 Ap 8 Ju 8 Oc 8 8 1 r-1 l-1 t-1 1 r-1 l-1 t-1 1 r-1 l-1 t-1 1 r-1 l-1 t-1 n- n- n- n- Capital adequacy ratio NPLs to total loans Ja Core inflation CPI inflation Food inflation Loan loss provisions to total loans Return on assets Non- food inflation Services inflation Return on equity cs. Source: CBR and Haver Analyti Source: CBR. The banking sector is relatively weak but stable, owned banks, including systemically important with lending growth resuming across various ones. The CBR intends to privatize these banks sectors. Despite recent bailouts and a continuing once recapitalization procedures are complete and sector clean-up, Russia’s banking sector remains market conditions become more favorable. With relatively weak with less capital buffer (12.2 percent increasing public dominance in the financial sector, as of end-September) and a higher NPL ratio (10.8 private and smaller banks find it more difficult to percent as of end-September, Figure 6a) than other compete as public banks often enjoy preferential BRICS (15.6 percent and 4.4 percent, respectively). access to government programs, clients, cheaper However, credit is expanding, albeit at a differential funding and large distribution networks. Increasing pace across various segments (by 9.7 percent, y/y in competition in the financial sector has thus become the corporate sector compared to 22.5 percent for one of the priorities of the CBR’s financial sector households as of end-October). To address the risks development strategy for 2018-2021. linked to accelerated consumer lending growth, predominantly driven by unsecured loans and The fiscal balance improved at all levels of the mortgage loans, CBR tightened its risk-weighting budget system. The general government surplus requirements for unsecured consumer loans with an widened in the first nine months of 2018 (to 4.7 annual percentage rate (APR) in the range of 10-30 percent of GDP compared to 0.6 percent in the percent, with plans to further tighten requirements same period last year); the federal budget deficit in for mortgage loans with lower down payments. 2017 (of 0.3 percent) turned into a surplus of 3.6 percent in the first ten months; and the consolidated However, concentration and public dominance in regional budget surplus improved to 1.0 percent the banking sector increased even further. Five of GDP from 0.8 percent of GDP in the first nine large banks control 60 percent of the system’s months of 2018 (Figure 7a). The across-the-board assets – up from 52 percent at the end of 2013. improvement in the fiscal stance was due to higher Furthermore, state-owned entities account for oil prices, combined with a weaker ruble, a better nearly 70 percent of Russian bank assets. One tax administration and a conservative fiscal policy. reason for this increase was an establishment of The reduction in the non-oil/gas primary deficit is the recent Banking Sector Consolidation Fund noteworthy, from 5.9 percent of GDP in 2017 to 4.3 (BSCF) by the CBR to resolve insolvent financial percent in the first ten months. institutions. The BSCF took control of eight privately v Russia Economic Report | Edition No. 40 Executive Summary Figure 7a: Budget balance improved at all levels of the - Streamlining taxation of the oil sector by 2024 budget system (would mobilize revenues worth 0.2 to 0.4 (Percent of GDP) percent of GDP in 2020 and 2021); and 5 - Raising the retirement age (would mobilize 4 revenues in the long-term; see Box 7). 3 2 The government also plans a temporary relaxation 1 of the fiscal rule in 2019 – 2024. In this period, instead of targeting a zero federal budget primary 0 deficit (at the benchmark oil price of USD 40 per -1 barrel in 2017 prices), the fiscal rule would now General Government Federal Budget Regional Budget Budget Balance Balance Balance target a deficit of 0.5 percent. This expenditure 9 months of 2017 9 months of 2018 increase (of 0.5 percent of GDP) would be financed Source: EEG. Notes: The federal budget balance is for 10 months of 2018. mainly via domestic debt issuance. The funding of the “May Decree” goals put an Prima facie, while fiscal risks would increase with impetus on revenue mobilization but increases higher debt level, they are contained, given Russia’s fiscal risks. To boost growth, in May 2018, the sound macro fundamentals. The federal budget President issued a “May Decree” which introduced is expected to register surpluses of 1.8 percent of a set of goals to be reached by 2024. These goals GDP, 1.1 percent of GDP, and 0.8 percent of GDP have already moved the government to increase in 2019, 2020 and 2021. The general government spending on education, health, infrastructure, budget is expected to register surpluses of about social policy, digital economy, support of SME and the same scale. A temporary relaxation of the fiscal exports starting in 2019. Twelve national projects rule would increase the public debt. However, and the comprehensive plan for modernization Russia’s public debt is low (15.5 percent of GDP in and expansion of infrastructure are included in the 2017 compared to the OECD average of 73 percent), federal budget for this purpose. Additional budget and the Russian domestic bond market (of about 19 spending in these areas is expected to be about 8 trillion rubles) is sizable compared to the additional trillion rubles over six years (or about 1.1 percent of issuance (of about 1.5 trillion rubles). annual GDP, on average). As a result, overall federal budget spending is expected to total 17.0 percent There is room to mobilize more revenues. To fit in of GDP in 2019, 17.2 percent of GDP in 2020, and higher spending, other measures such as increasing 16.9 percent of GDP in 2021 (compared to previous tobacco taxation and cutting tax expenditures (by plans of spending 15. 9 percent of GDP in 2019, and reconsidering and reducing preferential tax rates), 15.6 percent of GDP in 2020). The most important currently estimated at 2.8 percent of GDP, can help steps to mobilize revenues for the May Decree mobilize more revenues. goals include: - Increasing the VAT rate from 18 to 20 percent (would mobilize revenues worth 0.5 to 0.6 percent of GDP annually; also see Box 6 for distributional impact of VAT increase); vi Russia Economic Report | Edition No. 40 Executive Summary III. Russia’s medium-term economic prospects: Export diversification is limited. Since 2014, 2018 – 2020 Russia’s non-energy export volume growth has R ussia’s growth prospects for 2018-2020 remain been outpacing that of energy and contributing modest, forecasted at 1.5 to 1.8 percent (Figure to export diversification. Yet Russia’s progress in 8a). This suggests that growth rates in Russia will stay export diversification is limited, with the share below the EMDE average (4.6 percent) and exceed of oil/gas products still totaling a high 59 percent the AE average (1.7 percent) only in 2020. Higher- in exports of goods in 2017; about 25 percent of than-expected oil prices could favorably affect the fiscal revenue; and with diversification happening growth forecast. Unfavorable factors stem from mainly through active (as opposed to new) lines of the potential expansion of sanctions and continued products (Figure 9a). Moreover, Russia’s integration elevated geopolitical tensions, which translate into into the global economy has not changed much high uncertainty that dampens domestic demand. (Figure 10a). In addition to any short-term A marked escalation of trade tensions among major gains from currency depreciation, it is essential economies could negatively affect growth in Russia for diversified growth that there are strong and globally. A potential sudden tightening of institutions capable of managing macroeconomic global financial conditions could negatively affect volatility and delivering public services such as growth in Russia by pressuring the financial account health, education and infrastructure. With flexible and exchange rate, translating into higher inflation exchange rates and a renewed fiscal rule now in and lower domestic demand. Inflationary risks place – both measures that rein in macroeconomic stem from the VAT rate increase, pass through from volatility – the “May Decree” and other initiatives the ruble depreciation, a higher-than-expected of the government, aimed at investing in human rise in gasoline prices, a closing of the output gap, capital and infrastructure, are steps in the right elevated inflation expectations and heightened direction. In the case of human capital, as Box 8 external volatility. And with a large state footprint, discusses, Russia performs well and achieves a lot the risk of contingent liabilities (in the banking in terms of ensuring the equal access and quality of sector, for instance) are elevated. On balance, education for students. Yet problematic areas such thus, unfavorable factors outweigh favorable ones, as socio-emotional skills or skills of the 21st century keeping the emphasis on maintaining stability. need improving. Figure 8a: The forecast for Russia suggests modest Figure 9a: Azerbaijan succeeded best in introducing growth new export lines, Russia least (real GDP growth, percent) (number of new lines) 3 110 600 2 1.5 1.6 1.5 1.8 100 90 500 1 0.7 80 US$ per barrel 70 400 Percent -0.2 0 60 50 300 -1 40 -2 -2.8 30 200 20 -3 10 100 -4 0 0 2014 2015 2016 2017 2018 2019 2020 2014 2015 2016 2017 Oil price, average, rhs GDP growth Russia Kazakhstan Azerbaijan Source: Rosstat, World Bank. Source: Comtrade, WB staff calculati ons. Note: “New” lines are defi ned as lines of export becoming ve, aft acti ve years of inacti er two consecuti vity. vii Russia Economic Report | Edition No. 40 Executive Summary Figure 10a: Russia’s progress in integration into the means-testing to some programs currently not global economy through global value chains was limited means-tested; consolidation into a single program (Market share, percent) providing much higher benefits; and a significant Intermediate electronics increase in child allowances for families with three Intermediate apparel & footwear or more children and for single-parent families. Intermediate vehicles Taking a longer perspective, various government Final electronics initiatives could double Russia’s potential growth Final textiles rate to 3 percent by 2028. As discussed in Part 3, Final apparel & footwear Russia’s potential growth peaked before the 2008 Final vehicles (pass+comm) global financial crisis and continued to decline up to 2017. The estimated potential growth rate was 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 2017 2013 3.8 percent in 2000-09 and 1.7 percent in 2010-17, Source: WITS. a 2.1 percentage point decline. The most recent deceleration was due to a slowdown of productivity IV. Russia’s longer-term economic prospects: growth and a shrinking potential labor force rather select issues beyond 2020 than a shortfall in capital accumulation. Regarding its future trajectory, under the baseline scenario, T he May Decree goal of halving poverty by 2024 could be within reach. Driven by a rebound in real wages and disposable incomes on the Russia’s potential growth is expected to continue its gradual downward trend from 1.5 percent in 2017 to bottoming out at 1.3 percent in 2022. back of low inflation, the number of poor people But it is expected to recover gradually afterwards, decreased by 1.1 million in the first half of 2018. primarily driven by a stabilization of the labor force. As Box 6 analyzes, the proposed VAT rate increase Simulations of an increase in the retirement age would also have a relatively neutral effect on the (see Box 7 for a detailed discussion on pension overall income distribution. However, the poverty reform measures), more inward migration, higher rate remains over 13 percent and is projected investment, and gradual acceleration of Total Factor to average 12 percent over the next three years Productivity (TFP) growth could double Russia’s – still above the pre-crisis rate of 10.8 percent in potential growth rate to 3.0 percent by 2028 (Figure 2013. Specifically, Box 9 discusses what would it 11a). Potential growth is found to be most sensitive take to halve the poverty rate from 13.2 percent to changes in TFP growth. to 6.6 percent by 2024. The poverty rate target of 6.6 percent by 2024 could be achieved even An important element for inclusive and diversified under a modest growth scenario of 1.5 percent growth is strong micro fundamentals. There has annual growth. Additional redistribution of 0.39 been some progress towards strengthening micro to 0.45 percent of GDP annually, through social fundamentals. Russia continued its efforts to assistance and transfers, would achieve this. enhance the regulatory environment for SMEs by This estimated additional redistribution assumes carrying out four reforms in the past year. Because improving targeting from the current 20 percent of these latest reforms, Russia advanced to 31st to around 60 to 70 percent (in line with other place in the global ease of doing business ranking, countries). Efficiency gains from existing programs representing an improvement from the 35th place could partly fund or replace the required additional last year and 40th place two years ago (Russia was redistribution. These efficiency gains could be ranked 120th seven years ago). However, as Box 10 realized by an increase in the targeting accuracy discusses, there is room for further improvement of existing means-tested programs; extension of in several areas, such as Trade Across Borders, viii Russia Economic Report | Edition No. 40 Executive Summary Figure 11a: Comprehensive reforms can raise Russia’s of 137 countries on the Global Competitiveness potential growth Index’s competition perceptions indicator. The (Percent) continuing presence of high price-cost margins, 3.0 Productivity increase lower-than-average market entry rates and lower 2.5 levels of private investment in innovation all point More investment to limits to competition. 2.0 Pension reform 1.5 Higher migration The trinity of maintaining stability, doubling growth, and halving poverty can be completed. 1.0 Maintaining stability will require a high level of 0.5 skill to navigate an increasingly uncertain external environment and mobilizing additional revenues 0.0 Baseline Reform (by increasing tobacco taxation and cutting tax expenditures for example). Doubling growth will Source: World Bank. require, in addition to expanding the labor force Resolving Insolvency and Protecting Minority through higher retirement age, the implementation Investors. And even though the regulatory of reforms that increase inward migration, boost environment for SME reforms is improving, the investment, and increase TFP growth. Increasing overall volume of outstanding SME loans remains competition and targeted interventions in human below the pre-crisis level (see Box 5). Moreover, capital that specifically build socioemotional skills competition conditions in Russia have not improved and skills of the 21st century would help boost TFP as rapidly as broader investment-climate conditions growth. And halving poverty will require additional (see Box 9). Product market regulations remain the – but modest – redistribution. most restrictive in the OECD and Russia ranks 95th ix Russia Economic Report | Edition No. 40 PART I RECENT ECONOMIC DEVELOPMENTS I. Recent Economic and Policy Developments 1.1 Global growth: weighed by weakening recovery in trade and manufacturing Weakening recovery in trade and manufacturing acti es is weighing on global growth. Global goods viti trade has decelerated more rapidly than expected. EMDE fi ons are ti nancial conditi ghtening but spillover from the turmoil in major EMDEs has been limited. Crude oil prices have averaged USD70/ on in Russia reached an all-ti bbl in 2018 so far. Producti me high of 11.4 mb/d in October. G lobal growth is broadly stable but risks from rising trade tensions are increasing (Figure 1 and Box 1). A weakening recovery in trade and EMDE financial conditions are tightening but spillover from the turmoil in major EMDEs has been limited. Divergent monetary policy and growth manufacturing activities is weighing down global prospects among the United States and other major growth. Global goods trade has decelerated economies contributed to a significant appreciation more rapidly than expected; global capital goods of the U.S. dollar in 2018. This, together with production, which is highly trade-intensive, has also intensifying trade tensions, deteriorating growth moderated in recent months, and new export orders prospects, and renewed attention to external continue to deteriorate. U.S. tariffs and retaliatory vulnerabilities, has contributed to significant responses of trading partners have affected 2.5 depreciations and capital outflows in many EMDEs. percent of global goods imports. A third of the EMDE currencies – including the Russian ruble – manufacturing companies surveyed in the United fell and cumulative portfolio outflows from EMDEs States and Japan said that they would reconsider surpassed those seen after the 2013 taper tantrum. their investment plans if trade tensions escalated, Economies with external vulnerabilities, including while a small fraction of companies have already Argentina, Indonesia, and Turkey, experienced changed their investment plans. In China, less than sharp currency depreciation. While spillover from one-third of exporters surveyed in October expects those countries has been limited, reflecting weak full-scale trade war and decline in orders. These direct linkage, the intensification of turmoil could surveys suggest that the risks of a possible trade lead investors to reevaluate their exposure to war have not yet fully materialized. EMDEs and to capital outflows. Figure 1: Global growth is broadly stable (Percent) Crude oil prices have averaged USD 70/ bbl in 2018 so far, an increase of 33 percent relative to 2017, 4.7 4.7 5.0 4.3 4.3 4.5 and are expected to average US 71/bbl over the 4.5 3.7 3.7 next three years.1 Oil prices have been buffeted by 4.0 3.5 3.1 3.1 3.0 an array of geopolitical and macroeconomic factors 2.9 3.0 2.8 2.8 2.4 this year, with the price of Brent, the international 2.5 2.3 2.3 2.2 1.9 1.7 2.0 1.7 marker, ranging from $59/bbl to $86/bbl (Figure 2.0 1.5 4). A key development in oil markets this year was 1.0 the announcement by the U.S. of its intention to 0.5 reimpose sanctions on Iran, which led to concerns 0.0 2014 2015 2016 2017 2018f 2019f 2020f about oil supply—when sanctions were previously World Advanced economies EMDEs implemented in 2012 they resulted in a reduction Source: World Bank. in Iranian exports of around 1mb/d. Production has also continued to decline in Venezuela, falling to 1.3mb/d in October, roughly half the level of production in 2016. These factors supported prices in September and early October. 1 The World Bank oil price is an average of three prices (Brent, WTI and Dubai oil prices). 2 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure 2: Trade Policy uncertainty is rising Figure 3: Capital flows to EMDEs are declining (Index, 3-month moving average) (US$, billions) 60 400 350 40 300 250 20 200 0 150 100 -20 50 0 -40 Jan-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Feb-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Feb-18 2006 2008 2010 2012 2014 2016 2018 Global policy uncertainty U.S. trade uncertainty Source: Baker, Bloom, and Davis (2016). Source: Insti tute of Internati onal Finance and World Bank. Note: Trade policy-related uncertainty in the United States is Note: Capital fl ows refers to all types of net fl ows from both based on an index presented in Baker, Bloom, and Davis (2016), residents and non-residents covering portf olio fl ows, banking and computes the frequency of arti c newspapers cles in domesti ows, direct investment, and other components of the fi fl nancial menti s, oning terms related to trade policy (e.g., import tariff account in a nati on’s balance of payments. Last observati on is import barriers, WTO, dumping, etc.). August 2018. However, prices fell sharply in early November also significantly increased this year, in response to after the United States announced it would grant concerns about a shortfall in supply, with the largest waivers to its sanctions on Iran to eight countries, increases in Saudi Arabia and Russia (Figure 5). including China and India. This development Production in Russia reached an all-time high of 11.4 coincided with an upward revision to production mb/d in October (see Box 2). The announcement in the United States, which is estimated to have of waivers, together with the increased supply reached 11.5mb/d in October. Production by other from other countries, shifted market concern away OPEC members, as well as their non-OPEC allies, has from a supply shortfall towards fears of oversupply. Box 1 Recent development in major economies United States: forecasted robust growth of 2.7 percent in 2018 is amid pro-cyclical fiscal stimulus, solid private investment, and still-accommodative monetary policy. The labor market remains robust with the 50-year low unemployment rate while long term inflation expectations remain contained. Euro Area: growth slowed notably in 2018. High-frequency indicators suggest possible downward revision from current 2.1 percent growth forecast, dragged by softening net exports. Higher energy prices raised headline inflation to target, and the European Central Bank stopped adding assets to its balance sheet. China: resilient consumption and rebound in private investment is supporting growth in 2018, forecasted at a still-robust 6.5 percent. However, export growth has declined, reflecting easing external demand and new U.S. tariffs. Monetary and fiscal policies have become more supportive of growth to offset the weak external demand. Eurasian Union (excl. Russia): external factors are promoting continued strong 2018 growth in member countries. Recovery in the Russian economy increased exports from Belarus and remittances to the Kyrgyz republic. Elevated commodity and oil prices for Kazakhstan and copper prices for Armenia supported those economies. 3 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure 4: Crude oil prices have averaged USD 70 / bbl Figure 5: Production by Russia and Saudi Arabia in 2018 so far significantly increased this year, in response to concerns about a shortfall in supply (US$/bbl) (Mb/d) 0.4 90 0.2 80 0.0 70 -0.2 60 -0.4 50 -0.6 40 -0.8 Jan -17 Mar -17 May -17 Jul -17 Sep -17 Nov -17 Jan -18 Mar -18 May -18 Jul -18 Sep -18 Nov -18 Oct -16 Oct -17 Oct -18 Apr -17 Dec -16 Apr -18 Dec -17 Aug -17 Aug -18 Feb -17 Feb -18 Jun -17 Jun -18 WTI Brent Russia Saudi Arabia Source: Bloomberg. onal Energy Agency, World Bank. Source: Internati Note: Figure shows the change in oil producti on since October 2016. Last observati on is September 2018. Metals and agricultural prices declined in the Figure 6: Metals and agricultural prices declined in the third quarter of 2018 third quarter of 2018 (Figure 6). Metals prices (Index, January 2017 = 100) fell nearly 10 percent on weaker global demand, 120 as well as concerns about the effects of the U.S.- China trade dispute on global trade and economic 110 activity. For aluminum, these effects were partially offset by supply constraints, including the closure 100 of the world’s largest supplier of alumina, and environmentally driven reductions in production 90 in China. While most oilseed and grains prices fell on ample supplies and trade tensions, wheat prices 80 May-17 May-18 Mar-17 Mar-18 have been supported by poor harvests in Europe Nov-17 Sep-17 Sep-18 Jan-17 Jan-18 Jul-17 Jul-18 and Central Asia, where production has been Agriculture Metals adversely affected by heat-waves. Source: World Bank. Box 2 The Russian oil and gas sector: record levels of production Russian production of hydrocarbons has reached record highs. Crude oil production reached a record level of 11.4 million barrels per day (mb/d) in October (Figure B2-1). Yet in August the U.S. overtook Russia as the largest producer of oil in the world. While production has been rising, consumption of oil has been relatively flat, so exports of oil have continued to rise (Figure B2-2). In 2017, Russia overtook Saudi Arabia to become the world’s largest exporter of crude oil and oil products. Production in Russia had been restricted by an agreement between OPEC and some other non-OPEC producers in late 2016 to cut production in order to ease a supply glut and support prices.Russia agreed to a 0.3mb/d cut starting in January 2017. However, the group decided to allow some increases in production in June this year to offset greater- than-expected falls in production in Venezuela and more recently, Iran. Since the end of this agreement, Russia has more than reversed its cut, with production increasing by around 0.4mb/d. The increase was driven by higher output from Rosneft, as well as increases from production-sharing agreement producers and other smaller players. Gazprom’s Neft saw a small fall in production. The International Energy Agency expects oil production in Russia will continue to increase in 2019, by approximately 0.3mb/d. 4 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Russian production of natural gas reached a record high of 640 billion cubic meters in 2017, making it the second-largest producer after the United States (Figure B2-3). However, it is the world’s largest exporter of natural gas, as the United States consumes most of its domestic production. Russia exports almost all of its natural gas to Europe via pipelines, although its exports of liquified natural gas (LNG) are increasing, destined primarily for Japan and other Asian countries (Figure B2-4). The BP 2018 Energy Outlook expects Russian production of natural gas to continue to rise steadily for the foreseeable future, with further increases in LNG exports. Figure B2-1: Russian production of hydrocarbons has Figure B2-2: Russian crude oil consumption has been reached record highs relatively flat (Mb/d) (Mb/d) 12 12 10 10 8 8 6 6 4 4 2 0 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2 2006 2008 2010 2012 2014 2016 2018 U.S. Russia Saudi Arabia Consumption Export onal Energy Agency. Source: Internati sti Source: BP Stati cal Review. Figure B2-3: Russian production of natural gas reached Figure B2-4: Russia is the world’s largest exporter of a record high in 2017 natural gas (Billion cubic metres) (Billion cubic metres) 800 250 200 600 150 400 100 50 200 0 Russia Qatar Norway USA Canada Australia Algeria Netherlands Indonesia T&T 0 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Russia United States Iran Qatar Pipeline LNG sti Source: BP Stati cal Review. sti Source: BP Stati cal Review. Note: LNG stands for liquifi ed natural gas. T&T stands for Trin- idad and Tobago. 5 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments 1.2 Russia: growth momentum slowed down in the third quarter er relati Aft vely robust growth in the fi rst half of 2018, growth momentum stalled in the third quarter. A weaker harvest, sluggish performances in manufacturing and constructi on, waning eff ects from the FIFA World Football Cup, led to this stalling. Since 2014, non-energy export volume growth has been outpacing that of energy, contributi ng to limited export diversifi on. A more diversifi cati ed export base will require further strengthening of insti ons capable of managing macroeconomic volati tuti lity and delivering public services such as health, educati on and infrastructure. With fl exible exchange rates and a new fi scal rule now in place, recent policy initi ves aimed at investi ati ng in human capital and infrastructure are steps in the right directi on S upported by a pick up in global growth, rising oil prices and macroeconomic stability, growth momentum improved in the first half of 2018 Domestic demand continued to recover in the first half of 2018, although its growth slowed down in the second quarter of 2018 and net (Figure 7). Moreover, GDP growth (1.3 and 1.9 exports, supported by the FIFA World Football percent, y/y, in Q1 and Q2, respectively) was broad- Cup, emerged as the main contributor to demand- based and in line with the economy’s potential, side growth (Figure 10). With inflation remaining with non-tradable sectors as its main drivers. In the low, wages and pensions continued to increase in tradable sectors, manufacturing was the engine of real terms, supporting households’ consumption. growth, supported by robust global demand, real Historically low interest rates and deferred demand effective exchange-rate (REER) depreciation, and fueled consumer loans. Fixed capital investment a recovering domestic demand (Figure 8). Growth growth slowed down in the first quarter of 2018 in mineral-resource extraction was limited until due to a drop-in investment in mineral-resource June 2018 by the OPEC+ agreement, supported by extraction (partly due to the high base of last year), Russia (Box 2). In the second quarter of 2018, GDP and further in in the second quarter. In addition, growth momentum accelerated to 0.9 percent, restocking by firms decelerated in the first half of q/q, adjusted for seasonal and calendar factors, 2018, which led to negative contribution of gross gaining from the FIFA World Football Cup hosted capital formation to GDP growth, with the effect by Russia, which accelerated growth in the non- being especially strong in the second quarter of tradable sector (Figure 9), and by the relaxation of 2018. The FIFA World Football Cup supported export production limits in the oil sector in June. growth, meanwhile, lower restocking and a weaker Figure 7: Growth continued in 2018 Figure 8: Within tradeable sectors, manufacturing was the main engine of growth in the first half of 2018 (Percentage point) 6 130 0.8 5 120 0.6 4 110 3 100 0.4 U.S. Dollars 2 90 Percent 1 80 0.2 0 70 0.0 -1 60 -2 50 -0.2 -3 40 -4 30 -0.4 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2012 2013 2014 2015 2016 2017 2018 -0.6 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 GDP growth, percent, y/y GDP growth, percent, qoq, sa Oil price, Brent, US/bbl (rhs) Agriculture, forestry and fishing Mineral extraction Manufacturing Source: Rosstat. Source: Rosstat 6 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure 9: Contribution to growth from retail and wholesale Figure 10: Net exports became main growth driver in trade, transportation, and hotels and restaurants increased the second half of 2018 in the second quarter in view of the FIFA World Football Cup (Percentage point) (Percentage point) 2.5 10 2.0 8 1.5 6 1.0 4 0.5 2 0 0.0 -2 -0.5 -4 -1.0 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 -6 Electricity and gas Water -8 Construction Retail and wholesale trade Transportation and storage Hotels and restaraunts -10 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018 Information and communication Finance and insurance Real estate Professional, scientific and technical activities Administrative and related activities State management, national security, social security Consumption GCF Education Health and social services Gross fixed capital formation Export Culture, sport and entertainment Other services Import (-) Stat error GDP growth Housekeeping services Source: Rosstat Source: Rosstat. ruble in the second quarter of 2018 resulted in the Figure 11: Share of oil/gas products totaled about 59 slowdown of import growth, making net exports percent in export of goods in 2017 the main contributor to GDP growth. (Percent) Energy products 59.3 Growth momentum appears to have weakened Metals 10.4 Machines 7.9 in the third quarter of 2018. Rosstat preliminary Chemicals 6.7 estimates suggest that GDP growth stalled: 0 Food products 5.8 percent growth, q/q, adjusted for seasonality (1.3 Wood and pulp 3.3 percent, y/y). This slowdown is on the back of Prec metals and stones 3.1 a weaker harvest and sluggish performances in Other 2 Mineral products w/t oil 1.1 manufacturing and construction, waning effects Tex tile, clothing and shoes 0.3 from the World Football Cup. Demand side has Leather and fur 0.1 possibly registered some slowdown in export and 0 10 20 30 40 50 60 70 further restocking deceleration. sti Source: Russian customs stati cs. Since 2014, non-energy export volume growth was registered in other major carbon-exporters of has been outpacing that of energy, contributing Europe and Central Asia region: Kazakhstan and to export diversification. Yet progress has been Azerbaijan. limited, with the share of oil/gas products totaling about 59 percent of total export of goods in 2017 In Russia (as in Kazakhstan), export diversification (Figure 11). During the period 2014-2017, Russia happened mainly through active (as opposed to had made progress in export diversification, which new) lines of products:2 the share of energy items was reflected in a lower share of the top-ten decreased, while the share of active non-energy product lines in the total export of goods as well items grew (Figure 13 and Figure 14). Lower oil as in a lower value of the Theil index (Figure 12). prices (price for Brent oil dropped to US$54.4 in A similar improvement in diversification of exports 2017 from US$108.9 in 2013) were also important 2 We use decompositi ti on of Theil’s index into “between” and “within” group components with a parti ve and on of export lines into acti ve ones. The result is a mapping of changes in the “between” groups component of Theil’s index into changes in the extensive margin inacti of exports and of changes in its “within” groups components into changes in the intensive margin of exports. (see “Export diversifi cati on: what’s behind the hump?” Cadot, at al. 2007). 7 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure 12: Russia has made some progress in export diversification (2013 - 2017) Share of top 10 products in total export of goods cati Theil index for exported goods (HS 2012 classifi on, 6 digits) 1.0 9 0.9 8 0.8 7 0.7 6 0.6 5 0.5 4 0.4 3 0.3 2 0.2 1 0.1 0.0 0 n n a ey ia il d via a ta n ija n ti az ay a y sia zil n in d ia a ss rk ta ja ke ati oa la n in t hs tv Ch Br ba a rw Ru La la s ai Tu s Po Ch Br r Cr Ru o La ak kh Tu Po er b No Cr er z za Az Ka Az 2017 2013 Ka 2013 2017 Source: Comtrade, WB staff ons. calculati calculati Source: Comtrade, WB staff ons. Figure 13: In Russia and Kazakhstan export diversification happened mainly through active (as opposed to new) lines of products Russia Kazakhstan 6 7 6 5 5 4 5.2 5.2 5.2 4 4.8 4.6 4.6 5.7 6.0 5.9 3 5.6 5.5 5.3 3 2 2 1 1 0.1 0.1 0.1 0.1 0.1 0.1 0.7 0.6 0.6 0.6 0.5 0.5 0 0 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017 Theil index (extensive) Theil index (intensive) Theil index (extensive) Theil index (intensive) Azerbaijan 8 7 6 5 4 6.3 6.1 6.1 6.1 3 5.9 6.0 2 1 1.6 1.6 1.6 1.5 1.2 1.1 0 2012 2013 2014 2015 2016 2017 Theil index (extensive) Theil index (intensive) calculati Source: Comtrade, WB staff ons. 8 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments contributing factors. The share of energy products manufacturing only just started in 2018,5 FDI in oil in total goods exports3 fell from 70.2 percent in and gas sector outperformed FDI in manufacturing 2013 to about 65 percent in 2017. in 2014-2017; and employment levels (and shares) in manufacturing and agriculture decreased Russia’s integration into the global economy has compared to the levels of 2013 (Figure 16 and not changed much since 2013. Russia’s shares in the Figure 17). world’s market of final and intermediate groups of manufacturing products stayed at about the same The lack of significant diversification of the levels (Figure 15; latest data available for 2016). Russian economy despite REER depreciation could be partly attributed to a high share of imported Economic diversification in Russia has been goods and tradable raw materials in the costs of limited. The recovery in fixed capital investment in manufacturing production. In addition, as the Figure 14: Azerbaijan succeeded best in introducing Figure 15: Russia’s progress in integration into the new export lines, Russia least4 global economy through global value chains was limited (Number of new lines) (Percent) 600 Intermediate electronics 500 Intermediate apparel & footwear 400 Intermediate vehicles Final electronics 300 Final textiles 200 Final apparel & footwear 100 Final vehicles (pass+comm) 0 2014 2015 2016 2017 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 Russia Kazakhstan Azerbaijan 2017 2013 calculati Source: Comtrade, WB staff ons. Source: WITS. Figure 16: Employment in manufacturing decreased Figure 17: FDI in oil and gas sector outperformed FDI in manufacturing in 2014-2017 (Change in employment levels, 2017 vs 2013, percent) 15 30,000 80,000 70,000 10 25,000 60,000 5 20,000 50,000 15,000 40,000 0 mln USD mln USD 10,000 30,000 5 20,000 5,000 -10 10,000 0 -15 0 -5,000 -10,000 y g on re n vit in es g th tio d er de n fe dm e tio in ica an tu cti r nc cti liti al h tu a in ca ul Ot de a -10,000 2010 2011 2012 2013 2014 2015 2016 2017 -20,000 Tr He tru un rt la Uti ac M ric d blic u m o cia uf Ed ns m sp Ag Pu an Co an co an an M Agriculture Minig+oil products Manufacturing w/t oil products Total (rhs) Fin T r Source: Rosstat. Source: CBR. 3 Source: Russian customs data. 4 New lines were defi ve, aft ned as lines of export becoming acti ve years of inacti er two consecuti vity. 5 Data for large and medium enterprises. 9 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments study “Diversified Development” (World Bank, right direction. There have also been substantial 2014, Indermit Gill et al), states, building strong improvements in Russia’s business climate (see institutions (the mechanisms to manage resource Box 10). However, there is still room for further rents, administer social services, and regulate gains (especially in easing excessively burdensome economic production), which would provide for administrative procedures in external trade). a level playing field and the rule of law, is a key Moreover, worldwide governance indicators reveal condition for economic diversification. Recent that Russia lags behind Upper Middle-Income initiatives of the government aimed at investing in countries in such categories as “Regulatory quality,” human capital and infrastructure are steps in the “Rule of law” and “Control of Corruption.” 1.3 Balance of payments: Current account surplus widened, capital outflows increased In January – September 2018, the current account surplus widened, supported by an increase in the terms of trade, robust global growth, and REER depreciati on. Net capital outf lows increased because cal tensions. To reduce volati of turbulence in emerging markets and elevated geopoliti lity on the nancial markets the CBR suspended its daily currency purchases in the fi fi scal rule framework unti l end-December 2018. S upported mostly by rising oil prices, the current account surplus widened to about 6.3 percent of GDP (USD75.8 billion) in January-September of harvest in 2017), leather, metals, and machinery. Import value growth in annual terms was high in the first quarter of 2018 but decelerated in the 2018 from 1.7 percent of GDP (USD19.7 billion) in second quarter and turned negative in the third, the same period last year (Figure 18). A stronger as the REER depreciated and domestic demand trade balance supported the current account: both growth slowed down. In January-August 2018, energy and non-energy exports increased (Table 1). FX interventions within the fiscal rule framework, Energy exports grew mainly on the back of higher conducted by the Central Bank on behalf of the oil prices (+38 percent, y/y). Non-energy exports Ministry of Finance, supported the current account were supported by growth of both prices and by putting downward pressure on the ruble volumes (Figure 19). In the first half of 2018, non- (Figure 20). The balance of services, primary and energy export volume growth was broad-based, secondary income balances changed marginally. In but particularly high in food products (after a good January-September 2018, the non-oil/gas current Figure 18: The current account surplus widened Figure 19: Non-oil/gas export volume growth was robust in the first half of 2018 (Billion, US$) (Percent) 60,000 Other 50,000 Machinery 40,000 30,000 Minerals (incl. oil) 20,000 Oil products 10,000 Chemicals, rubber 0 Metals -10,000 Leather, fur -20,000 Wood, pulp -30,000 -40,000 Textiles Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Food products Goods Services Compensation of employees Investment income -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 Transfers Current account balance H1 2018 (average) H1 2017 (average) Source: CBR. cs. Source: CBR, Haver Analyti 10 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments account deficit improved from 9.3 percent of GDP last year. Banks continued debt repayments in an to 10.5 percent of GDP in the same period last environment of limited access to international year, largely reflecting improvement in the non- financial markets. In the non-banking sector, net oil/gas fiscal balance. capital outflows increased largely due to a slump Figure 20: Import growth decelerated in 2018 in incoming net FDI in the third quarter, reflecting (y-o-y) reduced interest of foreign investors in Russian 110 assets. Foreign-currency purchases within the 100 fiscal rule framework weakened the link between 90 oil price fluctuations and the exchange rate, thus 80 70 despite growing oil prices, downward pressures on 60 the exchange rate prevailed. The REER depreciated 50 by 8.2 percent, y/y, in the first nine months of 2018. 40 30 20 International reserves gained USD 31.1 billion in Jun -18 Sep -18 Jun -17 Sep -17 Dec -17 Mar -18 Dec -16 Mar -17 Dec -15 Mar -16 Jun -16 Sep -16 Mar -15 Jun -15 Sep -15 Jun -14 Sep -14 Dec -14 Dec -13 Mar -14 the January-September 2018 period compared to Oil price (Brent), Dec 13 = 100 Import of goods, Dec 13 = 100, SA an increase of USD 14.4 billion in the same period, REER, Dec 13 = 100 last year. The international reserves growth stalled Source: CBR. in September when the Central Bank suspended FX interventions in the fiscal rule framework to stabilize In the second and third quarters of 2018, the financial markets. Reserves amounted to USD 460.6 expansion of sanctions and increased geopolitical billion at end-September 2018, compared to USD tensions, exacerbated by the changed risk 432.7 in the end of 2017. The import cover stayed perception of the emerging economies, resulted at a comfortable level, and slightly higher than as of in increased net capital outflows, pressure for end 2017 (15.9 months of goods and services in the depreciation on the exchange rate and downward end of September 2018, compared to 15.8 months pressure on the asset prices. Net capital inflows of at the end of 2017). The Central Bank refrained turned into net capital outflows in the government from intervening on its own, in line with its flexible sector, mainly through the sell-off of OFZ bonds: exchange-rate regime. Relatively high levels of share of OFZ bonds held by non-residents dropped international reserves, relatively low external debt from 33.1 percent in the year beginning to 25.8 levels (about 29 percent of GDP), and the recently percent in the end of September. Net capital established macroeconomic framework would help outflow increased in the private sector in the Russia to limit exposure to external volatility and first nine months of 2018 to 3 percent of GDP, absorb external shocks. compared to 2.2 percent of GDP in the same period Table 1: Balance of payments, 2015 – 2018 (US$ billions) Q1 Q2 Q3 9m 2015 2016 2017 2018 2018 2018e 2018e Current account balance 68.8 25.5 33.3 30.3 19.1 26.4 75.8 Trade balance 111.5 66.4 115.4 44.1 45.6 46.7 136.3 Non-oil current account balance -134.5 -129.6 -160.2 -31.3 -44.4 -39.9 -115.5 Capital and financial account -69.4 -11.1 -14.0 -12.8 -9.7 -21.4 -43.8 Errors and omissions 2.9 -4.6 3.8 2.3 2.3 -0.2 4.4 Change in reserves (- = increase) -1.7 8.2 -22.6 -19.3 -11.3 -5.0 -35.6 Source: CBR. 11 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments 1.4 Labor market and poverty trends: Unemployment declines and wages are recovering Unemployment declined further in the third quarter of 2018 to a current 4.6 percent, while real wages and disposable incomes increased on the back of low infl on. In 2018, wage growth was highest in ati the public sector and above the rate of infl on in the non-tradable and public sectors. The poverty ati rate under the nati niti onal defi on decreased in the fi rst half of 2018, driven by a rebound in household incomes. The extreme poverty rate remained marginal, below one percent. Halving poverty over the next 6 years is within reach and will require mobilizing additi on. onal – but modest – resources for distributi T The employment and labor-force participation rates remained at high levels while unemployment was close to minimum. The reverted). Most of the unemployment is still long- term: 30 percent of the unemployed had been looking for a job for over a year. Unemployment absolute numbers of employed people increased by regions remained unequal and followed the by 200,000 to 73.2 million in September 2018, declining national trend. compared to the levels of a year earlier (Figure 21). At the same time the measure of the total labor Other labor-market indicators have not been force decreased by the same amount to 76.6 million overly affected. The vacancy rate6 increased slightly people in September 2018. The employment rate to 3.0 percent in second quarter of 2018, compared grew marginally by about 0.3 percentage point to to 2.7 percent a year ago, reflecting a gradual 60.3 percent. The labor force participation rate recovery in the real sector. The number of part- remained unchanged at the level of 63.2 percent. time employees increased slightly in the first half of High employment rates, in combination with the 2018 but remained far below the levels of the 2009 continued decline in the working-age population, crisis period. The average number of hours worked led to a further reduction of the unemployment decreased marginally for both genders. rate. It decreased to 4.6 percent in the third quarter of 2018, compared to 5.2 percent a year With inflation low, wages continued to grow in earlier (Figure 22). The structure of unemployment real terms. Real wages growth in January-October remained the same. The gaps between male/ of 2018 was 7.6 percent, compared to the same female remains stable – unemployment for women period of 2017 (Figure 24). The fastest real wage is usually around 0.3 percentage points lower growth was in public sector: health (23.3 percent than for men (except for June 2018, when this gap in the first nine months of 2018), education Figure 21: Labor force and employment (mln people) Figure 22: Unemployment rate (Percent) (Percent) 6.5 78 76 6.0 74 5.5 72 5.0 70 4.5 68 2015 2016 2017 2018 4.0 Labor force Employment 2015 2016 2017 2018 Labor force, SA Employment, SA Total SA cs. Source: Rosstat and Haver Analyti cs. Source: Rosstat and Haver Analyti 6 o of vacancies to the total numbers of jobs. Rati 12 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments (11.2 percent). Real wage growth in the tradable The official poverty rate continued to decrease sector was much lower: 4.2 percent on average slowly in the first half of 2018. Driven by a rebound (8.3 percent in mining, and only 0.9 percent in in real disposable income, the poverty rates in manufacturing). Among non-tradables, the highest Russia decreased in the first and second quarters of real wage growth rates were in the sector of 2018 (Table 2). hotels and restaurants (8.2 percent), while wages in construction increased only by 1.0 percent in The share of the economically secure the January-September 2018 compared to the same population stayed unchanged in 2017. The share period last year. of economically secure population decreased by 5 percentage points from 79 percent in 2014 to Real disposable income dynamics remain volatile. 74 percent in 2015 and further to 72 percent in Income started to grow in the beginning of 2018. 2017. 7 This contraction was driven by a massive Its average growth rate in real terms in the first ten contraction of disposable incomes and wages months of 2018 was 1.6 percent (Figure 23). Labor in 2015, and a continued decline in incomes in pensions were indexed by 3.7 percent in January 2016-2017. 2018 and social pensions were indexed by 2.9 percent in April 2018 – slightly above the current One of the May Decree goals is to halve poverty in rates of inflation. As a result, the real growth of the next six years. We analyze the feasibility of this pensions in the first nine months of 2018 in Russia goal (Box 3). was only 1.2 percent (Figure 23). Figure 23: Real incomes dynamics Figure 24: Real wages growth by sector (Percent, y-o-y) (Percent, y-o-y) 20 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 2015 2016 2017 2018 -20 Wages Pensions 2015 2016 2017 2018 Disp income Disp inc., 12-months MA Tradables Non-tradables Public Source: Rosstat and World Bank staff mates. esti esti Source: Rosstat and World Bank staff mates. Note: pension and disposable income dynamics adjusted for me payment. January 2017’s one-ti Table 2: Poverty (Cumulati ve) Q1 Q2 Q3 Q4 Q1 Q2 2010 2011 2012 2013 2014 2015 2016 2017 2017 2017 2017 2018 2018 Poverty rate, percent 12.5 12.7 10.7 10.8 11.2 13.3 13.3 15.0 14.4 13.8 13.2 14.2 13.6 Source: Rosstat. 7 The World Bank. Towards a New Social Contract. htt ps://openknowledge.worldbank.org/bitstream/handle/10986/30393/9781464813535.pdf. The ne the threshold of 11 US$ a day or more in 2011 PPP, which corresponds to almost 8,700 Russian rubles per person per month in 2017 prices, is used to defi on”. lower bound for “economically secure populati 13 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Box 3 Halving poverty in Russia by 2024: What will it take? We identify the conditions in terms of economic growth and public transfers required to “…reduce poverty in the Russian Federation by half by 2024” as stated in the President Decree of May 17, 2018. The current poverty rate is 13.2 percent and halving it would mean reducing the current rate to 6.6 percent by 2024. We estimate that average annual growth of 1.5 percent would bring down the poverty rate from 13.2 percent to only 10.7 percent by 2024. But even if Russia were to be able to catch up with the rest of the world and grow at 3.2 percent annually, its poverty rate would fall to 8.1 percent – still above the stated goal of 6.6 percent. Consequently, to reach the presidential target of 6.6 percent, we estimate that the annual required growth rate would need to surge to 4.4 percent. But the poverty rate target of 6.6 percent by 2024 could be achieved even under a scenario of 1.5 percent annual growth. This can be done via additional redistribution, for example, in terms of social assistance and transfers. Indeed, we estimate such additional redistribution to amount to around 0.27 percent of GDP per year. Of course, accelerating economic growth would make the task of poverty reduction easier. If Russia were to grow at 3.2 percent (slightly above the global growth rate of 3 percent), under perfect targeting, we estimate such additional redistribution to be around 0.10 percent of GDP. We caution though that this estimate assumes perfect targeting, and as such, should be viewed as a lower bound.8 Indeed, if the assumption of perfect targeting is dropped, under current conditions where only around 20 percent of the allocated budget reaches its intended beneficiaries, Russia would need to mobilize 1.35 percent of GDP to be able to redistribute 0.27 percent of GDP to the poor. However, improving targeting from the current 20 percent to even around 60 to 70 percent, which is in line with other countries, would require mobilizing only 0.39 to 0.45 percent of GDP annually. Achieving the goal of halving poverty by 2024 therefore puts a sizeable premium on improving the targeting efficiency of Russia’s social assistance system. Efficiency gains from existing programs could partly fund these additional transfers. These measures could include better targeting accuracy of the existing means-tested programs, including their consolidation into a single program providing much higher benefits; extension of means-testing to some of the currently not means-tested programs; and a significant increase in child allowances to children in families that have three or more children and children of single parents. 1.5 Monetary Policy: after a prolonged period of loosening, the Central Bank hiked the policy rate in September in the face of elevated inflationary risks In 2018, monetary policy remained consistent with the inflation-targeting regime. Since July, inflation has been increasing, but stayed below the CBR’s target of 4 percent in annual terms. Ruble depreciation on the back of increased geopolitical tensions and turbulence in emerging markets; weak harvest; and higher gasoline prices pushed up consumer inflation to 3.5 percent in October (y/y, annual) from 2.2 percent in January. In order to reduce volatility in the foreign exchange market in August, the CBR suspended FX interventions in the fiscal rule framework. The upcoming increase in VAT rate in 2019; closing of the output gap; and elevated depreciation pressure raises inflationary risks. T he Central Bank hiked policy rate as inflationary risks increased. Between January and August 2018, the CBR lowered the key rate twice by 25 basis hiked its key policy rate by 25 bp to 7.5 percent and left it unchanged at the October monetary policy meeting (Figure 25). Among the main reasons points (bp), thus bringing it down from 7.75 percent to behind this decision was growing inflationary 7.25 percent in annual terms. However, in September risk due to the ruble depreciation prompted by 2018, for the first time since December 2014, the CBR elevated geopolitical tensions and turbulence in 8 Perfect targeting assumes that the poor and their income are identified precisely, and they receive the exact amount of social transfers needed to bring them to the level of the poverty line. In other words, no targeting errors are assumed. In reality, both errors of inclusion and exclusion are commonly found in poverty-targeted income support programs. The policy maker’s objective is to minimize both errors, and countries such as Poland, Turkey, Azerbaijan, etc. have achieved a high targeting accuracy of 60-80 percent. See, for example: The State of Social Safety Nets, (2018), World Bank, Washington D.C., April 2018. 14 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments emerging markets. The Central Bank also took into headline inflation, 1.5 percentage points (pp), while consideration a planned increase in the VAT rate, food inflation and inflation in services contributed by which would result in inflation increase in the end 1.0 pp (Figure 28). The increase in inflation since end- 2018 - 2019. According to the Central Bank, the policy 2017 has been mostly related to three factors. First, the rate is close to neutral level in the short term, given low-base effect from last year’s food price dynamics increased country risk premium. In the medium to due to an exceptionally good harvest in 2017. The long term, the estimated neutral interest rate has second factor was higher prices for oil, which affected shifted closer to its upper bound within the range of gasoline prices and transportation costs for producers. 6 to 7 percent. The third was the ruble depreciation, which exerted upward pressure on inflation through higher prices of To reduce volatility in the foreign exchange (FX) imported food and utilities. market and its influence on inflation, the CBR suspended FX interventions in the fiscal rule Household inflation expectations remain framework during the period of August 9th to 17th elevated, prompted by a gasoline prices hike and August 23rd to the end of December 2018. (Figure 28). Although in October they dropped to The suspension of the CBR’s FX purchases reduced 9.3 percent from 10.1 percent in September, likely ruble liquidity, contributing to the stabilization of due to the stabilization of the ruble exchange rate financial markets. The CBR is going to compensate and gasoline prices, they still remain above the levels its suspended FX purchases in the market in the recorded in the year beginning. Moreover, it is likely future when market fundamentals improve. that the October decrease in household’s inflation expectations could be unsustainable, as they Consumer price inflation has been on the rise remain sensitive to ruble depreciation, geopolitical since July 2018, though it stayed below the CBR’s uncertainties, and to one-off factors, including target of 4 percent in annual terms (Figure 27). In price increases to individual products. Domestic October 2018, headline and core inflation increased inflationary risks stem mainly from VAT rate increase, to 3.5 and 3.1 percent respectively (year-on-year). the closing output gap in 2018, pass-through from Headline inflation in annual terms accelerated for the ruble depreciation, and elevated inflation all categories - food, non-food items, and services. expectations. Risks to inflation are therefore tilted Non-food inflation was the major contributor to the to the upside. Figure 25: The CBR hiked its key policy rate by 25 bp in Figure 26: Inflation rose but remained below the CBR’s September target (Key policy rate, percent) (CPI index and its components, percent, y-o-y) 12 25 11 20 10 15 9 10 5 8 0 7 -5 Ap 5 Ju 5 Oc 5 Ja 5 Ap 6 Ju 6 Oc 6 Ja 6 Ap 7 Ju 7 Oc 7 Ja 7 Ap 8 Ju 8 Oc 8 8 6 1 r-1 l-1 t-1 1 r-1 l-1 t-1 1 r-1 l-1 t-1 1 r-1 l-1 t-1 n- n- n- n- Sep - 15 Dec - 15 Jan - 15 Mar - 16 Apr - 16 Jun - 16 Jul - 16 Sep - 16 Oct - 16 Dec - 16 Feb - 17 Mar - 17 May - 17 Jun - 17 Sep - 17 Oct - 17 Dec - 17 Feb - 18 Mar - 18 Apr - 18 Sep - 18 Oct - 18 Ja Core inflation CPI inflation Food inflation Non- food inflation Services inflation Source: CBR. cs. Source: CBR and Haver Analyti 15 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure 27: Inflation expectations are high Figure 28: Non-food products influence the headline inflation (Percent) on to infl (Contributi on by component, percent) ati 20 18 18 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 Ap 5 Ju 5 Oc 5 Ja 5 16 Ju 6 Oc 6 Ja 6 17 Ju 7 Oc 7 Ja 7 18 Ju 8 Oc 8 18 Apr -17 Jul -17 Oct -17 Jan -18 Apr -18 Jul -18 Oct -18 Apr -15 Jul -15 Oct -15 Jan -16 Apr -16 Jul -16 Oct -16 Jan -17 Jan- 14 Apr -14 Jul -14 Oct -14 Jan -15 1 r-1 l-1 1 r-1 l-1 1 r-1 l-1 1 r-1 l-1 n- t- n- t- n- t- n- t- Ap Ap Ap Ja CPI inflation Expected inflation Food Non-food Services CPI Source: CBR. Source: CBR. For the period of January-October 2018, the ruble ruble depreciation, m/m, with the ruble hitting a depreciated 11.1 percent against the U.S. dollar, 2-year low. In an attempt to reduce volatility on the while oil prices (Brent) increased by 25.3 percent financial markets, the CBR raised the policy rate and (Figure 30). In the first quarter of the year, the ruble suspended its daily purchases of foreign currency in had slightly strengthened on the back of higher oil the fiscal rule framework during the period August prices, relatively favorable external conditions and 9-17 and August 23 to the end of December 2018. the continued demand for Russian financial assets. The CBR’s policy move provided the ruble with Meanwhile, currency interventions conducted by additional support from relatively high oil prices. the CBR on behalf of the Ministry of Finance exerted Figure 29: Ruble depreciation since the beginning of downward pressure on the ruble. Compared to 2018 previous years, the ruble’s exchange rate correlation Change in oil prices and the nominal exchange rate, logarithmic scale with oil prices weakened. Starting from the second 5 3.5 quarter, elevated geopolitical tensions, tightening of 4.8 3.6 monetary policy in the US and investor risk aversion 4.6 3.7 4.4 3.8 to emerging markets (EM) resulted in the ruble’s 4.2 3.9 depreciation, even though the ruble performed 4 4 3.8 4.1 better than many other EM currencies. The most 3.6 4.2 significant depreciation happened in the period from 3.4 4.3 3.2 4.4 August to mid-September. New sanctions, enacted 3 4.5 under the Chemical and Biological Weapons Control 10/9/14 10/9/15 10/9/16 10/9/17 10/9/18 1/9/14 4/9/14 7/9/14 1/9/15 4/9/15 7/9/15 1/9/16 4/9/16 7/9/16 1/9/17 4/9/17 7/9/17 1/9/18 4/9/18 7/9/18 and Warfare Elimination Act (CBW Act), and elevated Oil price (Brent), ln Oil price (Brent), ln geopolitical tensions, coupled with capital outflow Source: CBR. from the emerging markets, led to a 5.1 percent 16 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments 1.6 The Banking Sector: largely stable despite remaining weaknesses and increasing concentration Despite recent bailouts and a conti nuing sector clean-up, Russia’s banking sector remains relati vely weak. However, the situati on has stabilized, credit is expanding, albeit at a diff al pace across erenti various segments. The structure of the Russian banking system remains largely unchanged, with concentrati on and public dominance increasing even further due to the recent government bailouts of several private banks and further industry consolidati on. External risks have increased due to fi nancial turbulence in emerging markets and the possible expansion of sancti ons D espite recent bailouts and a continuing sector clean-up, Russia’s banking sector remains relatively weak, with less capital buffer (12.2 to accelerated consumer lending growth in 2018, the Central Bank of Russia (CBR) tightened risk- weighting requirements for unsecured consumer percent as of end-September) and higher NPL ratio loans with an annual percentage rate (APR) in the (10.8 percent as of end-September) than other range of 10-30 percent. The new requirements BRICS (15.6 percent and 4.4 percent, respectively) apply to consumer loans issued after September (Figure 30). However, the situation has stabilized, 1, 2018. The CBR also plans to further tighten risk- lending activity is recovering, and profitability is weighting requirements for mortgage loans with improving, though the sector remains weighed low down payments (in the range of 10 percent – down by high provisioning charges. Lending growth 20 percent), due to come into effect on January 1, continued in both the retail and corporate segments, 2019. Approximately 44 percent of mortgage loans though it was much weaker on the corporate in 1H18 were issued with down payments of less side due to weak economic growth. Credit to the than 20 percent, despite the initial increase in risk corporate sector grew by 9.7 percent, y/y, in the weights since the start of 2018. Strong demand for last ten months. During the same period, loans to residential mortgages has been driven by declining households grew by 22.5 percent, y/y (Figure 31). interest rates and anticipated increases in real The growth was predominantly driven by unsecured estate prices due to a change in a funding scheme loans and mortgage loans, and household debt is at for the construction companies. an all-time high (Box 4). To address the risks linked Figure 30: Overall financial sector indicators remained Figure 31: Credit growth is higher in the retail broadly stable segment (Key credit and performance indicators, percent) (Percent, y-o-y) 16 24 14 21 12 18 10 15 12 8 9 6 6 4 3 2 0 0 -3 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Oct-18 -6 -9 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Capital adequacy ratio NPLs to total loans Loan loss provisions to total loans Return on assets Return on equity Companies Household Source: CBR. calculati Source: CBR, World Bank staff ons. 17 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Box 4 Stock of household debt is at maximum levels The total household stock of bank loans is currently at maximum levels. On September 1st, 2018 the total amount of accumulated household loans exceeded 14 trillion rubles. This is the highest amount registered in modern Russian history. If measured as share of 12-month household income, the total stock of debt reached 24.8 percent. This number exceeds the previous peak of late 2014 (Figure B4-1). The composition of household loans also changed over the last 10 years (Figure B4-1). Household debt denominated in foreign currency almost disappeared in Russia. The current share of loans denominated in rubles is 99.3 percent. The share of mortgages rises. The share of ruble-denominated mortgage loans rapidly increased in Russia since 2008, then remained stable up to 2014. Moreover, the foreign currency-denominated mortgages in Russia decreased to marginal numbers over the that period. Starting in 2014, the share of mortgages started to increase again and currently reaches 42.5 percent of total household indebtedness. Figure B4-1: Household debt stock is rising as share of disposable income (Percent) 100 30 90 25 80 70 20 60 Percent Percent 50 15 40 10 30 20 5 10 0 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Mortgage RUB Mortgage FC Other RUB Other FC Total stock of loans as share of 12-month income (right axis) esti Source: CBR, Rosstat and World Bank staff mates. Note: Data on mortgage loans are available from 2008 onwards. FC – foreign currency. Since the beginning of 2018, lending to SMEs has Russian banks remain largely funded by customer revitalized, overperforming corporate loans. IIn deposits. Retail deposits have been moderately the first 6 months of the year, loans to SMEs grew decreasing since August 2018, by 0.6 percent, m/m, by 10.8 percent. This is largely due to massive and 0.8 percent, m/m, in August and September, state support measures undertaken in 2017-2018. respectively. Banks began increasing their retail Nevertheless, despite some emerging positive deposit rates in anticipation of, and following, a dynamics in SME lending, the overall volume of recent 25 bps increase in the CBR key policy rate. outstanding SME loans remains below the pre-crisis This may indicate the reversal of a prior trend of level. SME development is among the top national declining deposit rates, and a likelihood that banks’ priorities outlined in the President’s May Decree. funding costs will increase through the remainder The Russian government and the central bank of 2018. In August-September, corporate deposits developed additional measures to expand access in rubles increased by 0.5 percent, m/m, and 1.6 to finance for SMEs to meet ambitious national percent, m/m, respectively. This could be due to growth targets (Box 5). a conversion of some USD-denominated deposits into rubles. 18 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Box 5 Russian Government and Central Bank propose measures to expand access to finance for SMEs As of October 2018, there were 5.95 million SMEs in Russia employing 15.98 million people. 95 percent of the SMEs were micro enterprises, accounting for 47 percent of SME employment. SMEs account for 22 percent of Russia’s GDP and 25 percent of total employment. Though their numbers were growing, they are still considerably lower than in both developed and developing countries. In the OECD group, SMEs account for 60 percent of total employment and for 50 to 60 percent of GDP. The government of Russia has adopted a number of strategic documents aimed at SME development and growth. For example, the long-term SME Development Strategy through 2030 sets an ambitious target of nearly doubling the share of SMEs in Russia’s GDP by 2030, to 40 percent. The mid-term National Project on SME and Individual Entrepreneurship Support (also known as the National SME Project) calls for increasing employment in SMEs by 1.5 times to 25 million people and raising their contribution to the GDP to 30 percent by 2024. SMEs could become an even more important source of growth and jobs in Russia if their access to finance were improved. Access to finance is among the key business environment obstacles (following regulations and taxes, administrative burden, poorly educated workers and overall macroeconomic conditions) to SME growth, with an estimated financing gap of $222 billion. According to the Russia Small Business Index (RSBI), as of the first quarter 2018, difficulties in obtaining loans were reported by 25percent of surveyed SMEs. Micro enterprises experienced a higher rejection rate compared to small and medium companies. Credit to SMEs declined during the recent recession as more credit was directed to larger enterprises. This trend was reversed only recently, but SME lending volumes are still below the pre-crisis level, amounting to 11 percent of total credit and 12 percent of GDP. More recently, the Russian government has signaled even stronger support for the SME sector, with emphasis on strengthening the legal and institutional frameworks and developing financial and non-financial support measures for SMEs. The National SME Project aims at substantially expanding SME access to finance by: (1) simplifying access to subsidized finance and increasing its volume; (2) facilitating access to capital markets for SMEs; (3) improving access to leasing instruments; (4) facilitating access to micro finance and crowdfunding. The Central Bank of Russia developed a corresponding roadmap to support the implementation of the above goals. The roadmap is aimed at leveling the playing field between SMEs and large corporates in their ability to access finance by lowering disincentives for banks and non- bank financial institutions to engage in SME financing as well as increasing financial literacy of SMEs. The SME Development Strategy calls for improved access to finance for SMEs that would increase to 23 percent the ratio of SME loans to total credit by 2030. A number of policy measures to support bank financing of SMEs have been introduced, including streamlining provisions of credit guarantees through a three-tiered national guaranty system, introducing a soft-loan program by the Central Bank of Russia (the so-called “6.5 program”), provisioning the interest rate subsidies from the budget to select banks that lend to SMEs, and developing legal and regulatory framework and operational standards for the securitization of SME loans, as well as non-financial support for SMEs. While these measures, coupled with the economic recovery, have helped to reverse the declining trend in SME lending, SME access to finance still remains constrained by both demand and supply-side factors. SMEs are challenged by high collateral requirements by banks, difficulties in accessing government support programs, a limited number of suitable financial products for SMEs beyond traditional bank loans (e.g. leasing, crowdfunding, factoring), and weak financial knowledge and skills. Key constraints for SME access to finance on the supply side include stringent regulatory requirements for banks to lend to SMEs, uneven access to government funding programs for banks, depriving smaller private banks of such access, and market distortions caused by the administration of the state support programs. Until recently, most government initiatives that were aimed at expanding SME access to finance were focused on supporting bank financing to them. The new policy measures include complementary policies to support access to a wider range of finance instruments, such as capital market financing, crowdfunding, leasing, securitization etc. This two-pronged approach, which seeks to complement policies to ease SMEs’ access to credit with initiatives to support a more diversified financial offer for SMEs, is in line with the G20/OECD High-Level Principles on SME Financing. While many governments use subsidized loans to ease SME access to finance, this policy instrument should be used selectively to enable access for those SMEs who otherwise can’t get finance. Not all types of SMEs are equally sensitive to the cost of funding, especially when interest rates are at historically low levels. Subsidized finance programs should aim at bringing additionality by targeting SMEs unable to get loans on market terms. 19 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Concentration and public dominance in the banking of Finance and Ministry of Economic Development. sector increased even further. Five large banks Proposed measures include elimination of control 60 percent of the system’s assets9 – up from preferential access to various government programs 52 percent at the end of 2013. Furthermore, state- (e.g. subsidized lending programs etc.), limiting the owned entities account for nearly 70 percent of state in acquiring shares of financial institutions, Russian bank assets. One reason for this increase was development of financial technologies to lower an establishment of a Banking Sector Consolidation competitive disadvantages for smaller players and Fund (BSCF) by CBR to resolve insolvent financial other measures. Proportional regulation for banks institutions. In 2017-2018, the BSCF took control of introduced by CBR, which will fully come into effect in eight privately owned banks, including systemically 2019, is aimed at decreasing regulatory compliance important ones. CBR intends to privatize these banks costs of the smaller financial institutions, thus once recapitalization procedures are complete and removing some of their competitive disadvantages. market conditions become more favorable. With increasing of public dominance in the financial The banking system has sufficient liquid FX assets sector (not only in banking, but also in insurance, to repay its maturing external debt. The new bank financial infrastructure), private and smaller banks resolution mechanism supports financial stability as find it more and more difficult to compete, as public it provides for the quick restoration of the solvency banks often enjoy preferential access to government profiles of large and systemically important banks, programs, clients, cheaper funding and large though it can induce moral hazard in the long run distribution networks. due to limited bail-in. To reduce potential risks in the system, the CBR has taken measures to restrict Increasing competition in the financial sector has growth in some of the riskier retail segments. To push become one of the priorities under the CBR financial the banks to further de-dollarize their loan portfolios, sector development strategy 2018-202110. In August the CBR also tightened risk-weight requirements for 2018, the Russian government approved a three-year FX-denominated loans. High international reserves roadmap (2018-2020) for enhancing competition in (29.4 percent of GDP) and a flexible exchange-rate various sectors of the Russian economy, including regime should keep serving as substantial buffers financial sector, which will be implemented jointly against external shocks. by the CBR, Financial Antimonopoly Service, Ministry 1.7 Fiscal policy: reforms are planned to support the ambitious goals set in the President’s May Decree Higher oil prices, combined with a weaker ruble, a better tax administration, and a conservative fiscal policy further improved fiscal balances at all levels of the budget system. New development goals set by the President in the May Decree moved the government to increase spending on education, health, and infrastructure starting in 2019. This puts an emphasis on revenue mobilization through a VAT rate increase and tax maneuver in the oil sector. To fit in higher spending, the fiscal rule has been temporarily relaxed. These measures increase fiscal risks but fiscal risks are contained, given Russia’s low public debt and manageable financing needs. T he fiscal balance improved at all levels of the budget system. The general government surplus widened in the first nine months of 2018 (to 4.7 percent turned into a surplus of 3.6 percent in the first ten months; and the consolidated regional budget surplus improved to 1.0 percent of GDP from 0.8 percent of of GDP compared to 0.6 percent in the same period last GDP in the first nine months of 2018 (Figure 32 and year); the federal budget deficit in 2017 (of 0.3 percent) Table 3). The across-the-board improvement in the 9 Source: CBR. As of September 1, 2018. 10 https://www.cbr.ru/Content/Document/File/44185/onfr_2019-21(project).pdf 20 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure 32: Budget balance improved at all levels of the budget system (Percent of GDP) The General Budget 35 8 30 6 4 25 2 20 0 15 2 10 4 5 6 0 8 Primary expenditures Oil and gas revenues Non- oil/gas revenues 9 months of 2017 9 months of 2018 9 months of 2017 9 months of 2018 Non -oil/gas primary balance Primary balance The Federal budget 20 6 18 4 16 14 2 12 0 10 8 -2 6 -4 4 2 -6 0 Revenues Oil and gas revenues Non- oil/gas revenues -8 10 months of 2017 10 months of 2018 10 months of 2017 10 months of 2018 Non- oil/gas primary balance Primary balance The Regional budget 12 1.4 1.2 11.5 1 11 0.8 0.6 10.5 0.4 10 0.2 9.5 0 9 months of 2017 9 months of 2018 9 months of 2017 9 months of 2018 Revenues Primary expenditures Balance Primary balance Source: EEG. fiscal stance was due to higher oil prices, combined To boost growth, in May 2018, the President of with a weaker ruble, a better tax administration and Russia issued a “May Decree” which introduced a a conservative fiscal policy. The non-oil/gas primary set of goals to be reached by 2024. Among others, fiscal deficit improved to 4.3 percent of GDP in the they seek for Russia to become one of the five largest first ten months of 2018, compared to 5.9 percent economies in the world (currently Russia is 6th in of GDP in the same period last year. PPP terms); for the GDP growth rate to be on par with the world’s average; halving the poverty rate; 21 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Table 3: Budget system balances General government (% of GDP) 9 months of 2017 9 months of 2018 Revenues 33.5 35.8 Expenditures 32.9 31.1 Primary expenditures 31.9 30.1 Balance 0.6 4.7 Primary balance 1.6 5.7 Federal government (% of GDP) 10 months of 2017 10 months of 2018 Revenues 16.6 19 Oil and gas revenues 6.4 8.7 Non-oil/gas revenues 10.2 10.3 Expenditures 16.9 15.4 Primary expenditures 16.1 14.6 Interest payments 0.8 0.8 Primary balance 0.5 4.5 Non-oil/gas primary balance -6.7 -5.1 Balance -0.3 3.6 Consolidated regional government (% of GDP) 9 months of 2017 9 months of 2018 Revenues 11.5 11.5 Expenditures 10.8 10.5 Primary expenditures 10.6 10.2 Balance 0.8 1 Primary balance 0.9 1.3 Extrabudgetary funds Revenues 13.4 12.5 Expenditures 13.3 12.5 Balance 0.2 0.1 Source: Economic Expert Group. fostering population growth; raising life expectancy 16.9 percent of GDP in 2021 (compared to previous to 78 years; and paving the way for the digital plans of spending 15. 9 percent of GDP in 2019, and economy to reach 30 percent of GDP. These goals 15.6 percent of GDP in 2020). The most important have already moved the government to increase steps to mobilize revenues for the May Decree spending on education, health, infrastructure, goals include: social policy, digital economy, support of SME and - Increasing the VAT rate from 18 to 20 percent exports starting in 2019. Twelve national projects (would mobilize revenues worth 0.5 to 0.6 and the comprehensive plan for modernization percent of GDP annually; also see Box 6 for and expansion of infrastructure are included in the distributional impact of VAT increase); federal budget for this purpose. Additional budget - Streamlining taxation of the oil sector by 2024 spending in these areas is expected to be about 8 (would mobilize revenues worth 0.2 to 0.4 trillion rubles over six years (or about 1.1 percent of percent of GDP in 2020 and 2021); and annual GDP, on average). As a result, overall federal - Raising the retirement age (would mobilize budget spending is expected to total 17.0 percent revenues in the long-term; see Box 7). of GDP in 2019, 17.2 percent of GDP in 2020, and 22 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments The government also plans a temporary relaxation • Another option for the government to fit in of the fiscal rule in 2019 – 2024. In this period, higher spending is to increase tobacco taxation instead of targeting a zero federal budget primary and cut tax expenditures (reconsider and reduce deficit (at the benchmark oil price of USD 40 per preferential tax rates), currently estimated at 2.8 barrel in 2017 prices), the fiscal rule would now percent of GDP11. target a deficit of 0.5 percent. This expenditure • A temporary relaxation of the fiscal rule would increase (of 0.5 percent of GDP) would be financed increase the public debt. Public debt increase mainly via domestic debt issuance. could potentially crowd out private debt, but this • At projected government oil prices of USD 63.4 effect is difficult to assess at this point (especially per barrel, USD 59.7 per barrel, and USD 57.9 per in view of risk-averse behavior with regard to barrel in 2019, 2020, and 2021 respectively, the emerging markets). However, Russia’s public debt federal budget is expected to register surpluses is low (15.5 percent of GDP in 2017 compared to of 1.8 percent of GDP, 1.1 percent of GDP, and the OECD average of 73 percent), and the Russian 0.8 percent of GDP. The general government domestic bond market (of about 19 trillion rubles) budget is expected to register surpluses of about is sizable compared to the additional issuance the same scale. (of about 1.5 trillion). Additional domestic • The initiatives of the government on debt issuance would also broaden the set of increasing spending on health, education, and instruments for state banks with limited access to infrastructure are all steps in the right direction, international financial markets. and, if resources are spent efficiently, should positively affect the labor force, productivity, and connectivity. (Please see Box 8, which covers problematic areas in the Russian education). Box 6 The proposed VAT rate increase would have a relatively neutral effect on the overall income distribution The value added tax (VAT) is due to increase Russia. Starting in January 2019, the standard VAT rate in Russia is due to increase from the current 18 percent to 20 percent. Some food products, children’s supplies, books and other products are taxed at a reduced rate of 10 percent. The reduced rate will not change. The analysis below estimates the distributional effect of the VAT increase in Russia using the static microsimulation model RUSMOD.12 The VAT rate increase could lead to welfare losses of around 1 percent of disposable income. The model assumes that economic incidence of VAT fully falls on consumer. This corresponds to the assumption that the final consumers’ price would increase to the same amount as the additional tax. Under this case the effect on welfare loss of VAT increase is estimated at the level of 0.8 percent of disposable income on average. According to the model, additional budget revenue collection of VAT could grow by 8.4 percent. The proposed VAT increase would have relatively neutral effect on the distribution. According to simulations, the distributional effect of VAT increase in Russia would not be strongly progressive, nor regressive (Figure B6-1). Usually yet indirect taxes are regressive because households at the lower part of the distributions have fewer savings and spend a higher share of their income on current consumption. This is also the case in Russia. However, there is another effect – the effective rate of VAT is lower on foods and clothes. These two effects compensate each other and lead to a relatively neutral effect of VAT rate increase on the distribution in Russia. 11 Estimate of the Ministry of Finance. 12 More details of the model can be found in Popova, D. (2013). Impact assessment of alternative reforms of Child Allowances using RUSMOD – the static tax-benefit microsimulation model for Russia. International Journal of Microsimulation, 6(1), 122-156. 23 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Figure B6-1: Distributional effect of VAT increase in Russia by deciles and types of families (Percent of disposable income) 0.0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 -0.9 -1.0 1 2 3 4 5 6 7 8 9 10 TOTAL Lone parents Couple 1 child couple 2 children couple 3 + children Only adults Only pensioners Mixed Source: World Bank staff mates using RLMS-HSE-2016 data. esti mated using RUSMOD – a stati Note: Esti on model, spin-off c microsimulati of EURMOD. The model does not take into account second-order and ects. It also assumes that economic incidence of VAT fully falls on consumers. Deciles are defi behavioral eff ned based on per capita disposable income. Box 7 Russia’s new Pension Law On October 3, 2018, the President of the Russian Federation signed Federal Law № 489161-7 On Amendments to Several Legislative Acts of the Russian Federation on Pensions. The cornerstone of the law is a gradual increase of the retirement age to 60 years for women and to 65 years for men. Starting from 2019, the retirement age would increase in six months increments in the first two years and then in 12 months increments for the rest of the transition period, ending in 2024. The new retirement age would result in longer service periods, later exits from the labor market, stronger pension contribution revenues and a lower deficit. In the long run, longer service periods imply higher pensions. Raising retirement age is undoubtedly the strongest pension system measure in the current package. In addition to the general retirement-age increase, the new law has also introduced other changes (Table B7-1). Table B7-1: List of pension reform measures Pension type/measure Final version according to the new law 65/60 General retirement age (6 months gradual increase during first two years of reform) Social pensions eligibility age 70/65 Survivors (parents or spouse) 65/60 Survivors (grandparents) 65/60 Employees in the far North regions 60/55 Mothers with three/four/five and more children 57/56/50 Early retirement based on length of service 42/37 55-60 Theatre employees (condition for early retirement with 15 - 30 years service) Cosmonauts and their family members 65/60 24 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Pensions in the Russian Federation consist of a fixed part (“basic pension”) set by the law and a variable part (“insurance component”), which reflects an individual’s length of service and paid contributions and is captured in the number of pension points that individual accumulates prior to official retirement. Starting from 2025, an individual must collect a minimum of 30 pension points and complete a minimum of 15 years of service to be eligible for an old-age pension. An individual can accumulate a maximum of 10 qualifying points per calendar year if they do not contribute to the funded pillar, or 6.25 pension points if they do contribute to the funded pillar. The pension reform package has set both the fixed part of the pension and the point value for the 2019-2024 period (Table B7-2). Moreover, the fixed part indexation, which resumes from February 1, 2019, can be adjusted based on the previous year’s consumer price index (CPI) growth: Table B7-2: Fixed part of pension and point value 2025 - in RUR 2019 2020 2021 2022 2023 2024 onwards Value of one individual CPI + residual 87.24 93.00 98.86 104.69 110.55 116.63 pension point wage growth Fixed part of pension benefit 5334.19 5686.25 6044.48 6401.10 6759.56 7131.34 TBC (basic pension) Adjustment (indexation) of CPI + residual CPI (linked to the pension point value) + residual point value growth pensions in payment wage growth Source: Rosstat. During the period of 2019-2024 the pensions in payment (“indexation”) will be adjusted (“indexed”) in two rounds reflecting CPI and residual point value growth. From 2025 the adjustment of point value and pensions in payment would be identical. On February 1, pensions will be increased in accordance with the last year’s consumer price index (CPI) growth. On April 1, it can be increased for a second time with a difference between average wage growth and the CPI (residual wage growth) but only if that difference is positive and up to growth rate of the Pension Fund revenues per pensioner. 25 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments Box 8 Russia performs well and achieves a lot in terms of ensuring the equal access and quality of education for students, yet there are some problematic areas that need to be tackled The recently announced Human Capital Index put Figure B8- 1: HCI and Components Russia in a group of high performing countries (see Figure B8- 113). Given the comparatively low share of human capital expenditures over the last several years, Russia has managed to do relatively well. In addition to sustaining gains in early childhood development, this is largely attributable to Russia’s good performance in international assessments. Starting from 1995, Russia is the most consistent participant of PISA, PIRLS, TIMSS and other international studies14. The participation in international assessments enabled Russia to conduct rigorous research and find the weak points in education policy as well as address them timely. Recent World Bank analysis of education equity in Russia showed that the country performs well in terms of ensuring the equal access and quality of education for students15. Moreover, the sound progress of resilient schools in the same study shows the strong potential of the education system to serve as a social elevator and allow people to realize their potential in life16. The performance of Russian students aged 15 years in PISA 2015 reached the OECD average in mathematics and reading comprehension, while it is very close to the average in science. These cognitive domains are important, and in cognitive tests, the Russian students perform well starting from the end of primary schools. For instance, in PIRLS 2016 Russian students took the 1st place, and TIMSS 2015 Russian students reached the 7th place in mathematics and 4th Source: World Bank. place in science. Yet, the area that needs more attention of the government is the socioemotional skills or skills of the 21st century (see Figure B8-217). Recent PISA 2015 had a hardwired study of students’ collaborative problem solving (CPS), that grasps the students’ ability to build the shared understanding, solve problems, and organize teams. Russian students appeared to be below the OECD average. Moreover, the distance in scores between the main PISA test and CLPS appears to be the largest among all participating countries. That may mean that the current education gives students personal skills at the level of the OECD average. However, the socioemotional and life skills might be underrepresented in the curriculum and education practices. 13 p://www.worldbank.org/en/publicati htt on/human-capital 14 Developing the enabling context for student assessment in Russia. Viktor Bolotov, Galina Kovaleva, Marina Pinskaya, Igor Valdman. The onal Bank for Reconstructi internati on and Development. The World Bank, 2013. 15 p://documents.worldbank.org/curated/en/139291530189329351/pdf/P164840-Summary-Report.pdf htt 16 nes as resilient the schools, operati The study defi cult social conditi ng in diffi onal results. ons that are able to achieve high educati 17 World Bank World Development Report 2018. 26 Russia Economic Report | Edition No. 40 I. Recent Economic and Policy Developments With a goal to move the Russian education system into Figure B8- 2: Technical, socioemotional, and cognitive top 10 education systems globally, the Government skills interact is now working on the design and implementation of several projects. The large “National Project Education” would bring nine previously federal level projects under one umbrella. The topics of those nine projects include modern schools and learning environments, digital education, successful learners, modern parents, teacher of the future, young professionals, new opportunities for all, social responsibility of youth, and improving the competitiveness of higher education. Another identified government goal is to bring Russia to the top 5 countries with the leading research and development systems in the several priority areas Source: World Bank. of the technological development. To support this goal, the large “National Project Science” will bring together three federal level projects. These will include: development of cooperation between research and industry, development of the research infrastructure, development of research capacity. The government is currently working on the metrics and results indicators. Some challenges on this front include measuring the impact of the proposed federal projects, providing for improvement of socioemotional skills development and orienting the national educational system towards the benefits of 21st-century learning, improving the efficiency of the overall program and its components. 27 Russia Economic Report | Edition No. 40 PART II GROWTH CONTINUES, BUT RISKS ARE ELEVATED 29 Russia Economic Report | Edition No. 40 II. Outlook and Risks External economic conditions are expected to weigh on growth. External financing conditions for EMDEs are also expected to tighten further in coming years, resulting in higher borrowing costs and a moderation of capital flows. Growth in major trading partners is expected to slow. Russia’s growth prospects for 2018 - 2020 remain modest, with growth forecasted to be between 1.5 and 1.8 percent in the 2018 - 2020 period subject to mostly unfavorable risks. E xternal economic conditions are expected to weigh on growth. External financing conditions for EMDEs are expected to tighten further in possibility of new production cuts by OPEC and non- OPEC members, of around 1 mb/d, in response to the recent weakness in oil prices, although it would coming years, resulting in higher borrowing costs have to convince other countries, notably Russia, to and a moderation of capital flows. Growth in major also participate. Production is expected to continue to trading partners is expected to slow. Euro Area decline in Venezuela and will likely fall in Iran when the growth is projected to decelerate toward potential, waivers expire in 2019, although there is uncertainty from 2.1 percent in 2018 to 1.5 percent in 2020. about the speed and size of these developments. In Growth in China is expected to slow from 6.5 addition, geopolitical risks remain elevated in other percent in 2018 to 6.2 percent in 2020 (Table 4). key oil producers, such as Libya. The level of spare capacity among OPEC members is estimated to be low Oil prices are expected to average $71/bbl over the at present, suggesting there are limited buffers in the next three years, although there is considerable event of a sudden shortfall in supply of oil, raising the uncertainty to the forecast. Demand is expected to likelihood of oil price spikes in 2019. remain robust, with the International Energy Agency forecasting an increase of 1.4 mb/d, although their Metals prices are forecast to gain 5 percent in forecast has been revised down relative to earlier 2018 and stabilize in 2019. The key downside risk is estimates as a result of weaker global growth and a worsening of trade tensions between the United higher prices. Non-OPEC oil production is expected States and China, as well as weaker global growth. to increase 2.0 mb/d in 2019, with much of the Upside risks include stronger demand from China additional supply coming from the United States due to policy stimulus, and policy actions that limit despite significant bottlenecks such as a lack of production, such as environmentally-driven cuts, pipeline capacity and labor shortages. notably in China. Agricultural prices are projected to gain nearly 2 percent in 2019 as input costs rise, As non-OPEC oil supply growth is expected to including energy and fertilizers. Downside risks to be greater than that of global demand, the the price forecast emanate from escalating trade outlook for oil prices depends heavily on supply tensions. On the upside, persistently high energy from OPEC members. Saudi Arabia has raised the prices could raise fuel costs and fertilizer prices. Table 4: Global growth is broadly stable (GDP growth projections, percent) 2016 2017 2018f 2019f 2020f World 2.4 3.1 3.1 3.0 2.9 Advanced economies 1.7 2.3 2.2 2.0 1.7 United States 1.5 2.3 2.7 2.5 2.0 Euro Area 1.8 2.4 2.1 1.7 1.5 Emerging and developing economies 3.7 4.3 4.5 4.7 4.7 China 6.7 6.9 6.5 6.2 6.2 Russia -0.2 1.5 1.6 1.5 1.8 Source: WDI, World Bank staff projections. 30 Russia Economic Report | Edition No. 40 In the absence of a sharp escalation of geopolitical Figure 33: The growth forecast for Russia suggests benign growth tensions, we expect Russian economy to (Real GDP growth, percent) continue modest growth supported by relatively high oil prices. 3 110 2 1.5 1.6 1.5 1.8 100 90 Russia’s growth prospects for 2018-2020 remain 1 0.7 80 US$ per barrel 70 modest, forecasted at 1.5 to 1.8 percent (Figure Percent -0.2 0 60 33 and Table 5). This suggests that growth rates -1 50 40 in Russia will stay below the EMDE average -2 -2.8 30 (4.6 percent) and exceed the AE average (1.7 20 -3 percent) only in 2020. In 2018, we expect growth 10 -4 0 in the fourth quarter to accelerate slightly q/q, 2014 2015 2016 2017 2018 2019 2020 compared to the previous period. Consumption Oil price, average, rhs GDP growth would support growth driven by higher demand Source: Rosstat, World Bank. for durable goods ahead of VAT rate increase. Overall growth for 2018 is expected a notch above will accelerate, supported by public spending on 2017, at 1.6 percent. infrastructure projects and the slightly positive contribution from restocking (compared to The fiscal rule suggests reduced sensitivity of destocking in 2018). Yet, household consumer Russia’s GDP growth to oil price volatility. A demand is expected to slow down on the back simulated decrease of 10 percent in oil prices would of lower real wages growth. Public sector wages reduce growth in Russia to 1.4 percent in 2019 and growth will slow down from a high base of 2018. 1.7 percent in 2020. A simulated rise of 10 percent in oil prices would increase growth to 1.6 percent Higher inflation would weigh on real wage growth for 2019 and 1.9 percent in 2020. in the private sector. Meanwhile, credit growth will continue supporting consumer demand. Export In 2019, we expect growth to slow down slightly growth will decelerate slightly as growth in Russia’s to 1.5 percent. Fixed capital investment growth major partners is expected to slow. Table 5: Projected growth rates are modest (Major macroeconomic Indicators) 2017 2018f 2019f 2020f GDP growth, percent 1.5 1.6 1.5 1.8 Consumption growth, percent 2.5 2.0 0.9 1.5 Gross fixed capital formation growth, percent 4.3 2.2 2.0 2.5 General government balance, percent of GDP -1.5 2.0 2.0 1.5 Current account (US$ billions) 33.3 97.6 100.5 89.0 Current account, percent of GDP 2.1 6.0 5.9 5.0 Exports (GNFS), bln USD 411.3 497.1 524.4 539.7 Imports (GNFS), bln USD 326.9 349.5 372.6 397.8 Trade balance (GNFS), bln USD 84.3 147.6 151.8 142.0 Trade balance (GNFS), percent of GDP 5.3 9.1 8.9 8.0 Capital and financial account (US$ billions) -19.6 -65.6 -36.1 -30.5 Capital and financial account, percent of GDP -1.2 -4.0 -2.1 -1.7 CPI inflation (average) 3.7 2.9 5.1 4.2 calculati Source: WB staff ons. 31 Russia Economic Report | Edition No. 40 II. Outlook and Risks In 2020, we expect GDP growth in Russia to elevated geopolitical tensions, which translate into accelerate to 1.8 percent. Household consumption high uncertainty that dampens domestic demand. growth will somewhat restore after its 2019 A marked escalation of trade tensions among major deceleration. If the Fund for Development establishes economies could negatively affect growth in Russia itself as an efficient government tool, fixed capital and globally. A potential sudden tightening of investment growth would also slightly rise. global financial conditions could negatively affect growth in Russia by pressuring the financial account Supported by relatively high oil prices, the general and exchange rate, translating into higher inflation government budget is expected to stay in surplus and lower domestic demand. Inflationary risks in 2018 – 2020. A temporary relaxation of the fiscal stem from the VAT rate increase, pass through from rule would increase the public debt level, although the ruble depreciation, a higher-than-expected to a still modest level of about 18 percent of GDP rise in gasoline prices, a closing of the output gap, by 2020. The current account will stay in surplus elevated inflation expectations and heightened but decrease slightly as import demand grows. external volatility. And with a large state footprint, International reserves will increase due to currency the risk of contingent liabilities (in the banking purchases in the fiscal rule framework. sector, for instance) are elevated. On balance, thus, unfavorable factors outweigh favorable ones, The moderate poverty rate is expected to continue keeping the emphasis on maintaining stability. to decline in 2018 and throughout 2020 (Table 6). A rebound in the economy, wage growth in As discussed in Section 1.2 on growth, REER the private sector, and the indexation of pensions depreciation is not enough for economic to inflation will support disposable incomes and diversification, which would make the country contribute to a gradual decline in the poverty rate. more resilient to external shocks. The government However, many individuals lack formal employment is undertaking important measures which could and many households remain close to the poverty raise human capital potential (national projects line, suggesting a level of social vulnerability that targeted at human capital) and improve connectivity will continue to require close monitoring. (infrastructure investment). Substantial progress has been achieved in enhancing regulatory Risks to the outlook are mostly unfavorable. Higher- environment. Another key dimension is providing than-expected oil prices could favorably affect the for level playing field (Box 9) and reducing the state growth forecast. Unfavorable factors stem from footprint. the potential expansion of sanctions and continued Table 6: The moderate poverty rate is expected to continue to decline in 2018 and throughout 2020 2010 2011 2012 2013 2014 2015 2016 2017 2018 f 2019 f 2020 f Poverty rate, percent 12.5 12.7 10.7 10.8 11.2 13.3 13.3 13.2 12.4 12.0 11.6 Source: Rosstat, WB staff calculations. 32 Russia Economic Report | Edition No. 40 II. Outlook and Risks Box 9 Competition conditions in Russia have not improved as rapidly as broader investment climate conditions yet there are some problematic areas that need to be tackled Product market regulations remain the most restrictive in the OECD (OECD Product Market Regulations Index) and Russia ranks 95th of 137 countries on the Global Competitiveness Index’s competition perceptions indicator. The continuing presence of high price-cost margins, lower than average market entry rates, and lower levels of private investment in innovation all point to limited levels of competition. Competition policy has become an increasing priority for the government and in December 2017, Presidential Executive Order No. 618 was adopted on State Competition Policy Guidelines. The guidelines are in line with good global practices and outline policy objectives and expected outcomes and include a National Competition Development Plan for the 2018 – 2020 period. The Government of the Russian Federation coordinates the implementation of the guidelines among stakeholders including the Federal Antimonopoly Service (FAS), ten federal ministries, executive authorities of the regions of the Russian Federation, and local self-government bodies. Numerous reforms have been introduced to federal laws and by laws under the guidelines, with a focus on an initial set of 13 sectors. At the regional level, a ‘Competition Standard’ was put in place in 2015 to establish a common approach to promoting competition. The standard sets a number of measures grouped in seven requirements to be implemented by each region ranging from the development of roadmaps to promote local competition to awareness raising with market participants. Regions are measured annually on progress against the competition standard and the standard itself is currently being amended to incorporate feedback from the regions. While considerable progress has been achieved in establishing a functioning legal and institutional competition framework, several challenges need to be addressed to make this framework more effective in enhancing competition: - reverse a trend towards cartelization of the economy, especially, in public procurement (Source: Federal Antimonopoly Service). - promote competitive neutrality principles among SOE and private sector actors; - ensure the transparency of state support and privileges to minimize competition distortions. 33 Russia Economic Report | Edition No. 40 II. Outlook and Risks Box 10 Russia continued its efforts to enhance the regulatory environment for small and medium enterprises carrying out four reforms in the past year The reforms aimed to improve the business climate for domestic small and medium enterprises as applied to both Moscow and St. Petersburg, the two Russian cities benchmarked by the Doing Business report. As a result of the latest reforms, Russia advanced to 31st place in the global ease of doing business ranking (Table B10-1), representing an improvement from the 35th place last year and 40th place two years ago. Russia was ranked 120th seven years ago. Highlights of the past year’s reforms are: • Dealing with Construction Permits was made faster by reducing the time needed to obtain construction and occupancy permits. Quality control measures during construction were also enhanced by introducing risk-based inspections. • Getting Electricity was made faster by imposing new deadlines for connection procedures and by upgrading the utility’s “one-stop shop” as well as its internal processes. Getting Electricity was also made cheaper by reducing the cost to obtain a connection to the electric grid. • Paying Taxes became less costly by allowing a higher tax depreciation rate for fixed assets. • Trading Across Borders was made easier by prioritizing online customs clearance and introducing shortened time limits for its automated completion. • Russia excels in the area of Getting Electricity, with a global rank of 12. With the latest reform, it now takes only 2 procedures and costs 5.7 percent of income per capita to get connected to the electrical grid, compared to the average of 5 procedures and 325 percent of income per capita in the Europe and Central Asia region. The number of days needed to obtain an electricity connection also has been reduced to 73 days from 83 earlier. Here again, Russia performs significantly better than the regional average, which is 110 days. • Registering Property and Enforcing Contracts are also areas of strength for Russia. Registering Property has been a focus of reforms in recent years, which have helped place Russia in 12th place globally. In the area of Enforcing Contracts, it takes only 337 days for a business in Russia to resolve a commercial dispute through a local first-instance court, compared to 496 days in the region. However, there is room for further improvement in several areas, in which ranking exceeds Russia’s average score (Figure B10- 1), including Trade Across Borders, Resolving Insolvency and Protecting Minority Investors. Russia scores only 2 out of 10 in the extent of director liability index, which means that in case of misuse of corporate assets, directors would be held liable in very few situations. Table B10-1: Top 5 economies in Doing Business Figure B10-1: Ranking in five areas exceeds Russia’s 2019 ranking average score substantially Economy Global Rank (Percent) New Zealand 1 120 Trading Across Borders Singapore 2 99 Protecting Minority Investors 100 Resolving Insolvency Denmark 3 Paying Taxes Hong Kong SAR, China 4 80 Dealing With Construction Permits Korea, Rep. 5 Starting A Business 60 57 55 53 Source: Doing Business 2019. 48 Getting Credit 40 Enforcing Contracts 32 Getting Electricity 22 18 20 12 12 Registering Property 0 Source: Doing Business 2019. 34 Russia Economic Report | Edition No. 40 PART III POTENTIAL GROWTH: OUTLOOK AND OPTIONS FOR RUSSIA* al growth: Outlook and opti * This part of the report is based on a World Bank Policy Research Working Paper “Potenti ons for Russia” by Yoki Okawa and Apurva Sanghi (published on December 2018) and with valuable contributions from Sinem Kilic Celik and Y. Modeste Some. The paper has benefited from comments and suggestions by Zoran Anusic, Olga Emelyanova, Evsey Gurvich, Andras Horvai, Sandeep Mahajan, Alexander Morozov, Franziska Ohnsorge, Irina Rostovtseva, Marc Stocker, Maria Ustinova. III. Potential growth: Outlook and options for Russia Russia’s potential growth peaked before the 2008 global financial crisis and continued to decline up to 2017. The estimated potential growth rate was 3.8 percent in 2000-09 and 1.7 percent in 2010-17, a 2.1 percentage point decline. The most recent deceleration was due to a slowdown of productivity growth and a shrinking potential labor force – rather than a shortfall in capital accumulation. Regarding its future trajectory, under the baseline scenario, Russia’s potential growth is expected to continue its gradual downward trend from 1.5 percent in 2017 to bottoming out at 1.3 percent in 2022. But it recovers gradually thereafter, primarily driven by a stabilization of the labor force. The simulations of proposed reform measures being currently considered by policymakers, which include a combination of pension reform, more inward migration, higher investment, and gradual acceleration of Total Factor Productivity (TFP) growth can double Russia’s potential growth rate to 3.0 percent by 2028. 3.1 Evolution and drivers of potential growth As Figure 34 shows, Russian TFP growth began in the short- and long- term: productivity, to slow down during the global financial crisis capital, and labor period in 2008-09, and ultimately declined to 1.3 A fter demonstrating remarkable resilience in the early 2000s, Russia’s potential growth — the rate at which the economy can grow when percent in 2017. The declining trend in TFP is a global phenomenon. Weaker productivity growth has been attributed to slower investment growth, labor and capital are fully employed — slowed partly because of deleveraging pressures and in the late 2000s and continued to weaken. The other crisis legacies, combined with population recent potential growth slowdown is a global aging and maturing global value chains (World phenomenon. However, in Russia the slowdown of Bank 2018). In Russia, TFP growth slowed as potential growth was more serious than the rest of productivity gains from first generation reforms the world, reflecting weaker productivity growth wore off (World Bank 2014). The changing and worse demographic outcomes. This analysis composition of investment from machinery to showed that the average potential growth rate was construction could have also contributed to 3.8 percent in 2000-09 and 1.7 percent in 2010-17, lower TFP growth (Voskoboynikov 2017). a 2.1 percentage point decline. On the other hand, the potential growth rate for advanced economies B. Capital declined by 0.7 percentage point in the same period. Globally, investment growth halved between The recent deceleration was due to a slowdown of 2010 and 2016, with the weakness shifting from productivity growth and a shrinking potential labor advanced economies to EMDEs over this period. force rather than a shortfall in capital accumulation. In Russia, although investment growth slowed from an average growth of 10.4 percent during A. Productivity the previous decade to 2.8 percent in 2010 – 2017, Russian productivity growth outpaced the the investment as a share of GDP increased. This advanced economy (AE) average and global helped to accelerate capital growth over the period average during the previous decade. On average, 2010-1718 (Figure 35) (Voskoboynikov 2017). TFP growth was 2.9 percent in Russia compared to 0.7 percent in AEs in 2000-2009. This high While investment weakness in advanced TFP growth reflects a one-off transition process economies mainly reflects sluggish demand and characterized by the reallocation of excess capacity output growth, in EMDEs, a broader range of to more productive sectors of the economy (World factors has been at play. In commodity importers, Bank 2014). slowing FDI inflows and spillovers from soft activity 18 While investment growth and capital accumulation are closely related, they sometimes do not move together. When the level of investment is high relative to GDP or capital, the capital growth rate is high. 36 Russia Economic Report | Edition No. 40 Figure 34: Slower potential growth was driven by TFP growth slowdown and decline in labor force A. Decompositi on of potenti al growth b. Labor 5 1.0 2 4 0.5 1.5 Percentage point 3 Percent Percent 0.0 1 2 1 -0.5 0.5 0 -1.0 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 -1 2000-09 2010-17 Capital Labor TFP Potential growth Labor force Fertility rate (LHS) Source: Internati onal Labor Organizati on(ILO), World Bank. Notes: A. Average contributi on to the potenti al growth for capital, labor, and total factor producti vity (TFP) for Russia. The diamonds show average al growth. potenti B. Labor force is the esti mated annual potenti lity rate is ILO model esti al labor force growth. Ferti lity rate. mate of total ferti Figure 35: Russia’s Investment-to-GDP ratio stopped increasing, and its capital-to-GDP ratio remains low A. Investment B. Capital 30 400 25 Percent of GDP 300 Percent of GDP 20 200 15 10 100 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Russia Advanced economy Russia Advanced economy Source: World Bank. Notes: A. B. Red line indicates GDP weighted average of 32 advanced economies. xed capital formati A. Gross fi on as a percent of GDP for Russia B. Capital as a percent of GDP for Russia. in major advanced economies accounted for much Directly, increasing the working-age population lifts of the slowdown in investment growth after 2011. the potential labor force and has been associated In commodity exporters, including Russia, a sharp with “demographic dividends” to output growth. deterioration in terms of trade (particularly for Indirectly, a higher share of the working-age energy exporters), slowing growth in China, and population has been accompanied by higher capital mounting private debt burdens accounted for much accumulation and employment (Bloom and Canning of the slowdown in investment growth. 2004; IMF 2004). C. Labor Russian demographic trends are worse than Growing working-age populations can lift potential those found in other EMDEs as the country’s low growth through both direct and indirect channels. total fertility rate in the early 1990’s accelerated 37 Russia Economic Report | Edition No. 40 III. Potential growth: Outlook and options for Russia population aging. Russia’s total fertility rate 1.3 percent in 2023 (Figure 36). It is expected remained low until the mid-2000s. The decline to bottom out in 2023 and to recover gradually in the total fertility rate began to take a toll on thereafter. This recovery is primarily driven by the working-age population after 15 years, with labor inputs. According to the UN’s forecasts, the potential labor force growth peaking in 2007 at 0.7 rate of contraction in the working-age population is percent before declining to -0.7 percent in 2017. expected to bottom out in 2022 (0.9 percent decline) but subsequently bounce back. While our forecasts 3.2 Russia’s potential growth: outlook contain significant variations, the upper bound of Factors weighing on potential growth for Russia forecasts without reforms is expected to remain are likely to persist over the next decade. below 2.5 percent in our forecasting horizon. Demographic trends are expected to become less favorable. This will weigh on potential growth even Figure 36: Russia’s potential growth is expected to decline slowly due to declining productivity growth if trend improvements in human capital and labor (Percent) force participation continue. Short of unexpected 4 surges in productivity growth, these trends imply an outlook of mediocre potential growth. 3 2 The forward-looking scenario (“baseline scenario”) presented below applies the production function 1 approach to assumed paths for capital, population 0 statistics, and education and health outcomes: 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 -1 • Investment to potential GDP ratio is assumed to stay at the 2010-2017 average level (of 23 -2 Russia Advanced economy percent). This means investment growth is roughly in line with the potential growth. Source: World Bank. Notes: Blue line indicates potenti al growth esti mates and forecasts for • The size of the Russian population and its Russia using a producti on functi on approach. Orange line indicates GDP weighted average of potenti al growth esti mates and forecasts for composition are assumed to grow in line with a 23 advanced economies. The shaded area is maximum and minimum median fertility scenario (as in the UN Population of 10 potenti al growth esti mates for Russia (Producti on ap- on functi proach, multi variate fi lter, Hodrick-Prescott lter, Baxter and King fi fi l- Projections). ter, Christi ano and Fitzgerald fi lter, Butt erworth fi lter, 5 years ahead • Labor market participation rates are taken from forecasts from IMF World Economic Outlook and Consensus Economics, potenti al growth esti mates from OECD Economic Outlook and OECD International Labour Organization (ILO) forecasts. Long-Term Baseline Projecti ons). It is assumed that confi dence interval remains constant for the year 2018 and aft er. The baseline scenario focuses on long-term factors, i.e, the supply side of the economy. While In 2019, Russian potential growth is expected to be demand side factors such as oil price fluctuations below the advanced economy average for the first can have large, short-term impact on growth time in 20 years, reflecting a faster contraction through changes in demand, they have a limited of the potential labor force. The difference is at impact on long-term growth.19 most 0.2 percentage point and well within the confidence interval. While expected demographic Under the baseline scenario, Russia’s potential improvements will raise the Russian potential growth is expected to continue a gradual growth above the advanced economy average downward trend from 1.5 percent in 2017 to again in 2026, a minor difference in potential 19 ect the long-term potenti Higher oil prices could aff onship al growth through higher investment. However, we found that the empirical relati between oil prices and investment is not robust in Russia. 38 Russia Economic Report | Edition No. 40 Figure 37: The simulated effects of pension reform in Russia A. Labor market for aged workers al employment growth under pension reform scenario B. Potenti 1.0 80 80 Labor force participation, percent 70 70 0.5 60 60 Percent Age 0.0 50 50 40 40 -0.5 30 30 Male Female Male Female -1.0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 Retirement age Labor force participation Median Russia Baseline Reform Source: Internati onal Labour Organizati on for Economic Cooperati on (ILO), Organizati on and Development (OECD), World Bank. Notes: A. Ri. Blue indicates median of OECD countries. Yellow lines indicate fi rst and third quanti rement age means mandatory reti le. Reti rement age. Labor force parti cipati on rates are for ages 55-64. B. Potenti al employment growth under pension reform scenario discussed in this secti ons menti on. Baseline scenario refers to the assumpti oned in the outlook secti on. growth suggests that Russia’s catching-up to the to the baseline scenario. The potential growth rate advanced economy average is expected to stall for is expected to increase by 0.3-0.4 percentage point the next decade. over 2020-2028. The cumulative impact of pension reform is around 3-4 percent of potential output 3.3 Boosting potential growth: role of during 2020-2028 (after which additional increases pensions, migration, investment and productivity will be negligible). We emphasize that the realized impact of the reform could be smaller than this A. Pensions number. Data limitations forced an emphasis on In 2018, the Russian government proposed a evidence from advanced economies to estimate gradual increase in the retirement age—by five the impact of retirement age reform. Also, reforms years to 65 for men to 60 for women—starting could be potentially backtracked during the in 2019 and ending in 2028.20 We simulated the implementation period. impact of this reform on potential growth. In line with the other countries, we assume that this reform B. Migration will increase the average retirement age by half as Traditionally, linguistic, family, cultural, and much as the increase in the mandatory retirement economic ties between Russia and neighboring age.21 As a result, pension reform is expected to countries created strong migration flows to raise the potential growth throughout the enacted Russia, especially from Central Asia (World Bank time period (Figure 37). During 2020-2028, with a 2017). An increase in migration flows will partially rise in the retirement age for both men and women, offset the adverse demographic implications on potential labor force growth is expected to increase potential growth. by about 0.9 percentage point per year compared 20 The proposed pension reforms go beyond reti ect of only the increase in rement age reform. For purposes of this paper, we consider the eff rement age. reti 21 rement age of the aff In the United States, the mean reti ected cohorts has increased by about half as much as the increase in the normal rement age (Giovanni Mastrobuoni 2009). Similar evidence was found in Germany (Börsch-Supan et al. 2008; Fehr et al 2012) and reti Switzerland (Lalive and Staubli 2014). 39 Russia Economic Report | Edition No. 40 III. Potential growth: Outlook and options for Russia The model simulated the impact of increased ultimately declined to 1.3 percent in 2017. The migration on potential growth.22 In this scenario, decline of TFP growth in Russia is supported by the number of net migrants per year increases firm-level data (World Bank 2016), Firm-level TFP to 289,000 until 2028 (while the United Nations has been declining since 2007 in all sectors. At the forecast is 100,000 in the same year). This results same time, productivity dispersion, especially in the in a 0.2 percentage points higher potential growth. service sector, has risen since 2005, which may imply The effects are expected to continue after 2028. The increasing economic distortions. These economic cumulative impact of increased migration is around distortions ultimately create an uneven playing field, 2 percent of potential output during 2018-2028. limiting the entry and expansion of more efficient firms and the exit of less efficient ones. C. Investment Russian investment needs are vast and estimated Assuming a gradual acceleration of TFP growth at 75 percent of its 2015 GDP (World Bank 2016). of an increase by 0.1 percentage point in 2028 By mobilizing private capital through public-private from its 2017 level (instead of 0.2 percentage partnerships (PPPs) and opening up infrastructure points decline expected in the baseline scenario), subsectors to direct private investment, this increase would push potential growth up by infrastructure can be expanded without creating 0.3 percentage points. The cumulative impact of excessive pressure to the fiscal deficit. increasing the TFP growth rate is around 2 percent of potential output. Unlike for capital and labor, The investment growth path is taken from a one percentage point increase of TFP growth the Ministry of Economy and Development’s would increase potential growth by the same one projections up to year 2025 and extrapolated percentage point. afterwards. These forecasts imply that the ratio 3.4 Can Russian potential growth match global of investment to potential GDP is expected to growth? increase from 23 percent23 in 2017 to 34 percent by 2028. Since 1990, more than 70 countries Global growth is expected to remain around 3 have experienced such an increase. Other than percent. As we have seen, in the baseline case, the well-known example of China, other relevant Russian potential growth is expected to remain examples include Indonesia, India, the Republic of around 1.3 to 1.5 percent for the same period. This Korea, Saudi Arabia and Turkey. All these countries suggests a relative decline of Russian economy for experienced over a 11 percentage points increase the coming decade. in their investment rates in 11 years. However, simulations of specific reform measures The increase in the investment/GDP ratio raises currently being considered by the government potential growth by 0.2 percentage point in 2020 such as pension reform, more inward migration, and 0.6 percentage point in 2028. The cumulative higher investment, and gradual acceleration of TFP impact of the higher investment rate is around 4 growth can increase Russia’s potential growth rate percent of potential output during 2018-2028. to 3 percent in 2028 (Figure 38). Pension reform, and increases in inward migration, investment, and D. Productivity productivity contribute 0.4 percentage points, 0.2 Russian TFP growth began slowing down around percentage points, 0.6 percentage points, and 0.3 the global financial crisis period in 2008-09, and percentage points, respectively, to the increase 22 Even though the government projects higher net migration, it is worth noting that recently, Russia saw less, not more net in-migration due to a weaker exchange rate and mediocre income growth, which has made Russia less attractive for migrants. Also, due to data limitations, we do not consider the quality of migrant labor. As of now, most migrant labor into Russia is cheap, unqualified labor, in low-productivity sectors of economy. 23 23 percent refers to the investment to GDP ratio using 2010 PPP numbers. Russia’s nominal investment to GDP ratio was 21.6 percent in 2017. 40 Russia Economic Report | Edition No. 40 III. Potential growth: Outlook and options for Russia Figure 38: Comprehensive reforms can raise potential growth to the global growth A. Impact of reforms vity B. Total factor producti 3.0 3.0 Productivity increase 2.5 More investment 2.5 2.0 Pension reform Percent 2.0 1.5 Higher migration 1.0 1.5 0.5 1.0 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 0.0 Baseline Reform Reform Baseline Source: World Bank. Notes: ons menti A. B. Baseline scenario refers to the assumpti oned in the outlook secti on. Reform refers to the assumpti on V. ons outlined in secti al growth rate esti A. Potenti mate in 2029. B. Annual growth rate of total factor producti vity. Baseline scenario refers to the assumpti ons menti oned in the outlook secti on. in the potential growth rate. Improvement in the • cal economy. It is important to emphasize Politi demographic conditions by 2028 contributes to the that any structural reform creates winners and potential growth rate as well. Even without reforms, losers. Moreover, minority vested interests may the potential employment growth rate in 2028 is upend reforms that benefit the public at large. 0.2 percentage points higher than that in 2023. The current cyclical upswing is an auspicious time for Russia to implement reforms that may There are several additional considerations for the yield long-term gains. Mitigating pressures from implementation of the reform package in Russia: short-term risks and long-term headwinds requires • Synergies. Implementing multiple reforms the adoption of appropriate policies over time. A simultaneously rather than piecemeal can package that delivers substantial material benefits generate mutually-reinforcing synergies. at an early date thus stands more chance of success • Timing. Reform payoffs may take more time in the long run. to materialize than in the stylized scenarios discussed here. Russia Economic Report #40, November 2018 © 2018 International Bank for Reconstruction and Development / The World Bank Some rights reserved 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is available under the Creative Commons Attribution 3.0 IGO license (CCBY 3.0 IGO) http://creativecommons.org license/by/3.0/igo